Can Default be Contagious?

August 7, 2015

Default & Its Consequences. Puerto Rico, in uncharted fiscal, and public health territory in the wake of its default and its current drought, confronts increased borrowing costs and greater public demands. The U.S. territory’s decision, last month, to cease setting aside funds to meet its general obligation bonds now raises constitutional and legal questions with regard to how and whether Puerto Rico will make payments to its general obligation bondholders next New Year’s Day, when a $375 million payment to GO bondholders is due. Because such obligations have a superior claim on revenues, that could force the government to syphon off fiscal resources from public services, including infrastructure, schools, health care, and other authorities in order to make the payment: that is, the Solomon’s Choice between essential public services and critical access to capital is looming. Article VI, §8 of the Puerto Rico constitution provides that “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.” Nevertheless, on Monday, Puerto Rico posted a statement on EMMA that it had “temporarily suspended” the set asides. Last month, Luis Cruz Batista, Puerto Rico’s Director of the Office of Management and Budget told El Vocero that the GO payment was not assured—an uncertainty confirmed this week by Government Development Bank President Melba Acosta Febo, who stated she could not guarantee the general obligation payment to bondholders would be made, albeit she made clear Puerto Rico working to improve the central government’s liquidity so that it would be able to make the payment, noting to El Vocero: “We recognize the GO’s priority over other debts and its difference from other debts, but we must also recognize that there is a duty of the state to maintain health services, education services, and some security to our people – we must look at those things.” Indeed, the island’s general obligation debt holds a superior claim to revenues compared with other government debts and claims, meaning that, for instance, motor vehicle fuel taxes, crude oil, and derivative products excise taxes, cigarette excise taxes and license fees allocated to the Puerto Rico Highways and Transportation Authority can be diverted to meet the island’s general obligation debt, at least according to the official statement for its March 2014 Puerto Rico GO bond sale. Moreover, there is authority to divert some rum tax payments allocated to the Puerto Rico Infrastructure and Finance Authority, as well as hotel occupancy tax revenues currently flowing to the Puerto Rico Convention Center District Authority in order to meet general obligation debt; however neither Puerto Rico’s constitution, nor its applicable laws specifically mandate funds to revert to the central government “even if other available resources of the commonwealth are insufficient for the payment of public debt.”

Promises, Promises…Could Puerto Rico Be Contagious? Just as Chicken Pox can be contagious, so too there can be apprehension that political promises to pay—when perceived to be welshed upon, can create contagion fears and higher costs to cities, counties, and states in other places—especially on state or local debt supported only by a legislature’s, county or city council’s promise to pay. Thus it is that S&P this week abruptly downgraded Chicago’s Metropolitan Pier and Exposition Authority’s rating from its stellar AAA status to near junk: why? Because Gov. Bruce Rauner and the Illinois legislature are in a stalemate: the state has yet to appropriate funds to meet its promises to pay the bondholders. It is unsurprising that state and local bondholders in other states, counties, and cities—observing an inability to make a promised payment—might insist upon a higher interest rate to reflect the political risk. Whereas a general obligation or revenue bond issued by a state, local government, or authority provides the municipal bondholders with claims to designated revenues, so-called appropriation bonds might be perceived to give bondholders claims only to promises to pay. Moody’s unmoodily this week illustrated the extreme distinctions: examining the Motor City’s municipal bankruptcy, the credit rating agency wrote that holders of Detroit’s certificates of participation, which had neither the city’s taxing power nor dedicated specific revenue streams, received only twelve percent of what they were owed—some 16 percent of what Detroit’s general obligation bond holders received under the city’s federally approved plan of debt adjustment. Under San Bernardino’s proposed plan of debt adjustment pending before U.S. Bankruptcy Judge Meredith Jury, the California municipality has proposed paying its pension-obligation bondholders only one cent on the dollar. Already the Puerto Rican contagion seems to be giving potential Jayhawk development finance authority bond investors the eeby-jeebies. With Kansas collecting $3.7 million less in taxes than anticipated this month, potential investors in the $1 billion of debt it is seeking to sell next week through its development finance authority to shore up its underfunded workers’ retirement system are almost certain to be affected—especially as the prospectus circulated to potential buyers warns that if Kansas does not allocate cash to pay investors, the agency “has no obligation to seek or obtain any source of moneys for deposit to the Revenue Account, other than State appropriations.”

Advice and Consent. The Wayne County Board yesterday voted 12-2 to enter into a consent agreement with the state to handle its financial emergency and avoid insolvency. The strong vote means Wayne County and Michigan Treasurer Nick Khouri have started the clock ticking over the next 30 days during which to negotiate a draft of an agreement—one which the County hopes would enhance its authority vis-à-vis labor contracts as well as allow the county to continue to maintain local control over its restructuring. Wayne County Executive Warren Evans noted: “Today Wayne County continues on its road to financial recovery…We have already made significant strides towards getting Wayne County back on the right fiscal path. The consent agreement will ensure our ability to fully implement our recovery plan and stabilize the county for the future.” The next steps are to negotiate with the state over the terms of a consent agreement, or, as Executive Evans noted: “As we finalize the terms of the consent agreement with the state Treasurer, we will continue in our commitment to negotiate in good faith with our unions…Although a consent agreement will eventually give the county the ability to set the terms of employment, our preference is to reach agreements at the bargaining table.” Any final consent decree will affect Detroit—the County seat in the middle of Wayne County—thus one might imagine a double helix with the city and county interlinked in their fiscal fates.

Heard It Through the Grapevine. First recorded 49 years ago in Detroit by producer Norman Whitfield with various Motown artists by the Miracles on August 6th, yesterday’s anniversary marked a miracle of a different kind: Detroit posted preliminary bond documents for what will be its first public sale of municipal bonds since its historic municipal bankruptcy: sale through the Michigan Finance Authority is tentatively set for a week from Wednesday, marking the city’s first public market access since it received the rhythm guitar playing U.S. Bankruptcy Judge Steven Rhodes’ approval of its plan of debt adjustment of the largest municipal bankruptcy in U.S. history last December. In contrast to the kinds of appropriation bonds which have both worried investors and driven up the cost of borrowing for states and local governments, this new issuance is expected to benefit from a remarkable state role through which Michigan makes use of a statutory lien on income-tax revenue and an intercept feature by means of which the income-tax revenue is first routed to a bond trustee before the rest is sent back to the city—meaning that S&P has already assigned an A rating to the deal. In addition to the relatively unique statutory lien and intercept feature, the sale also provides that about 8 percent of the income-tax revenue, will first be sent to the police budget, a pledge that is senior to bondholders’ under the deal. The Motor City is issuing the debt to repay Barclays for a $275 million loan, the proceeds of which the city used to help finance its exit from municipal bankruptcy. Notwithstanding the nice rating and excitement about the city’s return to the bond market, Detroit’s preliminary municipal bond documents hint at the uncertainty of how the liens might be interpreted in a U.S. bankruptcy court: “The bankruptcy court would not be bound by legal opinions other than binding precedent, and there currently is no binding precedent regarding these matters…Thus, the opinion of bond counsel to the city is not (and cannot be) a guaranty that the pledged income tax revenues would be treated as subject to a statutory trust or lien.” The documents note other potential risks, including the possibility of another bankruptcy filing; the uncertainty of future income tax revenue; limitation on rate of income tax; and Detroit’s economic and fiscal condition.

Yet, as Motown singer Ted Nugent, in his “Motor City Madhouse Lyrics” sings:

Who! Welcome to my town
High energy is all around tonight
Who! You best beware
Well, Detroit city, she’s the place to be.

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.