The Securities Litigation Expert Blog

I am pleased to announce the publishing of a new white paper: "Company Town Investing: The Case of Puerto Rico."

This paper examines a risk that is commonly missed by financial advisors: that of common exposures across an investor’s total wealth.  I call this phenomenon "Company Town" risk, harkening back to the small towns that sprang up around a local mill, mine, or factory.  As those who have lived in Detroit could attest, the company town exists today.

In this paper, I use Puerto Rico as an exemplar of the modern company town.  I show how the island became dependant upon the Section 936 U.S. tax incentive, and how it's expiration sent Puerto Rico into a brutal secular decline.

Furthermore, I show that if Puerto Rico residents had been diversified away from Puerto Rico exposed investments, they would have done very well through the economic decline.  This will be of particular interest to those attorneys with municipal bond cases in Puerto Rico.

Paper sections include:

• Puerto Rico - A Company Town with One Large Exposure
• Section 262 and 936 Tax Incentives
• Statistical Evidence of Section 936 Impact on Puerto Rico Growth
• Correlations of Puerto Rico Total Wealth
• Investing for Company Town Residents

Click to Download: Company Town Investing - The Case of Puerto Rico

To learn more about author Jack Duval, click here.

This blog post continues my series on Company Town investment risks to total wealth.  I have been using Puerto Rico as an exemplar of these risks.  For an introduction to Company Town risks see this.

Section 262 and 936 Tax Incentives

The U.S. government has a long history of supporting it’s territorial possessions through tax and other development incentives.  Amongst all the territories, Puerto Rico has been the primary beneficiary of these incentives.

The first tax incentive for Puerto Rico came to be under Section 262 of the Revenue Act of 1921.[1] This incentive exempted qualified U.S. firms from taxes on all income derived from sources outside the United States. However, to qualify, the U.S. firms had to derive 80 percent or more of their gross income from operations in U.S. possessions, among other requirements.

Section 262, along with a local tax incentive in Puerto Rico called “Operation Bootstrap”, lead to a long manufacturing boom in labor-intensive industries from 1948 to 1972.[2] By 1978, that boom had faded and GNP and physical investment in Puerto Rico were in decline.

In 1976, the modern version of the Section 936 tax incentive was formed under the Tax Reform Act.[3] It was further revised in 1982 under the Tax Equity and Fiscal Responsibility Act and then again in 1986 and 1993.[4] In 1996 President Clinton repealed Section 936 and instituted a ten-year phase out that was completed in 2006.

The continuance of the Puerto Rico tax incentives in 1976 contributed significantly to Puerto Rico’s eventual recovery and economic expansion after the sluggish mid- to late-1970s period.  While it did not see a second wave of labor-intensive manufacturing gains, Puerto Rico did experience an expansion of capital-intensive manufacturing, particularly in the pharmaceutical sector.

The reliance on these tax incentives became self-evident in 2006, the year Section 936 was completely phased out.  It was this year that marked the beginning of Puerto Rico’s secular decline.

Chart 1:  Puerto Rico GDP and Section 936[5]

To download a higher resolution image, click here.

 

As can be seen clearly in Chart 1, above, Puerto Rico’s economic growth became highly dependent upon Section 936.  Unlike most company towns, which are created around a natural resource or location advantage, Puerto Rico became a company town based on U.S. tax policy.

This is an unsteady foundation to build an economic house upon.  U.S. tax laws change with the wind as public opinion shifts, party majorities switch, and new presidents are elected..

This company town reliance can be seen in Table 1, below, which summarizes the number of years of growth or no growth for the years when Section 936 was in force and when it was not.

Table 1:  Contingency Table of Puerto Rico GDP Growth and Section 936[6]

 

	Growth	No Growth	Total
Section 936	28	3	31
No Section 936	7	7	14
Total	35	10	45

What was obvious in Chart 1, above, is even more starkly portrayed in the table. During the 31 years when Section 936 was in effect, the Puerto Rico economy achieved growth in 28 years, or 90.32 percent of the time.  In the 14 years when Section 936 was not in effect, Puerto Rico achieved growth in only seven years, or 50 percent of the time. 

Logistic Regression

We can also use logistic regression to see what impact Section 936 had on Puerto Rico growth. Logistic regression is a statistical technique that measures the impact of one or more categorical or continuous variables on another categorical variable.  A simple example of this is the application of medicine to a sick patient:  a categorical independent variable (did the patient receive the medicine? – yes/no); is used to explain a dependent variable (did the patient get better? – yes/no).

In this case, the “medicine received” is Section 936, and the observed response is “did the economy grow?" From the logistic regression we can calculate the odds ratio.  For our data, the odds ratio gives the change in the odds of achieving economic growth resulting from the application of the Section 936 “medicine”. In this model, the odds ratio is 8.75.[7] This means the odds of Puerto Rico achieving growth were almost nine times higher when Section 936 was in force than when it was not.

These data tell us that Puerto Rico had become a company town built upon the shifting sands of U.S. tax policy.  Indeed, the island economy had already experienced the boom and bust cycle of reliance upon U.S. tax policy going back to 1921.

