Is Puerto Rico the next Detroit? (CNN Money)

By Maureen Farrell   @CNNMoneyInvest

puerto rican bonds

Interest rates in Puerto Rico have soared since the summer as investors grow more worried about whether the U.S. territory can repay its debt. But hedge funds smell an opportunity.

NEW YORK (CNNMoney)

Puerto Rico has been called the next Detroit and the next Greece. It’s buried in debt and possibly teetering on the edge of bankruptcy.

But that isn’t scaring away hedge funds. So-called vulture investors that buy the bonds of troubled companies (and municipalities) have been scrambling to purchase as much of Puerto Rico’s roughly $70 billion in outstanding debt as possible over the past several months. Their interest comes following a huge plunge in Puerto Rico’s bond prices over the summer.

 

“There’s so much Puerto Rican debt out there. When the prices became really low, the situation suddenly became interesting,” said a manager at a distressed hedge fund who declined to be named.

The price of Puerto Rico’s debt plummeted nearly 40% in just a few months. That pushed interest rates on Puerto Rico bonds up to nearly 10% from 5%. (Bond prices and rates move in opposite directions.)

Related: The hottest, riskiest muni bonds around

Analysts at Citigroup said Puerto Rico’s debt was one of the most actively traded types of municipal debt in August and September, and hedge funds were thought to be the biggest buyers.

Why did Puerto Rico’s bonds fall so dramatically? Concerns that the Federal Reserve would soon cut back on its massive bond buying program caused a broad-based slump in the bond market earlier this summer.

Even though the Fed has yet to taper its asset purchases, Detroit’s bankruptcy filing in July spooked investors further. Puerto Rico, which already was struggling with a stagnant economy, was widely viewed by municipal bond investors as another problem about to explode.

Once prices dropped to a certain level, the sell-off intensified because many U.S. mutual funds that invest in tax-free municipal debt had a high concentration of Puerto Rico’s debt and were forced to sell to avoid massive losses.

Roughly 80% of Puerto Rico’s $70 billion in debt is held in these muni bond funds, and Morningstar estimates that 180 mutual funds have 5% or more of their portfolio concentrated in Puerto Rico’s debt. Among the major holders: nine tax-free funds operated by Franklin Mutual; six of Oppenheimer’s funds and funds operated by Nuveen, Putnam, and Dreyfus.

Vultures smelled opportunity: But several hedge fund managers thought that Puerto Rico wouldn’t default on its debt in the short-term, and the bonds were oversold. Many hedge fund managers, including the one quoted in this story, tried unsuccessfully to buy up Detroit’s debt earlier this summer.

Because the stock market has been doing so well and most municipalities are not in dire fiscal straits, distressed debt hedge funds have struggled to find good investment opportunities. Puerto Rico suddenly looked like a place with big profit potential.

Why there isn’t a bond bubble

The price of Puerto Rico bonds have since rebounded a bit and yields have drifted back to 8.5%.

What’s next for Puerto Rico: Hedge funds and longer-term investors have sharply divergent opinions on what will happen to the price of Puerto Rico’s bonds.

Most analysts believe Puerto Rico has enough financing to make it through mid-2014 without tapping the public markets again. Hedge funds are betting that Puerto Rico can survive longer than that, but how long is the question.

Puerto Rico has been stuck in a recession since 2006. The situation seems to be getting worse. Between 2012 and 2013, Puerto Rico’s economy contracted roughly 6%. The unemployment rate tops 13%.

Related: State finances are looking good

Ratings agency Fitch noted in March that even though Puerto Rico has been cutting costs and taking other steps to cure its fiscal problems, its economy continues to shrink, making the problems worse. It’s similar to the challenges Europe faced when many European nations were emphasizing austerity over economic stimulus.

Puerto Rico’s pensions have been underfunded, and the government has been operating through a budget deficit.

