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Puerto Rico: Colonial Chickens, Structural Priority, and Contingent Debt

posted by Anna Gelpern

It has been a humbling torrent of creativity, and I am honored to chip in a tuppence at the eleventh hour. After an existential preface, I consider how one might use (or resist using) federal credit enhancement in the inevitable debt exchange.

By way of a preface, my dominant sense of Puerto Rico's crisis continues to be that it is all about colonial chickens coming home to roost (see Melissa's roundup). One could, therefore, get on a high horse about mismanagement and corruption--but staying on the horse is hard when you consider that the Commonwealth economy is entirely a function of its century+-long relationship with the United States. The Jones Act, the military bases, the random tax breaks, and the massive but incoherent patchwork of federal transfers are symptoms of the broader dysfunction (this is where comparisons with Greece and the young euro sound especially beside the point). A durable solution to the crisis therefore requires a vision of what Puerto Rico's economy should be about in the United States and in its Caribbean neighborhood, which therefore implicates the status question. Until then, it is important to keep in mind--as Adam Posen said in December (at the very very end of the video)--that investing in the people of Puerto Rico is not necessarily the same as investing in the place. It might just be that even a perfectly reformed Puerto Rico is a much smaller place for the foreseeable future.

Onto the less-intractable business.

First, picking up on some of Adam Levitin's themes, I think that the question of priorities is central, and that the situation is worse than it looks. The government borrowed too much using different agencies, different collateral, different contract and payment routing schemes. There is constitutional priority, statutory priority, contractual and structural priority. That structural variety strikes me as especially problematic because it operates by creating facts on the ground, such as payment streams that require laws and lawsuits to reroute. Similarly, two identical general obligation bonds, both of which have constitutional priority, may not be equal at all if one is governed by the law of Puerto Rico, and another by New York law. In other words, there is priority, and there is facts-on-the-ground priority.

This is where the absence of a comprehensive, collective, binding process like bankruptcy feels like a huge problem. Debtors will pursue piecemeal settlements, creditors will jostle for advantage, the meek shall inherit bupkes, and the next round shall have more convoluted debt structures and more over-borrowing. (Note I am eating a bit of crow here, since I had advocated more contractual prioritization in sovereign debt ten years ago. I had in mind an alternative to hidden structural priorities, not a steroidal expansion thereof.)

Therefore - whether this ends with a federal oversight board-cum-restructuring authority, a giant distressed exchange with federal credit enhancement (eg, bullet repayment or rolling coupon guarantees/UST collateral), or a combination of the two ... the outcome has to be a super-simple, transparent, explicit capital structure. Most especially, federal credit enhancement should not be used to validate attempts at  creating super-senior general obligation bonds governed by New York law over the hoi polloi general obligation bonds governed by Puerto Rican law. It would be exceptionally ... un-federal.

(Aside: a U.S. state (or territory) that can no longer issue debt under its own law probably should not be issuing more debt.)

Second, Puerto Rico's bond restructuring proposal contains an intriguingly fashionable component, namely, state-contingent debt (see p. 11 for Growth Bond description, and here for graphics, despite somewhat purple text). Creditors get paid more if revenues go up, less if they go down. They have a stake in the well-being of the debtor's economy. It is sort of like ... equity.

Serious economists love contingent debt. It also makes huge intuitive sense--if it is well designed, it could counter cyclical fiscal pressures, help manage crises, compensate creditors ex ante, and add a modicum of predictability ex post in this bankruptcy-free space. On the other hand, market participants have been forever lukewarm on contingent debt, for reasons that do not seem entirely compelling to me.

The most common objection is that, when the payments are indexed to something within the debtor's control or calculation purview, like GDP and especially revenues (Puerto Rico's proposal), the numbers will be cooked. Let's put aside the question of why a government would understate growth (presumably raising its new borrowing costs) just to save a few pennies on the old indexed debt--who knows, some might. The answer should be to raise the cost, not to reject the contingent instrument altogether. Another alternative would be to pick a source of relevant statistics that is not under the government's control, like the IMF for foreign sovereigns, or a federal oversight body in the United States. If the debtor fails to supply verifiable data to that body, it does not get the benefit of the contingency. Incentives aligned.

