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Wall Street Journal Puerto Rico's Borrowing Bubble Pops Wall Street Journal The sad state of its fiscal accounts is rivaled only by its economy, which is also in disarray. Detroit, anyone? Now would be a good time to try a little hon...
July 6, 2014 6:04 p.m. ET
Here we go again: Another big-government paradise is running out of other people's money—to paraphrase Margaret Thatcher. This time it's the commonwealth of Puerto Rico that has borrowed too much and is now signaling that it might not be able to pay it all back. The only question that remains is who will eat the losses.
Head doctors say that addicts have to reach rock bottom before they find the will to change their ways. It may be that Puerto Rico, high on cheap money from American creditors for the last decade, is reaching its nadir. The sad state of its fiscal accounts is rivaled only by its economy, which is also in disarray. Detroit, anyone?
Now would be a good time to try a little honesty about what has caused this desperation. But so far Puerto Rico's political class seems more inclined to stick it to creditors and keep on keeping on.
Puerto Rico's governor Alejandro Garcia Padilla Reuters
In late June Puerto Rican Gov. Alejandro García Padilla signed a bill into law allowing the restructuring of more than $19 billion of debt of the commonwealth-owned electricity, water and highway monopolies. The law stunned the municipal market because Puerto Rico has had a strong tradition of backstopping public-monopoly debt when necessary.
The electricity company known by its initials in English as Prepa has been a particularly pesky problem because of theft, the failure of big customers, such as government entities, to pay their bills, and the high price of oil, which it uses as fuel. But as expenses in the government's general fund have been outstripping revenues for nearly a decade, it has become more difficult to rob Pedro to pay Pablo. Recently the company had to dip into its capital account to pay its oil bill.
The new restructuring law may have been meant to reassure general-obligation bondholders that Puerto Rico is safeguarding the funds necessary to pay them first. Yet on June 30 Moody's MCO+1.10% Moody's Corp. U.S.: NYSE $90.02 +0.98 +1.10% July 3, 2014 1:04 pm Volume (Delayed 15m) : 477,379 AFTER HOURS $90.02 0.00 0.00% July 3, 2014 1:52 pm Volume (Delayed 15m): 10,929P/E Ratio 23.50 Market Cap $19.24 Billion Dividend Yield 1.24% Rev. per Employee $358,08391908910a11a12p1p2p3p 07/07/14 Wildcat Strike at Impala Plati... 07/06/14 Mary O'Grady: Puerto Rico's Bo... 07/03/14 Moody's Move to Change Ontario... More quote details and news » MCO in 
Your Value Your Change Short position Analytics reported that its one-year measure of Puerto Rico's "expected default" is higher than that of Argentina, Venezuela and Ukraine.
Your Value Your Change Short position Analytics reported that its one-year measure of Puerto Rico's "expected default" is higher than that of Argentina, Venezuela and Ukraine.
Investment companies Franklin Templeton and OppenheimerFunds, which together hold $1.7 billion of Prepa debt, have challenged the new restructuring law in U.S. District Court in Puerto Rico. They argue that only the U.S. Congress can make bankruptcy rules. Puerto Rico says that there are no immediate plans to default, and on Tuesday Prepa remained current on its debt by making $418 million in payments to bondholders.
But Puerto Rico's Government Development Bank has also said it believes the island has the authority to enact the new law. Last week Moody's said that the law "provides a clear path to default for public corporations."
A Puerto Rican default should not surprise anyone. According to Carlos Colón de Armas, acting dean of the School of Business Administration at the University of Puerto Rico, for eight years from 2005 through 2012, government expenses exceeded revenues on average by approximately $1 billion annually. The dean told me by telephone that total commonwealth debt is now around $73 billion and in 2013 it was 101% of the island's gross national product (GNP) up from 57% in June 2001. (Although gross domestic product is the most widely accepted measure of an economy's size, it reflects the profits of large multinational corporations booked for tax purposes in Puerto Rico but not retained in the local economy. Therefore, GNP, a measure of what is produced by locals, is a more accurate tool to assess the economy.)
This fiscal profligacy is a significant departure from the three previous decades, Mr. Colón de Armas said. He noted that the island's economic competitiveness has been in decline since the 1970s due, in part, to the distortions created by special tax incentives for U.S. multinationals (aka "936" for its designation in the IRS code), which shifted the tax burden onto local entrepreneurs. Yet for more than three decades, despite economic decline, the debt to GNP ratio remained stable.
Now conventional wisdom blames the debt crisis on the 2005 phaseout of "936." But Mr. Colón de Armas holds that the mess was caused simply by gross government overspending and overborrowing. It began with $550 million loans in the fiscal year budget of 2004-2005. Thereafter borrowing, largely to finance operational expenses, took off. The Federal Reserve's low interest policy and the appetite for triple-tax exempt debt (which throws off income that is free of federal, state and local tax) among municipal bond investors fed the frenzy.
Gov. García Padilla, who took office in 2013, increased expenses by almost $600 million in his first budget. While he is now cutting spending, the cuts are mostly from that increase, according to Mr. Colón de Armas. Some $500 million-$800 million in fat—from subsidies to special interests to funding for political parties—remains untouched in the $9.6 billion budget.
It may be tempting to try to preserve Puerto Rico's top-heavy state and pass the cost of bad management onto investors who didn't do their homework. But creditors are paying attention now, and bad faith won't go unnoticed.
Write to <a href="mailto:O'Grady@wsj.com">O'Grady@wsj.com</a>
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