Puerto Rico’s secular decline began during the expiration of the Section 936 tax incentive. As you can see here, the ensuing brutal recession affected all aspects of Puerto Rico residents total wealth.

__________

For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

Notes:

[1]        J. Tomas Hexner and Glenn P. Jenkins; Puerto Rico and Section 936: A Costly Dependence; 10 Tax Notes International 235; January 16, 1995; P. 237. Available at: http://www.queensjdiexec.org/publications/qed_dp_119.pdf;  Accessed January 22, 2015.

[2]        Id.

[3]        Id.

[4]        Id.

[5]        Data obtained from the World Bank and updated as of December 18, 2014. Note that World Bank data are calendar year, whereas Puerto Rico Government Development Bank data are on a July-June fiscal year.  World Bank data are converted to a 2010 base year.  World Bank data available at: http://data.worldbank.org/country/puerto-rico; Accessed February 28, 2015.

[6]        Summary statistics will be published in my forthcoming white paper.

[7]        The logistic regression model will be published in my forthcoming white paper.

 

 

 

In my last post in this series, I discussed how Puerto Rico residents could have diversified themselves given the company town risks they faced. (For an explanation of the "company town" phenomenon, see my first post in this series, here.)  I proposed using their financial assets as their "completion portfolio" to balance out the systemic risks they faced.

Some of those financial assets could have included:

• Money market funds;
• High quality U.S. municipal bonds;
• High quality U.S. corporate bonds;
• Blue chip U.S. and international equities;
• Commodities.

These investments have historically had a low correlation to Puerto Rico GDP and home prices.  This was true during the secular decline, and investing in them would have reduced Puerto Rico resident's exposure to company town risks.

Table 2.  Correlations of Non-Puerto Rico Assets to Puerto Rico GDP and Home Prices[1]

 

The majority of the Puerto Rico investments have high negative correlations to non-Puerto Rico investments.  (Meaning they tend to move in the opposite direction.)  The others have low or very low positive correlations.  (Meaning they move relatively independently of each other.)

These simple statistics show the obvious need to diversify away from company town risks would have paid off handsomely for Puerto Rico residents.  Gains in their non-Puerto Rico investments would have offset potential losses in other aspects of their total wealth.

Disclaimer:  I am not giving investment advice.  For all investors, the exact composition of their completion portfolio would depend on their individual facts and circumstances, investment objectives, risk tolerance, and cash flow needs, among other considerations.

__________

For information about Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

Notes:

[1]           Correlations based off data from June 2007 through October 2014.

 

 

 

For an explanation of the "company town" phenomenon, see my first post in this series, here.

As would be expected of a company town, all elements of Puerto Rico resident’s total wealth have been highly correlated.  While this has proven difficult for Puerto Rico residents, it has been devastating for residents who also had their financial assets concentrated in Puerto Rico municipal bonds and funds that invested in them.

Correlations between Puerto Rico total wealth asset classes included:

• Home Prices to Real GDP: 0.82;
• Real GDP to Total Payroll Employment: 0.78;
• Within Municipal Bond Types: 0.76 to 0.98;
• Uninsured PREPA Bonds to Home Prices: 0.49.

In sum, these numbers show that as the Puerto Rico economy declined, employment dropped, as did home prices and municipal bonds, and local pensions became increasingly underfunded, putting their future cash flows to pensioners in jeopardy.

To download these visualizations, click here.

Chart 1.  Puerto Rico Home Prices to Real GDP

 

Chart 2.  Puerto Rico Real GDP to Total Payroll Employment

 

Chart 3.  PRTRS Pension Funded Ratio and Puerto Rico Real GDP

Chart 4.  Selected Puerto Rico Municipal Bond Prices

Table 1. Correlations of Selected Puerto Rico Municipal Bonds

	Uninsured University	Insured Highway/Trans	Insured PREPA	Uninsured PREPA
Uninsured University	-	0.76	0.88	0.98
Insured Highway/Trans	0.76	-	0.88	0.77
Insured PREPA	0.88	0.88	-	0.96
Uninsured PREPA	0.98	0.77	0.96	-

 

Chart 5.  Uninsured PREPA Bond Price to Puerto Rico Home Prices

 

Investing for Company Town Residents

A critical question for those living in company towns is how to invest, given common exposures across all elements of their total wealth.

If the investor is retired, they have no human capital (in the sense of future cash flows), pension income streams are out of their control, and residences are unlikely to be sold for diversification purposes for a variety of economic and psychological reasons.

Which leaves financial assets.

For most investors, their financial assets are their most liquid and can be used as a “completion portfolio” to balance non-diversifiable risks that exist throughout their total wealth.  That is, investors living in company towns should invest their financial assets last, after having evaluated their company town specific risks.

After having identified their company town risks, these investors can use their financial assets to diversify away from their exposure to the “company” in whatever form it takes.

In the case of most Puerto Rico residents, this would mean owning very little or no Puerto Rico municipal bonds or funds that invest in them, preferred stocks from local banks, and any other investments with significant exposures to the island economy.

Needless to say, this would preclude using leverage to invest in any Puerto Rico-related assets.

