Sen. Robert Menendez (D-NJ) is taking the lead from the U.S. Treasury Department in his proposal to resolve the Puerto Rican economic crisis with legislation that sets a dangerous precedent by elevating public pensions over the island's other liabilities. The senator's proposal magically endows the public pensions with the status of "senior secured debt," advancing public pensioner's claims over those of bond investors, most of whom are retirees and pensioners themselves, and undermines the territory's constitution.
As importantly, the proposal shakes the foundation of the broader municipal market by undermining the time-honored priority of general obligations for the purposes of essential services and projects. With nearly 70% of public infrastructure financing sourced from this market, it is astounding that Sen. Menendez would put forth a proposal that most certainly increases borrowing costs for state and local issuers seeking to deal with the challenges of financing much-needed public infrastructure.
While there are few people who now doubt that Puerto Rico faces an economic and humanitarian crisis that needs to be addressed, this proposal will only create controversy and complicate Puerto Rico's path to a legislative solution. Further, many in the municipal market have tired with the island's narrative and are choosing to ignore the storyline. Some believe that what happens in Congress will have no impact on the marketplace. I disagree. With the House of Representatives set to produce a bill by the end of this month, the Treasury proposal and Sen. Menendez's legislation are likely to play a role in the final outcome and new precedents for the entire municipal market are conceivable.
Similar to the Senate draft legislation, the Treasury proposal states that before any plan of debt adjustment can be confirmed for Puerto Rico that it must "not unduly impair the claims of any class of pensioners." This statement would directly put pension claims senior to those of investors, effectively asking retirees in the United States to bail out Puerto Rican pensioners. Currently, there has been neither legislative action at the state or Federal level nor any judicial judgement on the status of pensions or creditors when liabilities become unpayable. Treasury argues that no legal precedent is being set for the 50 U.S. states because Puerto Rico is a territory. This shows a lack of appreciation for how financial markets function and how investors will perceive this as a new risk for the municipal market. The municipal investment thesis of buying only secured credits grows under this new paradigm.
Any government finance officer in the country should be concerned that investors will view their debt offerings as subordinate to pension liabilities if a new federal standard is adopted and only more so for issuers with underfunded pensions. Interestingly, it is in the Senator's own state of New Jersey where municipal bond investors are already reflecting related concerns. In response to the underfunded pension liability and large budget deficits, credit spreads for the state's GO and appropriation-backed debt are more than 100 basis points wider than a year ago. New Jersey is not alone as a state with a large tax-supported debt program and considerable unfunded pension liabilities.
Further, just consider how the market responded to equity-analyst Meredith Whitney, who in late 2010 went on the program 60 Minutes and claimed that municipalities would see "hundreds of billions" of bond defaults in the coming year because many pensions were largely unfunded. While that never occurred, in the subsequent six months, investors pulled more than $40 billion of assets out of the market. The result was disastrous. In many cases this doubled issuer borrowing costs and in some, temporarily made the market inaccessible. If Congress ratifies the notion that pensions are senior to bondholders, the market could be looking at yet another Meredith Whitney moment. Although setting this precedent would last indefinitely. This becomes particularly important as we watch Chicago, Detroit, Illinois and New Jersey, among others, struggle to fund pension liabilities and maintain essential services within their jurisdictions.
These proposals also set new expectations for the $3.7 trillion municipal market when it comes to general obligation (GO) bonds, which make up roughly 40% of each year's municipal bond sales by states and localities. These expectations are twofold:
1) The GO bond pledge is particularly important in this context as it entails the full faith and credit of the issuer – in most cases, its taxing power. By explicitly placing pension claims above constitutional GO claims in Puerto Rico as the Treasury and Senate proposals do, the entire concept of a bedrock security for many states and municipalities is eroded. This will only increase the cost of capital for states and municipalities going forward as investors' confidence in a government's willingness to pay debts decreases.
2) The Treasury plan deviates from how the rest of the market functions in that it would allow Puerto Rico GO debt, which has explicit constitutional protection, to be open to restructuring. U.S. states cannot access bankruptcy protection and have no legal remedy for restructuring their debts. It is the gold standard for the municipal markets and investors place a high value in that fact. If the Puerto Rican GO pledge can be restructured under U.S. law as is being proposed, the GO pledge nationwide will be negatively affected.
At some point, this country should, and likely will, debate and eventually find a solution for its large and growing pension liabilities, but Puerto Rico should not be the stage for those looking to take advantage of a crisis for their own political aims.