What Are the Consequences of Default?

August 4, 2015

Default & Its Consequences. The Puerto Rico Public Finance Corp. (PRPFC) yesterday defaulted on 99% of its due payment of some $58 million, according to Government Development Bank for Puerto Rico president Melba Acosta Febo, with Mr. Acosta stating that the decision by the Puerto Rican government not to appropriate funds to pay the debt “reflects the serious concerns about the commonwealth’s liquidity in combination with the balance of obligations to our creditors and the equally important obligations to the people of Puerto Rico to ensure the essential services they deserve are maintained.” Puerto Rican officials have said that the PRPFC default does not constitute a Puerto Rican government default; nevertheless, the default marked the first default by the U.S. commonwealth and could open a Pandora’s Box as the U.S. territory now enters unknown territory in seeking to restructure about $72 billion in debt without access to a federal bankruptcy court. But like the first skittering of stones marking an avalanche, yesterday’s default appears likely to be the first in a broad series of defaults in coming days and months. The bank did pay about $628,000 remaining from prior funds.

The event came as the cost of debt for the island continued to escalate: Puerto Rico municipal bonds were trading at levels more than 30% below their issuance levels of just a year ago yesterday in the wake of the default. Because the defaulted bonds were so-called “appropriation bonds,” as opposed to full faith and credit general obligation or revenue bonds—that is, bonds backed by the legislature’s willingness to appropriate funds to pay the interest rate payments due to holders—the bonds (and bondholders) have far fewer protections than most municipal bonds issued by states and local governments. Indeed, the official statement for the 2011 series A PRPFC bonds states on its first page: “The 2011 series A bonds will not constitute an obligation of the commonwealth or any of its public instrumentalities (other than the corporation), and neither the commonwealth nor any of its political subdivisions or public instrumentalities (other than the corporation) will be liable thereon.” Nevertheless, Puerto Rico yesterday afternoon announced that it had “temporarily suspended” setting aside funds on a monthly basis for general obligation debt service payments, notwithstanding assurances by government officials that the commonwealth will nevertheless make the GO bond payments. Puerto Rico has said its debt includes about $18.6 billion of general-obligation bonds and government-guaranteed debt, $15.2 billion of sales-tax-backed bonds and $24.1 billion of bonds issued by government agencies, like the Puerto Rico Electric Power Authority, which is already negotiating a restructuring with creditors. Many investors in every state across the U.S. hold Puerto Rico’s municipal bonds across the different sectors, meaning they might which could recover different amounts in a restructuring. Fabulous Matt Fabian, a partner at Municipal Market Analytics, remarked that while worries about Puerto Rico have had little impact on the broader market for state and local capital debt, the deliberately skipped payment could spur new selling by investors of other Puerto Rico commonwealth debt. Moody’s Investors Service vice president Emily Raimes said, “Payment of debt service on these bonds is subject to appropriation, and the lack of appropriation means there is not a legal requirement to pay the debt, nor any legal recourse for bondholders. This event is consistent with our belief that Puerto Rico does not have the resources to make all of its forthcoming debt payments. This is a first in what we believe will be broad defaults on commonwealth debt.”

What’s Next? The default entered Puerto Rico in a place beyond San Bernardino, or Detroit, or Jefferson County, because the U.S. territory has no legal access to ensure protection for essential public services, much less a federal judge to preside over negotiations with the islands thousands and thousands of creditors. A group of Puerto Rico policy makers is working on a restructuring plan—such as a plan of adjustment negotiated by a city in municipal bankruptcy—but without those protections. The policy makers hope to present their findings at the end of August. Creditors, including mutual funds, hedge funds and other distressed-debt investors, have been splitting into committees based on which kinds of Puerto Rican municipal bonds they own—but it promises to be an unprecedented restructuring process unlike any that has ever occurred in U.S. history.

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