Puerto Rico Restructuring: Unique Problem Requires Unique Solution

Puerto Rico Restructuring: Unique Problem Requires Unique Solution

Puerto Rico’s debt crisis is coming to a head in the coming months. Here’s a quick summary of the issues, timing and our views:

  • U.S. Congress is getting close to action. Over the past several weeks, experts from different disciplines have descended on Washington to offer Congress views on Puerto Rico. Yet, Congress struggles to decipher fact from myth in search of a solution to the Commonwealth’s debt and economic crisis. Nevertheless, we expect Congress to produce new draft legislation by House Speaker Paul Ryan’s 31 March deadline.
  • U.S. Treasury recently provided a sensible proposal, which Congress should embrace. Puerto Rico needs time to address the escalating crisis without fear of mounting litigation. Treasury suggests a broad territorial debt restructuring authority combined with federal fiscal oversight which would ensure fiscal consolidation. The proposal would also include a stay on litigation, allow voluntary negotiations among creditors and ultimately bind holdout creditors. In our view, this proposal could succeed in achieving sustainable debt dynamics through a consolidation of the island’s byzantine claims structure that includes $72 billion of disclosed public debt, 18 debtors and $43 billion of unfunded pension claims.
  • Unfortunately, an effort is underway to prevent Congress from providing Puerto Rico tools to achieve sustainable debt dynamics. PIMCO concluded long ago the Commonwealth’s debt load was not sustainable absent sustained economic growth. Denying Puerto Rico a comprehensive tool that includes the ability to restructure all of its financial liabilities serves to delay an inevitable outcome and ensures further population flight. Below we address a few misconceptions that have clouded the discourse:
    • Myth 1: Restructuring Puerto Rico’s general obligation (GO) debt will spill over to the broader municipal market. This risk is greatly exaggerated. Municipal investors understand Puerto Rico is an anomaly given its unusual limbo status as neither state nor city. Furthermore, over half of the states provide their municipalities access to Chapter 9. Municipalities in Michigan have not suffered any long-term adjustment in risk premiums following the City of Detroit’s bankruptcy, despite concerns voiced at the time of the city’s filing. Investors also understand that investing involves varying degrees of risk, including the risk of default, regardless of whether bankruptcy is a legally permissible option. Finally, Puerto Rico’s distressed bond yields suggest investors have already experienced economic losses in anticipation of a restructuring.
    • Myth 2: Restructuring Puerto Rico’s GO debt could result in states requesting debt restructuring authority in the future. State access to a theoretical federal bankruptcy regime is fantasy. Access to a federal bankruptcy regime could trigger constitutional questions regarding state autonomy, which may serve to limit the effectiveness of any proposed federal restructuring regime for states. No state since Arkansas in 1933 has defaulted on debt, and during the global financial crisis states adroitly managed revenue shortfalls and budget gaps. For example, California for a few years faced massive budget deficits, yet the state’s ratings never fell below investment grade and California is on a much sounder financial footing.
    • Myth 3: Restructuring Puerto Rico’s GO will lock out the Commonwealth from future market access. The municipal market has evolved and financial markets are forward-looking. Capital will return to Puerto Rico after the Commonwealth has consolidated the number of debtors with overlapping claims on revenue, reduced debt service to sustainable levels, improved transparency and tax collection and implemented reform for growth. The U.S. Treasury’s plan will pave a path toward this future.
  • Failure to grant Puerto Rico restructuring authority would not assure the timely repayment of debt service. Puerto Rico’s emergency liquidity measures are exhausted. We believe the Commonwealth has neither the will nor the capacity to cover debt service payments due in May and July. The risk of a disorderly default is increasing and would exacerbate the crisis and raise the costs associated with Puerto Rico’s restructuring. Passage of a solution appears destined for the coming second quarter and Congress should adopt a proposal similar to that of Treasury. The longer our leaders wait for the crisis catalyst, the greater the damage to Puerto Rico’s market structures and economy.

Read more: PIMCO Insights on Municipal Bonds


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