What would a Puerto Rican bankruptcy look like?

Puerto Rico has been enmeshed in a recession for a decade, and the attendant revenue decline has wreaked havoc with its budgets, a fact that a series of governors have done their best to paper over. The sad reality is that at present, Puerto Rico is simply unable to pay back all of its $72 billion debt.

{mosads}Congress has belatedly come to acknowledge this sad reality and is debating taking action. It has ruled out a bailout while contemplating the creation of a fiscal control board to take control of the commonwealth’s taxing and spending decisions. Debates over additional necessary steps to return the island to solvency need to be resolved soon.

The discussion thus far has centered on whether Congress should extend the same Chapter 9 bankruptcy protection to Puerto Rico that is available to states. Chapter 9 allows states to authorize municipalities and independent agencies to declare bankruptcy, but does not permit states to themselves declare bankruptcy and restructure general obligation (GO) debt. Puerto Rico, a territory, has been excluded from state-like powers under Chapter 9 for reasons that no one seems to remember. Correcting this oversight would provide a clear and predictable framework for the island to restructure its debt.

Unfortunately, Gov. Alejandro García Padilla and the U.S. Treasury want to go a radical step further and establish a “super” restructuring framework that would include the commonwealth’s own general obligation debt. This proposal risks dragging every other state/municipal debt issuer in the United States into Puerto Rico’s crisis.

Puerto Rico’s bond-offering circulars filed with the Securities and Exchange Commission describe the constitutionally protected GO debt as “irrevocably pledged” and that it “constitutes a first claim on available resources.” The mere talk of breaking that pledge has driven up the costs of borrowing in places like Guam, Illinois and Chicago. Borrowing costs could rise further if the Treasury-Padilla proposal gains traction. That is why a myriad of governors in states far removed from Puerto Rico’s travails have warned against such a restructuring plan.

Proponents of super-restructuring say that abridging general obligation debt is necessary to put Puerto Rico on a path to sustainability. However, the general obligation debt represents only $18 billion, a fraction of Puerto Rico’s $72 billion debt. Investors will demand a much higher premium to cover their risk of investing in Puerto Rico in the future. The 2015 morass over the Greek debt restructuring illustrates how difficult it is for a government to regain the confidence of investors after they break a promise and how other borrowers can be impacted when one government mishandles a restructuring.

El Nuevo Dia, a Puerto Rican newspaper, argued against a super-restructuring, noting that anything that makes it more difficult for the island to reenter bond markets or attract investment in the future is little more than a Pyrrhic victory.

Global investment flows to where there is respect for the rule of law. The new president of Argentina, who ran on a promise of returning his country to fealty to the rule of law, has already seen a flood of major corporations approach him about expanding investment in the country.

The reflexive opposition to bankruptcy that Republicans have shown is understandable: Previous Puerto Rican governments refused to make hard spending decisions and used cheap debt to cover budget holes. However, at this point, some kind of debt restructuring is the only viable option, hopefully accompanied with sufficient constraints to keep the island’s government honest.

Any debt restructuring should be done within the constraints that would be imposed via a standard Chapter 9 bankruptcy, which requires all major debtor groups to agree to any plan. This should preclude any fiscal control board from imposing any debt haircut concomitant to its spending and tax reforms; giving them that ancillary power would be a step too far and could end up being a backdoor super-restructuring. It’s worth noting that Washington, D.C.’s fiscal control board in the 1990s — perhaps the best analogy for Puerto Rico today — was not given the power to reduce debt obligations.

A fiscal control board with the ability to make short-term spending, tax and regulatory decisions for a government that long ago abdicated its responsibilities along these lines is a necessary first step toward the federal government assisting the island. Any concomitant debt reduction should be done solely within the confines of the current Chapter 9 bankruptcy law.

Brannon is president of Capital Policy Analytics, a consulting firm in Washington.