By: David A. Smith
History does not repeat itself, but it rhymes
– Attributed to Mark Twain
No sooner had the cacophonous European financial orchestra put down its instruments after playing its discordant improvisation – not the end of the Grexiad symphony, mind you, merely an intermission where too many people will be queuing for the crowded loo – than the melodies and chords of sub-sovereign default have been taken up over here, for the time is nigh for America’s Caliban, Puerto Rico, as reported on last week’s Wall Street Journal (July 30, 2015; gray font):
It seems the bottom only because the chart cuts off at that point
Deadline Draws Near for Puerto Rico
When its history is finally written, this era will be seen remembered as the decade of defaults, where a whole theory of government finance and budgeting was exploded by bankruptcies, one after the other, from small (Prichard, AL) through medium (Scranton PA, Harrisburg PA, Stockton CA, Jefferson County AL) to large (San Bernardino, Detroit) and leviathan (Chicago? Greece? Puerto Rico? Illinois?). As Greece’s travails are still fresh in our minds [No, they’re not over; Yes, Grexit is still coming; Yes, I’m working on a major post covering the subject; and No, it’s not done yet – Ed.], it’s well worth comparing the looming Puerto Rican “bankruptcy” (either by that name or another) with Greece’s externally imposed and unbelievably bungled (in totality, not individually) “austerity” financing extension.
Statistics compiled by David Smith
Hey, I got them from the Internet – they must be true!
A. Greece’s doppelganger
Both Greece and Puerto Rico are economic islands relative to their sovereigns, buffeted by forces set in motion hundreds of miles away by those for whom their insolvency is a sideshow to other political and policy issues. Also, both situations are unprecedented: Greece, as a sovereign nation with a non-sovereign currency, had an independent polity that nevertheless could and did run out of money. Puerto Rico, though a sub-sovereign entity independent from the Federal government, can’t actually file bankruptcy the way US cities can:
Under US law, Puerto Rico, unlike cities such as Detroit, can’t seek protection under chapter 9 of the US Bankruptcy Code. All states are barred from filing for bankruptcy protection. Puerto Rico is lobbying Congress for a law to allow some of its entities to access chapter 9 protections.
We’ll also see that the approaches being taken could scarcely be more different – whereas Greece’s latest bout of mud wrestling was dominated by high abstruse policy and politics and resulted in a cluster duck, Puerto Rico’s recapitalization is shaping up to be, if nothing else, at least professional:
“Tell Puerto Rico it was only business. I always liked it.”
Investors are bracing for Puerto Rico to miss about $58 million in bond payments in coming days, as the US commonwealth attempts to restructure $72 billion of debt.
The Journal is careful to avoid the term ‘default’, even though you or I would call failure to pay a default, because the bonds are an unusual form of financing, moral obligation bonds, as pointed out by the New York Times (July 29, 2015; blue font):
The payments coming due are on so-called moral obligation bonds, which the government can issue without any legal requirement to repay.
Moral obligation bonds were created by John Mitchell in the 1960s when he was counsel to Gov. Nelson Rockefeller of New York.
Principal sources used in this post
America’s Cyprus, America’s Caliban (March 4, 2014; Part 1, Part 2, Part 3, Part 4; grayblue font)
New York Times (July 29, 2015; blue font)
Wall Street Journal (July 1, 2015; brick-red font)
Wall Street Journal (July 30, 2015; gray font)
The moral obligation bond was invented in 1960 by John Mitchell, back then merely a municipal bond lawyer, so that Nelson Rockefeller could sell state bonds without obtaining voter approval (via referendum) because the state was not legally obligated to pay them (Cranston Herald, June 12, 2013; magenta font):
I’ve got so much money I don’t actually have to guarantee to pay you back
With moral obligation bonds, Rockefeller could incur debt for a housing authority and numerous other programs without obtaining voter approval through a bond referendum.
We certainly wouldn’t want the voters to have a shot at a referendum about the obligation of their future tax payments, would we?
Governor Rockefeller was trying to fight the loss of manufacturing jobs by mounting huge building projects –
Too bad the Olympics were unavailable.
Mexico had already grabbed ‘em
– and did not want to go through the unpredictable process of letting voters approve general obligation bonds.
As we saw in (of all places) Harrisburg, when elected officials start dreaming of large-scale development projects to reverse economic decline in their town, voters should lock down their wallets and not let themselves be bypassed because most of the time they get stuck with a much bigger bill.
Years later, after Mitchell was released from prison for his crimes associated with Watergate, he was questioned as to whether moral obligation bonds were simply a means of bypassing the rights of voters to approve debt in a referendum, and Mitchell admitted that this was “exactly the purpose” of moral obligation bonds.
Why invent a workaround unless you’ve got an obstacle you want to work around?
So handy was the voter-avoidance workaround that it was later picked up by Rhode Island so it could get rapidly into the business of financing housing:
In 1973, James Skeffington, a lawyer eager for bond work, drafted legislation that created the Rhode Island Housing and Mortgage Finance Corporation (RIHMFC). This legislation avoided the need for a referendum by giving RIHMFC the authority to issue moral obligation bonds.
[As far as I know Rhode Island Housing never defaulted on any of its bonds. – Ed.]
Saturday’s deadline could mark the first skipped payment to bondholders since Gov. Alejandro Garcia Padilla last month said that the island’s debts were unsustainable and urged negotiations with creditors. Because Saturday is a weekend, payment can be made Monday, a spokeswoman for Puerto Rico said.
But it won’t be, because there’s no money in the bond-paying entity:
Public Finance Corp., a financing unit for Puerto Rico’s government, this month notified holders of appropriation bonds, typically those backed by funds set aside by the legislature, that it hadn’t transferred money to a trustee to pay the debt due at the beginning of August.
CC is the lowest rating possible
None of this, mind you, comes as the least surprise: PFC never got the money because the legislature didn’t appropriate it.
The corporation said the legislature never actually appropriated the funds. The missed transfer led some ratings firms to say the island was highly likely to default.
Fortunately [Yes, fortunately! – Ed.], the resale price of Puerto Rico’s outstanding debts has dropped and dropped, concentrating the debt in the hands of those willing to settle it at a discount. As I wrote a year and a half ago (America’s Cyprus, America’s Caliban, Part 1, Part 2, Part 3, Part 4; grayblue font), the hedge funds are Puerto’s new best friends:
Puerto Rico doesn’t have the recourse to file for Chapter 9 bankruptcy protection that other troubled U.S. municipalities (like ones named Detroit) do, and it remains completely unclear how any bond default would get resolved, should it come to that. The good news is that by now, most of the muni market, particularly its more conservative players, have gotten out of the way of any further damage.
‘Gotten out of the way’ means ‘sold for losses.’
‘More conservative players’ means public municipal funds.
As I said above, when it comes to insolvency, hedge funds may be your best friends.
Kiss a hedge fund manager today
[Having Puerto Rico cut off from the capital markets would] paralyze its efforts to dig out from under its mountain of debt.
If that happens, Lamba-Nieves, the director of the Center for a New Economy, said the federal government could feel pressure to step in with some type of bailout. “Puerto Rico might be a little too big to fail,” he said.
The Administration had better root for the hedge funds.
Like it or not, you want me on that buy side, you need me on that buy side
[Continued tomorrow in Part 2.]