My hunch, though, is that the reasons for market resistance are deeper than statistical integrity, and have something to do with the fact that government equity is inherently weird. Put aside the need for super-simple, information-insensitive debt to serve as a base asset in the banking system and the capital markets; assume instead that we are in the world of risky debtors like Puerto Rico.  What do you get as a creditor when you promise to forgo payments when the issuer is in distress? You do not get control rights or better collateral, you just get a promise of fluctuating returns in a world where everyone around you is playing structural priority games after the fact (see above). The entire picture comes to look too uncertain.

A few countries have issued little chunks of contingent debt in recent years, but they have been mostly distressed economies like Argentina, Greece, and Ukraine, promising their creditors value recovery later in exchange for deeper debt relief up front. In the past, the contingent component has been small. What Puerto Rico is proposing is pretty huge relative to the size of the debt stock--and given the size of the debt stock, the value recovery piece could be a liquid instrument in its own right.

It would be a good use of federal enhancement in a debt exchange to encourage properly designed contingent instruments, especially since these can serve as a vehicle to promote statistical integrity and halt structural priority races. If it works, it could even spread in the muni markets and beyond.


Value recovery piece a/k/a growth bond requires acute awareness of PR's failed economic development policies. These are based predominantly on tax incentives that are unmoored from inherent capacities and human capital. The media seldom explore this central issue.

Although there have been many excellent theoretical ideas presented in this blog (including Professor Gelpern's above) the approach being promoted by the US Treasury and Millstein and Cleary (PR govt's advisors) to restructure the entire debt stack are unlikely to receive support by Congress.

Puerto Rico has capacity to pay most of its senior debts.

The most critical need is for the advisors to immediately help the Puerto Rico governor place the Government Development Bank into receivership. The GDB has (as of June 30, 2014) public sector loans amounting to approximately $6.105 billion (identified as non-accrual) on its books. In other words it is Puerto Rico's bad bank and needs to be put into resolution.

In the last week GDB bonds traded between 20-23 cents on the dollar clearly demonstrating the market expects them to have very low recoveries.

More details on the GDB here on page 12: https://drive.google.com/file/d/0BwUldNJ-sOg_dldSeGdUM3ZTSDQ/view?usp=sharing

And my comments on PR and the GDB at 14:30


The Jones Act has to go. Senator Inouye protected Matson shipping here in Hawaii for years and later at the expense of our citizens. I can't tell you how frustrating it is for Hawaii and Alaska to be considered step children to the rest of the United States when it comes to shipping. And let me tell you - many companies make that extra shipping issue a profit center. Avon, for an example - could ship Priority Mail flat rate box and be half of the cost it charges for shipping. That said, numerous companies add on exorbitant cost to ship to Hawaii and Alaska. It is also reflected in our groceries - cereal for example is $6.50 a box! Milk is often $10 a gallon.

Building materials are higher priced because there is no competition in the shipping. Generally, the overall Jones Act is outdated and unnecessary in this "global" economy. Amazing that I can get products from China for a lot less and FREE SHIPPING - and in America the same items cost more and tack on a surcharge for shipping!

Besides the obvious legal pearls surrounding all this, perhaps the single most relevant aspect of all this drama is financio-political: why do private investors lend big time to will-obviously-go-bust socialistic governments? They did it with Puerto Rico, they did it with Venezuela (next big wake up call), they even did it with the Kirchners (post-default!) with successful private placements led by top investment banks!
One can only imagine global investors salivating at the prospect of buying bonds issued by the new Socialist Republic of Spain once a government is finally formed over there.
Frontier investing in the most exotic of emerging markets is one thing. Giving money to a political system destined to fail (destined to default in fact) must surely count as the most puzzling and possibly idiotic of investment activities out there.

We love all things Anna Gelpern and obviously Puerto Rico is important (especially for someone based in D.C), but what would be truly great is Gelpernian coverage of the Ukrainian pari passu saga.
We want to know if passing of the national law making holdouts subordinated in payment to exchange bondholders will be seen as not in breach of pari passu (thus "allowing" a default on Russia) given Ukraine´s odd type of pari passu clause.
What will the London courts say? How will Russia defend herself here?

