Bankruptcy for Puerto Rico?
If you overspend yourself into debt that you cannot repay, you have the unpleasant but useful option of bankruptcy. Businesses have that same option. So do county governments and cities, as Detroit illustrated in 2013. However, by federal law, states and territories do not have bankruptcy protection as an option. The case of Puerto Rico may test the boundaries of what is acceptable for states suffering from crushing debt obligations.
On May 2, Puerto Rico was unable to make a $422 million debt payment, submitting just $23 million to cover the interest component. A nearly $800 million payment is due on their general obligation debt on July 1, and governor Alejandro Garcia Padilla already announced that he did not expect Puerto Rico to make that payment. The overall debt for Puerto Rico is estimated at $70 billion.
A Grim Economic Situation
Like most entities unable to pay their bills, Puerto Rico did not get this way overnight. Years of bad fiscal policy have contributed to the mess. A White House fact sheet on Puerto Rico's crisis blames historically unrealistic estimates of revenue along with poor fiscal discipline and opaque disclosure laws, concluding that "annual budgets masked recurring structural deficits." Looming in the background is a major pension crisis. As of fiscal 2014, the three public Puerto Rican pension funds had approximately $2 billion in net assets to accommodate nearly $46 billion in estimated pension liabilities.
Economic growth alone can't solve this problem, and even if it could, it’s hard to imagine what might spark and sustain Puerto Rican growth. Since the early 2000's, the island’s population has dropped to near-1990 levels. Those who remain skew older and are generally not seeking work; the labor force participation rate is under 40%. Poverty levels are an astronomical 45%, and the prospect for attracting further investment in the territory’s public debt is remote, as the current bond fiasco makes plain.
The longstanding popularity of Puerto Rican debt is a big part of the problem. They were a favorite purchase for mutual funds and hedge funds because of their relative low cost and a mistaken belief that Puerto Rico's economy would rebound. Now, investors are just hoping to minimize their losses.
Consequences beyond Puerto Rico
Congress is now considering options for dealing with Puerto Rico's economic crisis. All agree that some form of oversight is necessary, but what form will it take? Some argue that a form of bankruptcy is necessary to give Puerto Rico the financial tools necessary to recover, but that will require legislation reversing 1984 legislation specifically prohibiting Puerto Rico from declaring bankruptcy.
In the meantime, the Government Development Bank (the primary fiscal agent for Puerto Rico) has worked out a tentative restructuring deal with some of the island's creditors. That plan will also require legislation from the federal government, and it is unlikely that everyone's goals will be met by whatever Congress decides to do.
There are a series of potential legal and financial minefields regardless of the path taken. Creditors who are left behind in bankruptcy could argue unconstitutionality from several directions, including the contracts clause and even the 10th Amendment; bankruptcy would put Puerto Rico under a federal judge's authority, violating sovereignty — if sovereignty applies to a territory.
Financially, bankruptcy would cause a reassessment of the safety of state bonds, sending the message that states can't simply overspend and expect to be bailed out by the taxpayers. Funds and individual investors will likely adjust risk factors accordingly, and as a result, some states may have greater difficulty raising necessary capital.
State politicians may also decide that if a bankruptcy option is available, that is preferable to the necessary (and fiscally responsible) raising of taxes or cutting of services. We suspect several state governments with huge debt problems, led by Illinois, are closely monitoring what happens in Puerto Rico to find a way out of their current mess.
Analysts in Illinois project $131 billion in pension commitments already earned with only $46 billion to cover them. That's a whopping $85 billion in unfunded pension liabilities alone. Illinois may not be far away from a tipping point where bankruptcy is inevitable — and while Puerto Rico seems remote to many Americans, the concept of a bankrupt state in the heartland will be hard for Americans to accept.
Treasury Secretary Jacob Lew prefers the legislative path. He has asked Speaker of the House Paul Ryan to provide "an orderly process to restructure" Puerto Rico's debts, combined with "strong, independent fiscal oversight," specifically avoiding the mention of bankruptcy.
Taxpayer bailout is another potential option, but in an election year, that is a particularly toxic — and unlikely — option. However, if you are a creditor expecting that you could be squeezed out under bankruptcy or legislation with a similar effect, a taxpayer bailout sounds great to you.
Who Gets Stuck with the Check?
In a typical bankruptcy, the hierarchy of creditors is fairly straightforward. In the case of Puerto Rico, with the potential for a legislative variant or a taxpayer-funded bailout, expect a great deal of behind-the-scenes maneuvering to make sure that certain creditors get preferential payouts. Mutual and hedge funds have huge investments in Puerto Rican bonds, and they are none too pleased about the potential losses. Pensioners will almost certainly have their pensions cut significantly; the only question is by how much. In the case of Detroit, pensioners lost up to 18% of their benefits. Puerto Ricans are likely to suffer even greater cuts based on the magnitude of the shortfall compared to skimpy revenues.
A taxpayer bailout spreads the pain more evenly across America, but that will be poorly received throughout the nation (as it should be). As with bankruptcy, bailout of a state government runs the risk of encouraging poor fiscal practices at the state level.
It is fair to blame the federal government for part of the problem through unfunded mandates to states and the increased use of the carrot-and-stick approach to enacting policy (such as Medicaid expansion and federal funding). It's hard for the federal government to chastise states for poor fiscal decisions when they are increasingly contributing to the problem.
Keep a close eye on how Puerto Rico's debt is resolved, because the resolution should provide a clue to how similar future crises will be resolved. A day of reckoning may come for several states that are dealing with combinations of current debt and future obligations — as well as the lack of political will to take unpopular policy measures to correct the problem.
Puerto Rico will likely end up taking a relatively traditional method of dealing with its debt through a federal oversight board as Congress is reportedly proposing, but we are living in such bizarre economic and political times that nothing can be taken for granted. When central bank interest rates are negative and one of the major presidential candidates (guess which one) tells you that he intends to reduce the national debt by negotiating the debt down with creditors — essentially undermining the "full faith and credit" of the United States Government and shaking worldwide faith in US Treasuries — how can anything be ruled out?
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