House Approves Puerto Rico Bailout; Short-Changes Bondholders

Come July 1 is D-Day. On that date, Puerto Rico is set to default on nearly $2 billion in bonds, about $800 million of which is of the general obligation type. In response, Congress is wrapping up legislation that would allow the island to declare Chapter 9 bankruptcy on $18 billion of over $70 billion in outstanding debt. On June 9, the House passed the Puerto Rico Oversight, Management and Economic Stability Act, by 297-127. Senate Majority Leader Mitch McConnell, R-Ky., also vows action. A seven-member board will exercise oversight. Supporters say the bill is a mere restructuring, not a bailout. Don’t believe them. Not only is it a bailout, it is a bailout unavailable to all 50 states. Bondholders will pay. To its credit, the Supreme Court ruled 5-2 last Monday, June 13, that a Puerto Rican law inspiring the House bill violated the U.S. bankruptcy code.

National Legal and Policy Center twice before has explained the origins, dimensions and consequences of the Puerto Rican economic implosion, in December 2013 and again in August 2015. That an implosion is occurring is indisputable. Puerto Rico has an estimated $72 billion (some observers say $73 billion) in outstanding bonds rated near or at “junk” levels. That represents about $20,000 for every man, woman and child on the island. With its population increasingly packing up and moving to these shores – Florida is by far the most common destination – Puerto Rico faces an economic collapse potentially rivaling the one happening in Venezuela. Puerto Rico’s unemployment rate is hovering around 15 percent. A third or more of its residents are on food stamps. The government is rationing water. The union-driven public employee pension system is underfunded by $46 billion. Violent crime, especially murder, is at shockingly high levels. The Zika virus is creating a public health crisis. Puerto Rican Governor Alejandro Garcia Padilla, pleading for aid, testified before the Senate Judiciary Committee last December 2 that his government has “no cash left.” All told, it’s not a pretty picture.

Complicating the economic conundrums is Puerto Rico’s political system, an awkward hybrid of sovereignty, colonialism and statehood. Puerto Ricans have a distinct ethnic and linguistic identity, but they do not have a country to call their own. They increasingly favor statehood, but their support is far from overwhelming. An independence movement has existed for decades, but it represents a small minority. The relationship between the territorial government and our own remains cordial, but strains are showing. Having to cover debts will do that to a country. And U.S. investors may have to cover them. Back in 2013, when it had become clear that a bad situation had become intolerable, three out of four of the more than 400 municipal bond mutual funds in this country had at least some Puerto Rican bonds in their portfolios; fully 55 such funds had at least 10 percent of their assets in Puerto Rico. If these creditors are denied their income stream by government fiat, it is virtually certain they will file lawsuits. Whether there is anything to collect beyond pennies on the dollar is an open question.

Lawmakers on Capitol Hill have come to see Chapter 9 bankruptcy as the best way to insulate the island from collapse. Having tried a couple of times previously, they have come up with what they see as an acceptable compromise proposal: the Puerto Rico Oversight, Management and Economic Stability Act. The bill, which originated in the House Natural Resources Committee, has a clever acronym, PROMESA, which by no coincidence is Spanish for “promise.” Rep. Sean Duffy, R-Wisc., a key sponsor, promises that the legislation will balance interests of debtors and creditors, while averting catastrophe. Without it, he remarked, “the Puerto Rican government is likely to collapse, participants in public pension plans will be terribly damaged, and almost all bondholders could lose their investments.” House Minority Whip Steny Hoyer, D-Md., likewise stated: “In a world of alternatives, this is an alternative we need to take.” House Speaker Paul Ryan, R-Wisc., House Minority Leader Nancy Pelosi, D-Calif., and Treasury Secretary Jack Lew each have expressed support as well. Speaker Ryan (in photo) put it this way on the eve of the House vote: “This bill prevents a bailout. That’s the entire point. If we do not pass this bill, then there is much more likely going to be a bailout because there is no other choice.”  He got his wish on June 9.

