President Trump, who knows a thing or two about bankruptcy, says Puerto Rico’s public debt should be wiped out. We agree.
The commonwealth owes bondholders somewhere on the order of $70 billion, with most of that debt tied to general-obligation bonds, revenue bonds and bonds issued by the Puerto Rico Electric Power Authority (PREPA).
Ahead of the wide devastation wrought by Hurricanes Irma and Maria, we were of the view that the commonwealth could manage perhaps 20 to 30 percent of its general-obligation and revenue-bond debt and that PREPA could pay off perhaps 30 percent of its debt.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Now, as the island and its economy reel from the carnage of the hurricanes, we see the only viable way forward as a zeroing-out of the bonds in question and an immediate cessation of interest payments. Puerto Rico’s badly-crippled economy must rebuild, and the only way for that to happen is for legacy governmental debt to be handled in a way that won’t impair the restoration of markets and physical development.
This is a necessary remedy that will affect three sets of bondholders.
First, the large investment houses like Franklin Templeton, Oppenheimer, Citi and JP Morgan, which own large chunks of bonds. These investment houses, however, have vast and diverse holdings in the trillions of dollars that are hedged against just about every eventuality.
Second, a host of hedge funds that bought into the Puerto Rico bond market at a discount. These hedge funds have made extraordinary gains on this debt by way of interest-rate payments on the face value of the discounted bonds.
Third, small investors who live in Puerto Rico and elsewhere who stand to suffer the most. These investors have no hedges against these losses, and (unlike hedge funds) have not reaped extraordinary gains on Puerto Rican debt.
The way out of this is not pretty but there is ample precedent.
Puerto Rico’s badly-crippled economy must rebuild, and the only way for that to happen is for legacy governmental debt to be zeroed out.
A considerable portion of these bonds are insured by MBIA, Ambac and Assured Guaranty, which are contractually obligated to take over payments, a reality that will cause some shock to their stock prices. Puerto Rico has made premium payments on its insurance policies and the guarantors must make good on their promise. To help offset their losses, these companies can be given first option on future bond offerings by Puerto Rico.
Bondholders are not without recourse. They can—and should—pursue a course of action against the underwriters, law firms, accountants, financial advisors and credit-rating agencies that put the bond deals together in the first place. Clues on how to proceed can be found in a 2016 audit of PREPA debt. The Securities and Exchange Commission can be pressed now on its investigation of PREPA’s bond deals, and the agency can be instrumental in streamlining a resolution and avoiding needless litigation.
BONDHOLDERS THROUGH THE AVENUES ABOVE CAN RECOVER a modicum of their original investment, and as Puerto Rico emerges from its crisis the its government alongside the federal PROMESA board can establish a claim-resolution process for small investors, who should be paid 100 percent of their principal.
Finally, liability must be apportioned, and criminal action must result so as to restore public trust that has been damaged by the failure of a whole “stakeholder” class that is responsible for what has happened debt-wise.
The PROMESA board, whose job it is to act as a comptroller, must come forward now and install new budgeting and debt policies, moving with an eye toward rebuilding the economy and supporting the citizenry. The board will need help from outside receivers and/or independent management. My organization, the Institute for Energy Economics and Financial Analysis, has recommended the appointment of a special inspector general.
Bond defaults in the municipal credit market are rare—especially big defaults like this one—but they happen. Moody’s Investors Services publishes an annual history of such events, and since 1970 has covered 84 instances of public bond defaults and bailouts.
Workouts typically allow some recovery by bondholders, but, more important, workouts—which vary widely by circumstance—can set the stage for borrowers to rebuild.
If the Puerto Rico economy is to have any chance of recuperation it cannot be saddled with the crushing effect of decades of bad deals.
The president presents a role model of sorts here, having been tied repeatedly to bankruptcy, and having always come back.
Tom Sanzillo IEEFA’s director of finance. A version of this column appeared yesterday on TheHill.com.