Shining a Light onto Municipal Bond Issuance Costs

In a recent study of 800 municipal bond issues for UC Berkeley, I found that issuance costs varied widely – from less than 0.2% of face value to over 10%. Issuance costs are to local governments like points are to a consumer taking out a home mortgage. In both cases, the goal should normally be to minimize them. While consumers have many forums to compare against and thus reduce financing costs, local government officials have been less fortunate – but that situation is starting to change.

Aside from publishing the study, I also released a data set showing each bond’s total issuance costs – as shown on Official Statements – and itemized details for a sub-sample of the bonds. My group obtained these details by sending Public Records Act or Freedom of Information Act requests to local government bond issuers. We found that the largest components of issuance costs were underwriting expenses, legal fees, financial adviser expenses, rating agency fees and bond insurance premiums.

While my study provides data for a nationwide sample of bonds, the California State Treasurer’s Office has now posted issuance cost details for all municipal bonds issued in the largest state. This impressive data set can be found here. The data were collected by the California Debt and Investment Advisory Commission (CDIAC), a unit of the State Treasurer’s Office. Under state law, California local governments must report their debt data to CDIAC. The commission had been publishing some of this data, but Treasurer John Chiang, an advocate for transparency, recently decided to publish everything, including details on issuance costs.

Issuance Costs often > 10%

A review of the California data shows numerous issuance cost ratios in excess of 10% of the issued amount - and even some exceeding 20%. Just like a consumer would never pay 20 points on a home mortgage, it is hard to understand why a bond issuer would do the same.

Many of the higher issuance cost levels were associated with small bond issues from rural school districts and special districts. Since some of the issuance costs don’t vary with issuance size, they can hit small issuers relatively hard. Further, small issuers often receive lower bond ratings, creating the necessity to purchase municipal bond insurance.

Monoline insurance was not a factor in a couple of the 20%+ cost of issuance situations I found in the CDIAC data. 

In 2013, San Jacinto special districts (called Community Facilities Districts) issued two special tax bonds totaling $985,000 and $925,000 respectively. In each case, cost of issuance exceed 20%.

Focusing on the $925,000 bond, we find that the district received a mere $532,066 of the bond proceeds (see the Official Statement).   The Estimated Sources and Uses of Funds on page 6 of the document, show $90,428 being deposited into a reserve fund and a total of $295,890 going to the underwriter and other service providers. The remaining $6,616 reflected an original issue discount, arising from the bonds being sold below face value.

The debt service schedule on page 10 of the Official Statement shows that the district will spend $1,240,252 of interest on the $925,000 of bonds through 2043.  Total debt service of $2,165,252 over the life of the bond issue is four times the net proceeds received by the district. All in all, not a great deal for San Jacinto's taxpayers.

In an influential 2011 paper, Andrew Ang and Richard Green found that state and local governments lose billions of dollars due to the opacity and illiquidity of the municipal bond market. They proposed the creation of a municipal bond issuer consortium (they called it CommonMuni) to share information and best practices in order to lower these costs. A cost of issuance data set that allows us to identify disparities across issuers seems like a good opportunity to begin realizing the CommonMuni vision.

EMMA: Time to Grow Up and Be Like Your Big Brother, EDGAR

In 2009, the Municipal Securities Rulemaking Board (MSRB) launched its Electronic Municipal Market Access (EMMA) system: the place to go for all things muni. EMMA contains information about all publicly traded municipal bonds and their issuers including offering documents, trade activity, ratings, issuer financial statements and event notices (such as those required when an issuer misses a payment or calls its bonds).

As a frequent user, I’m impressed not only by the wealth of information available on EMMA, but also with the system’s usability, reliability and ongoing feature improvements. That said, EMMA has very serious limitations that are inconsistent with both open government and a liquid municipal bond market.

