Everyone expected Puerto Rico to default on some portion of its nearly $1 billion in debt payments due January 4. While that did happen, the total sum in default, $37.3 million, was substantially smaller than feared. In fact, it came in lower than a previous $58 million default last August.
This has led to a lot of loose talk that Puerto Rico must be bluffing about the severity of their crisis, if they can still pay 97 percent of their debts. In fact, the theory goes, this is all a pretext to pressure Congress for bankruptcy protections, using minor defaults as a weapon.
Mark Palmer, an analyst with BTIG, told CNBC that “Puerto Rico opted for a default that would send a message about the need for Chapter 9 and the potential for a humanitarian crisis on the island.” John Muller of Nuveen Asset Management explained to The Wall Street Journal that Congress may see through the smokescreen. “The ability of Puerto Rico to keep making all but a few smaller payments may actually add to the skepticism there, and cause U.S. politicians to push for the release of current financials and the imposition of a control board,” he said.
It’s hard to see this as anything but a cultural bias, a reflection of assumptions about irresponsible, scheming Latin American politicians trying to wiggle out of their responsibilities. It also happens to be wrong. Puerto Rico is making the least disruptive defaults possible because they know the deck is currently stacked against them legally. And they’re imposing incredible hardships on their citizens to reduce that default impact.
As I explained in the winter issue of the Prospect, Puerto Rico used 18 different vehicles to issue debt. But to simplify drastically, some of that is protected in the commonwealth’s constitution, given senior rights of repayment above practically everything else in the Puerto Rican budget, and some is not. The two defaults thus far have come on debt that doesn’t feature this constitutional obligation. In August, they left Public Finance Corporation (PFC) bonds unpaid. This week, $1.4 million in PFC bonds and $35.9 million in Puerto Rico Infrastructure Finance Authority (PRIFA) bonds went into default.
The way the island made the constitutionally guaranteed payments, in particular general obligation (GO) bonds, was by clawing back funds earmarked to service other debt, in particular by diverting revenue from an excise tax on Puerto Rican rum. Some public corporations who saw their revenue stream cut off could use reserves to pay bond debt; PFC and PRIFA had nothing to give.
But that was not the only diversion of funds Puerto Rico has undertaken to service their debt, which has ballooned as high as $73 billion. The commonwealth has delayed tax refunds to its citizens, effectively using money owed to the people as an interest-free loan. They fired 30,000 public-sector workers and closed 100 schools. They increased the sales tax by over 50 percent, further burdening the public. They’ve handed community credit unions IOUs instead of owed funds, harming their ability to lend out and spark economic activity. And more recently, they have reportedly raided the public employee pension fund to pay back creditors.
To say that Puerto Rico “has the money” to pay its debts, and is just defaulting to try to win a handout from Congress, ignores the incredible strain they’ve placed on 4.5 million American citizens already. Successive Puerto Rican governments, seduced by financiers desperate for their triple tax-exempt bonds, made very stupid decisions to pile on debt over and over, papering over years of recession. But there’s no scheme here: They’re bludgeoning their citizens to pay off the debt. And the only way to keep paying is to bludgeon them more: witness the creditor anger over paying public employees a Christmas bonus, which is part of their pay package and required by a 1969 law.
The reasons are fairly simple: Litigation on the GO bonds, given the constitutional mandate, is a slam-dunk for creditors. Even the PRIFA and PFC bonds will likely trigger legal challenges, and the courts are unlikely to be kind to Puerto Rico there either. Minimizing the defaults, then, is simply a rational way to minimize the upheaval creditors can and likely will foment. The government may have other options, like challenging the constitutionality of the debt issuance itself. But they have thus far been extremely wary of making that case.
The creditors, meanwhile, are actually fine. Bond insurers will cover the missed payments by PRIFA and PFC. The Puerto Rican government has shown their willingness to go to all necessary lengths to prevent missing a GO bond payment (which is why GO bonds have rallied in recent days).
But that hasn’t stopped creditors from decrying an “insidious” scheme, in the words of Fundamental Credit Opportunities’ Hector Negroni, to use defaults to acquire bankruptcy protections from Congress, the same that states have for their municipalities. “It creates a lack of confidence, increases spreads, volatility and makes the cost of financing necessary infrastructure across the nearly $4 trillion marketplace much higher and less certain,” Negroni said, spinning a tale of ruthless politicians and blackmail.
This is ridiculous. Puerto Rico merely wants equality in how its debt gets treated by the courts. Investors should know that any lending arrives with risk, but they don’t want to acknowledge that in this case. Furthermore, Negroni’s claim that the commonwealth refuses to negotiate with creditors is undermined by the successful negotiation on a debt haircut for holders of bonds with the local energy company (PREPA). There’s nothing insidious about seeking needed relief; on the contrary, it’s what any responsible lawmaker would do in this situation.
Puerto Rico has lost 10 percent of its citizens over the last decade. Holiday sales dropped 30 percent over the Christmas season. These depressing statistics come from an island on the brink of destruction. It’s not some game. With Congress holding hearings on Puerto Rico next week amid a promise to deliver long-term relief by the end of March, they should pay attention to that.
Correction: An earlier version of this story stated that Puerto Rico's default totaled $37.3 billion. In fact, it totaled $37.3 million.