The Perverse Incentives of Puerto Rico's Debt Deal

Puerto Rico's Financial Oversight and Management Board, created under the administration of former President Barack Obama, recently reached an agreement with the Commonwealth's government to restructure the island's debt, which has been in default since 2017. Media outlets have speculated about a possible "end to the largest bankruptcy proceeding in U.S. history." The only remaining obstacle is the approval of Chief United States District Judge Laura Taylor Swain of the U.S. District Court for the Southern District of New York, who is in charge of the proceedings according to the 2016 PROMESA law (the Puerto Rico Oversight, Management, and Economic Stability Act).

The deal only reached Swain's desk, however, after the federal oversight board agreed to Puerto Rico Gov. Pedro Pierluisi's demands "of zero cuts to pensions of current retirees and current accrued benefits of active public employees," plus funding of $500 million per year for the University of Puerto Rico until 2027.

As John Dizzard of the Financial Times wrote, the holders of Puerto Rico's defaulted bonds "are being handed deep haircuts on their face value whilst pensions for retired public sector employees are left intact." As bondholders lose out to pensioners, politicians are turning the logic of secured credit investing on its head.

One of the hearings for Puerto Rico's defaulted debt concerned $3 billion "in bonds backed by Puerto Rico highway tolls and excise taxes," and $800 million "in debt secured by taxes on rum paid to Puerto Rico by the federal government," notes Courthouse News Service's Thomas F. Harrison. After the default, Harrison adds, "the insurers for the bondholders tried to collect from the trust funds" to which the revenues were supposed to be paid, only to find "that the (Puerto Rican) government had been diverting the money away."

One reason why the federal oversight board is legitimizing such conduct is the precedent from the 2008-2009 bailouts and bankruptcy proceedings of Detroit carmakers. Some of the same decision-makers of the financial crash era have also been involved in the Puerto Rican debt dealings.

In 2016, Obama named former judge Arthur J. Gonzalez to the federal oversight board for Puerto Rico. In 2009, Gonzalez was in charge of the Chrysler bankruptcy proceeding. As George Mason University law professor Todd Zywicki wrote of that "egregious" process: "Creditors who held the company's secured bonds were steamrolled into accepting 29 cents on the dollar for their loans. Meanwhile, the underfunded pension plans of the United Auto Workers—unsecured creditors, but possessed of better political connections—received more than 40 cents on the dollar."

Gonzalez resigned from the Puerto Rico oversight board in October 2020, a year after his original three-year term had expired. But the spirit of the Chrysler bankruptcy still permeates the recent debt deal. This could have effects beyond Puerto Rico.

As Marc Joffe, a senior policy analyst at the Reason Foundation (the nonprofit that publishes this website), comments: "What does it say to retail buyers of municipal bonds on the U.S. mainland about who is to be rescued after a default?" Political pressure groups in Puerto Rico have tried to put the spotlight on the speculators who have bought the island's defaulted bonds in expectation of a bailout, the hedge funds which they call "vulture funds," but the fact remains that over two thirds of municipal securities are "held by individual investors either directly or through mutual funds," according to the Municipal Securities Rulemaking Board.

Atara Miller, an attorney at the Milbank law firm in New York, told Courthouse News that Puerto Rico's debt proceeding leaves bondholders "with an umbrella that we can only use on sunny days." This risks the spread of contagion to states with high debt burdens and unfunded pension schemes such as New Jersey, Illinois, and Kentucky.

Besides its potential effects on the entire municipal bond market, which encompasses nearly $4 trillion in general obligation and revenue bonds, the Puerto Rican debt saga has also made a mockery of the rule of law. According to municipal finance expert Cate Long, who predicted that Puerto Rico would default on its debt as early as 2012, the island's government is three years behind on releasing audited financial statements, although "Congress explicitly required in the PROMESA law that Puerto Rico's financials had to be up to date."

While Puerto Rico has failed to make debt service payments since 2017, government spending is up over 12 percent since then despite a drastic population decrease. Long says Puerto Rican officials are realizing "how easy it is to hide financial data, pretend austerity, and fool their creditors." For its part, she adds, the U.S. government is creating all the incentives for Puerto Rico "to become a serial defaulter, like Argentina," a country on the brink of its tenth default since 1816.

The comparison is ominous; Argentina's longstanding practice of acquiring heaps of debt on the global markets before failing to repay it reflects the workings of its internal politics. As scholars Pablo Spiller (of the University of California, Berkeley) and Mariano Tomassi (of the Universidad San Andrés in Argentina) wrote in 2007, Argentina's brand of federalism combines decentralized spending for the provinces with largely centralized tax collection and funding schemes. The system, which began to arise in the late 19th century, still motivates "subnational governments [to] adopt a lax fiscal stance in the expectation that they will be bailed out in the event of a fiscal crisis." 

In turn, they write, the top regional politicians tend to be the crony machine operators "who are best at the game of extracting rents from the common central pool." Similarly, negotiating rescue packages with the International Monetary Fund has become a part of an Argentine president's unofficial job description. Will governors of Puerto Rico assume the same role vis-à-vis the White House and Congress?

Certainly, U.S. taxpayers should consider the long-term consequences of their bailout of Puerto Rico, where children of politicians tend to be overrepresented as recipients of six-figure government salaries and seven-figure government contracts. The habitual debt busts of Buenos Aires is one Latin American export that is better left on the dock.