What Does Puerto Rico’s Debt Crisis Mean for Bondholders?

Part One: How Real is the Possibility of Massive Haircuts?

A couple weeks ago, the Working Group assembled by Puerto Rico’s Governor Alejandro Garcia Padilla released its Fiscal and Economic Growth Plan. Among other things, this plan was intended to quantify the resources the Commonwealth would have available to satisfy its approximately $71 billion of existing commitments to bondholders and serve as a prolegomenon to restructuring negotiations.

One cannot emphasize enough that there has been a major change regarding how distressed municipal credits are rehabilitated. It also remains an open question as to whether new approaches will be successful beyond the short to medium term. Will the phenomenon of debt intolerance that has affected some sovereign borrowers become a feature of the municipal market too?

Some context…

Puerto Rico’s approach to managing its wholesale insolvency mirrors the example set by Detroit’s legal team — where investors were told to expect devastating haircuts long before the details of the city’s recovery plan were fleshed out. Bondholders are negotiating with a government that now regards its debt capacity as a residual calculation, not a trade-off, and has already surrendered the notion that maintaining constructive relationships with market participants is necessary. Relationships with market participants have been practically subordinated to domestic political relationships, which I have said on a number of occasions (see here and here) represents a predictable shift in economic incentives once affordable market access (read: the ability to kite payments) is lost. Lee Buchheit, whose firm is advising Puerto Rico, has cautioned against this trend within the context of restructuring too little and/or too late.

From the Bond Buyer:

The plan … offers revenue and expense estimates for both negative 1% annual economic growth rates and positive 2% annual economic growth rates in the next five fiscal years. In the former case the government would have $2.2 billion to spend to cover $18.2 billion in debt service, or 12%. In the latter case the government would have $4.1 billion to spend to cover the same amount of debt service or 23%.

On Tuesday night in a news teleconference a government advisor said the government might have as much as $5 billion for about $18 billion in debt service in the next five fiscal years, which would mean the government would pay 28% of debt service.

The Working Group also forecasts that Puerto Rico will run out of cash by the end of 2015, and likewise will have a $500 million shortfall when the fiscal year ends on June 30, 2016. An $805 million payment is due to general obligation bondholders on July 1st. The imminent liquidity crisis was disclosed in the bond documents for Puerto Rico’s recent (failed) bond sale.

I have long predicted that Puerto Rico’s debt crisis would result in monetary defaults and have been in the vocal minority maintaining that even the Commonwealth’s constitutionally protected general obligation bonds could potentially be impacted (absent federal intervention — more on that in a future essay). As I explained here, many market participants fail to recognize there is a paradigm shift underway. There is a small class of borrowers that exhibit both political dysfunction in the extreme and unconventional debt structures (due to the deferral of inconvenient decision-making and a lack of lender discipline) that are manufacturing financial crises on scales the market has never seen before. The pace of credit deterioration and the extent of investor/insurer losses involved in these situations has been consistently underestimated.

From Bank of America Merrill Lynch, September 18, 2015, Municipals Weekly:

According to a 10 September Moody’s report, Puerto Rico’s Working Group debt restructuring plan “may be negative for some security types if the debt restructuring process pushes expected bondholder recovery rates below what [Moody’s] currently anticipates.”

As we have noted in the past, Moody’s ratings at B1 and below carry rating-implied recovery rates. Moody’s rating on Puerto Rico securities are either Caa3 (such as the Commonwealth’s GOs and COFINA-senior-lien debt) or Ca (such as GDB notes and Highway and Transportation Authority debt). At Caa3, the rating implied recovery rate is 65% to 80%, while at Ca it is 35% to 65%.

But as we discussed last week, based on the Working Group’s financing surplus figures before debt service, recoveries may be much lower.

If, in the unlikely event, debt service on all securities is paid with the same priority, debt service payments on each security would have to be cut roughly 77% over the next five years. Even if all of the available funds for debt service are dedicated to GO and GO-guaranteed debt service, debt service would have to be cut 45%.

In the case of GO and GO-guaranteed debt consuming all available funds for debt service, the recovery (55%) would fall well below its Moody’s rating-implied recovery range of 65% to 80%, and would rather fall into the Ca-range. If moneys are diverted for other securities’ debt service, it could push recoveries even below the Ca-range.

