Caribbean Shell Game: A Q&A with Cate Long about Puerto Rico’s debt woes

Cate Long was, until recently, a contributor to on the municipal bond market, where she provided some of the most relentless coverage of developments in Puerto Rico.  She recently started Puerto Rico Clearinghouse, a research service for Puerto Rico bondholders. editor Steve Eide and Manhattan Institute Senior Fellow Nicole Gelinas  recently interviewed her about Puerto Rico’s debt challenges. Below is an edited transcript.

EIDE:  Does Puerto Rico have a fiscal problem or an economic problem?

LONG:  Puerto Rico has both.  It is an island economy with about 14 percent unemployment, very low labor participation rates, difficulty collecting taxes and the taxes they do levy are quite substantial for certain economic classes.  They have a fiscal problem in that the government has been the largest employer on the island for probably decades and used both federal funds and taxes they collected to support a very large public employee base.

Now that the economy has been weak and they’ve been cut off from getting funds in the bond market, they have to adjust the size of the government.  It’s a very difficult situation.

EIDE:  I have read that Puerto Rico’s debt is estimated to be around $70 billion. How much of that is actually backed by the government?

LONG:  About 50 billion of that has some kind of guarantee, through appropriation or constitutionally guaranteed. There is sort of a seniority structure for the debt that gives bondholders security.  About 20 billion of it is revenue-based debt and the cash flow comes from the revenues that the water and electric and transit authorities generate.   

EIDE:  Can you explain the “Public Corporation Debt Enforcement and Recovery Act” that was passed in June? 

LONG:  In the United States mainland, bankruptcies are all governed by the Federal Bankruptcy Code.  That code, when it was created and then redone, happened to leave out this small little section of Puerto Rico.  It was probably unintentional, but in Puerto Rico, public corporations do not come under the Federal Bankruptcy Code. So to create some kind of legal framework to do this restructuring, the Puerto Rico legislative assembly passed that law to create a legal system within the state court system of Puerto Rico to restructure the debts.

EIDE:  Some investors have filed suit claiming that the law is illegal.  What is their argument?

LONG:  There are a couple of arguments. One, which probably wouldn’t stand, is that Puerto Rico cannot create its own bankruptcy law. But in fact, it was exempted, it was left out, carved out or just sort of forgotten when the federal code was made.  The more important one is, under Chapter 11, what we call Section 903, the requirement that debtors be treated equitably in the restructuring. The way that Act 71, the Puerto Rico law is set up, it really crams down certain classes of creditors, bondholders particularly.  That is just generally not considered cool under US legal framework, and also under the constitution and the legal framework of Puerto Rico.

EIDE:  In situations of fiscal distress, in order for things to generate into a full-blown crisis, it often requires some sort of a trigger, like in New York City in the 70s, the banks balked at rolling over the city’s debt, in Detroit, there was a bond insurer who wanted to seize casino revenues over a soured swaps transaction.  Is there any trigger-like situation like that on the horizon for Puerto Rico?

LONG:  The primary one has already occurred for the electric monopoly called PREPA. They have an about $660 million line of credit with Citibank and ScotiaBank that is a revolving line of credit that was used primarily to buy fuel oil (most of the electric monopoly there is run on fuel oil).  They were unable to roll it. The banks said they did not want to extend that line of credit so, technically, PREPA or some part of the government needs to repay that $660 million. 

There is a stay. The bank has agreed to a stay on that line, but part of it is due at the end of July and the rest, August 15. So that was the precipitating event.

EIDE:  These public corporations like PREPA and the sewer authority-why have their fiscal problems been so much greater than the problems of the government in general?

LONG:  PREPA has been subsidized as has, to a lesser extent, PRASA, the water monopoly. The highway authority and the electric monopoly have been subsidized every year by the federal government, and then PREPA in turn supplies electricity to municipalities in the commonwealth government.  It’s not clear that they are paying for it, they are just accruing that as a liability on their balance sheet.  So it really just comes down to a cash squeeze.

