Monday, July 13, 2015

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.


lee woo said...
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