In a 2014 open letter to the MSRB, the Sunlight Foundation pointed out that restrictions on downloading and the fact that much of EMMA’s data is still in PDF form greatly limit the system’s transparency. In these respects, it is worth comparing EMMA with the SEC’s system for collecting and presenting company financial filings, which is known as EDGAR (Electronic Data Gathering, Analysis and Retrieval).

Unlike EMMA, EDGAR provides free FTP and RSS access, allowing users to consume as much content as they wish. EMMA only offers bulk downloads as a high cost subscription option and specifically forbids using automated techniques to quickly capture (or “scrape”) site content. It also limits the number of records that can be returned in “Advanced Searches”, hampering the ability of market participants and academic researchers to gather and analyze the big data EMMA contains.

EDGAR further facilitates analysis by providing key company disclosures – most notably quarterly (10-Q) and annual financial statements (10-k) – in machine readable format. Municipal financial statements on EMMA typically appear only in PDF form, requiring laborious parsing or re-keying to obtain usable data.

Recent legislation proposed by Congressman Darrell Issa (R-CA) and co-sponsored by 26 other representatives from both parties would require MSRB to implement machine-readable disclosures on EMMA. The Financial Transparency Act of 2015 (HR 2477) mandates the use of standards based, machine readable disclosures by all financial regulatory agencies and self-regulatory bodies deriving their powers from federal regulators. This includes the MSRB whose power to oversee the municipal securities market is delegated by the Securities and Exchange Commission (SEC).

The SEC also operates EDGAR, which – as we have seen – is far more open than EMMA. But the SEC has not always been an exemplar of open data. It took a combination of outside pressure and bureaucratic innovation to make corporate financial disclosure fully open.

As late as the early-1990s, the primary method of reporting corporate financial results to the public was through printed annual reports and paper regulatory filings. Even after the SEC received company filings electronically, it proved unable to share this machine readable data with the general public.

This situation changed by virtue of work done by Carl Malamud, a northern California open government advocate. Malamud obtained SEC disclosures and began posting them on a web site he built with a National Science Foundation grant. Seeing the success of Malamud’s efforts, the SEC was shamed into providing this service itself. More recently, Malamud, through this work at Public.Resource.Org, has made a similar breakthrough with not-for-profit organization disclosures submitted to the IRS –Form 990. Malamud’s group began putting these forms on line at no charge a few years ago, and recently won a court judgment against the IRS requiring the agency to provide the Form 990 disclosures in machine readable format.

Meanwhile, the SEC has continued to improve EDGAR data. When it began publishing corporate disclosures in the late 1990s, the data appeared in SGML format (SGML is a close relative of HTML). SGML is more easily parsed than PDFs, so the SEC was way ahead of the MSRB and the IRS from the start. But the SGML disclosures were not self-describing: the data files were not tagged in such a way as to provide consistency across files. In the mid-2000s, the SEC began to embrace eXtensible Business Reporting Language (XBRL) which is self-describing. Beginning in 2009, the SEC began to mandate that corporate filers use XBRL – starting with the largest companies and working down to smaller ones. Now EDGAR users can click an “Interactive Data” button next to each disclosure to see the XBRL rendered as an interactive web page.

To this author, it seems odd that private companies and now private, not-for-profit entities have more accessible financial filings than do state and local governments. Many private organizations affect relatively small number of stakeholders – perhaps just a few hundred customers, employees and shareholders. But governments large enough to issue bonds touch the lives of thousands of taxpayers, service users, beneficiaries and other parties: their financial affairs are much more a matter of public interest.

EMMA could serve that public interest if its content were more open – but a number of factors prevent this. For example, MSRB’s board contains members employed by firms in the municipal bond industry whose revenue might be reduced by greater industry transparency.

