January 29, 2019
Good Morning! In this morning’s eBlog, we report on the looming default of California pension municipal bonds coming in the wake of the horrific Camp Fire in California of Puerto Rico Governor Ricardo Rosselló Nevares’s announcement of a moratorium on payments to the Electric Power Authority and Aqueduct and Sewer Authority in order to relieve Puerto Rico’s employees affected by closure of the federal government. According to the statement, there are over 14,000 federal employees on the island, of whom about 4,500 have not been receiving a salary since the closure was decreed.
Collateral Fiscal Damage. Wildfires that devastated California last year caused at least $12.4 billion in insured losses, the state’s insurance commissioner announced Monday. Just three fires were responsible for $11.4 billion of the damage — and that total has climbed 26 percent since the initial loss estimate last month. All three of those fires occurred in November: The Camp Fire, which destroyed most of the town of Paradise in Butte County, killing 89 people and leveling 18,804 buildings, and the Woolsey and Hill fires, which killed 3 people and destroyed 1,643 structures in Los Angeles and Ventura counties. California Insurance Commissioner Richard Lara described these as “unprecedented numbers:” last month, the department estimated $9.1 billion in insured losses from the three big November fires; however, the numbers are expected to go higher: earlier this month, the German-based insurance company Munich Re estimated total losses from the Camp Fire alone at $16.5 billion and said that $12.5 billion of that was insured, describing the fire as the most expensive natural disaster in the world in 2018. Company officials called climate change a major factor for the dry, dangerous conditions that helped spark the fires so late in the year, with Munich Re Board member Torsten Jeworrek noting: “Such massive wildfires appear to be occurring more frequently as a result of climate change…Action is urgently needed on building codes and land use to help prevent losses. Given the greater frequency of unusual loss events and the possible links between them, insurers need to examine whether the events of 2018 were already on their models’ radar or whether they need to realign their risk management and underwriting strategies.” To date, insurance companies have paid some $6.3 billion in claims statewide. Mr. Jeworrek added that California state insurance workers have been in the burned communities from the beginning, noting they have helped people with claims and have worked to reduce fraud from non-licensed contractors pitching rebuilding contracts—and that the $12.4 billion in statewide insured losses does not include every wildfire in 2018: in addition to the three November fires, it includes two major fires in July: the Carr Fire near Redding, which killed 8 people and destroyed 1,604 buildings, and the Mendocino-Complex Fire, which burned 459,123 acres—making it the largest fire in California history, in Mendocino, Lake, Colusa, and Glenn counties, mostly in remote areas, killing 1 firefighter and destroying 280 buildings over a two-month period.
California Gov. Gavin Newsom announced earlier this month $305 million in new funding as part of his first state budget to expand the Golden State’s ability to fight wildfires and better alert residents of impending disasters, with his announced package including funds for retrofitting Blackhawk helicopters and C-130 airplanes acquired from the Air Force to use in firefighting; creating five new California Conservation Corps crews to thin forests and create fuel breaks; providing more money for communications systems to warn the public, particularly seniors and others when evacuations are needed; and setting up 100 infrared cameras, positioned in high-risk areas of the state, to spot fires early. His colleagues, Govs. Jay Inslee (Wa.) and Kate Brown (Oregon), joined with Gov. Newsom earlier this month in writing to President Trump to request doubling of federal assistance for fire prevention efforts in national forests in the three states—a request no doubt hindered by the President’s closure of the federal government. More than half of all forest land in the State of California is federally owned, and funding for thinning and controlled burn projects to reduce fire risks in those areas has been cut by the Trump administration, Gov. Newsom noted, even as the President has criticized the State of California for not doing more.
Carryover & Collateral Pension Damage. With a default seen as near certain, Moody’s Investors Service has downgraded to Caa3 from B1 a pool of California pension obligation bonds of which the largest component is from Paradise, the town decimated by the Camp Fire. An estimated 80%-90% of the town of just over 26,000 in Butte County, in the Sierra Nevada foothills above the northeastern Sacramento Valley was decimated—with Moody’s noting: “The downgrade to Caa3 reflects the near complete destruction of the Town of Paradise, the pension pool’s largest participant, by the Camp Fire in November 2018: The heavy physical, social, and economic damage to the town will inexorably devastate its financial position, realistically eliminating any short term ability to pay debt service on its share of the bonds, thus rendering a near-term default almost certain.” (Paradise has scheduled debt service payments of more than $1 million annually through 2029 on capital appreciation pension obligation bonds.) Moody’s notes it expects the June 1 debt service payment will be made, because it was fully funded prior to the fire and is currently held by the bond’s trustee; however, but its analysts anticipate the city will default on its December 1 interest payment. Moody’s reported it will take years for Paradise to rebuild; in the near term the fiscal and financial challenges mean that default is highly likely over the next several years—creating a complication because there is no cross-collateralization or default between the cities in the pool: no municipality is responsible for the bond repayments of any other municipality, and a default by one municipality will not constitute default of any other municipality.
Collateral Fiscal Damage II. In Puerto Rico, where Puerto Rico Treasury Secretary Teresita Fuentes has resigned, with her resignation coming just six months after she took office, writing to Gov. Rosselló: “Governor, my greatest wish, now that I return to my life as a prudent citizen, is to see a government that shows compassion, that publishes public policy with care and prudence and that seeks to cure and meet the challenges that are presented with love for others, but above all, patriotic love.” The Governor has reported that current Secretary of Internal Revenue Francisco Parés would serve as interim Treasury Secretary while he searches for a permanent replacement, noting that the resignation was due to “fundamental differences” linked to the office of the Chief Financial Officer of the government, a position held by the Secretary of the Interior Raúl Maldonado, adding, in an interview, that he had held two meetings with Secretary Fuentes to discuss “in depth” his “concerns and differences” with the CFO, noting: “Mostly, those that have to do with the public policy of the CFO of the government of Puerto Rico, are ones that were irreconcilable. They were fundamental differences.” In her letter of resignation, Secretary Fuentes included a quote from Roberto Clemente that alludes to compassion and patriotic love. Of those expressions, Gov. Rosselló Nevares said he interprets them as part of what his administration does: “In fact, we’ve been doing it with her: the work she has done to reduce the tax rate to citizens is going in that direction.”
Collateral Fiscal Damage III. César Díaz, a music teacher at the nonprofit Centro Esperanza and Councilmember in the municipality of Loiza, a municipio reported to have been incorporated as a result of a crown decree from Spain in the 1600s, a decree which instructed that slaves be sent to the region of Loíza. It was in 1692 that Loíza was officially declared an urban area due to its population (100 houses, and 1,146 residents), but it was in 1719 that the government of Spain officially declared it a town—one founded by Gaspar de Arredondo. Subsequently, its official status was demoted, before, on August 16, 1970, it was again established as a municipality—but one which, in 2017, suffered a catastrophic hit from Hurricane Maria. But its hard luck still appears to bedevil it: the Federal Emergency Management Agency denied his application for help to fix his damaged roof. He later qualified under a federally funded program run by Puerto Rico, but says the contractors sent for the job made the problem worse. Councilmember Díaz felt lucky that only a couple of leaks had sprung in his ceiling, even though Hurricane Maria tore the zinc panels off much of his roof. His real troubles began about a year after the storm, when a crew hired by Puerto Rico’s housing department showed up to make the repairs. He noted: “They weren’t very professional…They didn’t wear gloves, and they asked if I had an extra piece of wood,” adding that, within days, there were new leaks. Not only in the living room but in the bedroom, over his daughter’s crib, or, as the Councilmember added, referring to the leaks: “None of those were there before.”
As National Public Radio has reported, there is intense scrutiny on the government as Puerto Rico enters into the next phase of its reconstruction, a massive rebuilding effort funded by nearly $20 billion in HUD grants from a federal government which has been shut down—and could be again in the very near future. Moreover, the challenge for Puerto Rico has been further complicated by President Trump, who has reportedly tried to hold up various sources of funding for Puerto Rico in the wake of accusing its elected officials of being “inept politicians” likely to mismanage the funds. Gov. Ricardo Rosselló, sensitive to those apprehensions—and no doubt aware that the paper towels the President brought to Puerto Rico in the immediate wake of the devastation from the hurricane, appears all too well aware of these concerns—so much so that he has asserted that he has requested HUD officials to hold his government accountable for its spending, noting: “We have an opportunity we haven’t had in two or three generations…and that we may never have again if we don’t make the most of it,” referring to the $20 billion HUD allocation as an historic opportunity to fund public projects which the quasi-chapter 9 territory could never otherwise afford, especially in the wake of the massive budget cuts and austerity measures imposed by the PROMESA Oversight Board. Thus, the HUD grants offer a great fiscal opportunity—and governing challenge—as many residents and business owners are uncertain and wary with regard to whether the government is to be trusted to allocate the funds where they would do the most good—and, of course—gain the ok from the Oversight Board. Indeed, the governing challenge has been further complicated by charges that the Governor’s administration has so rushed through public comment periods that there has been an inadequate public outreach effort—and that the government has only posted contract bidding documents in English on an island where just 20 percent of residents report speaking the language well. A significant challenge will come as the government seeks to address the massive hurricane-caused displacement: how will the $1.5 billion HUD grant be allocated to address displaced families? What will the public process be? Will lessons from New Orleans and Houston help? In response, the Governor noted to NPR: “I’m telling you this from the bottom of my heart. We want this plan of reconstruction not to be the Governor’s plan or the mayors’ plan. It needs to be the plan of all Puerto Ricans,” adding that he takes the HUD public outreach mandate seriously: “But make no mistake about it, we’re moving fast, but we’re moving transparently and collaboratively so we can have the best long-term reconstruction of Puerto Rico: We want this plan of reconstruction not to be the Governor’s plan or the mayors’’’ plan: It needs to be the plan of all Puerto Ricans. Last week, the Center for the New Economy in Puerto Rico warned that while the Governor’s spending plans for the HUD grants do a good job of identifying many of the problems confronting Puerto Rico’s housing stock, such as unaffordability and widespread damage from the hurricanes, they fail to outline a comprehensive path forward.
