Puerto Rico Contagion Will Cost Taxpayers
Republicans have approached the looming fiscal crisis in Puerto Rico with the goal of returning the island to solvency without costing taxpayers any money. Unfortunately, the plans being discussed by the House of Representatives of late will not achieve either goal.
Puerto Rico insists (with Treasury's support) that any legislation to fix their plight include giving a debt haircut to all creditors, even those investors who own the just over $18 billion of secured debt that is backed by the full faith and credit of the Commonwealth. For perspective that's slightly more than 25% of the island's $72 billion of debt. The bill negotiated by the House Natural Resources Committee acquiesces to these demands; even though it parrots the rhetoric that this in no way constitutes a bankruptcy ,the bill incorporates over 100 line items from Chapter 9.
However, summarily setting aside a constitutional guarantee in Puerto Rico would set a precedent for other states to do likewise when they face their own debt problem, a day that is unfortunately coming sooner rather than later.
Several states have explicit promises both to bondholders and state pension recipients that they will not see their promised payments reduced. Clearly, a state that becomes insolvent cannot honor both promises--want to bet which one gets dropped first?
These events are not that far away. There are already law firms working on a possible Chapter 9 bankruptcy in Chicago, and Illinois' enormous pension problems will likely result in it needing to restructure debt in the next few years as well. The recent Chicago Board of Education bond issuance even required specific language that discussed contingencies in a non-existent bankruptcy regime. The likely outcome there--especially in a Clinton Administration, where the cast of characters in Treasury may not change all that much--will be to protect the pensions of current and retired government workers first and foremost and renege on the promises made to the lenders. How could anyone conclude differently?
The market will react to a Puerto Rican resolution that haircuts general obligation debt by demanding a higher return for municipal bonds, including states' general obligation bonds that are currently not covered by any sort of Chapter 9 bankruptcy. It's why six governors have asked that Puerto Rico's general obligation bonds be excluded from bankruptcy; The Island's two biggest newspapers also oppose such a policy, arguing that doing so would jeopardize the government's eventual return to bond markets. Each has pointed out that Detroit is almost three years removed from its bankruptcy and the debt cram down that the government imposed there has made it impossible for the city to return to bond markets without the help of the state of Michigan. There is no hope that private capital will return to Puerto Rico for essential services, from vendors, or for infrastructure if the Constitution of the Commonwealth is allowed to be circumnavigated.
A common argument against the precedent-setting nature of PROMESA--the name of the legislation currently being debated--recently cited by Pacific Investment Management Company (PIMCO), is that because states are sovereign entities, a restructuring framework applied to Puerto Rico cannot set a precedent for them. This is nonsense: Congress would set a precedent merely by demonstrating a willingness to retroactively change rules and abridge contracts to allow Puerto Rico to walk away from its debts, and it could create a similar bankruptcy framework for states with relatively minor tweaks. Defenders of a super chapter 9 who insist that state sovereignty would preclude the states from access to a similar structure are obfuscating: Horace Cooper, senior fellow at the Heartland Institute, suggests that the federal government could easily pass legislation allowing a state to file bankruptcy as long as the federal government does not force it to do so.
There is evidence that the mere introduction of this legislation is already having adverse effects on the market. The cost of credit default swaps on Illinois general obligation debt, which essentially function as insurance against default, has gone up nearly 100% this year, signaling a burgeoning uncertainty over the protections afforded to "full faith and credit" debt.
State and local governments issue about $400 billion of new municipal debt each year. If we assumed even a minor 10 or 15 basis point average increase in financing costs due to a general obligation bondholder haircut it would constitute an additional $4-$8 billion in debt service costs over the duration of that debt. Add that up over the next few years and the net result is that the Puerto Rican rescue is going to cost taxpayers plenty.
And it's not like the federal government will to get off scot-free either: extending the Earned Income Tax Credit and the Child Tax Credit to Puerto Rico--which does not currently participate in either program because its residents don't pay federal income taxes--will cost $12 billion over the next decade, and this is likely to get thrown into a final deal. Thus far Treasury has ignored requests to come up with commensurate spending cuts to pay for those spending increases per PAYGO rules.
The Puerto Rican government has gone to great pains to paint the general obligation bondholders as merely rich hedge fund investors, but the reality is that hedge funds own just 12% of these bonds, with Puerto Rican residents themselves owning nearly forty percent. And the notion that who owns the bonds (or when they bought the bonds) should impact the extent to which explicit, constitutional guarantees are honored is simply inane for a society built upon the rule of law.
The way out of this mess is simple: Congress should impose the same version of Chapter 9 bankruptcy that applies to the 50 states on Puerto Rico so as to give it bankruptcy protection to negotiate its non-general-obligation debts. This was, in fact, precisely what nearly 60 House and Senate Democrats proposed in 2015 with the Puerto Rico Uniformity Act of 2015. When House Republicans grudgingly came to accept such an approach, Democrats--abetted by the Treasury-- moved the goal post and began insisting that only Super Chapter 9 is sufficient. It should also ignore cries of colonialism and impose a strong and independent fiscal control board invested with the power to fix the commonwealth's budget problems.
A gross repudiation of the rule of law--which is precisely what a Puerto Rican settlement that punishes the holders of guaranteed bonds would be-- is not only unnecessary but it would also cost U.S. taxpayers and potentially prolong the island's economic morass.