It’s not all R&R (Rum & Recreation)…

While much of the world has been transfixed by events in Greece and China (what happened to the Ukraine?), the US has its very own potential fiscal train wreck gathering speed in the form of the Commonwealth of Puerto Rico, whose Government has finally stated publicly that the island’s public debt burden of some USD 72BN (some 100% of GBP as of end 2014) is unsustainable and needs to be restructured. The Commonwealth’s economy has been contracting for at least a decade; while the government has run persistent budgetary deficits; and, in the absence of significant and radical structural reforms, the ratio of debt to GBP will continue to rise inexorably. Something has to give!

Because of Puerto Rico’s unusual triple-exemption for investors in terms of US taxation, its debt has long been popular with individual and institutional investors; but it has also, more recently, become “prey” for a number of distressed debt and hedge funds, who hope to influence and profit from what will probably be a complex and protracted restructuring. In addition, a number of so-called monolines, in particular MBIA and Assured Guaranty, have provided guarantees of principal and interest (i.e. “wraps”) on significant amounts of debt- a level of exposure that actually led them recently to provide funding to the Island’s power utility, PREPA, to enable it to avoid a payment default, which might potentially have led to a cascade of further defaults. Of course, as usual, the rating agencies were lagging indicators, holding off downgrading the Commonwealth’s obligations below investment grade for far longer than was warranted by reality; and yet, on July 15th, one of its government-linked financing vehicles, the PRPFC, failed to provide funds to make an annual debt service payment of USD 94MM, so default looms.

Being a Commonwealth, not a municipality, means that the Government cannot currently seek to restructure under Chapter 9 of the US Federal Bankruptcy Code (as used by, inter alios, the city of Detroit). It has made several attempts to have legislation passed that would simplify its ability to restructure its own debts and  that of entities such as PREPA; but without success, so far. In addition, the Commonwealth’s constitution requires that any General Obligation debts be serviced before any other obligations; which, naturally, has created spread differentials between the various types of public sector obligations and the scope for arbitrage.

Given the complexity of the Commonwealth’s obligations; the diversity of those investing and speculating in them; and the absence of any clear mechanism for restructuring, it seems likely that only the lawyers are certain to get rich from the forthcoming legal battles. The Commonwealth’s government desperately needs to be given the tools and flexibility to negotiate with its creditors in a judicial rather than political process (even though, of course, political and policy decisions will be an essential component of any successful resolution.) Regrettably, there is no real sign of a dysfunctional and partisan US Congress taking steps to facilitate any of this, so one must expect crisis and confrontation à la Grecque before any eventual resolution.

At Awbury, we have no exposure, direct or indirect to the Commonwealth; but, as always, we pay close attention to events that can have consequences beyond the immediate and obvious. One can always learn from how decisions are made (or not); and how problems that may seem initially insoluble are eventually addressed. We simply hope that there will now be a concerted effort to deal with reality.

 

– The Awbury Team

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