I would think there would be a limited market for contingent debt simply because of the lack of certainty about payments. Money managers like fixed income investments because of the certainty of the payment stream, which they can match to their own liquidity needs. Contingent debt is more like taking an equity stake in the debtor, but without the upside the come with equity. I can see why a debtor would like this, but I can't see it being especially attractive to investors absent a very high (and self-defeating) coupon.

Adam, yes but that is not enough. There is a hoot load of neither-debt-nor-equity hybrids. There is even some contingent debt. Even the interwar German reparations debt had a contingent piece (they called it postponable annuities). So why not this variety? My hunch is that it has something to do with how little certainty this buys you in a world of so much jostling ex post.

Cate is always incredibly well-informed, and GDB is a mess to be sure, but the zillion dollar question is precisely what is covered by "most," and who is really "senior." Alas, our tasker from Melissa was what to do without Congress. I would prefer a comprehensive legislative fix, but am not holding my breath.

I therefore have some sympathy for Champerty's point, which I take to be that high-risk investments are, well, risky. As for Ukraine ... it's all about contract interpretation, where reasonable English lawyers will surely differ in the most gratifying ways. I should be glad to have the spotlight off the Second circuit...

Thanks very much for your kind and thoughtful comments!

Anna gets gold star as always by taking the prompt seriously - today's headlines illustrate why, at least for a bit, we challenged ourselves to paths that might avoid the need for Congressional action.

GDP securities sound good until you realize that they have been issued by economic basket cases. It´s not equity. It´s equity in penny stocks: yes, some significant potential upside but the company is also about to perish.
Argentina was lucky in catching a commodity boom rally and GDP securities paid handsomely for a while, but the economy soon returned to mediocrity.
Greek GDP securities won´t pay a dime with almost all certainty.
Puerto Rico? Unless there is some shock and awe strategy to deliver them from socialism, the economy is obviously hopeless.
There is a reason why investors always value these GDP securities at zero when issued: the issuer is hopelessly out-of-the-money save for some miracle.

After the fact, it's always easy to identify the basket case, a la Enron. Your average retail investor would have no idea the appropriate level of debt-to-GDP a Commonwealth, State or Nation should have. The difference between a "Frontier" Fund and the municipal bond market is one is dominated by professional investors, the other is dominated by individual, retail investors. The reality is, these investors took (on face value) statements of solvency from the Government reinforced by the investment bankers and rating agencies.

For those who rushed into the fire, no one should worry about whether they are *singed* but an investor who was investing in the "social bargain" that is municipal bonds don't deserve to be treated as collateral damage. Fact is, save the $3.5bln deal, the vast majority of the losses born by this crisis are going to be born by individual investors and the Puerto Rican people.

The investment banks/brokers, rating agencies and MOSTLY the Government of Puerto Rico were together implicit and actively promoted this Grand Lie.

One historically accurate way to detect a sovereign basket case is to see whether they are run by a socialistic-communistic regime-party-ideology. I think history is pretty informative in that respect. Anyone who goes long on Kirchnerite Argentina or welfare-addicted Puerto Rico or openly-spendthrift Greece without developing even the slightest view as to what kind of fiscal and economic policies obviously rule supreme over there should be categorized as a voluntarily misinformed (delusional?) investor.
Take Ukraine too. GDP securities issued by a war-torn economy in the midst of a nasty legal fight with a much-better-armed military foe. Should you go long such bet? Don´t say you were not forewarned (ever heard of Crimea?).
GDP derivatives were a pretty good idea when some banks tried to develop them for bond traders (hedge against bad economic outcomes). But that didn´t fly as far as I remember. The application to sovereigns again sounds good but you would need
issuers that at least don´t feel like perennial disasters. One reason to be suspicious of sovereign GDP securities is that they are most enthusiastically endorsed by those loudest for debt forgiveness (the jubilees of this world).

