If You're At All Exposed To Muni Bonds, You Need To Read This

by: Rodney Johnson

Summary

We’re about to see the same housing-bust we saw in 2008 again, but on a much larger scale.

The day before Puerto Rico owed $2 billion, Congress and the President approved a restructuring plan, called Promesa, allowing the Commonwealth to pay back less than it owes.

Puerto Rico continues trying to stiff bond investors despite a constitution that prohibits such a maneuver.

The housing bust was awful, particularly in Florida and other "sand states." As the economy slowed, consumers lost their jobs, and when they couldn't pay their mortgages, they then lost their homes.

Even though that wrenching period happened almost a decade ago, it will live in our memories for years to come. I can recall much of the pain, but also other aspects of the moment. Some people were desperate for the relief that came their way; others were using it as cover to game the system.

We're about to see the same thing happen again, but this time on a much larger scale. And the sucker on the other end of the line won't be a bank or faceless mortgage company, it will be individual investors, and once again they'll have government "help" to blame.

During the housing disaster, the government took a series of steps to ease the pain, including mortgage modification and relief from taxes on forgiven debt. At the time, government officials were looking for any tool that would stop the financial bleeding, and almost forcing the banks to write down loans seemed like a good way to do it.

Struggling homeowners able to modify their loans and stay in their homes were thrilled. Those that just wanted out of the trap went the short sale route and were also glad for a way forward. But another homeowner category rose to prominence: those looking to accrue ill-gotten gains.

These people simply stopped paying their mortgages, daring their lenders to foreclose and become stuck with the property.

At one point, foreclosure courts in Florida were running 600 days behind. Homeowners that chose not to pay knew that their lender couldn't move on the property for almost two years. I know of people who stayed in their homes without paying for over four years, pocketing the cash that would have gone to the lender.

This wasn't what the government had in mind, of course. Officials had a nice, happy plan where everyone plays by the amended rules and things come out well in the end.

It never happens that way, as we're seeing today.

Puerto Rico is out of money. The Commonwealth begged Washington for debt relief, since the territorial laws of the U.S. and the island's own constitution don't allow for paying creditors less than they are owed.

The day before Puerto Rico owed $2 billion in principal and interest, Congress and the President approved a restructuring plan, called Promesa, that allows the Commonwealth to pay back less than it owes, as long as it agrees to a federal financial oversight board and follows certain rules.

The move was hailed as a great step forward for the struggling territory, and showed that the federal government wasn't deaf to the fiscal woes of Puerto Ricans. Bondholders were furious. The Puerto Rican constitution demands bond principal and interest be paid first.

First, as in before any other expenses.

Instead, the federal government is allowing Puerto Rican officials to keep the lights on, paying civil salaries and meeting other essential obligations, even though they aren't making good on their debts.

But it didn't stop there.

Before the ink was dry on Promesa, Puerto Rican Governor Padilla unveiled his budget for fiscal 2017, which runs from July 1, 2016 through June 30, 2017. The document is a vivid example of putting politics ahead of contracts.

The governor approved the payment of half the debt service due in July, but not on the most senior, secured bonds. Instead, he authorized payment of junior bonds issued for the convention center and local roads that are more widely held by Puerto Ricans.

Beyond that, he authorized almost no debt service whatsoever for the entire year. He also approved moving $800 million to the public employee pension fund, which is $170 million more than would have been required during the year. Beyond the big-ticket items, the budget allocates $2.5 million for the Office of the First Lady to spend on incidentals, and money for the development of professional Puerto Rican athletes.

Investors went crazy when the governor presented the budget, and eventually filed a lawsuit to stop the Puerto Rican government from sucking all the money out of the system before any restructuring could happen.

Puerto Rican supporters claim investor fears aren't justified. If the oversight board deems the payments unnecessary, they can just claw them back. Really?

How do you claw back money paid out as principal and interest on junior bonds? How do you unwind payments by the Office of the First Lady for daily expenses? What sort of legal fight would start if the Puerto Rican government tried to reclaim cash from its woefully underfunded pension system?

Those dollars are gone forever, and the investors know it.

Take this as an example of things to come. When states in dire financial straits, like Illinois, Kentucky, and Connecticut, start scraping the bottom of their financial barrels, they will look for someone to sacrifice.

They'll eventually identify bondholders, claiming they couldn't possibly cut expenses in their own state, even if that's what the law requires. Eventually, the federal government will devise a plan for restructuring debt, but like Puerto Rico, there won't be any good faith effort to send bondholders everything they are due.

Instead, state politicians will gobble up any lingering grace period, and any leeway they can find, shoveling money to the most politically expedient places -- like underfunded pensions.

Municipal bond investors should view this as a wake-up call. No one wants to wake up owning bonds issued by the next Detroit or Puerto Rico.

Now is the time to review your portfolio and identify the potential investment landmines, then dump them in an orderly fashion.

If you don't, it's possible the government will have a hand in deciding how much of your money you get back, and it's a good bet you won't be happy.

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Rodney

Follow me on Twitter @RJHSDent

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.