Puerto Rico Debt Has Been a Big Payday for Wall Street

A recent article in the Wall Street Journal reports on the financial woes facing Puerto Rico over its troubled bond deals and how Wall Street banks selling Puerto Rican bonds to mutual funds, money managers and individuals fueled the island’s borrowing binge.

Since 2006, Puerto Rico and its public agencies have sold $61 billion of bonds in 87 deals, giving the island more municipal debt per capita than any U.S. state, according to the Wall Street Journal story. An unusually high portion of that debt consisted of deficit financing, or issuing debt to plug budget shortfalls and push debt payments into the future.

As part of the deals, Puerto Rico paid Wall Street securities firms, lawyers and others about $1.4 billion. In turn, the securities firms were able to charge underwriting fees higher than those assessed on other financially troubled U.S. states and cities, including Detroit, the Wall Street Journal says.

Now, those deals are facing increased scrutiny by regulators who want to know exactly how the debt deals were put together and whether investors who bought the bonds were properly informed about the risks involved.

Meanwhile, investors are getting anxious, as they watch the value of their Puerto Rico bond holdings continue to go south. Officials in Washington also want to know about Puerto Rico’s worsening financial situation; they’ve apparently been meeting to discuss how it could potentially impact the U.S. municipal-bond market. (Puerto Rico debt represents nearly 2% of the $3.7 trillion U.S. municipal bond market.)

Indeed, the financial plight facing Puerto Rico affects almost anyone who has a mutual fund invested in the muni market. Exempt from local, state and federal taxes, Puerto Rican bonds are held by 77% of muni funds, according to Morningstar.

Highlights of the Wall Street Journal story show that beginning in 2006 when Puerto Rico’s economy went into a recession, the island and its public agencies issued as much debt as state issuers in Virginia. During that time, the Puerto Rico government and public agencies paid about $764 million in fees to underwriters, lawyers, credit-rating firms and insurers backstopping many of the bonds and others that helped close the deals, the Wall Street Journal says. More than half of that amount reportedly went to underwriters, with Citigroup Inc. and UBS AG the top banks in that group.

Puerto Rico then paid at least another $690 million to Wall Street firms to cancel derivative contracts – i.e. interest-rate swaps – that were intended to lower Puerto Rico’s borrowing costs if interest rates went up. In some cases, however, that didn’t happen. Instead, the swaps became more costly for the government because interest rates remained so low.

Massachusetts Secretary of State William Galvin recently opened an investigation into Puerto Rico’s bond deals. Specifically, he wants to know whether investors in Massachusetts were adequately informed about the potential risks associated with Puerto Rico debt in municipal bond mutual funds. As part of his investigation, Galvin has sent letters of inquiry to Fidelity Investments, OppenheimerFunds, a unit of MassMutual Life Insurance Co., and UBS Financial Services. Galvin says he has not ruled out targeting more investment firms as part of the investigation.

The Securities and Exchange Commission (SEC) also is interested in what’s happening in Puerto Rico. As reported by the Wall Street Journal, the regulator has asked Nuveen Asset Management to provide information about a recent private gathering in which Puerto Rican government officials discussed their financial plans with investors.