Pain of Puerto Rico’s Debt Crisis Is Weighing on the Little Guy, Too
By MICHAEL CORKERY - AUG. 8, 2015
To Lev Steinberg, it seemed like a good place to park his nest egg.
Puerto Rico bonds offered high returns and tax-free income. And there was little chance, his broker assured him, that the government would default on its debt.
So Mr. Steinberg went all in, investing more than 85 percent of his retirement savings in funds with large concentrations of Puerto Rico bonds.
“They told me this was safe,” said Mr. Steinberg, a 64-year-old mathematics professor at the University of Puerto Rico, “that the legal protections to repay the bonds were strong.”
As it turns out, the bonds were far from safe.
Puerto Rico officials now say the government cannot afford to pay its $72 billion in debt. And last week, the government defaulted on a bond payment for the first time since the island came under the jurisdiction of the United States nearly 117 years ago.
More indebted than any American state by some measures, Puerto Rico sold its bonds far and wide, to everyone from wealthy Midwesterners to New York hedge funds. But more than 20 percent of the government debt is owned locally. And as values have plunged, some of the most intense pain is being felt by the tens of thousands of Puerto Ricans who bet much of their savings on the bonds.
“These are doctors, stay-at-home moms, teachers, older people, young people,” said Jeffrey B. Kaplan, a Miami lawyer whose firm represents more than 150 Puerto Rico bond investors. “And now they have all their eggs in one basket.”
How so many ordinary Puerto Ricans came to shoulder such a large share of the island’s debt can be explained by a confluence of factors: a local government desperate to borrow money, banks collecting fees for selling the bonds, and brokers encouraging residents to buy them.
Even some of the riskier debt, which previous administrations had difficulty selling to investors in the rest of the United States, found a home in the investment accounts of ordinary Puerto Ricans, according to former finance officials.
It was not just residents who were loading up on the bonds. The island’s 116 credit unions, which serve many poor and rural communities, also became big buyers after local regulators allowed these small lenders to take more risks with their investments.
A government spokeswoman says many locally owned bonds are insured, which could help limit losses. But already, individual investors have seen big hits to their retirement portfolios. At the same time, taxes have gone up and business has slowed in the face of a nine-year recession on the island.
Even when signs of a coming crisis seemed obvious to some analysts, local residents kept buying their government’s bonds.
A big source of that demand was a series of uniquely structured bond funds that were required to have two-thirds of their holdings in Puerto Rico investments, including government bonds and other forms of locally issued debt. The funds were an easy sell for brokers working for large banks like the Swiss bank UBS and Banco Popular of Puerto Rico because they were exempt from local taxes.
The funds could not be sold on the mainland United States because they did not follow federal investment rules, which, among other things, limit how much leverage, or borrowed money, the funds could use to buy bonds. Exempt from the federal rules, the Puerto Rico funds ramped up their leverage. In good times, the leverage strengthened returns. But it magnified losses when bond prices fell.
Still, investors like Jose Castrodad, a private-school operator in a mountainous town on the island, said he ended up sinking most of his retirement assets in UBS Puerto Rico funds.
So did his wife, his son, his sister-in-law and his 84-year-old mother-in-law.
The bond funds were not just used as nest eggs. When Mr. Castrodad’s sister-in-law needed cash for a medical procedure, her UBS broker persuaded her to take out a loan using her investment funds as collateral, according to a claim her family filed against UBS with the Financial Industry Regulatory Authority.
“This was like the bubble in mortgages,” Mr. Castrodad said.
The UBS funds were avid buyers of many government bonds, including those like pension obligation bonds that are now experiencing some of the biggest losses.
In 2008, with the island’s retirement system facing a big shortfall, the government sold about $3 billion in bonds to plug the hole.
Ideally, the pension funds’ returns exceed the interest rate on the bonds, making more cash available to pay the benefits of public workers.
The bonds used for this kind of arbitrage are typically not eligible for tax exemption in the United States, making them a tougher sell on the mainland.
But for island investors in the Puerto Rico funds, income from the pension bonds was free from local taxes.
One UBS Puerto Rico fund has about 45 percent of its holdings in pension bonds, according to fund documents. Today, the bonds trade for as little as 18 cents on the dollar.
“There is no question that some of the most toxic, radioactive debt got dumped into these funds,” said Andrew Stoltmann, a lawyer representing Mr. Steinberg, the math professor.
Another Puerto Rico resident, Georgina Velez Montes, and a group of other investors have filed a class-action lawsuit against UBS in Federal District Court in New York claiming the bank steered them into the funds because of the high fees the brokers were earning. The lawsuit notes that even as UBS brokers were being paid by people like Ms. Velez Montes to buy the bonds for their investment accounts, UBS’s investment bankers were being paid by the government to sell the bonds.
In court documents, UBS said that investors were told about the risks in the fund documents, which also explained the high concentrations of Puerto Rico bonds and the fact that the bank was sometimes acting as both seller and buyer.
“For more than 20 years, including through significant downturns in U.S. markets, investors in UBS’s Puerto Rico municipal bonds and closed-end funds received excellent returns that frequently exceeded the returns available through investments in other bonds or bond funds,” the bank said in a statement.
Credit unions in Puerto Rico were also attracted to those high returns and are now paying the price. Until 2009, the credit unions could invest only in the highest-rated bonds. But local regulators made an exception as long as the credit unions invested in Puerto Rico bonds.
As a result, the credit unions went from owning zero Puerto Rico bonds to holding about $1.1 billion worth today. And nearly half of the credit unions’ holdings is concentrated in debt issued by the island’s Government Development Bank, which has served as an emergency source of cash for the commonwealth. Because of concerns that the Government Development Bank may soon default, its debt trades as low as 29 cents on the dollar — raising fears in banking circles that losses on the credit unions’ holdings could force some credit unions to limit their lending.
A local banking regulator, Daniel Rodríguez Collazo, said the credit unions had enough cash to absorb any blow. Still, they are working with the government to restructure their holdings in ways that would minimize their losses.
“We are prepared,” said Mr. Rodríguez Collazo, who is president of the Corporation for the Supervision and Insurance of Cooperatives, which oversees the credit unions. “We have our reserves. We have our liquidity.”
But Mr. Steinberg was not prepared for this.
He made his first investments in the UBS bond funds in 2005, totaling $70,000. Over the years, he would regularly reinvest his dividends from the bonds. He transferred his annuities there, too.
In March 2012, Mr. Steinberg moved over $100,000 from his savings account, increasing his investments in the bond funds to $248,325.
A few months later, as the economic crisis in Puerto Rico intensified and bond value dropped, he checked his account balance. “The $100,000 was gone,” he said.
Mr. Steinberg had plans to retire in the next few years and buy a house in the mainland United States to be closer to his children. But with his savings in a shambles, he will have to keep working.
“I am a mathematician. I am not very good in this type of business,” he said. “They told me this was the best place to put my money, and I trusted them.”
A version of this article appears in print on August 9, 2015, on page A1 of the New York edition with the headline: Pain of Puerto Rico’s Debt Crisis Is Weighing on the Little Guy, Too .