STUMP » Articles » On Dreams of Bankruptcy » 10 May 2016, 05:53

I’ve seen a lot of bankruptcy talk lately. And no, it’s not all private pensions.

In one case, it was a friend who was calling out a rival business for a. having shoddy products and b. having gone bankrupt and shafted him, opening up biz under a new name (he had subcontracted…and thus there were bills gone unpaid). I’m not going to link to statement, because partly it was a message to people who knew him, and you don’t know him. I had heard the story about this particular bankruptcy before.

But it reminds one that there is a reason many outsiders are sour about bankruptcies. They’re often seen as cheap financial grace, and there’s a whole chain of repercussions. People focus on the entity given a “clean start”, but that means numbers of people who didn’t get paid… who had their own obligations to fulfill.

Just something to think about.

ILLINOIS

A guest writer, Joe Mathewson, at Wirepoints:

1. When will the Illinois legislature, due to adjourn at the end of May, address (and pass!) the necessary permissive legislation to authorize municipalities, including school districts and other special districts, to file for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy Code? The City of Chicago, the Chicago Public Schools and other debt-ridden municipalities have offered no plans for taxpayer relief, much less actual payment of these impossible obligations, so Chapter 9 must be considered.

In fact, Chapter 9 is the only feasible way that these ever-rising, existing debts, not to mention the impossible pension obligations that don’t officially count as debts, can actually be reduced to manageable level. The legislature must authorize that relief. The bill, H.B. 298, by Rep. Ron Sandack of Downers Grove (a former mayor), is in the House Rules Committee chaired by Rep. Barbara Flynn Curie of Chicago.

Ultimately, Illinois is going to go bankrupt, de facto, when they don’t have enough cash to pay for obligations. They’re already behind in paying their bills, and while it’s fun to blame the current budget stalemate on that, even if they had a budget passed, they’d have to borrow money to pay for these bills.

That is already a sign of bankruptcy.

DEFAULTING ON FEDERAL DEBT

Noted not-at-all-a-loose-cannon Donald Trump made some remarks:

That is to say, Trump’s latest proposed economic solution for federal debt is to do what Puerto Rico is likely going to have to do try to remain solvent—ask creditors to take a haircut on outstanding debts.

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Trump seems to have immediately backpedaled on the idea a bit and switched to suggesting that the U.S. could seek to repurchase its own debt on better terms, again something that’s not uncommon in the corporate world. But there’s a slight problem with trying to translate it to the United States: The government operates at a deficit and his solution would result in having to borrow even more money in order to pursue such a plan.

Trump’s perception of how debt works (“I am the king of debt. I do love debt. I love debt. I love playing with it,” he said) could help explain why thinks he can promote fiscally incoherent polices that call for both tax cuts and military spending increases (while maintaining Social Security). Trump believes that everything is up for negotiation—everything has the potential for a deal. This is not a bad trait for either a businessman or a politician, but it can reach a point where it becomes a default response when unable to actually explain how he’s going to get from Point A to Point B in policies. For Trump, making a “deal” is his variation of candidates like Bernie Sanders who want to paper over fiscal gaps in policy plans with promises to make rich people and corporations pay for it.

And then Trump discovered the really old trick of devaluing one’s money:

This is a guy, remember, who’s vowed to protect entitlements notwithstanding the dire risk that ballooning Medicare costs pose to the country’s creditworthiness. Presumably this is his fallback plan if/when America’s debt servicing grows so large that we simply can’t borrow enough to cover it anymore. I say, why wait until the crisis hits? Let’s print $19 trillion and pay off the whole thing now.

His point here to CNN is that his comments last week about the national debt were misunderstood. He wasn’t suggesting he’d stiff America’s creditors by offering partial repayment, he claims. He was suggesting buying back some of the country’s debt at a discount once interest rates rise and older treasuries with a lower yield lose value. Just one question: Where are we getting the cash to fund those repurchases?

Print it, duh. That’s the time-honored way for a sovereign power that has a fiat currency to deal with debt it doesn’t want to pay for.

Of course, you end up with a hyperinflation spiral if you have to do it too rapidly, but….

The Economist comments:

THE latest idea from Donald Trump, the Republican Presidential nominee, concerns the Treasury bond market. As pointed out before, Mr Trump’s plans to cut taxes, maintain entitlement benefits and balance the budget, don’t make sense. Instead, Mr Trump seems to be abandoning the balanced budget element, opting for Keynesianism with a twist. He told CNBC that

“I would borrow, knowing that if the economy crashed, you could make a deal.”

