Puerto Rico Debt Repudiation Raises New Risks for Munis
(Bloomberg) -- Congress created Puerto Rico’s oversight board in 2016 to allow the bankrupt U.S. territory to “achieve fiscal responsibility and access to the capital markets.”
Yet a lawsuit filed by the board -- in what is widely seen as tactic to strengthen Puerto Rico’s hand in negotiations with bondholders -- could undermine confidence in the $3.8 trillion state and local government debt market if it succeeds in court.
The overseers Thursday sued dozens of banks and bondholders to claw back more than $1 billion in fees and interest payments tied to as much as $9 billion of debt that Puerto Rico is seeking to repudiate on the grounds it breached the constitutional debt limit. The claim marks a stark about face for Puerto Rico, which assured investors at the time that the bond sales were safely within the cap, and raises the risk that others states or cities could try to someday void debts they said were legally sound.
“The oversight board is challenging the basic underpinning that bond investors can rely on information given by issuers,” said Kenneth Naehu, founder and managing director at Banyan Tree Asset Management in Los Angeles, who oversees about $1 billion of municipal bonds, of which less than 0.2 percent are from Puerto Rico. “If muni investors should be held responsible if an issuer provides false information, that will send a loud warning to muni buyers.”
The move by the oversight board is another example of how Puerto Rico’s bankruptcy is upending the secure reputation of one of the world’s safest havens for investors. In March, an appeals court upheld a ruling that Puerto Rico’s highway agency can raid tolls and other fee revenue dedicated to bondholders until the bankruptcy is settled. The legal fight, which could go to the U.S. Supreme Court, has the potential to erode the value of billions of dollars in bonds sold for highways, airports and water systems.
The debt repudiation lawsuit will likely be settled before it results in a court ruling, Nuveen analyst Molly Shellhorn wrote in January, when the commonwealth first said it would seek to invalidate the bonds. The prices of some of the securities have also been little changed, with those due in 2035 trading at an average of 51 cents on the dollar Friday, indicating that investors are speculating they won’t be invalidated outright.
Matthias Rieker, a spokesman for the oversight board, said it has a duty to act in the best interests of Puerto Rico and all its creditors. “Although we are mindful of the perceived unfairness to holders of invalidating bond debt and recovering these funds, we are also mindful that it is neither fair nor legal to burden Puerto Rico’s residents with that against which their Constitution protects them,” Rieker said in an email.
It’s not the first time that investors have said that a municipal bankruptcy could set a dangerous precedent, and warnings that governments such as Detroit and Jefferson County, Alabama, would face grave consequences from having their debts written down have proven off base. But a ruling invalidating Puerto Rico’s bonds on legal grounds -- an idea that was raised, but not implemented in Detroit’s case -- could cause the frequently skittish individual investors who dominate the municipal-bond market to pull back for fear that other fiscally stressed borrowers like Illinois, New Jersey and Connecticut could some day follow suit.
“When liquidity dries up, everything goes south -- see Bear Stearns and Lehman,” Naehu said.
Congress created the oversight board in 2016 as part of a bipartisan deal to manage the restructuring of Puerto Rico’s crippling debt load. The seven-member board would develop responsible budgets, ensure fair treatment of investors and restore the island’s access to credit markets, according to U.S. Representative Rob Bishop, a Utah Republican, who was at the center of negotiations.
‘Bait and Switch’
Pulling a bait-and-switch on bondholders doesn’t demonstrate financial prudence or build credibility with investors that Puerto Rico will need to provide capital for economic growth, said Jim Spiotto, managing director at Chapman Strategic Advisors and a municipal bankruptcy expert.
“If they want to be treated like Ecuador, Brazil, Argentina and Greece, it’s a pretty good way of starting,” he said.
One argument for allowing Puerto Rico to annul debt without paying restitution is that investors are sufficiently informed to evaluate a loan’s legality, wrote Mark Weidemaier, a law professor at the University of North Carolina at Chapel Hill wrote in January on the Credit Slips blog.
It’s difficult to gauge the impact because no state or territory has reputiated their debts in modern times, though it isn’t unprecedented. Following the financial panic of 1837, eight U.S. states and one territory, Florida, did so for debt issued for transportation projects and banking services. As a result, they either were locked out of the market or, if they could obtain financing, had to pay a 32 percent interest rate, according to Spiotto.
By the late 1840’s, seven of the eight states had renounced their repudiation and resumed debt payments so they could obtain market access at a lower cost.
“It’s one thing to say we don’t have the ability to pay,” said Spiotto. “It’s another thing to say I defrauded you, I represented to you something that wasn’t true and so I’m not going to pay anything. That’s an unwillingness to pay."
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