STUMP » Articles » Puerto Rico Finally Defaults -- Now What? » 4 August 2015, 06:32

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Puerto Rico Finally Defaults -- Now What?  

by

4 August 2015, 06:32

Of course, there are defaults and there are defaults.

This one is a bit of a whimper.

JUST THE FACTS, MA’AM

Before the commentary, let’s check the default announcement, via Mary Williams Walsh, NY Times’ expert on public finance and pensions.

Puerto Rico defaulted on a $58 million bond payment on Monday, a risky move that seemed to intensify the pressure on creditors for broader debt renegotiation, but might also make future borrowing far more difficult.

Whether Puerto Rico would make the payments was a subject of intense speculation among legal and financial experts for days as Monday’s deadline approached. Although the island made a payment on the interest of about $628,000, it said it lacked the funds to pay the full amount.

In a statement, Melba Acosta Febo, president of the Government Development Bank for Puerto Rico, which owes the money, said: “This was a decision that reflects the serious concerns about the commonwealth’s liquidity.”

While there was a deliberate decision not to make a full payment, one needs to realize this was not a total default. Some payments were being made.

Although this particular type of bond does not carry with it a legal requirement for repayment in the absence of a budget appropriation, market experts said Puerto Rico’s decision not to pay amounted to a default and left them perplexed about the strategy of paying some bonds while letting others lapse.

“It’s almost a kamikaze strategy,” said Sergio M. Marxuach, public policy director at the Center for a New Economy, a research institute in San Juan.

That’s a weird analogy.

But the point is that part of this jockeying for a bailout of some sort. They’re going to have to get in line on that one. I will write about the various people holding out the begging bowl toward the U.S. Congress… but not now.

NOT A SURPRISE

This was going to happen eventually.

A NOTE ON GREECE

I have no frickin’ clue what’s going on in Greece right now, btw.

I stopped posting because I couldn’t make sense of what was going… if anything is going on.

There was an agreement… but there seem to be things bubbling up. It doesn’t seem fully resolved. The Greek stock market reopened, and fell, and things just are muddling along, it seems.

I guess half of Europe is on vacation right now, so we will have to wait til September for things to resolve… oh wait, everybody will be hanging out for their New York City shopping trips (oh, I mean UN General Assembly) and amassing more parking tickets they won’t pay in September.

So I guess we have to wait til October to see if the Greek situation is settled… for this year… at least.

A WHIMPER AND THEN A WHIMPER?

Back to that last post:

Taking an analogy from stuff I do — I have dealt with error-handling in programming, and there are a couple ways to handle errors:

- Catastrophically
- Silently

(Yes, there are more than those)

But the problem with silent error-handling, where you just skip to the next line of code without notifying the user, is that often it ends up with catastrophic failures.

When it’s only a game you’re coding, it’s only a professional danger for the coder.

When your program deals with finance… it’s not so benign when the code goes loopy.

Similarly, the “kick-the-can” approach to public finance floats along, slowly degrading over time, and then BOOM.

It all falls apart.

It’s not fun to watch.

Well, a partial default on a bond is not exactly silent error-handling.

Is it a bang?

To many individuals, it likely will be:

The fallout: So who gets hurt if Puerto Rico doesn’t pay up — or if it only pays back a fraction of what it owes? It could be you.

A lot of regular Americans hold these bonds.

“I am worried. Any Puerto Rican is worried,” Rey J. de Leon, a 42-year-old lawyer in Puerto Rico told CNNMoney. “We have a lot of people who are seniors and they depend on the returns from those bonds to live on a month-to-month basis.”

Over 20% of bond mutual funds own Puerto Rican bonds, according to data from Morningstar (the exact numbers are 377 funds out of 1,884 United States bond mutual funds).

The majority of the funds with exposure are municipal bond funds or high yield bond funds. Puerto Rico’s bonds have municipal status, meaning they are tax exempt. That’s why a lot of retirees buy them.

Retirees (and bond funds) were getting hit with low yields, which is why they snapped up Puerto Rican bonds.

They were desperate for yield, you see.

Cash-strapped Puerto Rico last year sold $3.5 billion of junk-rated debt maturing in 2035 at an 8.72% yield.

That is high, my friends.

It’s also junk bond yields.