You're argument rests on being informed about the topic contemporaneously yet it fails to recognize the insidiousness of the deficit spending. The consistent deficits that were run up by the Puerto Rican government should have been alarming but where were the calls from the Ivory Tower since 2004? There's now a long list of people willing to say "I told you so" but much of the debt wracked up in 2004-2012 is debt that still exists today.

One could argue the retail investor should be more knowledgeable about what securities they have purchased before and what they have now. The facts on the ground change and if you're not an academic, journalist or in finance, the likelihood you recognized the death spiral was low.

A good corollary is Illinois currently, anyone buying right now is buying speculatively. Who is out warning people to sell their existing Illinois holdings? Do the individuals who purchased their securities years ago, are they aware of how precarious the situation is at this point?

Here is some preemptive I-told-you-so.
If Venezuela restructures and includes a GDP security and Chavismo remains in power, then it is the safest bet in the history of mankind that those securities won´t pay much.
Same could have been said for Argentina in 2005-2010 (obvious hard left regime) and Greece 2012 (what with the Syriza party already making waves).
It´s not the fluctuating fiscal policies, it´s the inescapable political nature of the issuer.
Would you buy a Chicago GDP bond right now? Would you buy a US GDP bond if Bernie Sanders wins the election?
Financial investing is hard, but some things are pretty much forecastable. Which is why GDP bonds will flourish when they are issued by non-predictably-bankrupt sovereigns.
So the really relevant discussion on GDP bonds should be: would Germany or Finland benefit from these instruments?

(1) Investors wouldn't purchase them in the ordinary course, which is agreed.
(2) They're only offered in situations where investors are being doled out current losses, which is also agreed.
(3) Why trust the government to suddenly turn over a new leaf? You won't, obviously.

However, if you purchased these securities when it wasn't readily apparent the issuer was on a path too destruction, you'd hope the issuer will do its level best to provide you the highest possible recovery. The average retail investor, with lot sizes of <$100,000, is going to have zero input into the restructuring, which is why I describe the muni market (unlike Greek debt and the like) as a social bargain. Individuals fund the government, have zero bargaining power, but trust the government and laws of the land will provide them adequate protections from aggressive government. Maybe that's naive but that's the reality.

Bottom line: GDP securities can be great for both issuers and investors, unless they fall "in the wrong hands".
It´s a default without a default, the dream of any clientelist populist regime looking at bilking investors (while being cheered on by debt-forgiveness ngos and a few Ivy League economists) and full in the knowledge that they sold an option that is destined to be out-of-the-money.
If I need money to fund a populist revolution and if I know (of course I know) that the end result is a bankrupt economy, then I would love to issue as many GDP securities as possible.
I have a feeling investors may have developed suspicions along those lines, ergo the zero value for Argie or Greek GDP warrants.

Bottom line: One of the largest benefits of doing business in the US is the stability in the legal system. Attempts at populist approaches that fundamentally undermine the faith in that system will have a "butterfly effect" the ultimate effects of which can only be guessed at.

If we don't like the way laws are doled out in banana republics, there should be limited tolerance of activity that looks, smells and feels like bananas.

Having a "vision" for an economy is a tall order; after all, we are not communists. What is easier to state is that an economy should not be based around borrowing a huge amount of public or private debt to over-consume, under-invest, poorly educate, and over-promise (especially pensions and other un-extinguishable senior claims).

Greece and PRC have two main things in common: they don't have their own currency, and debts in that currency to devalue; second, they are fiscally incontinent. Bonds are also owned by foreigners, so restructuring or defaulting is logical if refinancing becomes impossible.

Why do investors pour money in in such situations, Anonymous asks? Greed, duh. Returns are fabulous, until they're not: Venezuela has returned 10% per year since Chavez was elected; Russian Ruble bonds were yielding 60% in 1998; many PRC bonds are guaranteed by monolines and were rated "investment grade" (I know, after the subprime debacle, this is a stupid excuse); and finally, moral hazard and the lack of Chapter 9 means most believed PRC would be saved (just like Fannie Mae, Gazprom, Petrobras, Pemex, Eskom, Codelco going bust is simply unthinkable, especially if you refuse to think about it).
Good luck PR! Please behave responsibly and show Argentina and the Eurozone how to do this right!

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