After years of economic hardship, the government of Puerto Rico pulled the trigger on a bankruptcy-like filing on Wednesday, turning the page in a saga featuring public officials, creditors and the 3.4m residents who have lost control of the island.
At stake is more than $120bn of debt and pension obligations, with investors braced for billions of dollars of losses. What caused this crisis and what awaits the US territory? How did Puerto Rico get into this predicament? Many politicians and historians attribute the economic crisis to changes to the tax code in 1996, when incentives for doing business on the island were slowly phased out.
By 2006 economic growth had slowed markedly. As the credit crisis ravaged the US mainland, Puerto Rico struggled, too, and financial regulators were forced to seize several banks. Puerto Rico continued to decline. The government kept on borrowing to fund operations, running large budget deficits and now has bond debts of about $74bn.
A federal oversight board installed by the US Congress estimated the island could only afford a quarter of that amount. Anne Krueger, the former first deputy managing director of the International Monetary Fund, remarked bleakly in her 2015 report: “Structural problems, economic shocks and weak public finances have yielded a decade of stagnation, outmigration and debt.” What does the bankruptcy filing mean for Puerto Ricans? Puerto Rico’s near $50bn pension system is vastly underfunded and could be fully depleted by the end of this year. That would shift as much as $1.5bn on to the government’s annual budget, weighing on its ability to fund other public services.
Pensioners are preparing for cuts to their retirement pay. A fiscal plan proposed by the government has sought to cut payrolls, reduce subsidies to the island’s university system and slash spending on healthcare. Those changes could spur additional migration from the island, one of Puerto Rico’s most pressing problems. With more than 45 per cent of Puerto Ricans living below the poverty line, Puerto Ricans are moving to the US mainland in search of work.
What is Title III? Puerto Rico, like other US territories, was in no man’s land before the passage of the Promesa rescue legislation in Congress last year. The island is not a US local government or public corporation so it does not have access to typical bankruptcy protections. The rescue law borrowed heavily from the Chapter 9 bankruptcy code, allowing territories to restructure their debts under the purview of a control board in a process known as Title III.
The island must first prove that it attempted good faith negotiations with its creditors before the board can sign off on a Title III filing. Once it has, John Roberts, the chief justice of the Supreme Court, will designate a district court judge to oversee the court proceedings. Title III includes cramdown provisions, which can bind dissenting creditors to a plan that is signed off by the oversight board and the courts.
These provisions prevent holdout creditors from blocking a wider deal and needs agreement from only a single creditor class within Puerto Rico’s complex web of debt issuing agencies. “Title III puts a lot of power in the hands of the board, including seeking to have the court cram their plan down on to any dissenting class of creditors,” says Jim Millstein, the adviser to Puerto Rico’s previous administration and the former chief restructuring officer at the US Treasury, where he led the rescue of insurer AIG. “The risk of cramdown should alter everyone’s negotiating strategy, hopefully to prompt a settlement sooner than later.”
Who are the losers? Mutual funds, including Franklin Templeton and OppenheimerFunds, which are large holders of constitutionally backed general obligation bonds and junior sales tax-backed debt, are among the biggest losers in Puerto Rico’s default. The two fought vociferously against proposals under the previous governor, who offered higher payouts than the current administration. Monoline bond insurers, which insure a portion of Puerto Rican debt, are also facing losses. Distressed investors are in a difficult spot after the oversight board projected this year that Puerto Rico could afford far less on bond payments than previously predicted. Those investors, including Aurelius Capital Management and Monarch Alternative Capital, have already filed lawsuits against the territory.
How soon will this be resolved? No one knows how long a restructuring of Puerto Rico’s debts, the largest bankruptcy in the history of the $3.8tn municipal bond market, will last. In a best-case scenario, creditors could begin to settle with the oversight board in the next few months.
However, many advisers fear the process could last 18 months to two years — or even longer — costing millions in legal fees and depressing economic activity on the island. Litigation between creditors could also make its way to the Supreme Court, with holders of the sales tax-backed bonds — known as Cofina by its Spanish acronym — and general obligation bond investors both claiming they deserve seniority in a restructuring. “With that bankruptcy now started, the governor has forfeited all power over the restructuring, and the economy of Puerto Rico will be put on hold for years,” says Andrew Rosenberg, a lawyer with Paul Weiss who is advising some of the general obligation bondholders. “Make no mistake: the board has chosen to turn Puerto Rico into the next Argentina.”