Some of the content on EMMA is proprietary. This restricted data includes CUSIP numbers that identify each bond, as well as credit ratings. CUSIPs are owned by the American Bankers Association and administered by McGraw Hill Financial; they normally cannot be displayed on a web page without a costly CUSIP license. Although individual bond ratings may be freely reproduced, rating agencies take measures to prevent the bulk redistribution of credit ratings, because they sell ratings feeds to large financial industry customers. Finally, the MSRB also realizes revenue from selling EMMA content in bulk:  users are offered subscriptions to EMMA data feeds that includes various portions of the primary market and continuing disclosures available on the system.  If this material could be bulk downloaded at no charge, MSRB would lose subscription revenue.

While these institutional factors may preclude free bulk access to EMMA content, it is less clear why MSRB has not mandated filings in XBRL or some other open, standardized format – rather than PDFs. This idea appeared on an MSRB road map in 2012, but there does not seem to be momentum toward implementing it.

That situation would change if the Financial Transparency Act of 2015 (HR 2477) becomes law. Once PDFs are replaced by structured data, the cost of creating municipal finance data sets will greatly decline and their availability will greatly increase. The ultimate results should be better value for municipal bond investors and substantial cost savings for cities, counties, school districts and other issuers.

Investigations of Fund Fees (and Fees and Fees)

With the Blackstone settlement from earlier this week (see below), now is as good a time as any to start a list of investigations into fund fees.  If we're missing any, let us know!

1. August 2018: 18-229MR Update on financial advice institutions' fees for no service refund programs: "AMP, ANZ, CBA, NAB and Westpac have now paid or offered customers $222.3 million in refunds and interest for failing to provide advice to customers while charging them ongoing advice fees."


2. June 2018: THL: Accelerated Fees: "This matter arises from inadequate disclosures by private equity fund adviser THL regarding THL’s potential future receipt of lump sum fees from the portfolio companies of two THL-managed private equity funds launched in 2000 and 2006."


3. April 2018: A.G. Schneiderman Releases New Report On Mutual Fund Fees, Announces Agreement By 13 Major Firms: "NEW YORK – Attorney General Eric T. Schneiderman announced that after an industry-wide investigation into mutual fund disclosures and fees, 13 major mutual fund firms—including those run by some of the largest players in the mutual fund industry—have agreed to voluntarily publish important information about their mutual funds to all retail investors."


4. Dec. 2017: TPG: Accelerated Monitoring Fees: "From at least April 2013 through April 2015 (“Relevant Period”), upon either the private sale or an initial public offering (“IPO”) of a portfolio company, TPG terminated certain portfolio company monitoring agreements and accelerated the payment of future monitoring fees pursuant to the agreements. Although TPG disclosed that it may receive monitoring fees from portfolio companies held by the funds it advised, and disclosed the amount of monitoring fees that had been accelerated following the acceleration, TPG failed to disclose to its funds, and to the funds’ limited partners prior to their commitment of capital, that it may accelerate future monitoring fees upon termination of the monitoring agreements."


5. April 2017: SEC Charges Credit Suisse and Former IA Representative With Breaches of Fiduciary Duty: "The [SEC] today announced that [Credit Suisse] and one of its former investment adviser representatives have agreed to pay almost $8 million to settle charges that they improperly invested clients in more expensive “Class A” shares of mutual funds rather than less expensive “institutional” shares for which they were eligible. The SEC’s orders find that Credit Suisse and Sanford Michael Katz breached their fiduciary duties and failed to adequately disclose the conflict of interest created by such investments as they enriched themselves at their clients’ expense."


6. September 2016: ING Bank compensates Living Super customers due to potentially misleading costs and fees statements


7. August 2016: SEC fines Wilbur Ross firm $2.3 million over fees: “Billionaire investor Wilbur Ross' investment firm WL Ross & Co agreed on Wednesday to pay a $2.3 million fine to the Securities and Exchange Commission to settle charges that it did not properly disclose some fees it charged investors."


8. August 2016: Apollo to Pay $52.8 Million Over Fee Practices: “A common theme in our recent enforcement actions against private-equity firms is their failure to properly disclose fees and conflicts of interest to fund investors,” said Andrew J. Ceresney, director of the SEC Enforcement Division.


