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Evan Horowitz | Quick Study

Trump’s talk of Puerto Rico debt deal briefly spooks investors

Boston hedge fund manager Seth Klarman is said to be one of the biggest owners of Puerto Rican government debt.
Scott Olson/Getty Images/file 2014
Boston hedge fund manager Seth Klarman is said to be one of the biggest owners of Puerto Rican government debt.

Puerto Rico’s finances were in disarray even before Hurricane Maria hit. Shut out of bankruptcy court but unable to pay its debts, the island’s financial fate was placed in the hands of a federal control board. The panel is still figuring out how many pennies investors will get for every dollar they’re owed.

So when President Trump casually mentioned Tuesday that all of Puerto Rico’s debts might be wiped out, it sent shivers through the bond market. For a brief moment, investors worried that the money they had lent Puerto Rico over the years might be lost for good.

One of the biggest losers would have been billionaire Boston investor Seth Klarman, well known as a deep-pocketed campaign donor and secret source of money in last year’s fight to expand charter schools. His hedge fund portfolio apparently includes nearly $1 billion in Puerto Rican bonds, according to recent reporting from The Intercept.

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Plenty of less-wealthy folks were vulnerable, too, including investors in certain mutual funds from familiar players such as BlackRock and Goldman Sachs, and many residents of Puerto Rico who bought government bonds as a kind of patriotic retirement planning strategy.

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Before concern spread too far, however, Trump’s budget director Mick Mulvaney stepped forward with an important qualification: Trump didn’t mean it. As of now, there is no plan to forgive Puerto Rico’s debt.

If nothing else, though, Trump’s words are a reminder that Puerto Rico’s future lies very much in the hands of Washington politicians, and not just because the federal control board overseeing the island’s finances is composed of presidential appointees.

There are a hundred ways Trump could boost the island’s economy, or stifle it. For instance, he could call for stepped-up reconstruction aid, permanently waive shipping restrictions that drive up the cost of goods, or perhaps even encourage the Federal Reserve to buy up Puerto Rican debt and retire it.

Alternatively, he could work to empower bondholders like Klarman, who are using their lobbying influence and legal might to ensure that they get the maximum possible payout, even if that money comes at the expense of school funding or retirement pensions for struggling folks in Puerto Rico.

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More far-reaching, he could decide to address what might be the deepest source of the island’s economic woes: the irregular relationship between Puerto Rico and the US mainland.

Puerto Rico didn’t decide to entice investors with the promise of tax-free bonds. It was the US government that determined that Puerto Rican bonds would be free from taxation by any state, city, or country — making it dangerously easy for Puerto Rico to accumulate an unaffordable amount of debt.

Likewise, it was Washington lawmakers who phased out a crucial Puerto Rico-specific business tax break in the mid-1990s and then blocked Puerto Rico’s access to bankruptcy.

Not that Puerto Rico is free from responsibility. The island’s public sector remains bloated, with the government employing about one-quarter of all workers — twice the number in Massachusetts. And rather than follow the kind of balanced-budget rules common in US states, Puerto Rico embraced deficit spending, which has now caught up with them.

How to move forward, then?

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Embracing Trump’s offhand suggestion to wipe out Puerto Rico’s debts would certainly be one approach. No doubt it would hurt bondholders, along with plenty of less-wealthy folks who jumped at the chance to include tax-exempt bonds in their retirement portfolios. But it would give the island a chance to start anew. In the desperate aftermath of Maria, there is bound to be more sympathy for that option.

But perhaps the deeper question is how to ensure that these same mistakes don’t just happen all over again: the over-borrowing, the excessive government employment, the capricious treatment from D.C.

Puerto Rico needs something more than a fresh start. It needs an opportunity to succeed, including a durable strategy for long-term economic development. That could mean new tax incentives for businesses, more direct oversight, or a more state-like status. But one way or another, it has to mean a clearer and more sustainable relationship between island and mainland.

Evan Horowitz digs through data to find information that illuminates the policy issues facing Massachusetts and the U.S. He can be reached at evan.horowitz@globe.com. Follow him on Twitter @GlobeHorowitz.