Everyone to whom Puerto Rico currently owes money knowingly gambled on the probability that, one day, the island’s leaders would simply announce—as Governor Alejandro García Padilla did last week—that their debts are “not payable.” In fact, bondholders charged higher interest rates precisely because of this potential outcome. So why is the current crisis perceived as a failure by Puerto Rico, not investors who shook off the warnings and lent the cash anyway?
For some reason, we habitually condemn the moral failings of borrowers when they break their debt obligations. But there are two sides to a debt contract. And in the case of Puerto Rico, the behavior of the lenders upends such high-minded assignments of blame.
According to the report commissioned by the Puerto Rican government and written by former International Monetary Fund and World Bank economist Anne Krueger, Puerto Rico’s economic woes have deep roots. Public sector debt has risen each of the last fifteen years, and GDP has been plummeting since 2006, when several tax breaks for the island expired. Like warm-weather states in the U.S., Puerto Rico had a housing collapse that continues unabated; median list prices are down 38 percent, and three-quarters of the decline in investment comes from reductions in residential construction. The Krueger report does indicate that unreliable government data has hid the severity of the island’s finances, but even a cursory glance would reveal significant economic stress.
In fact, the report notes, “starting in 2013, risk premia on general obligation bonds began moving up steadily.” In other words, lenders requested higher interest rates to guard against default. Credit rating agencies downgraded Puerto Rico below investment grade level by the beginning of 2014, raising rates even more. Bonds issued in 2014 initially carried a yield of 8.7 percent, much higher than the 2-3 percent available from U.S. Treasury bonds. Everybody willing to lend to Puerto Rico—the commonwealth and its public enterprises (like the state-run electric company) currently owe $72 billion, more than all but two states—knew the risks, and were paid for them accordingly.
Who are these investors? As a U.S. commonwealth, Puerto Rican bonds are considered municipal debt, with the same tax exemptions as domestic local government bonds. So Puerto Rico’s borrowing was stuffed into mutual funds and soaked up by muni bond investors. But that narrowed after the rating agency downgrades. Those who feared default got out, and distressed debt investors known as “vulture funds” swooped in, picking up the bonds at a steep discount. If they are paid back in full, they will make astronomical returns. While municipal bond funds like Oppenheimer and Franklin Templeton still own large quantities of Puerto Rican debt, hedge funds looking for a payday have been the only ones willing to lend over the past year.
After years of escalating borrowing costs, García Padilla on Monday asked to delay payments for several years while attempting to revive the economy. The immediate reaction from the vultures was to prepare for war. They pulled out of a debt deal with Puerto Rico’s Government Development Bank and started lawyering up. A $600 million payment by the national electric company has been temporarily postponed, but it’s unlikely that negotiations will lead to any shifting of the burden onto creditors. So many different hedge funds hold the bonds that an out-of-court settlement is simply unlikely.
The situation is similar to vulture investors who bought Argentina’s discounted debt and tried to force them to pay out. Argentina refused, despite a U.S. court order. But unlike Argentina, Puerto Rico has scant opportunity to avoid the vultures. The island’s constitution puts general obligation debt service ahead of practically all other obligations, so vultures would likely secure a claim on Puerto Rican revenues. The commonwealth must follow orders from the U.S. judiciary, the jurisdiction where vulture funds would appeal to recoup their money. Unlike Detroit or other municipalities, Puerto Rico is not eligible for Chapter 9 bankruptcy protection. They have no alternative lender available to sovereign nations, like the International Monetary Fund. And talk of a federal bailout elicits laughter in Washington.
So either the vultures were dumb enough to think that an economically sick territory like Puerto Rico could indefinitely pay high-yield bonds—and there’s some evidence of that—or they knew that they could force payment in court, discounted the risk, and just gouged the commonwealth and its taxpayers in a predatory lending scheme. So who exactly committed ethical lapses here, Puerto Rico or its creditors?
The job of a lender is to measure and price the borrower’s risk, and make prudent decisions on whether to lend. If the loan fails, that’s as much the fault of the lender as the borrower. And making high-interest loans to obviously uncreditworthy clients, while subsequently using the courts to force payment, sounds more like the occupation of a dignified loan shark, one that wields legal briefs instead of tire irons to make their money.
Puerto Rico did over-extend, although its overall debt to GDP ratio is just over 60 percent, lower than the United States or even paragons of fiscal soundness like Germany. But the over-extension can’t happen without a lender on the other side, chasing high yields and neglecting to account for Puerto Rico’s difficulties. Meanwhile, 3.5 million U.S. citizens, already suffering from double-digit unemployment and a depressed economy, are about to get hit even harder; either by default or the “structural reforms” designed to avoid it, including slashing the minimum wage. Puerto Ricans weren’t the only parties in the deal who made a mistake. Those other parties, vultures who ignored clear signals of default, could get away scot-free. Even the Krueger report, perhaps in a nod to the lack of options, proposes a debt restructuring that increases the value of the bonds.
The path to a solution begins with this: Congress needs to make Puerto Rico eligible for Chapter 9 bankruptcy protection, which a bill introduced yesterday by senators Chuck Schumer and Richard Blumenthal would accomplish. You can already hear politicians calling this a bailout of an island that foolishly rung up a bunch of debt. But failing to extend a bankruptcy option, as we do to every municipality in the United States, actually grants a back-door bailout to the hedge funds. They freely lent to a commonwealth that had no reasonable way to pay them back, and because they have Puerto Rico cornered like a rat, they may feel no price for that miscalculation.
Incidentally, even a bankruptcy where vultures take discounts would still work out well for them: They purchased the bonds cheap, and would therefore profit while sharing in the sacrifice. Since they helped to fuel Puerto Rico’s debt addiction, the forthright thing to do is to spread out the pain. Americans are often quick to point the finger at borrowers for their irresponsibility, but in this case, the lenders exhibited a combination of recklessness and greed. That shouldn’t be rewarded.