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.

Illinois’ Candidates for Municipal Bankruptcy

House Bill 298 would allow Illinois municipalities to adjust their debts through the Chapter 9 municipal bankruptcy process. The bill, endorsed by Governor Bruce Rauner, is currently in the house rules com-mittee.

If HB298 was enacted, which local governments might use the new bankruptcy option? To help answer this question, our team reviewed audited financial statements that (all but the smallest) municipalities must file. Most of these financial audits can be found on the state comptroller’s local government finance warehouse.

This article lists five municipalities that appear vulnerable based on information found in their audits. Among the indicators we considered were government-wide unrestricted net position and general fund balance. The first indicator shows the degree to which assets held by the government entity as a whole exceed its liabilities and are not locked up in buildings and other illiquid forms. The second indicator, general fund balance, focuses more narrowly on the government’s main fund – which is roughly analogous to an individual’s checking account. Low or negative general fund balances were cited in the bankruptcies of Vallejo and Stockton, California. It is worth noting that the five municipalities we identified are all located in Cook County, which also faces fiscal challenges. Our list does not include Chicago. Although that city’s financial struggles have made frequent headlines, several of its smaller suburbs appear to be in much greater fiscal distress. The five communities we identified are: Maywood, Sauk Village, Blue Island, Country Club Hills and Dolton.

In its 2013 financial statements, The Village of Maywood reported an unrestricted net position of -$47.4 million, and a general fund balance of -$8.2 million. While we found a number of jurisdictions with negative balances, these levels are quite pronounced for a relatively small municipality.  With general fund revenues of only $23.3 million and government-wide revenues of $44.1 million, it will take the village a long time to eliminate these shortfalls.

The Village’s 2014 financials should have been available by now, but, its reporting has been chronically late. Moody’s withdrew the Village’s credit rating in 2011 citing a “lack of sufficient current financial and operating information”. Despite the lack of credit ratings, Maywood was able to sell $16.3 million of bonds earlier this year.

In its 2014 financial statements, Sauk Village reported an unrestricted net position of -$36.7 million – a very large negative position considering that the village had only $29.6 million in assets and government-wide revenues of $13.4 million. Sauk Village also showed a negative general fund balance and unusually high interest costs. The village’s $2.1 million of interest expense accounted for over 15% of total revenue. In most of the Illinois municipalities we reviewed, the interest/revenue ratio was below 10%. To the extent that interest expenses crowd out spending on resident priorities, political leaders have an incentive to default on debt obligations as a way to shift spending to more popular purposes. Furthermore, the Village received an adverse audit opinion for its reporting of “Aggregate Remaining Fund Information” and a qualified opinion for its reporting of “Governmental Activities.”  The Police Pension Fund information was not included and has not been subject to an actuarial evaluation since May 1, 2011.

The City of Blue Island reported an unrestricted net position of -$15.2 million and a general fund balance of -$10.5 million in its 2013 financial statements – the latest available. The negative general fund balance is especially pronounced because the city only recorded $16.3 million in general fund revenue during fiscal year 2013. The city’s negative net unrestricted position appears to be understated because Blue Island did not report an Other Post-Employment Benefit (OPEB) liability. Government accounting standards require that municipalities report the present value of unfunded OPEB obligations on their balance sheets. This failure to report OPEB obligations resulted in the city receiving a qualified opinion from its independent auditor.

The City of Country Club Hills has yet to file audited financial statements for the 2013 fiscal year – making it the most delinquent filer among the municipalities we reviewed.  The city’s 2012 financial statements show a slightly negative unrestricted net position and a large negative general fund balance. Further, the city’s auditor was unable to render an opinion on the accuracy of these statements, saying:

Since the City did not maintain an accurate accounting of its revenue, expense/expenditure, bank reconciliations, and other assets and liability accounts, and we were not able to apply other auditing procedures to satisfy ourselves as to those balances, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements.

WGN Television has repeatedly unearthed financial irregularities in Country Club Hills.  Most recently, the station reported that Mayor Dwight Welch was being audited by the IRS for not declaring as income his personal use of a city vehicle. The station also reported that the mayor incurred large restaurant bills on a city credit card, and that the city mistakenly retained $6 million in tax revenue that was supposed to be remitted to Cook County.

The Village of Dolton reported a small negative net unrestricted position in its 2013 financial statements – the latest available. Although its general fund balance was positive, the amount was well below Government Finance Officers Association guidelines. GFOA recommends that a government maintain a balance equal to two months of expenditures. Dolton’s $1.3 million general fund balance would cover less than a month of general fund expenditures, which were $22.1 million for the 2013 fiscal year. Further, the village reported a $5.2 million general fund deficit. If this deficit persisted into 2014, Dolton may now be facing a negative general fund balance. Finally, the village also received an adverse audit opinion. According to the city’s independent auditor:

We were unable to examine supporting documentation for numerous expenditures out of various funds of the Village. We were unable to test the Village’s allocation of certain revenues collected by the water fund but belonging to the general fund and sewer fund. We were unable to obtain an aged trial balance supporting the receivable balances in the water and sewer funds. We were unable to obtain sufficient support for certain local revenues. We were unable to determine whether a net pension obligation should have been recorded in the government wide statements with respect to the police and firefighters’ pension funds. We were unable to obtain supporting documentation for certain payroll related liabilities such as compensated absences. We were unable to determine whether a lack of infrastructure assets was the result of a failure to include such information on the financial statements or whether the infrastructure had been fully depreciated in prior years. Due to the omission of financial statements for the discretely presented component unit, we were unable to determine whether the omission is material to the financial statements of the Village nor were we able to perform any auditing procedures on the component unit. We were unable to obtain confirmation from legal counsel as to whether any known actual or possible litigation, claims and assessments should be recorded or disclosed in the financial statements. Finally, we were unable to determine whether bond proceeds from a prior year were spent in accordance with applicable ordinances and requirements.

If HB 298 becomes law, these five communities may be among the first to utilize the municipal bankruptcy option. Regardless we hope that local leaders and active members of each community review the financial records we have referenced, and begin to pursue policies that bring their municipalities back from the brink. As Detroit and other cities filing Chapter 9 have found, municipal bankruptcy is an expensive process that transfers community resources to lawyers and financial advisors. While it may be unavoidable, bankruptcy should always be treated as the least best option.

This article was written by Marc Joffe on behalf of CivicPartner LLC.  CivicPartner is a Chicago-based startup that collects and analyzes government financial disclosures. Joffe is an independent researcher studying state and municipal fiscal conditions.