Bankruptcy for Puerto Rico would jeopardize shaky financial health of USA

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Condado Beach in San Juan, Puerto Rico.

Condado Beach in San Juan, Puerto Rico.

As if the financial troubles in the United States were not enough, we now have President Obama attempting to extend and expand bankruptcy protections to Puerto Rico, which is a territory of the United States, but not a state.

Under current proposals, the expanded bankruptcy coverage would also apply to the various provinces within Puerto Rico.

So you ask, why should I care?


Puerto Rico’s Governor, Alejandro Garcia Padilla, confirmed everyone’s worst fears recently when he testified before a Senate committee: “Puerto Rico will have no choice but to default.

Nobody wants this, but it is a reality, and the consequences will be grave.”

Indeed, with each passing week, it is looking more and more likely that Puerto Rico will run out of funds before the end of this year, becoming the first major U.S. jurisdiction to default on its bonded debt. Such a widespread and indiscriminate default could have a damaging effect on the U.S. municipal bond market, given that the island is the third-largest issuer in the capital markets behind the state of California and New York.

Moreover, such a default will make it extremely hard for Puerto Rico to return to the capital markets after the current financial storm eventually passes.

In workouts involving corporate or government entities, it is standard procedure to observe the established hierarchy of creditors, something that President Obama failed to recognize in his dealings with the bondholders of General Motors when he first took office, and Chrysler Corporation shortly thereafter.

Every issue of debt or equity has a specific seniority, or ranking, which determines the order of repayment in the event of a reorganization or bankruptcy. Everyone knows that preferred stock is ranked higher than common stock and that senior debt must be paid before subordinated debt.

Even sovereign governments in financial difficulty prioritize their payments, though they do not operate under a formal bankruptcy regime. For example, governments will keep servicing debts to official multilateral agencies such as the International Monetary Fund and the World Bank (widely regarded as senior creditors) even as nations cease paying their bondholders or bank creditors.

This is what Greece did in 2012, and even what Argentina has done in the past dozen years, in which it has been in and out of default to bondholders.

It is hard to understand why Governor Padilla is willing to take this position. The selfish reason why corporations and governments observed established payment priorities is because, in an eventual return to the markets, these entities can start out by issuing the type of obligations, which were respected in the worst of moments.

But who is going to invest in Puerto Rico again? The country will undoubtedly discover that its ability to raise capital will be greatly impaired.

The White House plan may not make a difference in the end, as the Congress must approve the plan and that appears highly unlikely. The plan they are discussing is using the Chapter 9 segment of the bankruptcy laws. To make matters worse, the White House is pushing a

‘Super Chapter 9’ status, which would create moral hazard for states and territories – a deviation from guarding against the risks and consequences of extraordinarily high spending.

If Puerto Rico were allowed to use Super Chapter 9, it would be able to restructure its constitutionally backed general obligation debts, something states cannot do under federal law.

Granting this authority to Puerto Rico would likely raise the borrowing costs and reduce ability to invest in vital services while eroding investor confidence in the nation as a whole. The proposed policy amounts to a bailout for Puerto Rico’s unwillingness to make tough decisions as has been the case with other states that have been making similar unwise choices.

In 2011, the Republican Governors Association in 2011 agreed that states should not be given authority to declare bankruptcy themselves because it would result in market volatility that would raise the cost of governance.

The U.S. Treasury first floated the idea of a Super Chapter 9 solution in late October 2011 as part of a four-part plan to help Puerto Rico. The plan also includes a federal oversight board and changes to the way the federal government treats Puerto Rico for tax and healthcare purposes.

The plan has not gained traction in Congress as a majority of legislators arguing for a bankruptcy solution only want the normal Chapter 9 provisions extended to Puerto Rico, a situation where the plan would be compatible with current federal law for states.

Recently, Puerto Rico announced recent talks with its creditors had failed. The Governor spoke to a Congressional hearing, where he urged Congress to again provide Chapter 9 bankruptcy protections. But even then, the governor argues that Puerto Rico needs more than just Chapter 9.

“Even if serious action is taken, Puerto Rico will still face a funding gap of approximately $14 billion over the next five years, which will require substantial debt relief.”

The argument from bondholders and critics is that Chapter 9 would take away the pressure for Puerto Rico, which has overspent for years, to enact fundamental reforms to improve the economy. Sounds pretty familiar, doesn’t it? In the future, there may be a role for Congress to play. But in the short term, Puerto Rico’s local government must prove it can implement real change.

Government officials in Puerto Rico state that the island has been in a recession for several years and that unemployment is rising while educated Puerto Ricans are leaving the island and moving to mainland United States.

The White House also urged Congress to provide equal Medicare and Medicaid funding to Puerto Rico like the states in this country have obtained. Medicaid funding for Puerto Rico could expire soon, which would leave 600,000 Puerto Ricans on the island without coverage.

As Congress considers the fiscal condition of Puerto Rico, President Obama seems intent to aggravate the financial condition in the United States — while not making any requirement that Puerto Rico provide the reforms that will be necessary for them to continue.