Treasury and Fed Team Up to Create the Next Meltdown
Sometimes it doesn't take the wisdom of Michael Lewis or Warren Buffet to see the underpinnings of the next financial crisis. For the Federal Reserve to contemplate allowing banks to hold state general obligation bonds as a hedge against future financial meltdowns while the Treasury is concomitantly taking steps to weaken the quality of those bonds is a recipe for future disaster.
In the last few months the United States Treasury has been advocating that Congress enact legislation that would allow Puerto Rico--which is not covered by federal bankruptcy law-- to escape its debts. Few people disagree that it needs some sort of legislative assistance to get out of its current predicament, but how the bankruptcy code will be applied to the island is contentious.
When a company declares bankruptcy it has two large classes of creditors: secured and unsecured. Secured creditors have a direct claim on the assets of the bankrupt and can use that claim to cover what's owed them. Unsecured creditors have no such claim and only get paid after secured creditors get their money. For this reason, unsecured creditors typically get paid a higher interest rate than unsecured creditors.
But this rule has been set aside a couple of times in the recent past. For instance, when Chrysler and GM filed for Chapter 11 bankruptcy reorganization in 2009, the resolution eventually arrived at imposed haircuts on secured creditors in order to protect the unsecured pensioners. Likewise, when Michigan put Detroit under bankruptcy protection in 2014 the final settlement promoted the unsecured claims of current and former city employees ahead of bondholders.
The impending bankruptcy crisis these days involves the Commonwealth of Puerto Rico, which has $72 billion of debt, a public pension with nearly empty coffers, and an economy that's been in recession for a decade. The island's government just enacted a moratorium on repaying any debt for the next year, which will result in a default in the next month absent a legislative solution from Congress.
Chapter 9 bankruptcy allows the fifty states to reorganize non-general-obligation debt, but makes no provision for reorganizing general obligation debt. Some people (like myself) have suggested that the least-bad option would be to extend Chapter 9 protection to Puerto Rico, but Treasury and Puerto Rico say that's not enough. Both want Congress to pass some sort of bankruptcy protection that would allow the island to write down all debt, even though less than one-third of its total debt is general obligation debt, but leave its unsustainable public pension debt intact.
There's lots of reasons this is a bad idea: For starters, it would mean that the Puerto Rican government would be setting aside an explicit constitutional promise to its general obligation bondholders that their debt is backed by the full faith and credit of the Puerto Rican government. Setting aside a guarantee that ironclad because it makes the current crisis slightly more tractable would be a terrible idea. Given that many states guarantee that the pension payments of all current retirees cannot be reduced, the sanctity of constitutional promises to creditors ought to be something the Obama administration would want to see held inviolate or else federal courts may have show less hesitation in weakening those constitutional guarantees as well.
Allowing Puerto Rico to haircut general obligation debt will set a precedent for states to do likewise when they find themselves approaching insolvency, and that's more than just a hypothetical these days: my home state of Illinois, for instance, has been making a hash of its finances for well over a decade and is currently saddled with a mountain of debt and a pension plan that no conceivable rate of return can rescue. Puerto Rico's precedent is going to make investors worry about the state maneuvering to haircut its own general obligation bondholders one day soon, boosting its borrowing costs today and potentially hastening its insolvency in the meantime.. Meanwhile, fund representatives with vested interests in seeing haircuts applied to Puerto Rico general obligation bondholders are testifying that Treasury's super chapter 9 scheme, which the House has moved toward, will have no spillover effects on funding costs to States that have played by the rules and wish to issue such obligations in the future.
But the Fed's recent decision to allow banks to use general obligation municipal bonds to meet capital requirements (alongside sovereign debt and debt sold by government-sponsored enterprises) creates a potentially larger problem that transcends the finances of any one state. These capital requirements are meant to ensure that banks can easily raise cash to withstand future financial crises, and after a prolonged debate the Fed decided to include state general obligation bonds in that pool as well--mainly because of their liquidity.
That the Fed is allowing banks to use general obligation bonds as "safe" capital precisely as Treasury is negotiating to effectively reduce their safety is a potentially disastrous confluence of events. What happens if--a decade or so from now--Treasury's Puerto Rico gambit does open the door for states to escape general obligation debt during a recession and banks find themselves holding capital that isn't as safe--or as easy to sell--as they had assumed? It's a recipe for a 2008 rerun, when federal regulators pushed community banks across the country to buy the debt of Fannie Mae and Freddie Mac to bolster the soundness of their balance sheet: When Treasury pushed the two into conservatorship a number of them went bankrupt while numerous others found it necessary to retrench and reduce loans in order to burnish their capital, which proved to be a drag on growth.
Others have suggested it could potentially create a scenario similar to the panic that ensued when money market funds broke the buck in September 2008.
This potentially calamitous combination of government regulatory degradation is possible when one regulatory body doesn't know what's up the sleeve of the other--or knows precisely what the other is doing but chooses to ignore the potential long-term problem in order to hew to its own agenda.
One of the objectives of financial reform was supposed to have been to reduce overlap in regulations and oversight, so companies cannot engage in regulatory arbitrage or play one oversight body against another. Yet, Treasury's creation of its Office of State and Local Finance in 2014 has now created oversight overlap between Treasury officials and the SEC in the muni space. If the Office of State and Local Finance is telling markets that Treasury's own super chapter 9 scheme will have no spillover effects that end up increasing expropriation risks and costs for State and local municipal debt, who really believes that the SEC will stand up and cry foul?
Either the Fed should reverse its decision and not allow state munis to be used as safe capital--and incur the wrath of the banks--or the Treasury should back off its desire to impose a super chapter 9 on Puerto Rico and help devise another way for the island to get its finances in order. But the current status quo creates a noxious policy mix that has the potential for fanning the flames of a future financial crisis.