The Senate is likely to take up a vote soon. Majority Leader Mitch McConnell, R-Ky., has indicated he wants a vote. He’s likely to run into resistance. Late last year, during a hearing of the Senate Judiciary Committee, Sen. Charles Grassley, R-Iowa, reminded his colleagues: “Let’s not forget that Puerto Rico issued its bonds with the knowledge that Chapter 9 bankruptcy wasn’t an option in the event of default. Is it fair to retroactively change the rules at the expense of these investors, if other options exist for addressing Puerto Rico’s debt problems?” Puerto Rican aid advocates, at least, are getting help from former Senator Judd Gregg, R-N.H. Now a consultant for mainland bondholders, Gregg, in a June 16 editorial for CNBC, praised the PROMESA bill as sound fiscal discipline:

The reality is Puerto Rico finds itself on the verge of economic cardiac arrest following decades of contraction, population flight and excessive spending. Although some interested parties have cast this crisis as a Washington-to-Wall Street issue, it is the Puerto Rican people who have been enduring the plight of poor government accountability and a regressing social infrastructure.

As a policy advisor to institutional and retail investors holding senior bonds backed by Puerto Rico’s sales tax revenues, I counsel a group that has “skin in the game” on the island and seeks to stem migration out of Puerto Rico to the mainland. That is why I have advised supporting legislation that pairs a respect for creditors’ rights with a process for achieving economic stability, government reform and creating an environment for growth.

On the surface, this view appears reasonable. Puerto Rico is experiencing a debt crisis. More than once the island has defaulted on scheduled payments, most recently this May to the tune of $370 million. Chapter 9 bankruptcy would create an opportunity to reorganize. A number of U.S. cities, most notably Detroit and Stockton, have gone the same route and managed to get back on track. Moreover, if the proposal stems the tide of migration from Puerto Rico, as its backers claim, our nation would be spared the expense and time of having to assimilate newcomers.

But before jumping in, let’s understand the downside of all this. Supporters of PROMESA downplay just how Puerto Rico got into this predicament. They gloss over the fact that by making Chapter 9 bankruptcy available to Puerto Rico, we effectively would be assigning to that island a higher legal status than that assigned to all 50 states. They have little or no problem with a grant of Chapter 9 authority to Puerto Rico heightening pressure to elevate the island to statehood. And they are advocating something that in all likelihood will not survive a court challenge. Let us flesh out these and other objections.

First, PROMESA likely is illegal. That’s not mere conjecture. Last Monday, June 13, the U.S. Supreme Court ruled by 5 to 2 that the Commonwealth of Puerto Rico, on its own, cannot file for Chapter 9 bankruptcy. Back in 1984, Congress passed a law explicitly barring this option, which is open to mainland municipalities and special purpose government agencies. Yet in 2014, Puerto Rican authorities, as a desperation move, passed something called the Recovery Act that would restructure more than $20 billion worth of debt. Creditors sued to invalidate the law, arguing that it ran counter to the U.S. Bankruptcy Code. A Boston federal circuit court in February 2015 ruled in favor of the creditors. Puerto Rican officials promptly appealed to the Supreme Court, winning legal standing in December. But last week on June 13 the High Court ruled that federal law must prevail. Writing for the majority, Justice Clarence Thomas stated: “The plain text of the Bankruptcy Code begins and ends our analysis.” Had Congress wanted to allow Puerto Rico to adopt bankruptcy provisions like this, he argued, it “would have said so.” Granted, PROMESA is not the Recovery Act. Yet the motive behind each law is similar. If the Supreme Court can invalidate the Recovery Act, it is capable of doing likewise with PROMESA, especially given that the bill runs counter to the Puerto Rican constitution (Article VI, Section 8), which states “interest on the public debt and amortization thereof shall be paid first.” Constitutionally-issued debt, as Rep. Tom McClintock, R-Calif., noted in his floor speech, is fundamentally different from standard government debt.

