The Steep Climb Out of Municipal Bankruptcy


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eBlog, 7/12/16

In this morning’s eBlog, we focus—again—on the ongoing challenges over Detroit’s future: a new study indicates that lingering impacts from the Great Recession are contributing to an exodus of middle and upper income families from the city, a trend which will create hard governance challenges. Then we look at the challenges in Puerto Rico—where Congress acted yesterday to pass and send to the Senate legislation to give investors equal protection to those in the rest of the U.S., and where the challenge of access to capital for the island’s water and sewer authority awaits action by the White House to name the island’s oversight panel created under the new PROMESA law. As we have already learned from Flint, the ability of a municipal utility to provide water and wastewater services is critical.  

The Steep Climb out of Municipal Bankruptcy. Professor Jonathan Silberman of Oakland University, author of a new Economic Data Center report, has written that the two-tier autoworker wage structures, flat compensation rates in recent labor contracts, and lingering effects of the Great Recession are among the key reasons metro Detroit is in a minority of metro regions which is experiencing a decline in middle- and upper-income households. His study makes a correlation between manufacturing sector declines, the growth of lower-income households, and a decline in middle- and upper-income households. Coming against a backdrop of significant uncertainty about the future for Detroit’s public schools, the research data find that the metropolitan region experienced a 6.9 percentage point increase in lower-income homes, from about 21.2 percent to 28.1 percent of all households; middle-income households declined by 3.7 percent, and upper-income households by 3.2 percent to just over 20 percent. Professor Silberman attributes the demographic change to recession after-effects, two-tier wages, and few recent union gains in contracts with the automakers: he notes that the average manufacturing production worker hourly wage fell from $31.57 in 2004 to $22.02 in 2014 by 2014 dollars; total manufacturing employees were off by about 50,000 in the Detroit-Warren-Livonia metropolitan statistical area over the same period. In his original report, Kevyn Orr, the Emergency Manager appointed by Gov. Rick Snyder to take over Detroit and guide it into and out of chapter 9 municipal bankruptcy, described the city as “dysfunctional and wasteful after years of budgetary restrictions, mismanagement, crippling operational practices and, in some cases, indifference or corruption.” We noted that residents could “escape these debts simply by moving away; many have done just that: Of the 264,209 households in Detroit, only 9.2% are married couple families with children under 18. Another 78,438 households — or 29.7% of the total — are families headed by women—of which families more than half have children under 18.” This news does not gainsay the significant strides and progress Detroit has made, but demonstrates how great the challenges it faces are.

Equal Protection for Puerto Rico. The U.S. House of Representatives yesterday approved the U.S. Territories Investor Protection Act of 2016 (H.R. 5322), a bill to put an end to a current legal loophole that a lawmaker contends has led to financial losses for many Puerto Rican investors and retirees. The legislation, authored by Rep. Nydia M. Velázquez (D-NY) would close a decades-old loophole that has caused significant financial losses for many Puerto Rican investors and retirees. The bill (HR 5322) would extend to investment companies operating in Puerto Rico and all the U.S. territories the same rules as those that apply on the U.S. mainland—or as the Congresswoman yesterday told her colleagues: “For too long, this massive oversight in federal investment law meant that residents of Puerto Rico did not have the same consumer safeguards as are available on the mainland…The result has been that many retirees and others have suffered enormous losses on financial products they have been sold by unscrupulous companies.” She noted that it has been publicly reported that some actors in Puerto Rico have used the current law’s loophole to act both as an underwriter for the issuance of bonds, and then repackaged those same bonds into mutual funds which are sold exclusively to investors on the island—something permissible in Puerto Rico, but prohibited on the U.S. mainland. Now, as the Congresswoman notes, “The situation has been compounded by Puerto Rico’s ongoing debt crisis. Puerto Rican investors holding government bonds have suffered massive losses and are claiming that some financial companies did not properly disclose the risks of these funds, due to this conflict of interest”—adding: “I’ve heard of people losing their hard earned savings because of these gaps in the law: This bill would ensure statutory parity and prevent working families in Puerto Rico from being sold unsound investments that could not be marketed anywhere else in the U.S.” At the time the exemption was enacted in 1940, it was suggested that Puerto Rico and other “U.S. possessions” were physically located too far away for the Investment Act protections to be enforced.  Since then both Hawaii and Alaska, which are farther away from the mainland than Puerto Rico, have been granted statehood and, ergo, the protections in the 1940 Act. Additionally, air travel between the U.S. and Puerto Rico is common and many of these financial instruments are today traded electronically. Rep. Velasquez added the bill would ensure statutory parity and prevent working families in Puerto Rico from being sold unsound investments that could not be marketed anywhere else in the U.S.—noting that Puerto Rico’s current fiscal crisis has only compounded the negative effects of the loophole.

The Puerto Rico Aqueduct & Sewer Authority (PRASA) wants to issue the debt through a new agency to finance construction work delayed by the government’s fiscal crisis. As an inducement to skeptics, the agency would give investors first claim on revenue it collects from water and sewer bills, according to Efrain Acosta, the PRASA Finance Director. It may also exchange an additional $1.1 billion of securities for its outstanding bonds to investors willing to accept less than they’re owed. Yet, as Mr. Acosta notes, the municipal market is “tough at this moment,” adding: “[W]e have to go forward with our plan and see if we can get new money to pay our contractors and try to restart our construction plan.” Puerto Rico has not sold municipal bonds for more than two years. Now the uncertainty about new municipal debt issuance is further clouded by the uncertain governance situation: when will the PROMESA oversight board be named—and, when it is named by the White House—how will it act with regard to any new issuance of debt. Indeed, the day after President Obama signed the PROMESA act into law, Puerto Rico defaulted on nearly half of $2 billion of principal and interest that was due—a default which marked the single greatest payment failure ever in the U.S. municipal-bond market; instead PRASA negotiated with creditors to delay $12.7 million that it owed. That is, Puerto Rico is entering a very different kind of municipal finance territory than Detroit, Central Falls, Jefferson County, etc.—all previous chapter 9 municipal bankruptcy filers which have been able, post-bankruptcy—to return to the issuance of capital debt; but chapter 9 is not available to Puerto Rico, so now it has the very challenging task of determining what promise there might be in PROMESA: can the yet-to-be-named oversight board—as previous such boards did in New York City and Washington, D.C. help realign the fiscal stars to allow Puerto Rico to regain its fiscal feet. In addition to selling new municipal debt, PRASA would offer municipal bond investors a chance to exchange their securities at a 15 percent loss, according to Mr. Acosta: such new bonds would be backed by a pledge of as much as 20 percent of PRASA’s revenue.


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