I find it ironic that Lin Manuel Miranda, best known for his phenomenal creation of the Broadway show Hamilton, advocates for a complete debt forgiveness for Puerto Rico. He is not alone of course as the usual suspects in government are on the same boat. Martin Guzman, Joseph Stiglitz and Antonio Weiss, just released an op-ed in the Washington Post advocating for a total debt write-off too. Stiglitz is really the go-to guy whenever politicians are attempting to run away from their financial obligations across the globe, as he has seemingly never found a debt that should be repaid.
He is like the psychiatrist that will always say the defendant is mentally incapacitated regardless of the facts. Weiss’s involvement is even more distressing as he is essentially advocating that Puerto Rico breaks the law, which he helped Congress create via not respecting the Puerto Rico Constitution, or contracts.
Alexander Hamilton was the leading man in creating the economic dynamo that is the U.S. financial system. In 1789, the United States had $75MM in total debt. More than $44MM was owed to American citizens that had purchased war bonds during the revolution. Many of the original purchasers of these bonds had either passed away, or sold them at large discounts. Leaders such as James Madison, argued that the government should pay the market value of the bonds, rather than face value, which was far higher of course.
Others believed that the government should discriminate between the original purchasers or the debt and the speculators that had paid a lower price. In 1790, Hamilton’s “Report on the National Credit” was revolutionary. He recommended paying off the entire national debt at full face value and assuming all existing state debt. He understood that if the new nation failed to honor its obligations, citizens would lose faith in the credit and integrity of the new government.
Major creditors such as France would also lose faith. The new nation would have zero access to credit, which is the lifeblood for economic growth. Fortunately for all of us, Congress approved these proposals and the rest is history! I understand that Miranda and politicians advocating for debt forgiveness have their hearts in the right place, but ignorance of financial realities doesn’t do anybody any favors. Instead, it would promulgate the injurious behavior to other municipal governments. Investors would lose faith that the United States honors its laws and its constitution.
The issue is not Puerto Rico’s capacity to pay. Puerto Rico’s economy was outperforming expectations prior to the hurricane as measured by tax collections. The current financial situation is bad but there are considerable revenues, and much more could be generated via reducing government waste and inefficiency, such as its inability to collect on taxes due. The real issue is Puerto Rico and the Oversight Board’s willingness to honor its obligations.
The Oversight Board was created to instill fiscal discipline and to allow Puerto Rico to regain affordable access to capital markets. In doing this, it is required via Promesa, to “respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreement of a covered territory or covered territorial instrumentality in effect prior to the date of enactment of this Act.”
The Oversight Board and the government of Puerto Rico have done everything possible to break this law. They have refused to share basic economic assumptions with creditors, which are the foundation of their fiscal plans. Even worse, they have used the carrot of information that should be forthcoming, to try to obtain additional concessions from creditors. They have attempted to break pledges and liens that are the bedrock of our financial system.
In the fiscal plan that was approved for the commonwealth earlier in the year, the Oversight Board makes no attempt to differentiate between essential and non-essential expenses. This flies in the face of the plain language of Promesa. The Puerto Rico constitution also prioritizes GO debt over all expenses, including employee salaries.
The fiscal plans approved by the Oversight Board grossly underestimate our federal government’s commitment to the people of the commonwealth, by assuming no renewed federal healthcare funding, despite the U.S. government budgeting $1 billion for it. The fiscal plan includes a $600MM per year slush fund, which flies in the face of the Oversight Board’s purpose of budget restraint and accountability.
It is utterly terrible that Puerto Rico got hit by a hurricane and its people are struggling. I’d encourage anyone with the means to donate, and it is so inspiring to see people coming together across the country to donate their time and money to help their fellow citizens through these disasters. Remember though, many other areas have been hit by natural disasters including Houston, California, and the Florida Keys, and nobody is suggesting defaulting on their debt.
A hurricane certainly has the power to destroy your home, but it doesn’t take away your legal rights. This is a fact that seems to have slipped most people’s consciousness. Nowadays people seem to look at Detroit’s bankruptcy with rose-colored glasses, but was their situation really that different than Puerto Rico? Detroit faced a far greater population exodus and its primary manufacturing industry had been decimated by the Great Recession.
Most of the rich had migrated to the suburbs, and no offense to Detroit, Puerto Rico is quite a bit more desirable for tourism. Many of the homes were decrepit and filled with vagrants. Crime was rampant. Detroit still paid 74 cents on the dollar on their UTGO bonds. What type of precedent does the Oversight Board really want to create here?
If I were to issue debt backed by a sales tax, but instead of forwarding the sales tax to pay the debt service as mandated via contracts, I embezzle the funds, I’d go to jail. That is essentially what Puerto Rico’s government is doing with its Cofina creditors. In fairness it is Judge Swain who ordered Cofina funds held at the trustee to not be distributed until she makes her rulings, but it is the Oversight Board, which is leading the court down this path via a total disregard for ironclad contracts.
