Wednesday, July 29, 2015

Treasury Speaks to Puerto Rico's Debt Problem But Doesn't Say Much

Treasury Secretary Jack Lew sent a letter yesterday responding to questions posed by Sen. Orrin Hatch (R. Utah) about Puerto Rico.   Lew notes that the Obama administration is not considering a federal bailout for Puerto Rico. He said that returning Puerto Rico to a sustainable economic path requires "development of a long-term comprehensive fiscal plan" that addresses Puerto Rico's financial challenges (high unemployment, "labor market challenges" and high energy and transportation costs, "exacerbated by a history of less than adequate fiscal policy choices").  The plan must include input from stakeholders, be based on credible projections for revenue, expenses and growth, and include a "realistic and robust economic growth strategy that encourages new private investment, increases Puerto Rico's competitiveness, and strengthens its economic structure."  Lew said that Puerto Rico's situation requires "a collective action" and "the immediate attention of Congress."  Puerto Rico has about 18 different debt issuing entities that together owe about $72 billion.  Each entity's liability is unique based on the terms of individually negotiated and issued debt.

Puerto Rico's representative (non voting) in Congress has proposed legislation that would permit Puerto Rico's public bond-issuing entities to file for protection under Chapter 9 (H.R. 870). Chapter 9 of the Bankruptcy Code is titled "Adjustment of Debts of a Municipality."  Chapter 9 does not provide a way for a state government to adjust its debts.  Instead, only "a political subdivision or public agency or instrumentality of a State" (a "municipality") may be a debtor under Chapter 9, and only if the municipality is "specifically authorized... to be a debtor under such chapter by State law" or by a State officer empowered by State law to authorize it.  11 U.S.C. sec. 108(c) (requiring also that the debtor be insolvent, wants a plan to adjust its debts in Chapter 9, and has made an effort to work out the debt problem outside of bankruptcy).  The term "State" includes both D.C. and Puerto Rico "except for the purpose of defining who may be a debtor under chapter 9..."  11 U.S.C. sec. 101(52).  So, the proposed legislation amends current law to make Puerto Rico a State for purposes of access to Chapter 9 by Puerto Rican "municipalities". 

Even if Congress acts to amend 11 U.S.C. sec. 101(52) to open chapter 9 to Puerto Rico's municipalities, it's hard to imagine a bankruptcy court-supervised process that might yield economically and politically feasible plans of reorganization for Puerto Rico's municipalities.   Secretary Lew noted in his letter to Senator Hatch the mainland political issue ticking like a bomb within the Puerto Rican debt crisis.  Lew stressed that special bankruptcy legislation is not a "federal bailout."  And, he noted that a court supervised restructuring in a "tested legal bankruptcy regime" could mitigate "further harm [to] retiree investment portfolios across the country" that hold Puerto Rican debt.   More than 20% of mutual bond funds own Puerto Rican bonds according to Morningstar (377 funds out of 1, 884),  In 2012, Puerto Rican government agencies were the second busiest borrowers in the municipal bond market.  Only municipal bond issuers in California were busier.  (California's population is 10 times bigger than Puerto Rico's). Puerto Rican public agency bonds have long been popular because of high yields and triple tax exempt status (federal, state and local).  

How would municipal bond funds fare as creditors in chapter 9 relative to their chances outside of Chapter 9?  In Detroit's bankruptcy, bondholders were happy that the bankruptcy court ruled that union pension claims were not entitled to priority in payment, notwithstanding Michigan law which protected them.  (Contrast the preferred treatment United Auto Workers got in the GM restructuring in its June 2009 bankruptcy, which was achieved with significant Obama Administration intervention outside of bankruptcy.)   On the other hand, bondholders under Detroit's bankruptcy plan did take less than the full amount of their claims  and ultimately settled their objections to the confirmation of the plan on grounds it favored city pensioners over bondholders.  Even in a "tested legal bankruptcy regime" like Chapter 9, politically powerful groups can press their advantage and unlovable "Wall Street" creditors will absorb disproportionate pain.  

Several groups have considered Puerto Rico's financial situation and proposed in very general terms,  pathways out of the current financial disaster:  The New York Federal Reserve, Update on the Competitiveness of Puerto Rico's Economy (2014, updating 2012 report); Anne Kreuger, Rajut Teja, and Andrew Wolfe, Puerto Rico- A Way Forward (June 29, 2015); Centennial Group International, For Puerto Rico, There is A Better Way (July 2015).  The Centennial Group prepared its report for a group of hedge funds that hold Puerto Rican bonds.  Not surprisingly, the report recommended fiscal austerity and structural reform rather than write down of bond debt.

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