According to this NYT Dealbook piece, some of the mutual funds have been dumping the PR debt as default became more unavoidable, and PR got downgraded to junk status. Some funds are not allowed to hold junk.

(pardon me, high yield bonds)

Supposedly, some of the debt was snapped up by hedge funds. Should be interesting to see if any more highly-connected people will get hit with these losses — and as PR is a U.S. territory, perhaps these people can twist some arms for a bailout. Or maybe not.

The “What next?” is messy legal actions:

Numerous Oppenheimer Rochester municipal funds hold 15% or more of the fund in Puerto Rican bonds, including the Oppenheimer Rochester MD Municipal Fund (ORMDX), which is down 5% this year and has a 3-star rating from Morningstar.

These funds are making it clear that they will pursue legal action if Puerto Rico doesn’t pay.

“We expect Puerto Rico to act within the tenets of the law, including the Commonwealth’s Constitution, and are ready to defend the previously agreed to terms in each and every bond indenture,” said a spokesman from OppenheimerFunds.

In a blog post Tuesday, Franklin Templeton’s co-heads of the municipal bond group wrote: “At the very least, in our assessment, Puerto Rico can expect creditors to seek legal affirmation and protection of contractual rights.”

Thing is, Puerto Rico really can’t pay all their obligations.

If there were a real bankruptcy process for Puerto Rico, all of these creditors would be handled together. As they have no way of going through a formal bankruptcy process (yet), there will be a scrum among creditors, trying to grab onto the cash.

Good luck with that.

WATCH THAT LOBBY

While an outright federal bailout is unlikely for Puerto Rico, U.S. Congress allowing Puerto Rico to use the federal bankruptcy process is possible.

As Puerto Rico’s debt crisis came into clearer view this week, so too did a noisy faction of voices both supporting and opposing the Puerto Rican government’s push to allow the island to restructure its debt in bankruptcy.

The two sides of the debate have enlisted high-powered lobbying and public affairs firms to make their case as the long-simmering issue of Puerto Rico’s deteriorating financial condition is now coming to a boil.

Puerto Rico’s government is pushing Congress to allow it to seek Chapter 9 municipal bankruptcy, which is currently not permitted under the law because the island is a commonwealth, not a city or municipality. This would allow Puerto Rico to protect itself from creditors while it develops a plan to restructure debts.

….
The bankruptcy option is riling up some investment funds that hold a significant portion of bonds issued by Puerto Rico Electric Power Authority (PREPA), the cash-strapped government-owned utility. Bondholders bought the bonds with the understanding that Puerto Rico would not be able declare bankruptcy, and allowing the island to do so now would violate the terms of that agreement and impose a risk on bondholders that they did not anticipate. Some conservative groups are also fighting the legislation, arguing the bankruptcy option amounts to a government bailout.

There’s so much silliness here.

First off, the original bondholders who thought “well, they can’t go (legally) bankrupt” were essentially betting on a government bailout.

They had to have known that Puerto Rico could not have repaid that debt without U.S. federal government financing. They had been making a political calculation in assuming that the U.S. federal government would bar formal bankruptcy proceedings, but that still wouldn’t make them whole.

Yes, there are individual investors who may have thought “government doesn’t go out of business”, but they’re not the ones hiring lobbyists.

Second, Puerto Rico does not have the money to pay all their obligations. They are bankrupt in fact.

Setting up a formal process to have the various parties treated in public with agreements on the record is not a bailout. It does not make new money come into being.

Yes, some creditors will get less in bankruptcy than if they get to grab at PR’s assets individually through the courts. They have lawyers (you better believe they have lawyers) and may have felt they could outgame their competitors in getting what cash was available.

I am not a lawyer, much less a contract or Constitutional one. I can’t game out what all these lawyers will be up to. I do know that having no formal bankruptcy process means that there’s still all sorts of political jockeying and that many creditors will not get repaid.

Allowing a formal, public process is not a bailout.

Third, let’s check out these lobbying groups.

To help sell its message in Washington, the Puerto Rican government has hired SKD Knickerbocker, the public affairs agency led by former Obama White House communications director Anita Dunn, and Podesta Group, the powerhouse lobbying firm founded by Democratic lobbyist and mega-donor Tony Podesta. A spokeswoman for Podesta Group declined to comment. Lobbying records show the Puerto Rican government has paid the firm $1.15 million since 2013.