Despite a slowdown from the hurricane hurting the 4th quarter financial results, the Cofina revenue to debt service coverage ratio is 1.3. How do you justify not paying that? In another flagrant breach of trust, Puerto Rico has diverted revenues from fees such as Tolls and DMV registrations, which back bond issuances of their Highway Transport Authority, into their general account, while failing to pay creditors.
They rationalize this by invoking their “clawback” rights, but they ignore the fact that the only legal use for the “clawback” is to pay interest and principal on the GO debt when the Commonwealth is deficient. Obviously, they aren’t paying that either.
Promesa was created to provide a path towards restructuring the debt, favoring consensual negotiations. Creditors of PREPA had worked for years with the company and the government to create a consensual restructuring. Promesa even outlined that it expected the Oversight Board to honor preexisting agreements. Instead, the Oversight Board rejected it and PREPA has been an absolute disgrace in how it has handled the recovery from the hurricane, brought to the public’s attention by the infamous “Whitefish” contract.
On a personal level, one can only have the utmost compassion for the citizens of Puerto Rico that have been hurt for decades by the impact of this irresponsible government and now these hurricanes. 2017 has been a year of natural disasters and unfortunately, people all over the country are having to rebuild their lives due to no fault of their own. Now of course there are short-term negative financial impacts from the hurricane, as businesses have shut down, people have relocated, etc.
With that said, the long-term impact financially is likely to be very good despite what you hear. Firstly, you have a massive influx of cash coming into the economy from insurance claims. Like elsewhere in the United States, this stimulates the economy, and as we have seen after numerous disasters, growth accelerates after the initial dip. Think about New Orleans after Katrina, New York after Sandy, or Japan after its earthquakes and tsunamis.
In addition to insurance funds, the Federal Government is providing massive disaster assistance to Puerto Rico, Florida, and Texas, which is consistent with what they always do in cases of natural disasters. The hurricane is also forcing politicians to consider how Puerto Rico is treated via Medicaid and controversial laws such as the Jones Act, which ultimately will be another positive for the island.
Puerto Rico is a highly desirable place and if the government makes it a friendly avenue for business, entrepreneurs will flock there. None of this would happen though if they completely shatter the municipal bond market as we know it via a reckless lack of respect for the law and property rights. Once again, growth is likely to accelerate considerably after the initial dip.
Instead of taking a balanced view of things though by factoring in a decline in revenues short term and an acceleration long term, the Oversight Board is trying to blind the public. They are changing the 10-year fiscal plan to a 5-year fiscal plan, so that it captures the forecasted economic decline and not the recovery. This is important because the fiscal plan is the basis for the plan of adjustment, which then must be approved by Judge Swain.
Just as bad, the OB is demanding the submission of the new fiscal plan on December 22nd, before we even have clarity on key issues such as additional federal government assistance to the island, or even changes to the tax code. Clearly, this is a transparent ploy to make things look as bad as possible, as opposed to focusing on creating a feasible plan, with realistic data.
The OB understands that any upstanding judge that follows the law and has basic common sense, would ultimately reject any plan of adjustment based on these faulty facts, not to mention the complete incompatibility with Promesa. The idea behind the strategy is clearly to create a situation so dire for creditors that they ultimately agree to smaller recoveries than they are entitled to from the financial realities and their legal positions. The other idea is basically to spook creditors further and continue to drive down bond prices. I highly doubt that the struggling island’s residents that own these bonds are very appreciative of this.
While it is common for some media pundits, academics, and politicians to demonize creditors as “vultures,” the reality is quite different. The government of Puerto Rico just reported that as of 6/30/2017, $12 billion in PR bonds, are held by local investors. Almost all the rest is held by U.S. citizens and taxpayers. If I’m a citizen of Puerto Rico or anywhere else and I don’t want to wait the years it will take for the restructuring to be resolved and I need liquidity to pay bills or to generate income, is the person buying the debt a greedy opportunist?
Who are the investors in the mutual funds and hedge funds that have invested in Puerto Rico for decades? Are bond insurers who have allowed cheaper access to credit for Puerto Rico for decades immoral for asking for contracts and the rule of law to be honored? These people invested capital into the island to build infrastructures such as schools and roads.
Nobody is asking for a bailout except the government of Puerto Rico and its enabler, the Oversight Board, which wants a bailout from making the reforms necessary to the egregious policies that have created this mess in the first place. Greece, which is often compared to Puerto Rico, has begrudgingly made tremendous strides in reforming and its ten-year debt recently traded at an affordable 4.42% yield. It is a clear example of constituents such as the government and creditors working together to create a win-win, most importantly for the citizens of Greece.
Imagine what would have happened to other sovereign debt had Greece’s debt just been wiped out. Do you really think that Portugal, Spain, and Italy would be able to access capital markets? Conversely, what would the impact be on Chicago, Connecticut, and New Jersey if you wipe out the debt of Puerto Rico? Detroit still cannot access capital markets without guarantees due to the terrible precedent it set with how it restructured its GO debt where it flouted the priority status of the bonds in lieu of pensions.
