Puerto Rico now belongs to Wall Street

The governor of Puerto Rico has admitted that it can't keep paying down the over $72 billion worth of public debt obligations, and it finds itself in a uniquely awful position.

It can't go into 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 Connecticut-based fund Brian Kelly Capital. "We thought it would take 6 months to a year... the solution is a debt restructuring."

Of course, when you restructure in an economy that's 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 its $10 billion budget.

"My administration is doing everything not to default," Governor 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.

Earlier this month, bond god Jeff Gundlach of DoubleLine Capital told investors that he believed Puerto Rico would "make it to the goal line" adding that they will, at worst, restructure around 80 cents on the dollar."

That's not looking close to possible now, according to Kelly.

A lot of Puerto Rico's debt is in municipal bonds, and thus it's situation is similar to Detroit.

But unlike Detroit, Puerto Rico doesn't have the option of using the bankruptcy process to discharge its debt as a territory of the United States.

Consequently, it will be forced to negotiate with its creditors, making it a little bit more like Greece.

Once it does that could set off a lengthy, muddle-through like the one we're seeing in Greece where Puerto Rico must constantly go back to the table to restructure with its creditors. It won't 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 if Gov. Padilla is going to default on this obligation, it's going to take a referendum on a constitutional amendment.

And it looks like he's prepared to do 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 Garcia'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 financial services company MBIA's stock has fallen over 17%.

In any case, the admission 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 pointed out. "... 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 Garcia say, 'no more.'

He told the New York 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."

It's creditors have to feel the pain, as well, he said.

We'll see how much pain Wall Street is willing to take.