Home > Uncategorized > We Should Extend Chapter 9 to Puerto Rico

We Should Extend Chapter 9 to Puerto Rico

July 13, 2015

This is a guest post by Marc Joffe, a former Senior Director at Moody’s Analytics, who founded Public Sector Credit Solutions in 2011 to educate the public about the risk – or lack of risk – in government securities. Marc published an open source government bond rating tool in 2012 and launched a transparent credit scoring platform for California cities in 2013. Currently, Marc does municipal finance policy research for the Haas Institute for a Fair and Inclusive Society at UC Berkeley.

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 Buyerearlier 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.

PR debt:GNP ratio

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.

Categories: Uncategorized
  1. July 13, 2015 at 3:54 pm

    Thank you this report. I hope that Congress will act to help Puerto Rico, not harm it.


  2. July 13, 2015 at 5:05 pm

    Didn’t Puerto Rico get loans under the assumption that they could NOT declare Chapter 9 bankruptcy? What do we do for the creditors when we change the rules in the middle of the game? “that is all that really counts” doesn’t really do it.


    • July 13, 2015 at 5:08 pm

      I think this post explains the answer to that question. There is no bond you can buy that has no chance of default, except for perhaps US bonds. Also, why does it matter if the default comes through bankruptcy?


      • July 13, 2015 at 6:11 pm

        Because the default is now more likely than it was when you bought the bond, no?


  3. fc123
    July 13, 2015 at 5:31 pm

    This article is a very naive way of looking at default risk.

    “We can confirm that investors knew of the existence of default risk by comparing Puerto Rico bond yields to risk free interest rates.”

    Yeah, but that does not mean the spread can be attributed to a particular cause. You can as easily argue bond holders were properly compensated for the risk that *if the bond covenant was followed to the letter* they would not get their money back, and were pricing in other risks (builds a Jurassic Park and the critturs gets free, asteroid hits the island, everyone leaves etc).

    More realistically everyone trading some govt entity/sovereign debt knows there is some risk there will be reneging (govt can change the rules of the game and does, and hence something like the Ch 9 changes sought). But in case of a state/territory it is clearly understood there will be a hell of a court fight and the bondholders interest will only be put second in extremis — and while grim not clear PR is there yet.

    Put another way: Puerto Ricans already were compensated for the hellish difficulties they will face to change the rules, by the lower interest rate they got on their bonds earlier.

    GO status is an asset. If Puerto Rico had pledged land or paintings as collateral, no one would dispute the right of the bondholders to call in the collateral for non-performance simply b/c of unwillingness to pay.

    Not saying this is all great, just saying “you bondholders were paid, now give up” is a pretty dumb way at looking at bond default


  4. July 13, 2015 at 6:25 pm

    For a guy so responsible for the AAA ratings Moodys gave on credit related securities from 2005 and on, wreaking havoc on markets and huge losses for many, he sure feels comfortable preaching about what Puerto Rico bond holders should do upon facing staggering losses, Ask him about CDOs. A thousand mea culpas and 1000 years of penance cannot overcome the damage he caused and contributed to.


    • July 13, 2015 at 7:04 pm

      I share your critique of rating agencies, but you make an incorrect assumption about me being “a guy so responsible for the AAA ratings Moody’s gave on credit related securities”.

      I never rated a CDO. I worked at Moody’s Analytics – the part of Moody’s that does not issue credit ratings.


      • July 13, 2015 at 9:08 pm

        Just evaluates them.

        “Led a successful effort to integrate Moody’s CDO collateral data service with Wall Street Analytics CDOnet cashflow waterfall models in 2007. In 2009, took over a similar effort for RMBS – successfully completing that integration in early 2010.
        Engineered the successful relaunch of Moody’s CDOEdge product on a minimal budget using a team of offshore developers.

        From late 2005 to early 2007, as an employee of Moody’s Investor Service, I oversaw product improvements and participated in sales efforts that produced an increase in annual run rate from less than $100k to over $1 million.”


  5. Grwww
    July 14, 2015 at 9:32 pm

    Most of the problems with Money in the world today are related to the amount of cash in circulation. We have a lot of US dollars which are exiting the US economy, never to return because of US tax law. It doesn’t really matter how you slice it, we are at a point in the development of modern society where Money has become more of a burden to the growth of our society than an asset for promotion of non-lazy life style.

    Yes we need workers. But the actual fact is that we have non-workers that are more of a burden to the society without money than they would be if we just let them have a good life style so that they would be bored enough to want to do something creative and productive, because they weren’t constantly focused on trying to “exist” by stealing and rummaging to find food and other resources.

    We put them in jail which is an even larger burden because we put like minded people into a common place where they can all empower each other to do more bad things since we don’t try to repair or assist the broken elements of our society, but would rather punish them for making the wrong choices.


  1. No trackbacks yet.
Comments are closed.
%d bloggers like this: