Don’t let a fiscal control board haircut Puerto Rico’s debt

Despite everyone’s fervent wishes that the Puerto Rican government eschew crass politics and offer its citizens a realistic reform plan, the sad reality is that this isn’t going to happen. A fiscal control board of some sort is probably unavoidable at this point. Given that state of affairs, it’s worth debating what sorts of powers we should give it.

{mosads}The administration has made its position clear on how to deal with Puerto Rico’s insolvency: It wants to create a super-restructuring regime for the island that would allow it to haircut all debt, which would include both its constitutionally protected general obligation debt as well as the debts of its various public corporations and instrumentalities. The U.S. Treasury avers that it is impossible for the island to get back to solvency unless every last dime of its debt is on the table, precedents and consequences be damned.

Given that Illinois and Chicago may be one recession away from insolvency, with several other states and municipalities not too far behind, bondholders would have ample reason to fear that the Puerto Rico solution could set the standard for dealing with future defaults, impacting the borrowing costs in the rest of the country as well. Understandably, many have voiced strong opposition to the Treasury’s plan.

However, putting the island on the same playing field as the states by fixing Puerto Rico’s nonsensical exclusion from Chapter 9 of the bankruptcy code figures to be a far less disruptive solution and would give the island a firm pathway to restructure nearly three-quarters of its debts overnight.The only tranche of Puerto Rico’s debt exempt from a state-like Chapter 9 restructuring is the approximately $18 billion that is supported by the “full faith and credit” of the island’s Constitution, which, according to circulars filed with the Securities and Exchange Commission, is “irrevocably pledged” and “constitutes a first claim on available resources.”

I get why the Obama administration would be keen on going even further — they’ve essentially ignored bankruptcy law in the past (when Chrysler filed for bankruptcy and the workers got moved up ahead of secured debtholders) and they didn’t pay a price, either legally or electorally. Quite the contrary, in fact. If they can succeed in rewriting bankruptcy law for Puerto Rico, as they clearly intend to do by promising to put public sector pensioners before even constitutionally protected bondholders, it would be another high-profile, political restructuring victory.

At the moment, it’s hard to see how Republicans would ever go along with the Super Chapter 9 proposal put forth by the administration last year, but there’s another potential avenue for a haircut: It looks like one part of any legislative solution would be to create some sort of fiscal control board for the island consisting of a group of retired politicians, economists and the like to a board that would usurp the government’s power to tax and spend. The idea is that, freed from the political confines that constrain the current government, the board would be able to make necessary decisions that could return the island to a long-run balanced budget.

While doing such a thing seems to be a sensible approach — and a common maneuver in other governmental bankruptcies — some debtors fear that this entity could be given the power to haircut both general obligation and instrumentality debt as part of any spending cuts. This “super” control board would have the authority to restructure debts under the territories clause and may also have the power to reorder Puerto Rico’s hierarchy of payments in favor of government pensioners. Such a broadly powerful super board would be a direct affront to the island’s constitution and would have disastrous consequences for Puerto Rico and the U.S. municipal market as the aforementioned Super Chapter 9.

Most troubling, though, is what the unnecessary super board could mean for American taxpayers. In addition to disincentivizing profligate states from reforming their own broken economies, a crackdown on constitutionally protected bondholders may well represent a taking of private property by the federal government. If it were deemed as such, the government would assume the burden of compensating those bondholders in accordance with the Fifth Amendment, passing the costs directly to taxpayers across the nation.

Fear of such a super board has led many debt-holders to strongly resist the fiscal control board approach. It’s worth noting that while the Puerto Rican government and Treasury like to demonize the Puerto Rican bondholders who vocally object to debt haircuts, the majority of the island’s debt is owned by residents of Puerto Rico and retirees in the U.S.

Puerto Rico cannot pay the entirety of its debts; that much is indisputable. However, wiping the slate clean and allowing the island to continue along its merry way, hiring too many public workers and paying them too much while not taking serious steps to improve its efficiency, is a nonstarter.

Congress has the power to help Puerto Rico shrug off its ineffectual government and take some concrete steps toward escaping its decade-long recession and creating jobs again. Setting aside a constitutionally guaranteed promise given to general-obligation debt is not an ingredient to this renaissance, and the markets will make them — and myriad other government entities in the U.S. — pay for anything that might allow the island to renege on its promises.

Albright is director of fiscal policy for Capital Policy Analytics.