As a “comprehensive” wealth manager, I regularly have the opportunity to review and analyze clients’ debts (at all income levels). Polonius in Hamlet advised his son that he should “neither a lender nor a debtor be”, however I would offer that he was only half correct. In a prudent asset allocation model, in fact, it is advisable for a client to have multiple loans outstanding to various parties. The only difference is that in today’s financial world, the “loans” are seldom to friends but rather to corporations, governments, banks, etc. in the form of bonds and deposit accounts, for example. Assuming the loans perform as expected, it is advisable to be the biggest lender you can be because this will mean more income to you.
But what about being a borrower? So many of us in America are debtors and indeed having debt is not always a bad thing. I advise my clients that it is better to look at debt as a tool. Unfortunately, like other tools, if used incorrectly, debt can be dangerous. For above all, debt can lead to dependence.
A few weeks ago I was fortunate enough to see the debt/dependence paradigm in action. In August I got a phone call from a major airline advising that I had some unused frequent flier mileage that had been accruing for four years, and that if I didn’t book my free flight within 48 hours the miles would be forfeited. I scrambled to find a date on the calendar and settled on the beginning of December, choosing Puerto Rico as my destination. I had always wanted to go and I figured that while on vacation I could do some on-the-ground research into their current debt crisis.
First, a little background. Puerto Rico is a commonwealth of the United States, meaning that it is governed by US federal laws as well as US treaties with other nations. Most of its residents do not pay federal income tax and they cannot vote in US presidential elections. The island does have representation in Congress, however this “Resident Commissioner” does not have a vote in Congress, except in committees. Since San Juan harbor sits at the mouth of the Caribbean and therefore whoever possesses the island controls access to the entire Caribbean Ocean, Puerto Rico has witnessed many battles throughout its fascinating history. I recommend visiting the forts in Old San Juan for more, they are well worth the visit (see picture below). In any case, the island has been in recession since 2006 and experienced a population loss from 2000-2010 for the first time in census history. The Commonwealth’s debt-to-GDP ratio is a whopping 68%, it has been 15 years without a balanced budget, and experts seem to agree that a debt restructuring is starting. The locals are beginning to feel the pain, with 2014 tax increases on nearly everything; the House and Senate just approved a nearly 70% increase in the island’s oil tax. Considering that 41% of the population lives at or below the poverty level, it is easy to imagine how frustrated residents are becoming.
But how did things get so bad? I was eager to get some local perspective and received the first dose at the most unlikely time: while trekking through the canopy of the San Salvador rainforest. I was on a group hiking tour with Ecoquest Adventures & Tours and posed that exact question to guides Ludgardo Gonzalez and Bryant Huffmann. They gave amazingly fair and honest answers over the five hours of bouldering, rappelling, and zip-lining that afternoon. Ludgardo made a comment that I thought especially astute: “The federal money the island receives from the US [around US 20 billion of the Commonwealth’s 100 billion GDP] is also a curse. For too long we have been able to avoid reforms and avoid dealing with the debt”. He also mentioned that the Jones Act (a protectionist US maritime law) was a problem and that the advent of NAFTA had hit the island hard, since it still had to adhere to federal employment rules unlike its Caribbean neighbors such as the Dominican Republic. The pair acknowledged that they were fortunate to be in a better position than most since they worked in a booming tourist trade, while others were beginning to suffer. It’s amazing how open people can become when sailing 300 feet above the jungle floor or rappelling down a 50-foot waterfall.
The next day’s agenda called for relaxing activities: enjoying the beach and local fare. I didn’t stray far from the resort, instead opting to go over my notes from the day before. I wondered what Puerto Ricans saw as their options. Did they think that a bailout via the US taxpayer would be forthcoming? “Nunca” (never) was the response my question elicited from Patrick, who was manning the concierge desk that day and who didn’t want his last name used. While I was eating lunch (picture below) he explained to me in broken English that none of Puerto Rico’s options were good. They could either stop servicing their debt and not get any more money from lenders, cut government services and raise taxes, or try to renegotiate their outstanding bills. I added that unlike perennial defaulters such as Argentina, since Puerto Rico uses the US dollar as its currency, it cannot simply devalue its way out of the debt. As we talked I could see his large brown eyes get heavy with emotion. He told me that his family was struggling to maintain their standard of living and that ultimately he hoped that his two sons would be able to migrate to better opportunities on the mainland US.
Ultimately my experiences in Puerto Rico and my conversations with its kind inhabitants made me realize that debt and choice are interlinked. Used correctly, debt gives a person (or municipality or country) options that they otherwise might not have. However, when things don’t go well, and the borrower no longer has the wealth or wealth-generating capacity to back the debt, the money owed becomes shackles that discourage ambition and limit choices. At the macro level, it appears that Puerto Rico’s options are to either default or to go through the painful deleveraging process (much as Europe is currently doing), since again they cannot devalue. As managers of client funds, it behooves us to impart to all of our clients, young or old, richer or poorer, that it is very important that they control their debt or else, eventually, it will be the other way around. In other words, if each of us does not have some, at least minimal, sense of “internal austerity”, then rest assured there is much more suffering when the eventual austerity is imposed externally. No one would ever wish the anguish that poverty brings onto any family, whether or not the pain was self-inflicted. Therefore I always advise any client about to take on new debt that they be extra careful that they will be able to manage the debt and the limitations that the debt might place on their future, if any.