Unfederalism & Creating a New Municipal Future? The storm’s havoc stirred its own governance maelstrom, as competing pressures on the central government have come from Puerto Rico’s 78 mayors or alcaldes, private developers, and large nonprofits: they are vying for a major share of the federal assistance—and quickly. Or, as Mayor Edwin García Feliciano of Camuy put it, in the wake of Hurricane Maria, he had been frustrated by how long it took FEMA to fund important repairs in his municipio—indeed, he is still awaiting some promised assistance: his staff has been working to put together a list of projects he intends to submit to the Governor, including critical roof repairs for hundreds of families in his municipio still living under blue tarps, new pumping facilities to provide more reliable drinking water, and road improvements, among others. The Mayor notes: “I’ve been mayor for more than 16 years, and I’ve never had this kind of opportunity to improve Camuy.” Unsurprisingly, he and other mayors, including San Juan Mayor Carmen Yulín Cruz, are also seeking greater flexibility in how they spend HUD funds in their own communities. Mayor García said the central government may do a city-by-city assessment before deciding whether to grant such flexibility, noting that in some municipios, there are concerns about fiscal health, staffing levels, and corruption, adding: “Unlike some mayors, I have never been investigated for misuse of public funds…so I see no reason why I shouldn’t have that flexibility.”
But might all these dreams come to naught? With the federal assistance running ought, and the federal government contemplating still another federal government shutdown—as well as apprehensions with regard to Washington, D.C. micromanagement (and PROMESA Board) of the use of federal disaster assistance, there is uncertainty with regard to who will be in charge for the next recovery step: the implementation of some $20 billion in HUD grants—grants which have been reported to have gained the President’s attention, as he has reportedly tried to hold up various sources of funding for Puerto Rico in the wake of accusing its elected officials of being “inept politicians” likely to mismanage the funds. The concerns are great enough that Gov. Rosselló has reported he has requested HUD officials to hold his government accountable for its spending, noting: “We have an opportunity we haven’t had in two or three generations…and that we may never have again if we don’t make the most of it,” with elected leaders perceiving the HUD funding as offering an historic opportunity to fund public projects which the U.S. territory could never otherwise afford, especially in the wake of them massive budget cuts and austerity measures imposed by the shadow government—the PROMESA Oversight Board. For his part, the Governor noted: “I’m telling you this from the bottom of my heart. We want this plan of reconstruction not to be the Governor’s plan or the mayors’ plan. It needs to be the plan of all Puerto Ricans.”
Federalism. Mayor García reports the central government may do a municipio-by-municipio assessment before deciding whether to grant municipios flexibility, noting that, in some municipios there are concerns about fiscal health, staffing levels, and corruption; he adds: “Unlike some mayors, I have never been investigated for misuse of public funds, so I see no reason why I shouldn’t have that flexibility.” Now, with the federal government reopened—but threatened with still another closure, there are apprehensions that additional food aid for Puerto Rico’s low-income families will soon be exhausted without supplemental funds opposed by the White House. At the same time, billions in community development appropriations have yet to leave Washington—a year after gaining Congressional approval to assist in the recovery from Hurricanes Maria and Irma, or, as U.S. Rep. Jose Serrano (D-N.Y.) put it: “The territories have long been treated badly, like they’re not part of the American family…But Trump takes it to a new level of meanness.” To date, the seemingly discriminatory Trump Administration response has garnered two excuses: 1) the President’s concern with Puerto Rico’s (but not the federal) substantial debt and the notion that municipal bond holders will profit from disaster aid. The second appears to be political: what are the politics in Florida. Last October, the President, in a tweet, had triggered an outcry when he accused Puerto Rico’s “inept” leaders of trying to use “the massive and ridiculously high” amounts of disaster aid to pay off the commonwealth’s crippling debts. Independent observers said there was no factual basis for the President’s claim. Nevertheless, the Trump administration is reported to have explicitly warned Senate Democrats in advance that the President would not tolerate anything more for Puerto Rico in a disaster aid bill now pending in Congress—and, when the White House opted to include $12.7 billion in disaster aid as a carrot for its border wall funding bill, it first took the scalpel to all of about $1.3 billion in new disaster aid for Puerto Rico proposed by the House Appropriations Committee.
