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Puerto Rico Could Really Use a Bankruptcy

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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I'm pretty much a tourist when it comes to Puerto Rico, but I offhandedly suggested this morning that it might be a good idea if Puerto Rico could restructure its debts in an organized way mediated by a legal tribunal with the power to bind both Puerto Rico and its creditors. I don't just think that about Puerto Rico; it's kind of my default (sorry) view. I think it about companies, though I don't spend much time thinking it about companies, because bankruptcy law exists precisely to provide an organized, mediated, binding way for companies (and individuals) to restructure their debts. With companies, it's easy.

QuickTake Puerto Rico's Slide

I also think it about countries, though there it's not so easy. You could imagine an organized mediated bankruptcy process for countries, but it's hard to imagine a binding one. Like, Argentina and Elliott Management could go to the Imaginary Sovereign Bankruptcy Court, and the court could order Argentina to pay Elliott, and then Argentina could say no, and then what? The whole point of sovereigns is that they are sovereign, so they don't have to listen to the courts of other countries (or to imaginary international courts). As Elliott has in fact found out.

Argentina did go through a bankruptcy-ish process in 2005 and 2010, and got most of its creditors to agree to a restructuring, but that agreement didn't bind the creditors who disagreed, and so Argentina's default has continued untidily for, let's say, ever.  And people recognize that this is a problem, and there are various suggested improvements to make sovereign debt restructuring tidier and less subject to holdout problems. This is not just a matter of tidiness: If a borrower's debts are unsustainable, it can be in everyone's best interests to restructure them; creditors would rather get 60 cents on the dollar than nothing. But if everyone else agrees to take 60 cents, and you don't, and the restructuring makes the debt sustainable and you get your 100 cents, then you should do that. And if you should do that then everyone should do that, so the restructuring doesn't get done, and everyone is worse off.  So some method of binding everyone to an agreement would make everyone better off. That method is, customarily, called "bankruptcy."

So a sovereign bankruptcy process might be nice, but it would also be difficult. But a Puerto Rico bankruptcy process might also be nice, and that would be relatively easy. Puerto Rico is only sort of a sovereign: It is a U.S. territory and subject to U.S. law, so unlike Argentina, it can't just ignore U.S. court decisions.  And the U.S. already has a bankruptcy law for municipal bond issuers. It's called Chapter 9. Puerto Rico's issuers aren't allowed to use it.

(Here is a complication that you either won't care about, or will care about very deeply. It would be very hard for Puerto Rico to use the normal U.S. municipal bankruptcy process to restructure its bonds, and not just because Chapter 9 doesn't currently apply to Puerto Rico. Chapter 9 also doesn't apply to states: It can only be used by municipalities, including cities, counties, state agencies, etc., not the states themselves. Of course Puerto Rico isn't a state, but, you know, by analogy, etc. Also Puerto Rico's own constitution requires it to make payments on its general obligation bonds before any other payments, further complicating the prospects of imposing bankruptcy on its creditors. On the other hand, a lot of the debt that Puerto Rico is looking to restructure is the debt of its public corporations, including its electric power authority: "Of Puerto Rico’s $72 billion in bonds, roughly $25 billion were issued by the public corporations," and only $13 billion are general obligation bonds. The public corporation bonds might be eligible for Chapter 9 if Puerto Rico was a state -- except that those bonds are largely "special revenue" bonds, which also can't be adjusted in Chapter 9. So Chapter 9 is not quite the solution -- though some sort of customized federal bankruptcy process, or federal financial control board, might be.)

So, sure, a way for Puerto Rico to restructure at least some of its debt in a binding way would be nice. Last year Puerto Rico tried to invent its own bankruptcy process -- the Public Corporation Debt Enforcement & Recovery Act -- but that didn't go very well. (A federal court found it unconstitutional. ) But using the regular one, or some variant thereon, remains an outside possibility. Here is an amusing article from last month about how people are lobbying Congress for and against letting Puerto Rico use Chapter 9, and contesting ownership of a certain word:

One side argues that passing a bill allowing Puerto Rican government agencies to restructure their debts will stave off an eventual bailout of the whole island. The other side says that’s all wrong: The very act of approving the legislation will constitute a bailout.

The first argument is easy enough to understand: If Puerto Rico can't restructure its debts, and if it doesn't have the money to pay them back, it will have to go to Washington to ask for money. (Obviously Washington can say no, as it seems to be saying.) The second argument is ... well, also easy to understand, but not how we normally use the word "bailout" around here. When I say that Greece or Citigroup or AIG got a "bailout," what I mean is that someone came in and gave Greece/Citi/AIG a big pile of money, and then Greece/Citi/AIG went and handed that money to its creditors. What a "bailout" normally means in financial jargon is that someone borrowed too much money, and someone else then made sure that the people who loaned the money got paid back anyway. Letting Puerto Rico use Chapter 9 would be the opposite of a bailout: It would be someone else coming in to make sure that the people who loaned the money didn't get paid back in full.