9. August 2016: Suits Target University Retirement Plans: "Many of the cases challenge 403(b) plans’ use of retail share classes of mutual funds, rather than lower-cost institutional versions of the same investments. They also contend that the plans’ arrangements with multiple record keepers cause participants to pay excessive administrative fees"


10. August 2016: SEC Probes Silver Lake Over Fees: "Investigation is part of regulator’s broad push to make sure buyout firms are being upfront with investors"


11. July 2016: Investors Are Getting Ripped Off on Index Fund Fees, Lawsuits Say 


12. Feb. 2016: George K. Baum Overcharged School District, Regulator Says: “Municipal-bond underwriter George K. Baum & Co. agreed to pay a $100,000 fine over allegations it charged a school district four times the typical fee to sell debt, in part to help cover the cost of bond elections, a regulator of securities dealers said.”


13. Jan. 2016: SEC: Alternative Fund Manager Overcharged Fees, Misled Investors 


14. Oct. 2015:  Blackstone to pay about $39 million to settle SEC charges over fees: the payments Blackstone received "essentially reduced the value of the portfolio companies prior to sale, to the detriment of the funds and their investors."


15. Sept. 2015: CalPERS: Tensions rise over private equity fees


16. Aug. 2015: Private equity industry sees more federal regulation: OICE...examiners had turned up widespread "deficiencies" in how private equity firms charge clients for fees and expenses and the agency had found "violations of law or material weaknesses in controls over 50% of the time."


17. June 2015: Earlier this year, a senior executive of the California Public Employees’ Retirement System, the country’s biggest state pension fund, made a surprising statement: The fund did not know what it was paying some of its Wall Street managers.


18. April 2015: N.J. pension fund heads to investigate investment fees and bonuses to private companies.


19. Dec. 2014: Two of the biggest private-equity firms are disclosing fees that had largely been hidden as U.S. regulators demand increased transparency from the industry.


20. Dec. 2014: With private equity firms under the regulatory microscope, the balance of power may be shifting — at least a bit — away from fund executives and toward investors.
    


21. Nov. 2014: Blackstone Group, which manages $279 billion, no longer will pocket extra consulting fees when selling or taking public companies it owns.


22. Sept. 2014: SEC reviews completed as part of a two-year effort involving nearly 200 funds have found cases where potential investors were given only the most favorable description of past performance rather than full disclosure of winning and losing bets.


23. Sept. 2014: SEC Charges New York-Based Private Equity Fund Adviser With Misallocation Of Portfolio Company Expenses: "An SEC investigation found that while Lincolnshire Management integrated the two portfolio companies and managed them as one, the funds were separately advised and had distinct sets of investors. Despite developing an expense allocation policy as part of the integration, it was not followed on some occasions, resulting in the portfolio company owned by one fund paying more than its fair share of joint expenses that benefited the companies of both funds."


24. July 2014: Federal regulators are looking at commissions that buyout firms receive for helping companies they control get goods and services at discount prices, as part of a stepped-up probe of private-equity fees.


25. May 2014: The Deal’s Done. But Not the Fees: “In some instances, investors’ pockets are being picked,”


26. May 2014: BlackRock faces lawsuits over “disproportionately large” fees.


27. May 2014: The SEC found illegal fees or severe compliance shortfalls in more than half of the firms it examined since starting a review of the $3.5 trillion industry two years ago.


28. April 2014: More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors,


29. March 2014: Muni Investors Getting Fleeced On Trading Costs: Investors typically pay twice as much in trading commissions for municipal bonds as they would pay for corporate bonds.

Digging and Drilling in the Commodities Markets

Last week we updated you on the FX investigations.  This week, we learned just a little more about the supervisory interest in keeping tabs on the potential for commodities misconduct.

