STUMP » Articles » The Danger of Government Debt: Puerto Rico, Pension Obligation Bonds, and the Political Math of Bankruptcy » 10 August 2015, 21:57

Where Stu & MP spout off about everything.

The Danger of Government Debt: Puerto Rico, Pension Obligation Bonds, and the Political Math of Bankruptcy  


10 August 2015, 21:57

I have written before of why Pension Obligation Bonds (POBs) are of the devil.

People may think I’m being cutesy-poo, or trotting out some quaint Southernisms (when I start talking about a Come to Jesus meetin’, then yes. I’m using a Southernism. Go here for more Southernisms.)

But I am not joking. POBs are a fiscal evil and must be eliminated from the tools of taxpayer destruction (destroying the taxpayers… not…you know what I mean.)

Today’s lesson in POB evil comes from Puerto Rico:

In 2008, with the island’s retirement system facing a big shortfall, the government sold about $3 billion in bonds to plug the hole.

Ideally, the pension funds’ returns exceed the interest rate on the bonds, making more cash available to pay the benefits of public workers.

The bonds used for this kind of arbitrage are typically not eligible for tax exemption in the United States, making them a tougher sell on the mainland.

But for island investors in the Puerto Rico funds, income from the pension bonds was free from local taxes.

One UBS Puerto Rico fund has about 45 percent of its holdings in pension bonds, according to fund documents. Today, the bonds trade for as little as 18 cents on the dollar.

There’s a lot more to the NYT article — it’s not only POB debt overhanging Puerto Rico. Plenty of bonds have been issued by PR entities, and it’s becoming very clear that there will be bankruptcy in fact, even if a formal bankruptcy process isn’t allowed.



Let me backtrack in that NYT article.

Here is how it opens:

To Lev Steinberg, it seemed like a good place to park his nest egg.

Puerto Rico bonds offered high returns and tax-free income. And there was little chance, his broker assured him, that the government would default on its debt.

So Mr. Steinberg went all in, investing more than 85 percent of his retirement savings in funds with large concentrations of Puerto Rico bonds.

“They told me this was safe,” said Mr. Steinberg, a 64-year-old mathematics professor at the University of Puerto Rico, “that the legal protections to repay the bonds were strong.”

I’m assuming Prof. Steinberg is numerate, being a math professor and all. You would think that he would know not to put all his investment eggs in one basket….

….but having had worked at a company which has professors as its primary customer base, I am not at all surprised. I’m not going to tell tales out of school, but it was a good thing that the client magazine ran the letters-to-the-editor past the actuarial department before printing them. Because we got some real doozies. I had a lot of fun writing snarky responses to dumbass letters from socialist math professors.

Sorry, got a bit side-tracked there.

Even some of the riskier debt, which previous administrations had difficulty selling to investors in the rest of the United States, found a home in the investment accounts of ordinary Puerto Ricans, according to former finance officials.

It was not just residents who were loading up on the bonds. The island’s 116 credit unions, which serve many poor and rural communities, also became big buyers after local regulators allowed these small lenders to take more risks with their investments.

This is really bad. This is not unique to Puerto Rico, btw. This is what set off some of the Greece crisis back in 2010 (or was it 2011) — banks loaded up on Greek debt because: 1. it was high yield in a very low-interest-rate environment and 2. banks didn’t have to hold any capital against sovereign debt.

Unfortunately, this kind of witches’ brew of privileging governmental debt is widespread in the banking/credit union/financial services community and overarching regulation. The entities issuing the debt are the ones regulating the banks and other financial institutions.

You might see where there could be a problem with that.

The problem becomes that anybody who is trying to hold government to account for their dodgy accounting and fiscal irresponsibility will be accused of being partisan. And yes, that’s often the case, but just because it’s partisan doesn’t mean it’s false.


This morning, I read an excellent piece by Kristi Culpepper on municipal bonds. There are lots of technical details, and it’s well worth digesting, but I want to pull out some core ideas:

Brian Chappatta’s article, Puerto Rico Shows Perils of Muni Bonds Backed by Empty Promises, quoting a number of market participants and observers hyping the risks of appropriation-supported bonds versus other bond structures, has compelled me to write something about realistic versus sentimental perspectives on bondholder protections.

So S&P formerly rated Chicago’s Metropolitan Pier and Exposition Authority higher than it rates the United States of America, then noticed that (1) Illinois policymakers sometimes have difficulty agreeing on spending, and (2) the bonds are already in technical default — and the news story there is about the underlying debt structure? Come on, the super-downgrade is Onion material, not Bloomberg material.

