Thursday, May 5, 2016

How About a Real Federal Bailout for Puerto Rico?

Later this month, Congress will begin its race against a July 1st deadline to pass legislation addressing the financial mess in Puerto Rico. July 1 appears to be the date on which the Commonwealth will default on general obligation debt service payment – the first such default by a state or territory since 1933. The proposed bill, HR 4900, includes a combination of federal oversight over Puerto Rico finances and a mechanism to restructure the island’s public sector debt. Although the restructuring procedure would begin with voluntary negotiations between issuers and bondholders, the bill would authorize courts to impose cram-downs on holdout bondholders.

This last aspect has displeased hedge funds that own Puerto Rico bonds, and they have been trying to kill the legislation. The most visible part of this effort has been a spate of issue ads on TV urging voters to call their Representative to stop the so-called federal bailout. When people think of a bailout, they normally assume that taxpayer money is being spent on some objectionable purpose. In this case, the ad misleads viewers to think that Congress is trying to send more federal dollars to the island. In fact, the legislation does not provide any new funding to Puerto Rico whatsoever. Even the federal oversight board is to be funded with proceeds from new bonds that will be obligations of the Commonwealth. 

Although I like HR 4900 overall, I think it would be better if the federal government did make a financial commitment. Specifically, I suggest that Puerto Rico Commonwealth bonds be exchanged for newly issued US Treasury Bonds with similar maturities. The federal government would service these new Treasury Bonds by diverting grant monies earmarked for the Commonwealth government.

Right now, most Puerto Rico bonds carry coupons of between 5% and 8%. Treasury rates are below 3% at all maturities. Refunding Puerto Rico bonds at par with Treasuries saves bondholders from taking a haircut and saves taxpayer money viz.-a-viz. fully servicing the current bonds. The swap is thus a win/win situation.

While the debt burden would then be shifted onto the federal government’s books, there is a surefire way for federal taxpayers to be made whole. Each year, the federal government provides over $7 billion in grants to Puerto Rico’s public sector to support a variety of services. Under my proposal, any money needed to pay principal and interest on the newly issued Treasury bonds would be withheld from Puerto Rico and used instead to pay holders of the new Treasury bonds.

This concept has a rough precedent in the municipal bond market. Several states provide credit support to local school district bonds through aid intercepts. The state deducts principal and interest from money that would otherwise be apportioned to the school district borrower and remits it to bondholders. School bonds serviced this way carry ratings similar to those of the state, allowing small districts to realize substantial interest savings. (Typically the aid intercept mechanism is just a backup in case the school district fails to pay, so this is a bit different from my recommendation for Puerto Rico).

I propose this only as a solution for Commonwealth-issued bonds including General Obligations and COFINA sales tax supported debt. Debt issued by other Puerto Rico borrowers should be restructured either according to procedures laid out in HR 4900 or using the Chapter 9-like mechanism provided by the Puerto Rico Corporations Debt Enforcement and Recovery Act of 2014 now being reviewed by the Supreme Court. This non-Commonwealth debt is more akin to municipal bonds on the mainland that have been adjusted under Chapter 9, so there should be less political concern about using these mechanisms to restructure them.

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I have been writing a lot about Puerto Rico lately. Here are some of my other recent commentaries on the web:

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