Early in 2014, German regulator BaFin expressed its concern that precious metals manipulation (like currency manipulation) may be worse than the LIBOR-rigging scandal.

The LIBOR rigging is essentially centered in the window around 2007 to 2009/2010 and the FX and commodities misconduct may both have lasted longer.  From a benchmark rigging angle, the regulators have generally focused on 2009 - 2012, but the class actions are much broader, now often going all the way back to 2004.  Insofar as the guilty pleas are concerned, much of that is for misconduct after 2009/2010.

On Friday, the WSJ ran a very interesting story covering the FCA's (UK regulator) concerns about the monitoring of abuse in the commodities markets.  The WSJ article points out that the FCA's review "comes after recent changes in the market, in which a number of large banks, such as Barclays PLC and Credit Suisse Group AG, left commodity markets."

The FCA was really looking into internal surveillance procedures, but it did find certain lapses in (1) firms' monitoring of internal communications and (2) in their limited interest in submitting Suspicious Transaction Reports (or STRs) when noticing suspicious movements. This extract from the FCA's report captures some of their concern.

Firms that did not fully recognise the risks of market abuse were more likely to employ inappropriate surveillance, in terms of the choice of automated or manual systems, calibration of systems and frequency of monitoring. Overall, there was little order level monitoring, making it difficult for firms to demonstrate effective monitoring for market manipulation, and we often found surveillance being done on an inadequate or poorly targeted sample basis.  

Most firms’ communications surveillance captured Instant Messenger and recorded lines, but did not monitor these on a systematic basis. We observed more effective monitoring at firms where sampling was targeted at higher risk periods (such as at contract expiry or around important announcements) and at higher risk individuals.  

Many firms had inadequate STR procedures, with typically no written procedures and a lack of clarity on what constitutes an STR. The number of STR submissions within the commodities sector is low in comparison to other asset classes, which may indicate that potential suspicious transactions are not being appropriately reported. 

It will be interesting to see whether the FCA will succeed in getting the banks to self-police in the commodities space, especially given so many of the large banks are so heavily short, notably betting against silver and gold.  Courtesy of Ed Steer, here's a graphical depiction of the bank's overriding short interest in silver (via CFTC's data on futures contracts).

As you'll see, the banks really started to get short (particularly the US banks) in mid 2008, and have been heavily net short ever since. The dynamic is still true of non-US banks, but is far less pronounced.

Currency Probe Updates

There's been quite a bit of action on the FX side since we last updated you in June.

First up, we've had a few more settlements (mostly undisclosed, but BNP Paribas reportedly settled for $115 mm) in the investor class action, taking that total to over $1.7 billion.

Next, we've seen an interest among some of the side action litigants in combining their over-the-counter (OTC) and exchange-based claims with the existing behemoth case, In re Foreign Exchange Benchmark Rates Antitrust Litigation Case No. 1:13-cv-07789-LGS (S.D.N.Y.). (see examples here and here).

Third, we've seen reports that suggest that US law firms are setting themselves up to bring these currency cases in Europe.

Last, on the regulatory side, there have been reports that regulatory bodies are broadening the scope of their prior investigations to include other currency pairs and that German supervisory authority BaFin is (perhaps newly) concerned about the sheer scale of ForEx manipulation.  BaFin expects to conclude its investigation next year but was on record in early 2014, reportedly saying that currency rigging (and metals rigging) was worse than that of LIBOR.

Shaambles at AAMC

We have from time to time covered the mortgage servicing industry, paying particular attention to Ocwen (ticker: OCN) and its affiliates.[1]  While the past 20 months have been rocky for shareholders of Ocwen and its affiliates, for Altisource Asset Management Corporation (ticker: AAMC) it has been catastrophic.[2]

What is going on at AAMC?

Since reporting 2Q15 earnings before the open on August 10^th, shares of AAMC have plunged 75%!  By comparison, the Russell 2000 has fallen 6% over the same timeframe.  So … what is going on with AAMC that has investors panicked?    