Financial assets that could be utilized in a Puerto Rico resident’s completion portfolio include:

• Money market funds;
• High quality U.S. municipal bonds;
• High quality U.S. corporate bonds;
• Blue chip U.S. and international equities;
• Commodities.

For all investors, the exact composition of their completion portfolio would depend on their individual facts and circumstances, investment objectives, risk tolerance, and cash flow needs, among other considerations.

Conclusion

The company town is a real phenomenon that exists across the globe today.  It is likely to persist because of the natural tendency of certain locations to become a hub of commerce in a particular area due to geographic, industrial, or human capital considerations.  It is obvious that these hubs lead to economies of scale and higher returns to human capital (a lone genius in the woods is not going to be very productive, but drop her into MIT and she will flourish, along with those she interacts with).

However, the company town environment also contains systematic risks that are non-diversifiable, an individual living there has exposure to them just from living there. These risks must be addressed by investors and their financial advisors.

The easiest method of addressing company town risks is through the investment of an investor’s financial assets. These should serve as a completion portfolio, that is, they should be invested last, and used to diversify away from company town risks.

In the hundreds of litigation claims involving Puerto Rico residents, it appears that their financial assets were concentrated in company town risks, sometimes in leveraged format. If true, these investments needlessly increased their already concentrated exposures and exposed them to ruin, as all aspects of their total wealth declined suddenly, and simultaneously.

For our previous coverage of the Puerto Rico municipal bond crisis, see this.

__________

For information about Jack Duval, click here.

Notes:

 

For and explanation of the "company town" phenomenon, see my first post in this series, here.

Puerto Rico is a modern day company town.  As an island, it is isolated geographically and services and trade employ 34.2 and 23.2 percent of the labor force, respectively.[1] Much of the economy is either directly or indirectly tied to tourism.  Manufacturing is also a significant part of the Puerto Rico economy, employing 8.6 percent of the labor force (but accounting for 46.5 percent of GDP).[2] However, the fate of local manufacturing has been subject to the whims of U.S. tax policy.

The U.S. government has supported Puerto Rico growth with tax incentives dating back to 1921.  When the incentives were in place, the local economy grew.  When the incentives were removed, the local economy stalled or went into secular decline.

This is an example of company town dynamics coming from the systemic exposure of a local economy to one factor, in this case, tax incentives from a neighboring government.

Section 262 and 936 Tax Incentives

The U.S. government has a long history of supporting it’s territorial possessions through tax and other development incentives.  Amongst all the territories, Puerto Rico has been the primary beneficiary of these incentives.

The first tax incentive for Puerto Rico came to be under Section 262 of the Revenue Act of 1921.[3] This incentive exempted qualified U.S. firms from taxes on all income derived from sources outside the United States. However, to qualify, the U.S. firms had to derive 80 percent or more of their gross income from operations in U.S. possessions, among other requirements.

Section 262, along with a local tax incentive in Puerto Rico called “Operation Bootstrap”, lead to a long manufacturing boom in labor-intensive industries from 1948 to 1972.[4] By 1978, that boom had faded and GNP and physical investment in Puerto Rico were in decline.

In 1976, the modern version of the Section 936 tax incentive was formed under the Tax Reform Act.[5] It was further revised in 1982 under the Tax Equity and Fiscal Responsibility Act and then again in 1986 and 1993.[6] In 1996 President Clinton repealed Section 936 and instituted a ten-year phase out that was completed in 2006.

The continuance of the Puerto Rico tax incentives in 1976 contributed significantly to Puerto Rico’s eventual recovery and economic expansion after the sluggish mid- to late-1970s period.  While it did not see a second wave of labor-intensive manufacturing gains, Puerto Rico did experience an expansion of capital-intensive manufacturing, particularly in the pharmaceutical sector.

The reliance on these tax incentives became self-evident in 2006, the year Section 936 was completely phased out.  It was this year that marked the beginning of Puerto Rico’s secular decline.

Chart 1: Puerto Rico Economic Activity Index[7]

 

Puerto Rico’s secular decline began immediately after the expiration of the Section 936 tax incentive. As I will show in my next post, this brutal contraction effected all aspects of Puerto Rico resident's total wealth.

For our previous coverage of the Puerto Rico municipal bond crisis, see this.

__________

For information about Jack Duval, click here.

Notes:

[1]                 Government Development Bank  for Puerto Rico Fact Sheet.  Data as of December 2014. Available at: http://www.gdb-pur.com/economy/documents/PREconomicFactSheet-Dec2014.pdf;  Accessed January 16, 2015.

[2]                 Id.

[3]                 J. Tomas Hexner and Glenn P. Jenkins; Puerto Rico and Section 936: A Costly Dependence; 10 Tax Notes International 235; January 16, 1995; P. 237. Available at: http://www.queensjdiexec.org/publications/qed_dp_119.pdf;  Accessed January 22, 2015.

[4]                 Id.

[5]                 Id.

[6]                 Id.

[7]                 Data obtained from the Puerto Rico GDB website.  Available at http://www.gdb-pur.com/economy/pr-monthly-economic-indicators-time-series.html. Accessed January 29, 2015.