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Is Puerto Rico The “Big Short” Of 2016?

January 7, 2016 Blog

In the movie the ‘Big Short,’ a group of savvy traders in 2005 and 2006 saw the early signs of the collapse of the U.S. subprime market, weathered the storm and ultimately profited handsomely.

Many recent buyers of Puerto Rico bonds, mostly hedge funds, scooped them up at rock bottom prices, hoping for similar sweet profits. The bonds were guaranteed by the government and backed by Puerto Rico’s constitution, or so they thought.

Puerto Rico’s government has apparently moved to a strategy that appears to hinge upon a series of planned defaults in order to keep government services up and running while it waits for some form of legal remedy from the U.S. Congress. That means the hedge funds’ Big Short moment may be unraveling before their very eyes.

“Puerto Rico is scheduled to pay some investors at the expense of others today, likely opening new clashes with creditors that threaten to exacerbate the commonwealth’s financial crisis and adding to calls for action from the U.S. Congress,” according to a report on Monday by Aaron Kuriloff of the Wall Street Journal. “Gov. Alejandro Garcia Padilla last week said the commonwealth would make about $330 million in payments on its constitutionally guaranteed general obligation bonds after diverting money from debt with weaker legal protections.”

The island also plans to miss about $37 million in bond payments, mostly from the Puerto Rico Infrastructure Financing Authority, or PRIFA, Kuriloff reported.

And if that weren’t enough, Puerto Rico’s strategy could spur new lawsuits from investors.

“Several analysts said Puerto Rico’s ongoing defaults may provoke lawsuits as soon as this week against the commonwealth and its agencies, which lack access to the legal process used for U.S. municipal bankruptcies,” according to Kuriloff. “The governor said the island will avoid a surge of litigation that would have followed a missed payment on general obligation debt.”

One analyst told Kuriloff that Puerto Rico’s strategy of redirecting tax money from one set of bonds to another opens the island commonwealth to lawsuits from bond insurers or investors who may have legal remedies when the commonwealth defaults, either by breaching bond contracts or failing to pay.

“People who don’t get paid sue,” the analyst told the reporter.

In total, Puerto Rico defaulted on about $174 million of debt payments on Monday. In doing so, it took away cash from its lower-ranked creditors so that higher-ranked creditors could be paid in full, according to Mary Williams Walsh of the New York Times.

Much like the mortgage tranche “waterfall” that was the subject of the “big short”, Puerto Rico bonds have similarities. While the COFINAs (tax revenue) and GO (government obligation) bonds appear to have a higher credit rating and value than the infrastructure and PREPA and sewer bonds, much like the subprime mortgage waterfall, all are on the verge of collapsing under their own weight.

No significant difference in credit quality can be found among those bonds, which are all facing potential default.

“It’s very simple,” Gov. Padilla said in an interview. “We don’t have money to pay.”

Hedge fund investors in Puerto Rico debt were looking for quick, short term gains from distressed investments. They stand in stark contrast to the buy and hold, retail investors who bought UBS Puerto Rico bond funds at par value. Just like the mortgage borrowers featured in the Big Short, they are about to be left holding the bag.

Zamansky LLC are securities and investment fraud attorneys representing investors in federal and state litigation against financial institutions.