SKDKnickerbocker is the firm handling Planned Parenthood’s PR problems right now, though it sounds like they’ve been scrubbing that record. I can imagine they might like a nice juicy bankruptcy PR push to get the spotlight off the other things they may be doing.

Six investment management firms that hold PREPA bonds — BlueMountain Capital Management, Franklin Advisers, Knighthead Capital Management, Marathon Asset Management, Angelo Gordon & Co. and D.E. Shaw Galvanic Portfolios — have hired lobbyists at Venable to oppose the bill. BlueMountain has also retained lobbyists at Gibson Dunn, and paid the firm $50,000 so far this year.

BlueMountain holds more than $400 million in bonds issued by PREPA, according to Bloomberg.

BlueMountain and Franklin have also taken the battle to the courts, last year filing lawsuits in Puerto Rico seeking to block a law that allowed some public corporations to restructure their debt. A judge in February struck down the law, saying it is unconstitutional, The New York Times reported.

Whatever the fallout, it will be a mess, and yes, of course politics will be involved.

A BANG TO PREVENT LARGER IMPLOSIONS

While this bond underpayment is somewhat whimperish, the bang may very well come.

As of Friday, Puerto Rico’s bonds over all had already lost more than 10 percent of their value from the start of the year, closing at their lowest point since July 2009 as it became clear that the government was unlikely to make the $58 million payment.

J. R. Rieger, who tracks a broad sample of Puerto Rico’s bonds at S.&P. Dow Jones Indices, said that he was concerned not just about the portfolio losses but also that the market for Puerto Rico bonds might now dry up completely.

“Once a bond defaults, the number of buyers who are able to buy truly distressed debt is smaller,” he said, adding, “Will there be enough buyers to sustain an orderly market in Puerto Rico’s bonds?”

When you have a firesale like that, all sorts of vulture hedge funds may swoop in.

“The terms of these bonds,” she said, “stipulate that these obligations are payable solely from funds specifically appropriated by the legislature.”

Market participants dispute that assertion. But they said on Monday that investors might have to file suit in a Puerto Rico court to get a declaration of default, and there was no guarantee that the court would issue one. Then Puerto Rico might be able to turn around and sue the investors, saying their accusations of default had caused it irreparable legal and financial harm.

All the big guns will be between the institutional investors, the governmental borrowers, and plenty of politicians (lapping up the lobbyist attention).

But there will be smaller individuals hurt, and not just those on Puerto Rico.

“I am worried. Any Puerto Rican is worried,” Rey J. de Leon, a 42-year-old lawyer in Puerto Rico told CNNMoney. “We have a lot of people who are seniors and they depend on the returns from those bonds to live on a month-to-month basis.”

….
In total, bond mutual funds hold about $11.3 billion of the island’s debt. Another roughly $15 billion is held by hedge funds. The remainder of the debt is held largely by individuals — mostly Puerto Ricans and mainland Americans.

Oh, those contextless numbers. That’s about $26.3 billion in debt. What was Puerto Rico’s total debt?

While the island managed to avoid default by making its big July 1 bond payments, Puerto Rico still has over $70 billion in outstanding debt to go.

Remember that the bond mutual funds are primarily owned by individuals. The vast majority of people being hit will not be the hedge funds. The $15 billion held by hedge funds is a little over 20% of the debt. I am sure they were betting that Puerto Rico can pay at least 20% of their debt… and they’ve got the lawyers.

I am among those who hold for formal bankruptcy processes for governmental borrowers. It levels the playing field for smaller investors, in my opinion, and is more public.

I will leave this post with some inspiring words from Winston Churchill:

Puerto Rico and Greece are far from the last of these major governmental defaults (current wave). More will come.

I hope that these smaller-scale bankruptcies will help people prepare for the much larger structural defaults to come.

While Greece looks like it’s nowhere near settled, I’m hoping that at the very least we can get a true bankruptcy out of Puerto Rico. That might provide a model for others, and teach people the lesson not to shovel money at profligates assuming you can squeeze the most out of them in court.

Compilation of Puerto Rico posts

The State of the States: a Compilation


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