The idea, it seems, would be to get creditors to accept less than 100 cents on the dollar. This happens with corporate bankruptcies; if the market price has fallen to 60 cents on the dollar, and been snapped up by specialist hedge funds, then redeeming the debt at 70 cents on the dollar may be a good deal. Emerging economies have done the same in the past when they have fallen on hard times; it happened in Greece.

But with Treasury bonds, investors expect to get 100 cents on the dollar. It is the risk-free asset that underpins the entire global financial system.

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In what circumstances do Treasury bonds trade below face value? Remember that the coupon/price equals the yield. Take a bond that was issued with a 2% coupon. Inflation subsequently takes off and yields for bonds of the same maturity rise to 4%. No-one will want to buy a bond yielding 2% in such circumstances. So the bond price will fall until the yield hits 4%. How far it falls depends on the maturity of the debt. If it is due to be repaid next year, it is not going to drop very far below face value (100). If it is going to be redeemed in 2046, then it will fall quite a bit further.
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In short, any voluntary deal with the market would require the government to pay fair value. And unless you think the Treasury bond market is mispriced (and it is the most liquid market on the planet), the government is unlikely to profit. It might be sensible for the government to alter the patterns of new Treasury issuance; borrowing long-term to lock in low rates for a generation. The Treasury has discussed the idea of refinancing illiquid bonds to improve market liquidity. But that is quite a different idea from Mr Trump’s proposal; the interest savings would be trivial.

A forced deal, of course, would count as a default. Treasury bonds are at the heart of the financial system. Banks use them as collateral for loans; insurance companies hold them as reserves; pension funds own then to fund retirement benefits; mutual funds own them as well. Any default within the system would have cataclysmic consequences for the economy that would far outweigh any gains in refinancing costs. To cap it all, the Federal Reserve owns almost $2.5 trillion of Treasury bonds and the Social Security Fund some $2.8 trillion. So the government would, in part, be defaulting to itself.

Oh, but those aren’t “normal” bonds. You can’t trade them. It is exactly equivalent to Richard Carstairs in Bleak House making his mental accounting that he’s writing IOUs to himself.

It doesn’t really matter what happens in the real market —the Social Security Trust Fund bonds, so real that they had to print them on paper! (real bonds don’t have to be put on paper to try to make people believe they’re real), are living in an accounting fantasy world of their own.

Their whole purpose is to provide a trigger for Social Security benefits to be automatically cut without further action by Congress. It is a fake intergenerational equity.

In any case, I started this blog post yesterday, and for all I know, Trump is on a third or fourth explanation by now. I am not interested enough in keeping track of his “policy” pronouncements.

PUERTO RICO

You knew I’d get around to Puerto Rico eventually.

Reason has a good history on how Puerto Rico got to its current financial position:

After missing relatively small bond payments last August and this January, Puerto Rico’s public sector defaulted on at least $367 million of principal due May 1. As a consolation, investors did receive $9 million in interest from the defaulting entity, Puerto Rico’s Government Development Bank.

The fact that Puerto Rico even has a Government Development Bank should raise an eyebrow. State-owned banks are not a major feature of the mainland US economy, perhaps because failures of state banks contributed to a number of state bond defaults in the 1840s. Since the US didn’t take over Puerto Rico until 1898, the island was not around to learn that lesson. The GDB is one of over fifty public corporations dominating Puerto Rico’s economy. Others control the island’s electricity, water, and sewer services.

Public corporations date back to the 1940s and largely owe their existence to the efforts of Rexford Tugwell. “Red Rex” was a Columbia University economist who was sold on the virtues of the Soviet way when he visited Stalin’s Russia in 1927. He went on to play a leading role in implementing Roosevelt’s New Deal. In 1941, FDR appointed Tugwell as Puerto Rico’s governor, where he applied a similar state-led economic model. While much of the New Deal was unwound on the mainland, Puerto Rico’s public corporations persisted on the strength of borrowed funds.

Puerto Rico’s 1917 congressionally-imposed constitution limited Puerto Rico’s central government and municipal debt to 7 percent of assessed property values. It also mandated a balanced budget. These limits did not apply to public corporation debt, and these entities started borrowing liberally.

A new constitution ratified in 1952 as amended in 1961 relaxed constitutional limits on Puerto Rico central government and municipal borrowing. A major cause of this relaxation was a mistranslation of balanced budget language in the 1952 constitution. While the English version instructs the legislature to balance revenues and expenditures, the Spanish translation of revenues was closer to “resources”. The Puerto Rico government interpreted “resources” broadly, even including bond proceeds. It thus became possible to “balance” the budget with borrowed funds.

