puerto rico abandonedREUTERS/Alvin BaezAdvertising covers the abandoned structure of an unfinished condominium in the Condado tourist district of San Juan, Puerto Rico.
The governor of Puerto Rico has admitted that the territory can't keep paying down its over $72 billion worth of public-debt obligations.
As a result, it finds itself in a uniquely awful position.
It can't enter bankruptcy, according to its own laws, so now it has to deal exclusively with its creditors to restructure its debt.
That means it has to deal with Wall Street.
"I think the surprise was that it happened this quickly," said Brian Kelly, CEO of the Connecticut-based fund Brian Kelly Capital. "We thought it would take six months to a year ... the solution is a debt restructuring."
Of course, when you restructure an economy that is already in tatters, its ability to pay is reduced as it struggles to fulfill its obligations. It can be a vicious cycle.
And once you're in the cycle, Kelly said, "the question is: 'Is this the first domino to fall?'"
Here's the situation: Puerto Rico's economy is in recession with a 14% unemployment rate. With little money coming in, legislators were already debating major cuts to the country's $10 billion budget.
"My administration is doing everything not to default," Gov. Alejandro García Padilla said. "But we have to make the economy grow," he added. "If not, we will be in a death spiral."
But growing out of this is not an option.
For months, even as distressed debt buyers started circling, Wall Street remained optimistic that things would work out.
jeffrey gundlachREUTERS/Brendan McDermidJeffrey Gundlach has previously said Puerto Rico bonds look like a good opportunity for investors looking for risk.
Earlier this month, bond god Jeff Gundlach of DoubleLine Capital told investors that he thought Puerto Rico would "make it to the goal line," adding that they would, at worst, restructure around 80 cents on the dollar.
That's not looking close to possible now, Kelly said.
A lot of Puerto Rico's debt is in municipal bonds, and thus the country's situation is similar to Detroit's.
But unlike Detroit, Puerto Rico — a US territory — doesn't have the option of using the bankruptcy process to discharge its debt.
Consequently, it will be forced to negotiate with its creditors, making it a little bit more like Greece.
Those negotiations could involve a lengthy slog — such as the one we're seeing in Greece — in which Puerto Rico must constantly go back to the table to restructure with its creditors. It will not be able to access international markets in the state it's in.
Puerto Rico's constitution dictates that the debt has to be paid before any other financial obligation is met. So a default on this obligation will require a referendum on a constitutional amendment.
It looks as if García is prepared to pursue that if he must.
"There is no other option," he told The New York Times. "I would love to have an easier option. This is not politics; this is math."
On Wall Street, if you say you're defaulting, you might as well have defaulted.
And indeed the market is treating García's statements as fact. Bond insurers guaranteeing the island's debt are getting killed in the market. The stock of Assured Guaranty, which provides municipal-bond insurance and financial guarantees for infrastructure and structured financings, has fallen over 12%, while stock of the financial-services company MBIA has fallen over 17%.
Puerto Rico's Governor Alejandro Garcia Padilla REUTERS/Alvin BaezPuerto Rican Gov. Alejandro García Padilla delivering his state of the Commonwealth address in San Juan.
In any case, the acknowledgement is probably a good thing for Puerto Rico. Once you admit you're going down, you can start negotiating as soon as possible.
"Puerto Rico executed the mother of all news dumps on Sunday night," Kelley said, adding "the market must decide whether or not this is the beginning of a larger breakdown of the global Prisoner's Dilemma.
"In this case the Prisoner's Dilemma is if they all keep their mouth shut, investors keep buying their debt. On the other hand, the first few to confess may be able to negotiate a deal."
Puerto Rico was considering taking on another $2.9 billion of debt before it commissioned an economic study that made García say "no more."
He told The Times that the commonwealth "could not continue to borrow money to address budget deficits while asking its residents, already struggling with high rates of poverty and crime, to shoulder most of the burden through tax increases and pension cuts."
Puerto Rico's creditors have to feel the pain as well, he said.
We'll see how much pain Wall Street is willing to take.