Treasury Notes

 Puerto Rico Needs Access to Bankruptcy Protection

By: Kent Hiteshew

The Obama Administration recently released a package of legislative proposals to comprehensively address Puerto Rico's well-documented fiscal and economic crisis.  Our proposals include initiatives to restart economic growth, enhance labor force participation, increase Medicaid coverage and funding, and provide strong federal fiscal oversight to ensure that Puerto Rico adheres to a credible fiscal recovery plan and restores fiscal confidence among all its stakeholders.  But, these policies alone will not give Puerto Rico the runway it needs to recover.

In formulating our policy recommendations, Treasury evaluated a range of financial analyses to gauge Puerto Rico's debt burden.  As an example, we considered total net tax-supported debt service relative to annual governmental revenues – excluding federal transfers which are not available to pay debt service.  This approach is consistent with standard rating agency municipal credit criteria and includes all debt dependent on the Puerto Rico economy's limited capacity to repay.  On that basis, Puerto Rico's debt service consumes more than one-third of governmental revenues and is six times the U.S. state median. Also, the ratio of debt-to- gross national product has increased sharply over the past decade, and the Commonwealth's $70 billion of debt and $45 billion in unfunded pension liabilities now dwarf Puerto Rico's stagnant economy. 

Given these stark figures, it is time to face reality:  Puerto Rico has lost market access, is out of cash, and its debts are unsustainable.  This isn't a surprise to the market; its bonds have been trading in the range of 30 to 70 percent of par for more than a year.  Default, in fact, has already begun, and a broader default may be imminent without immediate action.

The Administration has concluded that, as part of a comprehensive approach to Puerto Rico's crisis, a tested federal bankruptcy regime is necessary to provide an orderly framework for restructuring the Commonwealth's large, complex and intertwined debt stock.  Without such a federal court-supervised process, Puerto Rico and its creditors face years of disruptive litigation that will only further depress the local economy, delay creditor recoveries, and make long-term recovery all that much harder.  Bankruptcy is not a cause of default; rather, it provides an orderly response to insolvency.

We have tailored our bankruptcy proposal to address moral hazard concerns raised by some market participants. Under the U.S. Constitution, territories and states have different legal relationships with the federal government -- our proposal is limited to the territories.  As under current law, states would remain ineligible to file for bankruptcy under this or any other bankruptcy regime. 

Furthermore, unlike a Chapter 9 proceeding, Puerto Rico would only have access to this new restructuring authority if it accepts independent and credible federal fiscal oversight.  Puerto Rico has a long history of weak fiscal controls, poor tax collections, and annual budgets that masked recurring structural deficits.  The habitual delinquency or even absence of Commonwealth audited financials must be rectified through any fiscal oversight mechanism. To be clear, Puerto Rico will have to put its own fiscal house in order as part of any recovery effort.

Some oppose a broader restructuring regime, citing concerns relating to pre-existing Puerto Rico constitutional, statutory, or contractual priorities among different classes of debt.  These are complex issues that are best addressed with legislation that fairly balances the interests of Puerto Rico and its creditors.  But it is clear that a comprehensive plan cannot be developed and executed if any one class of claims is excluded from the process at the outset. A court-supervised process would provide the most effective framework for untangling the Commonwealth's eighteen separate, but interdependent, credits and three different public pension systems, given the reality that Puerto Rico lacks the resources to make full and timely repayment on all of its existing debt.

Others have argued that our proposal would unfairly change the rules of the game for creditors, who lent Puerto Rico funds under the presumption that the Commonwealth would not have access to federal bankruptcy relief.  But given the history of bankruptcy jurisprudence in our country, creditors should understand that such laws may be changed by Congress.  In fact, this risk was clearly disclosed to purchasers – particularly hedge funds – of the Commonwealth's general obligation bond offering in March 2014. 

Some have also asserted that bankruptcy will forever prevent Puerto Rico from being able to borrow in the municipal markets.  First, let's remember the Commonwealth does not currently have access to the municipal markets – it was lost two years ago, and its bonds currently trade at double digit yields.  Second, once an issuer rebuilds its economy and restores fiscal confidence, markets have proven in the past that they will once again lend capital on terms consistent with that issuer's new credit fundamentals.

After 30 years in the municipal industry, I do not take lightly the prospect of using bankruptcy to resolve distressed municipal credits.  Any change to these laws must be undertaken with care and precision. Bankruptcy should be reserved as a tool of last resort.  But that is where Puerto Rico finds itself today.

We can no longer pretend that Puerto Rico's plight can be solved through fiscal austerity alone.

Instead, Congress should pass legislation that would narrowly address Puerto Rico's unique circumstances and provide needed independent oversight while continuing to respect the discipline of market forces.

Kent Hiteshew is the Director of the Office of State and Local Finance at the U.S. Department of the Treasury.
Posted in:  Puerto Rico
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