There are various reasons that people don't like bailouts, but the big one is moral hazard: It is much easier to run up unsustainable debts if your creditors know, or suspect, that they will be paid back no matter how much trouble you get in. One theory of how Greece ran up so much debt is that lenders thought there was an implied promise that no euro country would ever default: Greece borrowed not just on its own credit but on the implied support of the rest of the eurozone. With banks, people worry about the "too-big-to-fail subsidy," which is the amount of interest that big banks might save because their creditors think that the government would bail them out in a crisis.

Puerto Rico, obviously, has borrowed too much money, which necessarily means that people have been lending it too much money. Back in February Kristi Culpepper wrote that "hedge funds will continue to stuff Puerto Rico like a giant debt piñata until a shift in capital flows busts it open." She attributed hedge funds' willingness to lend Puerto Rico money that it couldn't pay back to low interest rates and a lack of compelling distressed corporate credit opportunities.  A lack of transparency about Puerto Rico's finances may also have contributed; the "most starting finding" in Anne Krueger, Ranjit Teja and Andrew Wolfe's report on Puerto Rico is "that the true fiscal deficit is much larger than assumed." Another possible culprit is Puerto Rico's unique tax status, which makes its bonds exempt from both federal and state taxes and thus irresistible to investors.  

But there may also be some blame for a legal structure in which Puerto Rico's public corporations, uniquely, are subject to U.S. law but not eligible for U.S. bankruptcy.  Unlike lending to Argentina, lending to Puerto Rico avoids the risk that the borrower will change the law on you.  Unlike lending to Detroit, lending to Puerto Rico avoids the risk that your bonds will be restructured in bankruptcy without your consent. Puerto Rico's legal position encouraged investors to lend it too much money, and pay too little attention to whether it could pay it back -- because they knew that, legally, it couldn't not pay it back.

That doesn't quite prove that the legal position should be changed now. The overborrowing has already happened, so changing the law now won't help with that. It's true that giving Puerto Rico bankruptcy protection would insulate it from the consequences of its profligate borrowing. (Of course, that's true of any bankrupt debtor, and yet bankruptcy exists. And denying Puerto Rico bankruptcy protection would insulate its lenders from the consequences of their profligate lending.) And there's a fairness argument against changing the law on people who loaned Puerto Rico money based on their then-existing legal protections. I'm not sure how compelling that is: If Puerto Rico doesn't have the money to pay them back, they're not getting paid back; the benefit of a bankruptcy process is not so much that it would reduce Puerto Rico's payments as that it would do so in an organized, fair, legal way.  

As it is, it's kind of a mess. Puerto Rico's government "will develop a debt-restructuring plan by Aug. 30" and present it to creditors. It was already negotiating with bondholders -- and bond insurers and the trustee -- of the Puerto Rico Electric Power Authority, whose bonds have the most immediate payments.  Any plan will have to be agreed to voluntarily by the creditors, meaning that maturity extensions will be more likely than principal write-downs, and coordinating negotiations among the various sets of creditors will be difficult. "The debt restructuring process is likely to be protracted and legally contentious," says Moody's. "Negotiations with creditors will doubtlessly be challenging: there is no US precedent for anything of this scale and scope, and there is the added complication of extensive pledging of specific revenue streams to specific debts," says the Krueger report. The state of the law makes it hard for Puerto Rico to fix its debt problems -- and also made it easier for it to create them.

  1. Not literally. Though wouldn't it be amazing if I was vacationing in Puerto Rico while my editor vacations in Greece?

  2. Also this morning the Bloomberg View editors, less offhandedly, endorsed this view.

  3. There are a lot of -- pretty compelling -- objections to the fairness of Argentina's 2005/2010 restructuring, but that's not the point here.

  4. Feel free to pretend I used a bunch of game-theory-ish words there.

  5. Though try telling that to Texas, har har har.

  6. Here is the opinion. Puerto Rico appealed, but the decision seems straightforward enough to me: Bankruptcy, in the U.S., is federal, and states and territories can't create their own bankruptcy mechanisms that conflict with the federal one.

  7. I have heard similar things said about Argentina: If you're a distressed-credit fund, and there are no distressed companies, you go looking for distressed sovereigns. And sometimes get in way over your head.

  8. Culpepper again:

    Puerto Rico has the distinction of being triple exempt. For this reason, the debt of Puerto Rico and its agencies has been uniquely desirable to mutual funds and other investors historically. This has provided an artificial source of demand that has allowed the island to borrow billions of dollars even as it approaches insolvency.

  9. That "uniquely" is a cheat; that sentence sort of describes U.S. states too, though states, unlike the Puerto Rico Electric Power Authority, in theory have the advantage of sovereign immunity. And special revenue pledges in other municipal bonds survive bankruptcy too.

  10. I mean, it tried, but failed -- see footnote 6.

  11. If you owned Puerto Rico's bonds, you might object that bankruptcy eligibility makes default more likely ex ante, but of course now the default has more or less already happened. When the governor publicly announces that the debt won't get paid, that's what a default is. So now the question is just, ex post, how ugly will the process be.

  12. Those bonds do not seem to have any supermajority modification provision under which most of the holders can bind the rest to a restructuring: 60 percent of the holders can agree to a modification, but not a modification that involves an extension of maturity or a reduction of principal or interest. (See page I-17 of the offering document.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Tobin Harshaw at tharshaw@bloomberg.net