Investors are waiting to see whether Puerto Rico’s government can radically reform its pensions and balance its budget. Fitch is skeptical. It downgraded Puerto Rico’s debt in March 2013 to BBB negative, a level just above investment grade. S&P also downgraded Puerto Rico’s debt in March to near-junk levels.

“Right now Puerto Rico really needs a plausible economic development scenario,” said Matt Fabian, a managing director at Municipal Market Advisors.

Should things get worse quickly for Puerto Rico few investors expect the United States government to offer aid to Puerto Rico. The thought is if the U.S. didn’t bail out Detroit, why would it rescue one of its territories? That would be bad news for the citizens of Puerto Rico and longer-term muni bond investors.

Still, it may not take much for the hedge funds that bought Puerto Rico’s bonds at distressed prices to make a profit. To top of page

First Published: October 31, 2013: 4:55 AM ET
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Saving Detroit: The Privatized Solution (Part 3: Shareholders)

By David Docekal, Editor, The Hypercapitalist

@DavidDocekal

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I briefly mentioned this in a comment on my last Detroit post but I still wanted to go more in-depth on the subject of shareholders for the City of Detroit.

Residents, I believe, would take more pride and feel more accountable if they had direct ownership in their city. One could argue that this is true with government as it is now but people don’t see government as an investment. They see it as an expense. Holding stock in a corporation, however, is like owning property. It goes up and down in value (hopefully you make a profit) and if you need to sell it, you can sell it. By holding a piece of paper that says you own equity in Detroit would be something that empowers you to be involved.

Residents would automatically get a set amount of shares for free when the city becomes private. These shares would not be allowed to be sold for a minimum of two years. This is to help maintain the stability of the investment pool. The free shares are given out in order to gain buy-in for the program and to release the burden of buying shares for residents who may not be able to afford them. This enables them to vote in city elections. Only shareholding residents may vote for the board of directors.

The return on investment would come in the form of shares of stock to investors in the city corporation. The shares would be valued by a marketplace set up specifically for the buying and selling of stock in the city. The value of course is worth the demand. Citizens of the city would automatically get a certain number of shares without having to purchase upon their first tax return (to prove residency) living in the city. That gives them the ability to be vested in their hometown without having to suffer a possible burden of purchasing shares. It would otherwise be like owning any other stock in a company. It would have the chance to increase in value and be sold as needed.

Additional shares can be purchased anytime. However, they would be designated “non-voting” until proof of residency is provided. Then they would be converted to voting stock.

The investment account could be managed online, on the phone, through your regular broker or at an office for the Department of Shareholder Affairs. This would accommodate low income stockholders who may not have access to the internet or even a phone.
Residents would be able to buy voting shares in the company. The annual voting would elect a board of directors that would in turn hire a CEO and vice presidents to manage the city day-to-day. Executives would receive sizable but not outlandish bonuses based on the city’s performance for that fiscal year.

Outside investors (or non-residents) can buy shares in the Detroit Corporation but they would be non-voting. This would minimize the risk of outsiders deciding city management but would afford the opportunity for the rest of the world to put their faith and support into Detroit. Non-voting shares are also given to any corporation regardless of residency. Voting shares are designated for resident individuals only.

This would all be backed up by the “I Own Detroit” ad campaign featuring everyday residents along with celebrity residents, like Eminem, sharing their pride in ownership and pride in their hometown.
The point is to promote pride, faith and commitment in the city. And above all: accountability.

Taxes would still be a factor. Property and Income Taxes would be used strictly for infrastructure, payroll and other day-to-day city services. Investment capital would be used for capital projects such as beautification, stadiums, parks, etc.
Other revenue would be from sales tax that could be partly allocated to a special fund for low-interest loans for qualified locally-owned small businesses provided by the company’s banking subsidiary. Other money would be donated to registered, accredited food pantries within city limits.

The corporation would take possession of all current city services including emergency services, schools, libraries, infrastructure, etc. Each department with a dedicated vice president appointed by the CEO.