By the early 1980s, public sector debt had reached 82 percent of GNP—not far below today’s level of about 100 percent. Puerto Rico muddled along with high debt levels until recently, when a long-lasting recession, out-migration, a string of unbalanced budgets, and loss of bond market access triggered the current crisis.

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Now that Puerto Rico’s crisis has deepened, House Republican leadership and the Obama Treasury Department have reached a broad agreement on what needs to be done. The plan, embodied in HR 4900, combines a new legal process for debt restructuring with a federal oversight board to help Puerto Rico balance its budget.

Oversight boards are undemocratic, but they succeeded in New York and Washington, DC. As I discussed in a recent paper for the Mercatus Center at George Mason University focusing on the historical causes and potential solutions for the crisis, this formula also proved effective in Newfoundland—which was transformed from an insolvent British Colony to a debt-free province of Canada by an appointed government.

Puerto Rico will be lucky to get an oversight board. I was wondering how they got to such an oversize amount of debt given their actual resources.

I think the best answer is everybody assumed a federal bailout.

Well, to quote the book I’m currently reading:

“Detroit has the misfortune to go bankrupt about two years too late… Detroit had the misfortune to fail when bailouts were passe. We were sort of done with our bailout phase as a government. There was no chance Congress would do this.”

That was Ron Bloom, who had been involved in the bailout of the U.S. car companies in 2009. Ron Bloom represented Detroit retirees in the bankruptcy.

I’m still only a couple chapters into Detroit Resurrected, a book about the bankruptcy. I will review it when I finish, but there’s been plenty to think about already.

Detroit had no chance of a bailout in 2013. Puerto Rico, which has an even worse debt problem, is also not going to get a bailout… at least not a no-strings-attached bailout.

MULTIEMPLOYER PENSIONS

This is a short followup to my post on the striking down of the Central States plan proposal.

John Bury notes a vested interest in the cuts by those running the plans:

The 5500 filing for 2014 for the Central States Pension Fund (CSPF) is 428 pages with 160 of those pages (12-171) being the Schedule C, a form where you report expenses being paid out of the trust which mostly go to Service Providers but for CSPF there are also several Trustees and Employees listed.

Were the Pension Benefit Guaranty Corporation (PBGC) to take over CSPF and cut benefits to the maximum allowed not only would participants take a substantial hit but these ‘Trustees’ and ‘Employees’ would be off the trust payroll entirely.

So it is that when the Treasury denied the CSPF rescue plan with its massive benefit reductions (encouraging larger reductions) the people who run the fund, on their website, fought back:

Let me check out that form 5500. I see the various asset managers are getting millions in fees. That’s probably only basis points on the assets, given that the whole plan had $ in assets as of that filing.

Thomas Nyhan, the executive director, was paid $268K. Ugh, this seems to be in random order. It’s giving me a headache. I found this other document listing the execs’ salaries — it doesn’t match this 5500 exactly, but it’s in the ballpark.

So yes, the executives have an interest in keeping the plan going, and if it requires benefit cuts to keep the plan going, I can see their direct interest.

But it’s also in the participants’ interest. At least those who plan on living longer than 10 years.

Because, as noted before, the maximum limit of benefits for multiemployer plans taken over by the PBGC is really low.

As I wrote, the Treasury rejection did note that the cuts proposed weren’t fair and weren’t clearly explained to the people to be affected. Those are relatively easy to fix.

But what’s going to be difficult is the main problem: that the cuts weren’t deep enough for the plan to survive past 10 years.

I can understand the plan proposers pushing back against that. The cuts being proposed so far are pretty deep for many of the retirees. It’s extremely painful.

But imagine what will happen when the plan completely runs out of money. Ready for even larger cuts?

BANKRUPTCY IS SUPPOSED TO BE A NEW START

This is the issue I have with some of the municipal bankruptcies I’ve seen. Even in the places where pension benefits have been cut as part of the workout, it’s not clear that those cuts were enough to prevent a repeat visit to bankruptcy court in relatively short order.

Detroit cut some of the most obvious problems, like the 13th checks. They’re also getting $$ from the Michigan government to help them. But what if that help goes away because the state is also stressed?

And what about California? We’ve seen in the Stockton and San Bernardino bankruptcies that Calpers has “won” – the obligations to them haven’t been cut at all. But that’s a short-term win.

How is it a new start if there are ongoing obligations… especially if those obligations were a huge strain on the budget to begin with?

If those entities can’t even deal with the obligations after the supposedly-final adjustments in the bankruptcy….

Well, we shall see.

Compilation of Puerto Rico posts

The State of the States: a Compilation