AAMC is “an asset management company that provides portfolio management and corporate governance services to investment vehicles that own real estate related assets.”[3]  By our reading, AAMC’s only significant client is another Ocwen affiliate, Altisource Residential Corporation (ticker: RESI).  RESI and AAMC are, uh, closely affiliated – they have the same management team (CEO; CFO; CAO; GC). 

Essentially all of AAMC’s revenue is dependent on the asset management fees it collects from RESI.  Those fees are determined by an Asset Management Agreement, which until recently, had been quite favorable to AAMC – at the expense of RESI shareholders.  (It probably won’t surprise you to learn that back in the day former Ocwen, RESI, and AAMC chairman William Erbey had a much larger dollar stake in AAMC than RESI.) 

But in February, RESI shareholder Capstone Equities complained about the one-sidedness of the arrangement, and demanded that the RESI board “terminate the Asset Management Agreement, dated as of December 21, 2012, (the “AMA”), for cause without paying a termination fee….” (emphasis in original) [4]

On March 31, 2015, RESI and AAMC revised their agreement[5], apparently (and oddly) to the relief of AAMC investors, who drove shares of AAMC up 40% over the following week.  Perhaps they were relieved that AAMC was able to retain its sole client.  But the new agreement apportions more of the pie to RESI and is much less favorable to AAMC. 

But the full extent of the damage to AAMC earnings may not have been readily apparent to shareholders until they were able to digest a quarter’s worth of post-agreement earnings, which they got August 10.  See table below for daily price action, which shows the slide beginning on the 10^th of August.  

------------------------------------------------------------------------------------------------

[1] You may recall that Ocwen has garnered the attention of regulators such as the CFPB, New York Department of Financial Services, and the California Department of Business Oversight, as well as investors such as BlueMountain Capital.

[2] AAMC is one of four companies to have spun off from Ocwen (technically AAMC spun off from ASPS, which itself spun off from Ocwen).

[3] http://www.altisourceamc.com/About_us.aspx

[4] http://bit.ly/1hhJkRc

[5] http://1.usa.gov/1NX4r6e

Should Puerto Rico Bondholders Get a Taxpayer Bailout?

Critics of extending Chapter 9 to Puerto Rico argue that the policy would allow the Commonwealth to wiggle out of its commitments. If Puerto Rico’s cities and public corporations can file bankruptcy petitions, they will be handed an option to avoid making debt service payments on time and in full.

Public sector entities don’t need municipal bankruptcy laws to default: thousands defaulted before Chapter 9 was first added to the bankruptcy code in 1934.  More recently, Harrisburg defaulted on multiple obligations despite the fact that Pennsylvania does not permit Chapter 9.

That said, opposition to Puerto Rico municipal bankruptcy is rooted in an important moral sense: when we make commitments, we should keep them. Performing on a bond indenture is just another form of keeping one’s word. If this moral underpinning of our debt markets were to seriously erode, borrowers would face much higher interest rates or even complete lack of access to funds.

But is this consideration an absolute or should it be balanced against other concerns? In the case of Puerto Rico, many public sector entities are no longer able to meet the expectations of all their stakeholders: which include public employees, service recipients and taxpayers in addition to bondholders.

Because bondholders have a written agreement that clearly outlines their claims, they warrant special consideration. That said, we need to recognize that bond commitments are often fulfilled by taking money from taxpayers - who may not have approved of the bonds in the first place.

In recent decades, conservatives have been very critical of taxation in all its forms. This stance is partially inspired by the libertarian view that “taxation is theft”. If we take this idea to its logical extreme, we conclude that the government has no right to service bonds with tax money – implying that all general obligation debt should be repudiated.

Since most of us have exposure, directly or indirectly, to tax supported debt, such a widespread repudiation would wreck considerable havoc. But, while we may shy away from the logical extreme, the taxpayer perspective deserves consideration. The bondholder’s right to repayment must be balanced against the taxpayer’s right to keep at least some of her income and wealth.