Second, the debt crisis has the words “Made in Puerto Rico” written all over it. Territorial leaders and allied interest groups may carp all they want, but it was decades of domestic incompetence and corruption that brought the island to its current morass, and not political, economic or cultural imperialism up north. Puerto Rico’s problems are self-induced. For years the Puerto Rican government borrowed aggressively, confident that mainland-based companies would cover public expenditures. It was a bad gamble. The bills are unpaid and coming due. Debt service now comprises more than a third of the annual Puerto Rican government budget, diverting funds from basic functions such as law enforcement, infrastructure and education. That figure may climb a lot higher. Peter Roff, contributing editor for U.S. News & World Report, summarized the problem this May:

Puerto Rico’s economic mess is of its own making. It borrowed until it couldn’t borrow anymore to pay for a slew of programs, public employee pensions and other pelf it couldn’t afford. Its political leaders expected they could push the day of reckoning off indefinitely. Now it looks as though it’s come…Congressional leaders can say all they want that this isn’t a bailout, but they’re arguing semantics.  The legislation gives a free pass for Puerto Rico’s political leadership by using the savings of bondholders to fund its government pension system. Whether or not that fits the speaker’s narrow definition of what constitutes a bailout is largely irrelevant.

Never underestimate the role of corruption. This Monday, June 20, in fact, Jose Gonzalez Amador, the owner of Puerto Rico’s largest oil supplier, was charged with diverting $11 million from the Puerto Rico Electric Power Authority, now laden with $9 billion in debt. Authorities accuse Amador and his company, PetroWest, with charging the authority a 0.5 percent tax, even though many municipalities charged a lower rate or no rate at all. The authority passed on the added cost to consumers. Want more? Ten Puerto Rican public officials and businessmen were indicted in federal court last December on 25 counts, including fraud, bribery, extortion, money laundering and obstruction of justice. According to prosecutors, Popular Democratic Party campaign finances chief Anaudi Hernandez Perez was at the heart of several schemes to set up corporations that were vehicles for influence-peddling. Last September, the FBI arrested 10 Puerto Rican police officers for stealing drugs and cash, planting evidence and taking bribes. The arrests were on top of a 2010 FBI sting that arrested 89 Puerto Rican cops for corruption, civil rights violations and murder; the move resulted in a federally-mandated 10-year reform plan. And a decade ago, a grand jury indicted 11 persons who sat on the executive board of the union representing employees of the Puerto Rico Aqueduct and Sewer Authority for stealing more than $15 million in health care premiums and other assets. Most, if not all, eventually were convicted. Puerto Ricans are paying the price for these and other violations of the public trust.

Third, the House bill, should it become law, will not compensate bondholders. To the contrary, it will rip them off. Congress effectively is telling the Puerto Rican government that it can rework $18 billion worth of general obligation bonds on favorable terms in federal bankruptcy court rather than through litigation. For all the complaints that the legislation is a gift to “Wall Street,” the truth is that it would punish mainland bond investors, especially retirees. PROMESA would impose a ban on bondholder litigation against the Puerto Rican government, rendering them powerless to recover their losses. This outcome would be all the more punitive if available funds are routed toward the island’s troubled public pension system. And Puerto Rico has powerful labor unions who want such an outcome. Yes, PROMESA is a bailout. But it is the Puerto Rican government that would be getting bailed out.

Fourth, PROMESA enjoys at best lukewarm popularity among island residents, a portent of possible decay in U.S.-Puerto Rican relations. The outcome of the New Progressive Party (NPP) primary for Puerto Rican governor, held June 5, is instructive. By a narrow 51-to-49 percent, Ricardo Rosello Nevares, a highly vocal opponent of the bill, defeated Pedro Pierluisi, Puerto Rico’s non-voting representative (“resident commissioner”) in Congress and a supporter of the bill. Both candidates, especially Rosello, support statehood.  Given the rising unpopularity of the ruling Popular Democratic Party, Rosello may well be elected. It isn’t just at the voting booth where opposition to a bailout has made itself known. According to a recent poll commissioned by Puerto Rico’s largest newspaper, El Nuevo Dia, 69 percent of all respondents opposed the PROMESA bill, while 54 percent opposed the very idea of an oversight board. A New York-based organization, the Committee for Fairness for the People of Puerto Rico, earlier this month took out a full-page ad in a number of U.S. newspapers, including the Washington Post (June 11), to denounce the bill. Titled “Fairness for the People of Puerto Rico” and slugged “Stop Vulture Hedge Funds from Destroying Puerto Rico,” the statement read as follows:

A group of greedy hedge funds are preying on Puerto Rico’s debt crisis to line their pockets at the expense of the Puerto Rican people and in violation of common decency.

