Fact One: There are 3.7 million Puerto Ricans, 45% of whom live in poverty. Fact Two: According to its April 3, 2012 Official Statement, Puerto Rico has $68 billion of debt. Fact Three seems obvious: it is going to be very difficult for the 2 million Puerto Ricans who do not live in poverty to pay $68 billion of principal, plus tens of billions of interest, plus uncertain amounts of swap termination fees, plus billions of unfunded pension obligations.
How was it possible for all this debt to have been accumulated?
From the issuer’s side, the reasons appear to be similar to those of other struggling governments: a deteriorating economic base, a chronic structural deficit, a failure to fund pension and OPEB liabilities, utilizing debt to plug budgetary deficits, utilizing debt to pay debt service on existing debt, use of interest rate swaps that end up losing money, and a general failure to manage finances successfully for many years.
Aside from all of these factors, were there other things going on in the public finance market related to Puerto Rico that also led to the accumulation of more and more debt?
In his book, The Big Short, Michael Lewis describes the evolution of the subprime mortgage securitization business: “The market might have learned a simple lesson: Don’t make loans to people who can’t repay them. Instead it learned a complicated one: You can keep on making these loans, just don’t keep them on your books.”
As Lewis describes in his book, over time the credit quality of the mortgage borrowers became completely irrelevant to the market. Fees were earned in originating the loans, in packaging them, and in selling the packages out to investors. The more loans that were made, packaged and sold, the more fees everyone made. The demand for more loans drove the credit quality requirements lower and lower until there were really no meaningful requirements at all. We all know what eventually happened: borrowers lost their homes, investors lost their money and taxpayers funded a bailout of certain financial institutions.
Is that also going to be the story of Puerto Rico?
Large amounts of fees have been earned by firms involved in Puerto Rico’s debt issuance, including fees for structuring and underwriting the bonds and swaps, fees for packaging the bonds in investment funds in Puerto Rico and across the United States, and fees for selling the fund securities to investors.
Puerto Rico’s triple tax exemption (exempt by federal statute from federal, state and local income taxes in every state in the United States) and above-market interest rates due to its relatively weak credit, combined to make its bonds a unique and desirable, high yield investment. Were these bonds so desirable that the credit quality of Puerto Rico became less and less relevant to the market, much like what happened with subprime mortgage borrowers?
The Securities and Exchange Commission is investigating how funds containing Puerto Rican bonds have been marketed and what disclosures were made by those funds. The SEC will look out for the interests of the investors.
Investors are important, but so are issuers and their taxpayers. Why is there a tendency, with many severely distressed governments, for the amount of debt being issued to accelerate as the government heads toward its point of meltdown? Are the debt structures being offered to these governments in their distress really helpful, or do they just delay the day of reckoning and increase the magnitude of their eventual fiscal crisis?
Why do the various actors in the credit markets fail to impose discipline on the distressed issuers (and on themselves) well before the issuers incur way too much debt?
The key to dealing with these troubled credits is for the market to insist on the development of and commitment to a real, viable, comprehensive workout plan by the issuer. Once the plan is in place, any debt issuance should be part of the implementation of the overall plan and not an exercise in kicking the can down the road while accumulating more and more debt.
David Unkovic is a public finance lawyer with McNees Wallace & Nurick LLP in Lancaster, Pa. He formerly served as the first state-appointed receiver for the City of Harrisburg.