Wednesday, July 22, 2015

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, 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.

No comments: