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:

• Puerto Rico Needs Debt Transparency, The Hill
• Why Hedge Funds May Not Get a Windfall from Puerto Rico, The Fiscal Times
• Puerto Rico’s Fiscal Crisis Has Been Brewing for 75 Years, The Fiscal Times
• Lessons on Handling the Puerto Rico Fiscal Crisis, RealClearPolicy
• Move Gitmo Prisoners to Puerto Rico?, The Fiscal Times

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.

For Puerto Rico, Low Transparency ==> High Yields

Puerto Rico 10-year bonds have been yielding around 8% in recent weeks. That’s a 400bp premium over bonds over AAA munis and 500bp over Treasuries – for instruments that are triple tax free throughout the US.

Muni market headlines focus on the Commonwealth’s large debt (over 100% by some measures), underfunded pensions and weak economic performance. Yet revenues are rising, the largest pension system has been reformed and the Commonwealth has enough cash on hand to avoid issuing any new GO debt for the remainder of Fiscal 2014.

Perhaps Puerto Rico’s risk is not as great as the 8% bond yields suggest. I say perhaps, because gaps in the Commonwealth’s disclosure make risk assessment and monitoring challenging.

Earlier this year, I built a fiscal model for Illinois that suggested the state’s absolute credit risk was limited. The model estimated the probability that interest and pension costs – two large uncontrollable, senior obligations – would claim 30% of state revenues – a level associated with previous defaults in US states and comparable jurisdictions. The state of Illinois supports modeling of this sort by providing a comprehensive annual financial report, interim financial reporting, a multi-year budget forecast and pension system actuarial reports that forecast contributions, benefit levels and other indicators over the next thirty years.

SPARSE, INCOMPLETE, LATE or OUT of DATE

Puerto Rico provides some of these elements, but many aspects of the Commonwealth’s fiscal disclosure are missing, delayed or incomplete.

For example, the Commonwealth’s 2012 CAFR appeared on September 16, 2013 – more than 14 months after the end of the fiscal year. This is later than every US state, and substantially later than most.

Although it takes time to produce audited financials, unaudited cash statements should be easy to generate shortly after the fiscal year end. Yet, as of early December, a statement of fiscal 2013 full year revenues and expenditures by category was still unavailable (see http://www.bgfpr.com/economy/General-Fund-Net-Revenues.html for where the report is supposed to appear). Since the fiscal year ended on June 30, prospective investors have now been waiting over five months for this statement. The Puerto Rico Treasury Department likely has this data: components have appeared in press releases and Treasury has already published comparable numbers for the first quarter of fiscal 2014.

Another shortcoming is the lack of a multi-year revenue and expenditure forecast. Illinois provides a three year general fund revenue forecast as part of its budget package. I have found no comparable report for Puerto Rico.

Finally, the Commonwealth’s pension reporting is relatively skimpy and has been rendered obsolete by the 2013 reform. There is no document that provides up-to-date forecasts of annual employer contributions, employee contributions, benefit levels, administrative expenses or asset valuations.

Thus, Puerto Rico asks investors to lend it money on a long-term basis but fails to provide them the tools necessary to readily forecast the Commonwealth’s ability to service these debts. The resulting uncertainty may well be feeding the frenzied selling that has recently taken Puerto Rico spreads to astronomical levels.

The current administration has been trying to step up its investor relations. There are investor calls, slide presentations and even a voluminous Commonwealth report. But the volume of interaction is a poor substitute for quality, consistency, and predictability – at least for those in the bond markets.

Rather than providing reams of assertions and stale data, the Commonwealth would do well to provide investors and other stakeholders, concise, timely and complete financial statements and projections. It’s the provision of the expected, necessary, transparency that could yield lower yields.