This moral balance can shift when the creditor is wealthy and at least some of the taxpayers aren’t. This is what united left and right in criticizing the 2008 bailout of AIG. It is important to remember that the largest beneficiaries of the AIG bailout were its creditors, many of whom were wealthy financial industry players like Goldman Sachs. The bailout of AIG thus constituted a wealth transfer from middle income taxpayers to the financial elite.

That could happen once again in the case of Puerto Rico. Much of the Commonwealth’s debt has been snapped up by hedge funds at steep discounts. If the funds can compel Puerto Rico public sector entities to service their bonds on time and in full, they will make substantial profits. One out of every five dollars of this profit will go to hedge fund managers, who will be taxed at lower capital gains rates.

For those reading this blog on the US mainland, the fact that taxpayer money might be unjustly diverted to hedge funds may not seem like a salient concern. But, it is, because a considerable share of Puerto Rico government revenue comes from taxpayers in the fifty states.

Public sector entities in Puerto Rico receive over $7.2 billion in federal grants annually. This amount represents over 10% of the Commonwealth’s GNP and 22% of total government spending. I have uploaded a list of recipient entities and amounts for FY 2013 here.

Further, according to USASpending.gov, the US federal government spent a total of $21.3 billion in Puerto Rico in fiscal year 2014, while the IRS reports that Commonwealth residents and corporations contributed just $3.6 billion in federal tax revenue during the same year. The difference between these two figures – net transfers from taxpayers in the fifty states - represents about a quarter of Puerto Rico’s GNP.

Thus, Puerto Rico and its governments derive much of their revenue from US taxpayers. Although federal grants are always made for a specific purpose, government revenues and expenditures are fungible. Governments receiving federal support can shift their own-source revenue away from federally subsidized priorities and towards other purposes – such as enriching hedge fund managers.

Consequently, the debate over debt relief for Puerto Rico cannot be properly addressed by platitudes about fiscal responsibility and the need to live up to one’s commitments. By denying the Chapter 9 option to Puerto Rico municipalities and public corporations, Congressional Republicans might well be doing a disservice to the middle class taxpayers they claim to represent.

The Specious Case against Extending Chapter 9 to Puerto Rico

Last week, Congressional Republicans blocked legislation that would have allowed Puerto Rico public sector entities to file municipal bankruptcy petitions. Among their arguments against extending Chapter 9 to the Commonwealth are that bond investors – who purchased Puerto Rico obligations with the knowledge that issuers could not file bankruptcy – would be unfairly punished and that the island’s government has not implemented sufficient austerity measures.

While buyers of Puerto Rico bonds may have known that issuers did not have access to Chapter 9, they were aware that default was a distinct possibility – and that is all that really counts. We can confirm that investors knew of the existence of default risk by comparing Puerto Rico bond yields to risk free interest rates.

In November 2009, Puerto issued 30-year bonds at a yield of 6%. At the time, 30-year US Treasury bonds were yielding under 4.5%. While differences in liquidity might explain some difference in yields – this effect cannot possibly account for a 150bp gap. Further, interest on Puerto Rico bonds is exempt from federal income tax whereas Treasury bond interest is not (interest on both types of bonds is exempt from state and local income taxes. This tax effect should easily overwhelm any liquidity effect.

I use a 2009 example to show that investors have been pricing Puerto Rico default risk for a long time. Those who bought Puerto Rico bonds more recently demanded and received much higher default risk premia. The Commonwealth’s 2014 issue yielded 500 basis points above 30-year Treasuries and the gap has widened further in secondary trading.

Thus anyone who purchased Puerto Rico bonds over the last several years was compensated for default risk. Indeed, depending upon the type of restructuring Puerto Rico implements, many secondary market investors could still see positive returns.