It is certainly worth noting that it is unclear whether these recovery levels would be made permanent, would last only for the next five years, or if any debt service payments will be made over that time span. Indeed, one of the main focuses of the commonwealth has been to have a debt service payment moratorium, possibly extending out five years.

A debt moratorium to play SimCity

That last sentence, of course, is a nod to the restructuring agreement negotiated with the Ad Hoc Group of PREPA’s bondholders, which some market observers have naively suggested as a potential model for restructuring other segments of the Commonwealth’s debt. The logic is essentially that if bondholders give the Commonwealth five years of cash flow relief, the Commonwealth can make a litany of improvements that will obviate massive haircuts. That is to say, restructure too little and too late.

If one looks at the Working Group’s plan from the 30,000-foot level, it basically reads like this:

(1) Torch the Commonwealth’s tax code and replace it with something more economic developmenty.

(2) Torch the Commonwealth’s social welfare programs and labor laws and replace them with totally new provisions.

(3) Find investors that the Commonwealth is not currently threatening with massive haircuts and convince them to enter into public-private partnerships for basically every essential government service. It is unclear whether the Working Group means under the demand or availability model, but both seem unlikely within the context of an uncreditworthy government and rapidly declining population. Members of the Working Group do not seem to understand that P3s represent an alternative procurement method — not a lender of last resort.

The plan also proposes blowing a portion of the proceeds from asset sales on incentivizing early retirement, which has to be dumbest policy recommendation in the history of policy recommendations.

(4) Create a control board whose decision-making may be vetoed by a governor that has only contributed to the Commonwealth’s debt burden (and is more or less a puppet anyway).

(5) Convince Congress to pass a whole bunch of legislation in its own right.

Of course, amidst all of this re-engineering of its society, investors can trust the budget scoring (except for the many proposals scored “it depends”) of a government that has been mostly unable to predict its financial position two months in advance under the current system. Even prior to the above reforms, sorting out the Commonwealth’s finances is one-half overcoming political propaganda and one-half archaeological expedition.

So it’s not just that bondholders are looking at the possibility of potentially devastating haircuts here. It’s that this entire conversation about recoveries is taking place within the context of a bunch of professionals showing off how awesome they were at playing SimCity as teenagers. This is absurd. A major reform measure in any one of the above elements is difficult to implement and evaluate under ideal circumstances. All, most, or some of them are impossible during a crisis.

Furthermore, if one is even remotely intellectually honest about Puerto Rico’s borrowing activities, the Commonwealth is already years into its own stylized debt moratorium. The Commonwealth has made extensive use of debt restructurings, capitalized interest, and back-loaded issues, just to name a few shenanigans.

Avoiding servicing its debt in any meaningful sense has failed to introduce any financial or economic stability so far. Why would one expect extending this situation under the same players to work out differently?

Second, and following up on the last point, bondholders could negotiate an arrangement that seems less brutal now, but risks being adjusted later if the Commonwealth is given access to Chapter 9, which the plan directly requests. (I am going to elaborate on some remarks I made on Chapter 9 and special revenues in a prior essay later on.)

How likely is it that Puerto Rico reaches timely settlements with bondholders?

Not likely at all. It is also unlikely that any settlements will have a template, in my opinion.

Puerto Rico’s situation is far more complicated than any insolvency the municipal bond market has ever seen.

First, the Commonwealth’s debt is spread out among 17 instrumentalities and structured in a variety of ways that will inevitably frustrate the mathematics of exchanges.

Second, the motives of investors even within the same classes of debt vary considerably. Creditors range from traditional investors like mutual funds and retail investors, and the monolines that wrap the debt — who want to minimize their losses altogether — to hedge funds — who picked up the debt within a wide range of levels and can be much more creative with how they resolve situations. The Commonwealth also lacks the ability to bind holdouts.

If it comes to litigation, retail investors lack the ability and organization for a protracted legal fight. The monolines and hedge funds, however, have the resources, sophistication, and motivation to fight to the death, as they have done in every other case. The monolines’ interests are more complex than any other parties’ because they have stakes across the spectrum of Puerto Rico’s debt-issuing authorities.

Third, some creditors have the right to bring suit in multiple jurisdictions.

Fourth, the government also has to face other stakeholders (such as pension beneficiaries, who are often overlooked by the media) and political opposition as fights with creditors crowd out its ability to serve constituents adequately.

In my next installment, I will provide an overview of creditors’ rights and remedies and how they conflict with one another.