When I think of the fiscal environment in Puerto Rico, I think of a shell game where money is often moved between either the commonwealth budget, the government development bank, which is like their funding structure, and then these other public corporations that are guaranteed. 

For the last 20 years, they have borrowed a lot of money in the guaranteed markets and they have moved it around between all these various elements.  They have just basically maxed out the credit card now.

EIDE:  Another thing that is unique about the situation in Puerto Rico is that the debt is exempt from all federal, state and local income taxes in America. Is there a lesson to draw here about moral hazard and the tax exemption on municipal bond interest?  Is there some way in which Puerto Rico over-borrowed because of the unique tax exempt status of its bonds?

LONG:  I think that is fair to say.  I think demand has been insatiable among the investor class for the higher tax brackets and that did fuel a lot of issuance.  It is very interesting that, now that the US investors, the traditional investment class has been cut off, yields for the general obligation bonds are 8.5-9 percent, which are astronomical.  You are looking at yields much higher than any stressed European country, in the realm of Ukraine, Venezuela, extremely stressed sovereigns.

GELINAS:  You mentioned that the government was the largest employer on the island.  Does Puerto Rico and/or all of these public authority entities owe unfunded promises to their workers and retirees in terms of pensions and healthcare, and if they do, where do those claims fall in terms of competing with the bondholders?  As we saw in Detroit, the city, with the agreement of the judge, favored the pensioners above other creditors, particularly unsecured creditors.  Is this a factor in Puerto Rico as well?

LONG:  It is really an entirely different situation.  Puerto Rico’s general retirement system has probably less than seven percent of the assets it needs; it’s like 95 percent unfunded.  There is basically nothing there, it’s on a pay-go basis. 

In contrast, I always considered Detroit’s pension funds to be pretty well funded by national standards.  You had that unfunded liability, so there was a question of its actual size, but there was a big pile of assets in Detroit for the retirees.  There’s nothing, really, in Puerto Rico. 

And the creditor structure, how that gets played out, it’s a question mark.  Honestly, I don’t know if Act 71, the restructuring law, if it particularly addresses them.  It pretty much shelters what is there but there is very little there.  What it does on a going forward basis to draw more assets into those retirement systems, I don’t know. 

EIDE:  Can you say something about the role that hedge funds are now playing in the restructuring?

LONG:  It’s a very interesting situation.  Cleary Gottlieb is the large restructuring firm, legal firm, that was hired by the Puerto Rico government. They also did the same work for the government of Greece, restructured their debt.  They have been involved in several sovereign restructurings. 

My view is that they used the hedge funds very opportunistically, either to prop up bond prices where they want or sort of move against certain bond prices within the whole Puerto Rico pie.  What I am saying by that is, this ad hoc group of hedge funds has come in to support the general obligation and COFINA sales-tax backed bonds.  They bought over four billion and said that they would be willing to lend more financially to the government.

In the meantime, that sort of draws a bright line, since Cleary brought the hedge funds on the side of the government, and the public corporation debt that they want to restructure is sort of out there without any public support by any parties.

EIDE:  And what are the prices that the hedge funds are paying for these general obligation bonds?

LONG:  The big one that was issued in March-eight percent interest due in 2035-the price I just saw when I last checked was around 89.  It came at 93 in March, so it has traded down about four dollars since then.  It has bounced around some.  But the interest rate on those bonds is around 9 percent now.

GELINAS:  How confident are investors in the structured finance issues? In other words, for a sales tax bond or another bond where certain revenues are supposed to be pledged, whether it is sewer revenue or power revenue, are these yields lower, do bondholders feel confident that the government will honor the structure, or is there a perception that these structures may be at risk, that in the end, the sovereign has police power and can override these structures if it wants to take that money out of the structured finance provisions? 

