Puerto Rico will default on a $422 million bond payment for its Government Development Bank, escalating what is turning into the biggest crisis ever in the $3.7 trillion market that U.S. state and local entities use to access financing.

Governor Alejandro Garcia Padilla invoked a debt moratorium law approved last month, saying during a televised address Sunday that the commonwealth needs to focus on providing essential services. The bank, already operating under an emergency period, had until the end of Monday to make the payment. The Government Development Bank reached a tentative framework agreement with investors who hold $900 million of its debt late Sunday under which creditors would accept a potential haircut, leaving them 47 cents on the dollar of the face value of their original securities, the bank said in a statement. The parties agreed to keep discussions out of court while they negotiate.

“Faced with the inability to meet the demands of our creditors and the needs of our people, I had to make a choice,” Garcia Padilla said during his 10-minute speech. “I decided that essential services for the 3.5 million American citizens in Puerto Rico came first.”

GDB’s missed payment may open the door to larger and more consequential defaults on general-obligation bonds, which are protected by the island’s constitution. Puerto Rico and its agencies owe $2 billion on July 1, including $805 million for general obligations. It also could imperil slow-moving efforts by U.S. lawmakers to resolve the biggest crisis ever in the tax-exempt, municipal bond market.

Puerto Rico officials have been negotiating with creditors to defer payments. No matter which route Puerto Rico took, credit-rating companies saw a default as inevitable. Moody’s Investors Service analysts said last week that any non-payment, even if creditors agree to it, constitutes a default in their eyes. S&P Global Ratings said a distressed debt exchange or temporarily withholding interest is synonymous to default.

The tentative accord with investors holding $900 million of debt involves bondholders swapping their securities in the near term at a 56.25 percent recovery rate, the bank said in a statement. If Puerto Rico at a later date reduces most of its debts through a broader restructuring, then the final recovery rate on GDB bonds would be 47 percent of the original value. The GDB will pay May 1 interest on the bonds in full.

The non-payment by the GDB alone will push the amount of outstanding munis in default up by 44 percent, to $23.6 billion from $16.4 billion, according to a tally from Municipal Market Analytics. That would make 0.64 percent of the $3.7 trillion market in default, up from 0.44 percent.

Puerto Rico racked up $70 billion of debt across more than a dozen issuers as it borrowed to paper over budget deficits. Garcia Padilla said 10 months ago that the obligations were unpayable. Yet, up until now, the commonwealth only missed $143 million of payments on appropriation bonds from the Public Finance Corp. and rum-tax securities from the Infrastructure Financing Authority.

The development bank, in contrast to those borrowers, is a prominent, visible and well-known Puerto Rico entity. It’s the fiscal agent of the commonwealth, lending to the island government and localities. For the past few weeks it has operated under a state of emergency to preserve cash.

Congressional Talks

The House Natural Resources Committee is working on a bill that would establish a federal oversight board to manage any debt restructurings and weigh in on spending plans. It’s set to file a new draft after lawmakers return from recess on May 10. The committee last month postponed a vote on the measure as lawmakers from both sides and the U.S. Treasury Department sought to make changes to the bill.

“We can’t wait longer. We need this restructuring mechanism now,” Garcia Padilla said about the federal bill. “We do not want and we haven’t been offered a bailout. A restructuring process will cost nothing to American taxpayers. We simply want the legal tools needed to address our insolvency crisis and ensure the sustainability of Puerto Rico.”

The island’s economy has shrunk since 2006 and 45 percent of residents live in poverty. Puerto Ricans have been fleeing the island at record rates for work on the U.S. mainland.

Credit Unions

Puerto Rico is struggling to pay fuel suppliers for police cars and emergency vehicles and provide services for special education students, the governor said. As half of the population receives health care from the government, including prescription medication, the administration must preserve its money for health and safety, Garcia Padilla said.

“At this point, we simply don’t have enough money to pay for all these services and pay our creditors,” the governor said.

Before the governor’s address, one TV station played a vintage television performance of ‘That’s where I’m from,’ a lively Caribbean song about local pride.

The GDB reached an agreement with some local credit unions to delay $33 million of bank debt due Sunday, affecting only a portion of the $422 million due that day. The credit unions agreed to swap their securities for debt maturing a year later.

The GDB bond in question, which matured May 1, is a $400 million taxable security issued in 2011 with a 4.7 percent interest rate. It last traded in March at about 32 cents on the dollar. 

Those with the largest positions, according to the latest disclosure filings compiled by Bloomberg: Thompson Investment Management, $24 million; Frost Investment Advisors, $11.2 million; Baird Financial Group, $5.1 million; Texas Mutual Insurance Co., $2 million; Merchants Mutual Group, $1.5 million; and UBS Asset Managers of Puerto Rico, $1 million.

The island owes $470 million in total to bond investors in May, including a small payout to general obligation holders that Moody’s expects the government to make.

A default on those constitutionally guaranteed bonds would be the first by a state-level borrower since Arkansas missed payments on its debt in 1933. That would likely trigger a restructuring of the commonwealth’s $13 billion of general obligations, which would be the largest-ever in the tax-exempt market.