Saving Detroit: The Privatized Solution (Part 2: Employees)

By David Docekal, The Hypercapitalist

@DavidDocekal

It would be arrogant of me to say I know what’s best for a city that I do not frequent, let alone live in. However I think my ideas hold water wherever they would be implemented. While I know I am providing broad strokes for problems that are not easily solved, it is important to remember that drastic change is needed and details can always be addressed later.

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City Employees

People are generally hesitant to allow privatization to enter government affairs because of past experiences. I attribute this fear to the lack of quality regarding some individual contractors. Contractors that typically handle one service in a community, such as parking or trash removal are less likely to provide acceptable service. My ideas revolve around privatizing the entire city under one company. This would allow for the retention of current city employees. Police officers, Fire Fighters, EMS, Public Works, administrative staff, etc that already work for the city will keep their jobs. This would help the economy recover. With investment and tax funds, more jobs could be created that would restore the proper staffing to support city services. This is a critical step in restoring safety and order to Detroit.

Contractor employees lack direct involvement and accountability within the city organization. Detroit would have very little say or control of who the contract company hires to provide service to the citizens. Under my proposal, all employees would be directly employed by the city as they are now. This helps to ensure quality and continuity of service that residents should expect from their local government.

Regular surveys from city employees would serve to expose flaws in the system and where the newly-privatized city could improve those areas. Feedback from staff is vital for improvement as they know the ins and outs of city operations. Consultants will also be used (along with focus groups) but sparingly and only in-concert with employee feedback committees.

Compensation levels would initially need to remain at present levels in order to allow the city to enter an era of sustainability. Additional vacation time and company stock would be given out in place of additional pay for the first 2 years. The company stock given would not be allowed to be sold for a minimum of one calendar year from the date it was received. This helps maintain the stability in the investment pool. This is the same policy that will be implemented regarding the residents auto-shares for living in the city. Stock will be covered more in my next “Saving Detroit” post.

If sustainable, profit sharing will also be provided to the employees of the company.

Insurance will be provided by third-party services (at least in the beginning) for city workers. Bids will be placed and providers assessed for price and quality before implementing an insurance plan. The idea is to minimize the burden on individual employees. The money saved by the employees will eventually help the city economy by being spent in local businesses. This is why it is crucial to provide affordable healthcare in the early stages.

Saving Detroit: The Privatized Solution (Part 1)

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By David Docekal, The Hypercapitalist

@DavidDocekal

Let me start first off by saying that I am not from Detroit nor do I visit it often but my theory for a solution to the problems plaguing the historic city can be applied universally if given the chance. My ideas for privatizing a large American city are not exactly original. Detroit was used for that very scenario in the Robocop movies however I have thought this out in a little more detail. I really am confidant that privatizing the city would not end with large robots equipped with big guns terrorizing citizens.

Detroit needs a reboot. It needs the confidence of its citizens and leadership. It needs the confidence and investment of the State of Michigan. There are dark days here now and there will be more ahead but renaissance is coming.

As I do more and more research, it seems more feasible. The question becomes ‘how?’. That is what I plan to address in this series.

It all comes down to money. This is true in pretty much every aspect of our lives. Money will be needed to save the city but where will it come from? It will come from the State of Michigan and the citizens of Detroit but not from tax money. The money will be raised with the purchasing of stock in the city. Michigan wouldn’t be bailing out the city, it will own part of it as an investment.

Privatization gets vilified in the Robocop movies but lets set that fictional account aside. The question is: would citizens take more pride in their city if they had actual equity in it? Had a direct stake in the city’s performance? I guess you could argue that with property taxes but pride in ownership goes a long way when its a private investment.

As I do research and post in this blog, I will go into more detail but for now lets reflect on what this could mean for the people of Detroit and the nation as a whole.

I welcome your feedback..

Please see comments. More info and feedback provided.