During the Depression era, sub-sovereigns in the US, Canada and Australia (operating under similar legal systems) extended maturities and/or unilaterally reduced coupon rates. In all these cases (Arkansas, South Carolina, Alberta, Australia and New Zealand), investors eventually received their full principal. These older cases may be more relevant to Puerto Rico than the oft-cited cases of Detroit, Stockton and Greece in which investors suffered significant principal losses. Puerto Rico is more analogous to a US state than either Stockton or Detroit, and it is not a serial defaulter operating outside Anglo-Saxon law like Greece. In her recent government-commissioned report, former IMF Managing Director Ann Krueger argues that the Commonwealth can obtain debt relief “through a voluntary exchange of old bonds for new ones with a later/lower debt service profile.”

Why Chapter 9 Is Needed

Puerto Rico’s headline debt number - $72 billion of par representing a 104% debt/GNP ratio – includes a lot of moving parts. Some of this complexity is captured by the Commonwealth’s debt statement shown below. 

The statement shows numerous classes of debt – with varying coverage pledges – owed by different types of obligors. But it hides an even greater level of detail: the Commonwealth’s $4 billion in municipal debt is owed by 78 separate municipos – county-like entities – on the island. The $30 billion of public corporation debt was incurred by six different entities.

These obligors have widely varying levels of credit quality. As I reported in the Bond Buyer earlier this year, the Commonwealth’s third largest city, Carolina, was running a balanced budget and reported significant reserves in its 2013 financial statement. By contrast, the small municipio of Maunabo, was flat broke – with a large negative general fund balance, bank overdrafts and defaulting on a US Department of Agriculture loan. The Chapter 9 process would provide an essentially bankrupt community like Maunabo with the ability to reorganize its finances in a more sustainable manner. Fiscally healthy communities like Carolina can signal their strength to investors by avoiding Chapter 9 and continuing to perform on their obligations.

Inconvenient Truths about the Austerity Argument

Almost half of Puerto Rico’s debt was issued by entities other than the Commonwealth government. The Commonwealth’s $38 billion of debt represents just under 70% of Gross National Product. If we use Puerto Rico’s less widely reported (bur more internationally comparable) Gross Domestic Product as the denominator, the ratio falls to around 37%. All this compares favorably to the US federal government’s debt-to-GDP ratio of 74%.

The accompanying chart and this Google sheet show the evolution of Puerto Rico’s debt ratios over the last 40 years. The main takeaways are that the Commonwealth has had a heavy public sector debt burden for a long time, but it rose steadily 2000 to 2014. 

Puerto Rico had a Republican Governor for a significant part of this period: Luis Fortuño. Not only was he a Republican, but he was a darling of the Party establishment: invited to address the 2012 Republican Presidential convention and receiving consideration as a Vice-Presidential nominee. During Fortuño’s last full fiscal year, 2011-2012, total governmental revenues were $15.8 billion and total expenditures were $21.0 billion. The $5.2 billion deficit was the worst in ten years. Since the Democratically-aligned Alejandro Padilla administration took control, deficits have fallen. According to the most recent Commonwealth financial report, the general fund deficit fell from $2.4 billion in fiscal 2012 to $1.3 billion in fiscal 2013 and $0.9 billion in fiscal 2014.

This progression toward budgetary balance and the Commonwealth’s loss of market access have produced a flattening of Puerto Rico’s debt ratios. In the nine months ended March 2015, total public sector debt actually declined slightly in nominal terms.

Puerto Rico’s fiscal policy has thus been more austere under the current left-of-center government than under the prior Republican administration. Moreover, the Puerto Rican government is accumulating debt at a slower rate than the US federal government – which is now mostly under Republican control.

Thus, Congressional Republicans seem poorly positioned to lecture Puerto Rico about fiscal responsibility. A better alternative would be to approve Chapter 9 legislation, so that Commonwealth entities can get on with the process of restructuring their diverse debt burdens.