The U.S. Treasury is considering assisting Puerto Rico with the issuance of a “superbond” to restructure the commonwealth’s $72 billion of outstanding bonded debt, The Wall Street Journal reported last week.
There are essentially two ways to view the superbond proposal. The first is that it is simply a tool to motivate Congress into authorizing bankruptcy. The second is that it is serious, and that it will result in an inevitable bailout by the U.S. government.
Puerto Rico officials have been pushing the superbond concept for a while now. The commonwealth does not have access to Chapter 9 like mainland local governments, which means there is not an organized forum for the commonwealth to adjust its debts. Puerto Rico’s non-voting member of Congress introduced legislation to include Puerto Rico in Chapter 9. Congress has responded by holding hearings on Puerto Rico’s fiscal crisis — but in committees that do not have jurisdiction over Chapter 9.
The commonwealth’s alternative to protracted litigation is to arrange consensual refinancings across the many distinct instrumentalities Puerto Rico has used to borrow money from a wide range of investors. Puerto Rico officials decided that the best path to take was not to negotiate restructurings for these instrumentalities singly, but to try to fit the majority of the debt into one massive transaction, aka a “superbond.”
The Governor’s Working Group recently released a document outlining the principles the commonwealth would use in structuring its so-called superbond. Needless to say, the idea is so outrageous that some market observers now openly suggest Puerto Rico officials want their superbond to be a spectacular failure — they want to manufacture a catastrophe that would force Congress to authorize bankruptcy. At least, that’s how it looked to some before reports of Treasury’s potential involvement.
While the superbond is not news, the disclosure that Treasury might be participating was. Up until this point, Treasury has been providing “technical assistance” to Puerto Rico. “Technical assistance,” of course, is bureaucratic code for, “There is zero political will for a financial bailout, but the optics of indifference are bad.”
It is worth noting that Treasury denied making any commitment to participate in such a transaction after The WSJ article was published. But if Treasury eventually contributes to the transaction logistically or bullies investors into accepting haircuts, U.S. taxpayers will own the outcome of the transaction, politically. The success of this transaction could potentially be construed as a moral obligation of the federal government. If the federal government goes down this path, it seems reasonable to question whether a financial bailout is on the horizon.
According to The WSJ’s unnamed sources, the plan does not involve Treasury issuing or explicitly guaranteeing the superbond. Instead, Treasury would play an administrative role in managing an account that receives some of the commonwealth’s tax revenues and applying those funds toward the payment of the debt. “Investors would receive less debt, likely taking an effective ‘haircut’ on the value of their holdings, but would have higher expectations for getting repaid,” The WSJ explained. Reporters from The New York Times piled on, calling the plan “a radical and aggressive response to the fiscal chaos engulfing Puerto Rico.”
There seems to be a lot of confusion about what a lockbox provision such as this would contribute to such a transaction credit-wise and how this feature figures into the feasibility of a meta-exchange. While a lockbox might appear exotic to some market observers, such arrangements are common in structured finance and with distressed borrowers.
What does a lockbox arrangement do from a credit perspective? It removes the revenues pledged to repay debt from the general operations of a government borrower. Changing the custody of the funds theoretically reduces the risk that the borrower would use the funds for another purpose than paying investors — making a pension contribution or paying for government programs, for example.
What does a lockbox arrangement not do from a credit perspective? It does not guarantee that the revenues available for making debt service payments will be sufficient. This is where The New York Times is incorrect in suggesting that a lockbox is similar to state intercept programs — which are intended to identify alternative sources of funds to avert a monetary default.
Lockbox provisions have been de rigueur for Detroit following the city’s bankruptcy, which mostly maintained pension benefits at bondholders’ expense. The city’s debtor-in-possession financing involved a lockbox, as did the $245 million of bonds the city issued back in August to refinance the debt. Importantly, eliminating concerns over custody has hardly cancelled out Detroit’s credit history or struggling economy in the eyes of investors. The city’s last bond issue ended up pricing 200 to 300 basis points over top-rated securities. As one money manager said, “It’s still Detroit.”
Puerto Rico does not need Treasury to provide a lockbox structure. The commonwealth could engage a commercial bank to provide the same service. In fact, the debt issued by the Puerto Rico Sales Tax Financing Corporation (known as COFINA) already involves a lockbox structure, which probably does not feel as secure to bondholders right now as it used to. One would imagine that the transfer of custody from one political animal to another would not be any more reassuring.
For bondholders to participate in a voluntary restructuring, they would need to be convinced that they are better off with the new structure than the old. This is not self-evident for the bondholders that have strong legal protections. Their best alternative to a negotiated agreement is not what is directly available for the repayment of their debt, but also what they can take from other bondholders with weaker protections. The only way these bondholders are better off is if the new structure involves a stronger security than they had before. This is not purely a question of custody.
Another important point is that Puerto Rico’s calculus regarding the debt it can afford does not take into account the pending insolvency of its pension system. It probably is not an accident that the Governor’s Working Group’s time horizon is five years. The year after that, the commonwealth’s pension system is estimated to be insolvent, at which point benefits are projected to consume one-quarter of Puerto Rico’s general fund.
Kristi Culpepper is a state government official with the Commonwealth of Kentucky. Among other things, she handles the structuring and sale of bonds for schools across the state. Previously, she worked for the Kentucky General Assembly analyzing state and local government bond issues and tracking the state’s capital construction programs. She has also worked at Merrill Lynch. Opinions expressed here are personal and not the opinions of her employer. You can follow her on Twitter @munilass.