These vulture funds have rejected offers to negotiate a reasonable restructuring of Puerto Rico’s $70 billion debt. Instead, they’re lobbying Congress to let them collect every last penny of debt they bought at a steep discount.

The economy of the island is in ruins and the people have suffered devastating cuts in health, education, safety and other public services. Tens of thousands have fled to the U.S. mainland to escape the punishing austerity, and hundreds more are leaving every day. There is no way the debt can ever be repaid if the economy continues to decline.

Congress is considering legislation that will ease Puerto Rico’s distress and point the way to a reasonable debt restructuring, which is in the bondholders’ long-term best interests.

Contrary to the claims of the vulture hedge funds, people who bought Puerto Rico bonds and who actually live in Puerto Rico support a bond restructuring.

If you agree that the best interests of the people of Puerto Rico – who are all American citizens – come ahead of greedy hedge funds, please write or call your U.S. senator and Congressional Representative to urge immediate action on a fair and reasonable debt relief plan.

Nobody is asking for a bailout. All that is needed is a reasonable legal process to reach a solution.

Aside from its caustic language, the statement is reprehensible for its denial of reality. Fiscal mismanagement by the Puerto Rican government, far more than “greedy hedge funds,” is what has caused the meltdown. Institutional investors who bought Puerto Rican bonds did so because the territorial government offered those bonds at an advertised price. Those bond sales were business opportunities, not scavenger hunts by “vultures.” Moreover, the authors of this agitprop, contrary to their own assertions, do want a bailout. They just don’t want one for the people they don’t like; i.e., Americans who want their money back.

Fourth, the law might not be effective if the proposed seven-member emergency control board is less than vigilant in its oversight. The board would have broad fiscal authority, including the power to enforce balanced budgets via asset sales and employee layoffs. The president would make all appointments. For the time being, that means President Obama, not one known for sympathy on behalf of bond buyers. He reportedly wants legislation that applies to the entire $70 billion-plus in outstanding debt, not just a fourth of it. Even if the eventual appointees don’t fully share the president’s views, it is likely they will look favorably toward salvaging the union-driven public employee benefits system. Such an outcome would have a ring of familiarity. The Obama administration effectively did this in 2009 when it arranged the bankruptcies and accompanying bailouts of General Motors and Chrysler. The transactions gave the United Auto Workers a large equity stake in each company; bondholders and stockholders, by contrast, got next to nothing.

Fifth, and perhaps most damagingly, the bill is a portal to potential statehood. To reiterate a point in previous NLPC articles: Statehood for Puerto Rico is not an alternative to a bailout; it is a bailout. As it is, the U.S. government pays for about a fourth of the Puerto Rican budget. That figure could rise much higher with statehood. NPP chieftain-Resident Commissioner Pedro Pierluisi has admitted as much. In a Washington Times editorial a few years ago, he wrote: “Puerto Rico loses out on billions of dollars annually because it is treated unequally under a range of federal programs, including tax credits available to millions of households in the states that do not pay federal income taxes.” To achieve statehood would make the island eligible for a subsidy windfall not available at present. And statehood would mean a full-fledged voting congressman ideally positioned to pressure colleagues to keep the subsidies flowing. Pro-statehood Republican politicians, such as Newt Gingrich and Jeb Bush, are delusionary. Puerto Rico’s longstanding political culture is not “conservative.” To the contrary, it almost guaranteed the current crisis. Statehood is not going to change this. If mainland political leadership in both major parties really were looking out for the best interests of this country (and Puerto Rico), they would be working toward Puerto Rican independence.

It may be too late to stop some kind of PROMESA legislation. But Senate lawmakers have an opportunity to make major alterations. A compromise plan must begin with an assumption that the Puerto Rican debt crisis is of the island’s own making and that its leaders must be prepared to deal on our terms. Supporters, unfortunately, have not worked on this assumption. They appear all too eager, in fact, to sacrifice American interests on behalf of those of Puerto Rico. Their understanding of the bond market seems as weak as their understanding of sovereignty. A bond is an instrument of indebtedness, a promise on the part of a borrower to pay back the money. A whole lot of bond investors in America are learning a hard lesson: Puerto Rico is the land of broken promises.