Puerto Rico: Colonial Chickens, Structural Priority, and Contingent Debt
It has been a humbling torrent of creativity, and I am honored to chip in a tuppence at the eleventh hour. After an existential preface, I consider how one might use (or resist using) federal credit enhancement in the inevitable debt exchange.
By way of a preface, my dominant sense of Puerto Rico's crisis continues to be that it is all about colonial chickens coming home to roost (see Melissa's roundup). One could, therefore, get on a high horse about mismanagement and corruption--but staying on the horse is hard when you consider that the Commonwealth economy is entirely a function of its century+-long relationship with the United States. The Jones Act, the military bases, the random tax breaks, and the massive but incoherent patchwork of federal transfers are symptoms of the broader dysfunction (this is where comparisons with Greece and the young euro sound especially beside the point). A durable solution to the crisis therefore requires a vision of what Puerto Rico's economy should be about in the United States and in its Caribbean neighborhood, which therefore implicates the status question. Until then, it is important to keep in mind--as Adam Posen said in December (at the very very end of the video)--that investing in the people of Puerto Rico is not necessarily the same as investing in the place. It might just be that even a perfectly reformed Puerto Rico is a much smaller place for the foreseeable future.
Onto the less-intractable business.
First, picking up on some of Adam Levitin's themes, I think that the question of priorities is central, and that the situation is worse than it looks. The government borrowed too much using different agencies, different collateral, different contract and payment routing schemes. There is constitutional priority, statutory priority, contractual and structural priority. That structural variety strikes me as especially problematic because it operates by creating facts on the ground, such as payment streams that require lawsand lawsuits to reroute. Similarly, two identical general obligation bonds, both of which have constitutional priority, may not be equal at all if one is governed by the law of Puerto Rico, and another by New York law. In other words, there is priority, and there is facts-on-the-ground priority.
This is where the absence of a comprehensive, collective, binding process like bankruptcy feels like a huge problem. Debtors will pursue piecemeal settlements, creditors will jostle for advantage, the meek shall inherit bupkes, and the next round shall have more convoluted debt structures and more over-borrowing. (Note I am eating a bit of crow here, since I had advocated more contractual prioritization in sovereign debt ten years ago. I had in mind an alternative to hidden structural priorities, not a steroidal expansion thereof.)
Therefore - whether this ends with a federal oversight board-cum-restructuring authority, a giant distressed exchange with federal credit enhancement (eg, bullet repayment or rolling coupon guarantees/UST collateral), or a combination of the two ... the outcome has to be a super-simple, transparent, explicit capital structure. Most especially, federal credit enhancement should not be used to validate attempts at creating super-senior general obligation bonds governed by New York law over the hoi polloi general obligation bonds governed by Puerto Rican law. It would be exceptionally ... un-federal.
(Aside: a U.S. state (or territory) that can no longer issue debt under its own law probably should not be issuing more debt.)
Second, Puerto Rico's bond restructuring proposal contains an intriguingly fashionablecomponent, namely, state-contingent debt (see p. 11 for Growth Bond description, andhere for graphics, despite somewhat purple text). Creditors get paid more if revenues go up, less if they go down. They have a stake in the well-being of the debtor's economy. It is sort of like ... equity.
Serious economists love contingent debt. It also makes huge intuitive sense--if it is well designed, it could counter cyclical fiscal pressures, help manage crises, compensate creditors ex ante, and add a modicum of predictability ex post in this bankruptcy-free space. On the other hand, market participants have been forever lukewarm on contingent debt, for reasons that do not seem entirely compelling to me.
The most common objection is that, when the payments are indexed to something within the debtor's control or calculation purview, like GDP and especially revenues (Puerto Rico's proposal), the numbers will be cooked. Let's put aside the question of why a government would understate growth (presumably raising its new borrowing costs) just to save a few pennies on the old indexed debt--who knows, some might. The answer should be to raise the cost, not to reject the contingent instrument altogether. Another alternative would be to pick a source of relevant statistics that is not under the government's control, like the IMF for foreign sovereigns, or a federal oversight body in the United States. If the debtor fails to supply verifiable data to that body, it does not get the benefit of the contingency. Incentives aligned.
My hunch, though, is that the reasons for market resistance are deeper than statistical integrity, and have something to do with the fact that government equity is inherently weird. Put aside the need for super-simple, information-insensitive debt to serve as a base asset in the banking system and the capital markets; assume instead that we are in the world of risky debtors like Puerto Rico. What do you get as a creditor when you promise to forgo payments when the issuer is in distress? You do not get control rights or better collateral, you just get a promise of fluctuating returns in a world where everyone around you is playing structural priority games after the fact (see above). The entire picture comes to look too uncertain.
A few countries have issued little chunks of contingent debt in recent years, but they have been mostly distressed economies like Argentina, Greece, and Ukraine, promising their creditors value recovery later in exchange for deeper debt relief up front. In the past, the contingent component has been small. What Puerto Rico is proposing is pretty huge relative to the size of the debt stock--and given the size of the debt stock, the value recovery piece could be a liquid instrument in its own right.
It would be a good use of federal enhancement in a debt exchange to encourage properly designed contingent instruments, especially since these can serve as a vehicle to promote statistical integrity and halt structural priority races. If it works, it could even spread in the muni markets and beyond.