LONG:  Each class of bonds has its own peculiar pledge in security, both within the law in Puerto Rico and depending on where it is restructured, what that law is. But the highest class of bonds for Puerto Rico is the general obligation bond.  They are guaranteed by the constitution to be repaid. We believe the Supreme Court of Puerto Rico would order that those bonds be paid.

And then you have the sales tax-backed which you mentioned, the COFINA bond, which the law, not the constitution but the law, guarantees that the proceeds of the general revenues of Puerto Rico will be directed to them before other uses.  There is an argument whether that can be clawed back or not, and that is why many investors are following this closely, especially the legal dimension of it.

GELINAS:  Which one has a higher yield, the COFINA or the GO?

LONG:  The general obligation yields are higher.

EIDE:  What type of systemic or contagion-type concerns do people have right now? In the case of Detroit, there is a great concern about what the impact that the actions taken towards bondholders will have on borrowing rates for other cities in Michigan.  Do any similar concerns like that exist for Puerto Rico?

LONG:  No, I don’t think so because it’s unique, being a commonwealth.  Some people mention the Virgin Islands and Guam, but they are tiny issuers in comparison.  They are more like a mid-sized city, in terms of how much debt they have outstanding.  Puerto Rico is the third largest issuer in the municipal market. But it is also again unique because it was triple tax exempt across the country, and it’s not on the mainland.  It’s really not comparable.

We saw some sell off from high-yield mutual funds when Act 71, the restructuring law, was passed at the end of June. When they file to restructure PREPA or one of the public agencies, if they do, there will be a shock.  There will be some selloff, but I don’t think it will last that long, personally. 

EIDE:  If there isn’t any type of contagion risk for other governments, what about financial firms, like certain bond funds, investors or bond insurers?   How serious of a risk are they running with Puerto Rico?

LONG:  The biggest exposure is the bond insurers.  In total, about a third of the debt that’s at risk is insured.  Analysts do sit around and calculate, if the bonds are haircut 20 to 30 percent, what the loss would be to the insurers, also the rating agencies do that.  Everybody basically feels like they have adequate capital to take these haircuts if they come. 

GELINAS:  Could they do an International Monetary Fund restructuring? Several sovereigns have gone to the IMF, both for standstill refinancing, restructuring debt. Or is Puerto Rico not eligible?

LONG:  They are not eligible.  You have to be a true sovereign.  That would be like maybe Hong Kong trying to go to the IMF when it is controlled by China.

GELINAS:  Are the vast majority of the investors here in the mainland US, or do they have South American, European, other international investors?

LONG:  Hard to say, because the hedge funds often have investors from around the world.  We know who a couple of them are, but recently they just added 15 more hedge funds. It’s truly hard in the municipal market to know what the ownership of bonds is.

GELINAS:  Did they do Build America bonds?

LONG:  Not that I am aware of.  They may have issued a small amount, but not really, they didn’t really need to.

EIDE:  How much longer do you think this saga could drag on for?

LONG:  A couple of years, easily.  The sum of money involved is enormous, and I think the courts are trying very hard to get prepared for all the legal activity.  We saw in Detroit a very fast Chapter 9. But still, they filed the middle of last July and it is now a year past later and they are still at it.  Stockton, they filed two years ago and they are still at it.  San Bernadino, same thing, filed two years ago and they are still at it.  These are very long and involved processes to restructure public debts or municipal debts.

EIDE:  In principal, the bankruptcy process is supposed to make it easier to do a workout. If you don’t have access to federal bankruptcy, it would be harder, I would think.

LONG:  Yes.  The thing is, it’s the first time it has happened in a lot of these instances.  In Michigan, it’s really the first big bankruptcy, so you had issues about the constitution and pensions and these auxiliary legal issues that haven’t been addressed before.  It’s not quite like a corporate bankruptcy where these things happen repeatedly in a state or federal jurisdiction and there is established law and processes.  Every one of these is unique and raises a unique legal question that hasn’t been addressed before.