Oh sorry, back to the piece:

“Legal protection” doesn’t mean what you think it means

It makes zero sense to make sweeping generalizations about the relative safety of debt based on the specific kind of pledge involved alone. And yet this is how the majority of folks in the municipal bond market think. What Chappatta is suggesting in this article fits the traditional way of looking at risk that old-school municipal bond attorneys frequently lay out in the press. But they are not the ones litigating Chapter 9 cases now, and that is a point that cannot be emphasized enough. There is a new landscape and even general obligation bonds involve very real risks in some distressed situations.

An investor’s first question should be “what kind of legal regime am I operating under here?” The legal and political contexts in which your bonds are issued are what make your rights and remedies relevant. If there is a lesson to be taken from the recent spate of financially challenged municipalities, this is it. General obligation debt is not the same security in different states depending on whether those states authorize Chapter 9, where it is treated as unsecured debt absent a statutory lien (which very few of the states that authorize bankruptcy offer) and may be adjusted.

Chapter 9 cases are now being litigated by corporate restructuring attorneys who have far less sentimental regard for general obligation debt than attorneys who specialize in municipal debt and, it seems from the article, many institutional money managers. The reason recent bankruptcies have been devastating for bondholders is that corporate restructuring attorneys will bulldoze anything and everything, and the law permits this. By the way, many of these attorneys are advising Puerto Rico’s government and Atlantic City.

Importantly, these recoveries are the products of negotiated settlements between the bondholders and the city, which are both arbitrary and path dependent. Negotiated settlements do not say anything about legal protections. A legal precedent regarding the status of the bonds could only be created through a ruling that is upheld by an appellate court. Even then, it would be difficult for it to translate state-to-state.

Bondholders were also practically subordinated to pension benefits, which were treated as another form of unsecured debt but arbitrarily had much higher recoveries. Such were their legal protections.

Had any of the parties settled earlier than the others, they could have received a higher amount. Had the grand bargain not have been involved, they could have received a higher amount. Had the judge not been a populist that often sided with pension beneficiaries, bondholders could have received a higher amount. The city could and often did play all groups of bondholders off of each other in the negotiation process. Theoretically, all bondholders could have been wiped out and stakeholders could still be fighting.

I’ve changed the emphasis from the original piece. Culpepper is talking about reality here, not some diaphanous concept of “It’s against the law!” When the other party is a governmental body, you have to be real careful about flogging the law. Governmental entities don’t make it easy for you to sue or collect on them.

Hard political risks are not one-off events. They are the slow-moving train wrecks — these are the situations like Puerto Rico, Detroit, San Bernardino — where the tone toward bondholders becomes increasingly adversarial and recoveries are inevitably low. The old guard way of handling these cases is to insist on the sanctity of contracts until an exhausted judge threatens to toss the case out. There are probably better ways of dealing with these situations, like resolving issues faster and being more creative about what you are willing to accept from the beginning.

This is not a legal issue.

When you have a governmental body involved, it’s a political issue.

As Culpepper notes, when Puerto Rico recently defaulted on a specific bond issue, they did actually have money on hand to pay. They came up with a legislative reason as to why they were not “authorized” to pay it (not having a budget and all), but this is primarily political posturing.

Puerto Rico, as an entity, is angling for a couple things: an outright federal bailout (highly unlikely), or permission to use the Chapter 9 bankruptcy process for its entities. Either way, something less painful than the legal process various extremely interested parties will put Puerto Rico through, and possibly protecting interests, such as the pensions and other governmental benefits.


I do have some sympathy for the small investor, but I have some sympathy for the lottery ticket buyer, and the compulsive casino gambler.

People need to remember the incentives of everybody involved. When it’s private bond issuers, like companies, there’s the SEC looking over their shoulder. While, theoretically, the SEC also looks over the shoulder of governmental issuers, and have indeed hit Illinois and New Jersey, they’re not quite on top of matters.

It’s kind of tough for governmental actors to go after other governmental actors. Much easier to regulate private companies… and even then….remember Madoff and all the regulators who didn’t want to listen.

So here comes my generic advice: there is no reason you, an individual, should be trusting politicians and governmental entities re: finance. Some do behave well. Many do not.

If you are going to invest in government debt, you’re going to need to make sure they’re not being reckless financially. Yes, those governments that are financially prudent pay lower yields on their bonds. But guess what? They are highly unlikely to default on you. Let institutional investors that keep lawyers on staff who know how to deal with bankruptcies and recoveries to invest in the higher-yielding governmental securities (that are also more likely to default).

There are some assets on which the naive (and even those who are somewhat sophisticated) will get eaten alive.

If you’re going to speculate, do it on private entities that have all sorts of regulators looking over their shoulders.

I feel for the small-time individuals who have lost their investments on Puerto Rico, and Greece, and Detroit, and Chicago…. but really.

Why did you think it would be safe?

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