Chicago just issued billions in debt backed by taxes because it couldn’t access capital affordably via GO debt. This is the same structure used by Cofina that the government of Puerto Rico is trying to break apart in its restructuring by saying that the funds should go in its general fund. Good luck selling that type of bond again if some terrible precedent is set by how that debt is treated in Puerto Rico.
Clearly, the Oversight Board has a tough job, so I am going to try to help it, and Puerto Rico doesn’t need to pay me half a million dollars a year like they pay the head of the Board, Natalie Jaresko. Firstly, be 100% transparent on the economic assumptions used in any analysis that will be used in the restructuring. Follow through on your responsibility to instill fiscal discipline on the island. This includes releasing updated and audited financial statements.
Puerto Rico’s latest one submitted was 2014. Work together with creditors towards more consensual restructurings such as the original deal with PREPA. Doing this would create workable solutions instead of initiating years upon years of litigation. Creditors are not all heartless bastards. The whole world is hoping and praying for the people of Puerto Rico and creditors are realistic in that they must make concessions and take haircuts. They have done this many times before in Detroit, Jefferson County, Stockton etc.
Dealing with creditors in a mature and fair manner will encourage private capital into investing in the island. Savvy investors such as John Paulson have already invested heavily in the island and I’d bet a lot that much more would be forthcoming if there was confidence that the government would act in a fiscally responsible manner, and that the Commonwealth would respect property rights. I certainly wouldn’t open my wallet to invest capital into any territory that has no regard for property rights.
For the government-run public entities such as PREPA, PRASA and the HTA, possible debt for equity opportunities might be negotiated. All of these entities generate considerable revenues, so it also wouldn’t be a stretch for them to simply service their debt with improved collections, and more efficient operations. A debt for equity swap would greatly reduce the debt load, increase productivity, and reduce the inefficiency of the enterprises.
No doubt the government of Puerto Rico would fight this aggressively as it would greatly negate its capacity to promote unqualified political allies to key roles and high salaries. The citizens of Puerto Rico would benefit greatly of course though as it would fuel investment dramatically, providing much-needed job opportunities. I highly doubt that 35% of Puerto Rico would still be without electricity several months after the hurricane had PREPA been a privately-run enterprise.
A more efficient HTA too would stimulate commerce and private capital can help fix a dilapidated infrastructure. Why does Puerto Rico feel like its government should run these utilities anyways? A two-year debt moratorium would be reasonable to boost liquidity considering these disasters, and debt can be extended, interest rates can be lowered. The weakest credits such as appropriation bonds and other unsecured debts would likely be written down to zero.
The senior debt such as GOs and Cofina should face minor haircuts, if any based on their immensely strong legal protections. This would greatly bolster access to capital markets once again. PREPA, PRASA, and HTA should have capital structures consistent with their revenue streams.
One outside the box idea if the U.S. government wants to take an even more proactive approach would be open market purchases of Puerto Rico’s debt. Many of these issues are trading for 25-35 cents on the dollar based on the uncertainty involved. As the restructuring process is completed, profits on these bonds would help defray the costs of aid to the island. Or, if they prefer, the government could only demand payment at the price that they paid for the bonds, which would result in a large windfall for the Commonwealth of Puerto Rico, while not costing U.S. taxpayers losses.
This isn’t much different than what the original TARP plan was to buy distressed mortgage backed securities and you aren’t taking away anyone’s legal rights. While the government instead opted for a different approach for TARP that also proved very profitable for taxpayers, subprime mortgages ultimately became one of the best investments made during the crisis and after. The short-term mark to market reduction in prices during the crisis greatly understated the actual economic value of the bonds, so smart buyers bought into the panic.
I believe the same situation exists in the bonds of Puerto Rico given the actual financial data for Puerto Rico and the legal protections on the securities. I’m not advocating for this approach but U.S. Treasury Secretary Steve Mnuchin is a smart guy, and I’d be surprised if this thought hasn’t crossed his mind given his background with distressed debt.
Lastly, I want to be clear that I am an investment manager for a small registered investment advisory. My clients aren’t the super-rich but instead are generally middle-class folks that pay taxes and rely on me to help fund their retirements via successful investing. We have investments in bond insurance companies, which we’ve been investing in for the last 8 or 9 years. Obviously, we are long-term investors and are not just interested in flipping securities for a quick profit.
Recently, I’ve been buying a small amount of the bonds of Puerto Rico because I believe the future is far brighter than current prices would imply. If the Oversight Board were to follow my recommendations, I’d happily donate any personal profits on these bonds to Puerto Rico as charity. Most of all, I don’t want to see the formula that has made America so great, get tossed aside. Rule of law and respect for property rights are some of the greatest attributes of our government that separates us from the likes of Venezuela. Let’s not go backwards and turn into a banana republic by following the path advocated by the Oversight Board.
Disclosure: I am/we are long AGO, MBI, AMBC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As stated in article, I've recently bought a small amount of Puerto Rico bonds of various classes.