Last week, Mitu Gulati and Mark Weidemaier in a post, “Puerto Rico’s Audacious Move: Can it Cut its Debt by $6 Billion?,” wrote that Puerto Rico, acting through the PROMESA Oversight and Management Board (and in conjunction with the creditors’ committee), had filed a claims objection seeking to invalidate roughly $6 billion of its General Obligation debt, reasoning that government allegedly borrowed in violation of the Debt Service Limit and the Balanced Budget Clause of the Puerto Rico’s constitution. They noted, however, that the Commonwealth does not gain much benefit from invalidating loans unless such actions also avoid the obligation to pay restitution; ergo the objectors make the additional argument that bondholders have no equitable right to restitution under a theory of unjust enrichment. While writing that there is some precedent for the objectors’ arguments in similar contexts, they referenced one law review article—a student note in the North Carolina Banking Institute journal (here)—which squarely addresses Puerto Rico’s argument, ultimately concluding: “How can Puerto Rico’s penalty for illegally borrowing above its means be that it is allowed to declare the debts void and keep the money for itself? Despite the manifest unfairness of such a result, the applicable law indicates that this is likely the proper legal result.
It might seem unfair for bondholders to get nothing. But as a matter of basic contract law, there is a plausible argument against restitution. Here’s §197 of the Restatement (Second) of Contracts: “[A] party has no claim in restitution for performance that he has rendered under or in return for a promise that is unenforceable on grounds of public policy unless denial of restitution would cause disproportionate forfeiture.” (The fact that bondholders will lose their expected payments does not make forfeiture “disproportionate.”) And here’s the most relevant exception, in §198: “A party has a claim in restitution…if (a) he was excusably ignorant of the facts or of legislation of a minor character in the absence of which the promise would be enforceable, or (b) he was not equally in the wrong with the promisor.” He then noted: the PROMESA Oversight Board “bases its argument on the Commonwealth’s law—for example, on the proposition that the Constitution invalidates other provisions of law (including the UCC) that might provide bondholders a remedy. We reference elementary principles of contract law only to show that readers should not view the objectors’ arguments as demanding radical changes to well-established law. It’s quite clear that the law permits (if not requires) exactly the result the objectors seek to achieve.” He noted, further: “One argument for allowing governments to avoid loans without paying restitution is that investors in these types of instruments are sufficiently informed to evaluate a loan’s legality. Put differently, and in terms that echo the Restatement (Second) of Contracts: investors are neither “excusably ignorant” of the debt limit violation nor less culpable than the government. Of course, the lawyers for the underwriters will issue an opinion letter affirming the legality of the deal, but investors are capable of conducting their own evaluation. Or perhaps investors should focus their ire on bond counsel instead (as the previously-linked note in the NC Banking Institution discusses at pp. 214-15).
At stake, he writes, were the shadow government PROMESA Board to prevail, are apprehensions that the territory’s borrowing costs would increase dramatically. To which, he notes: “Maybe; maybe not. Let’s assume part of Puerto Rico’s debt was illegally issued. Will the market penalize Puerto Rico for retroactively policing this illegality? This strikes us as an empirical question without an obvious answer. The economic logic behind constitutional debt limits and balanced budget rules is that such commitments help ensure fiscal prudence, which should reassure investors and protect the borrower’s citizens and residents from the costs of excessive debt. But these benefits require that the commitment to fiscal prudence be credible, and that requires institutions capable of enforcing discipline. (There is of course an important literature on this subject, including foundational work like Douglas North and Barry Weingast’s Constitutions and Commitments.) Allowing the government to avoid illegal loans ex post might create positive incentives. Perhaps the bankers who engineer these deals, and the lawyers who write comfort letters, will police transactions more carefully in the future. If so, investors may view the Commonwealth’s commitment to fiscal prudence as more credible, and borrowing costs might go down. Ultimately it’s an empirical question. For example, one might ask whether yields on Puerto Rico’s other, legally issued, debt are increasing thanks to this case (correcting, of course, for the effect of the reduction to the debt stock).” His bottom line: “This is going to be a fascinating case with big implications in the future.”