Puerto Rico needs compromise, not a cram-down

As the old joke goes, if you owe $1 million, you have a problem. If you owe $1 billion, your creditors have a problem. The commonwealth of Puerto Rico now owes about $73 billion, the bitter fruit of many years of political profligacy and fiscal irresponsibility. It cannot be repaid, and even the ongoing interest payments are proving problematic, in particular for bonds not classified as general obligation, which therefore do not enjoy the highest “full faith and credit” repayment priority under the commonwealth constitution.

{mosads}So Puerto Rico’s problem is that it cannot preserve its creditworthiness fully even as it needs access to credit markets so that it can finance its immediate budget requirements as well as its large longer-term needs for capital investments. And the problem confronting the current Puerto Rico bondholders and the other commonwealth creditors also is straightforward: They are entitled to be repaid under the agreed terms of the loans that they extended to the commonwealth, but they will not receive all that they are owed. And they must contend as well with the distortions and pressures introduced by political meddling of the sort that large government debt is all but certain to attract, because payments to creditors reduce the amount of budget dollars available for interest-group spending in the here and now.

About that meddling: It is not surprising that the Puerto Rico political establishment prefers to pay less rather than more, in particular because their political incentives lean heavily toward immediate budget relief over future creditworthiness, as erosion of the latter will create a very substantial adverse effect borne largely by their successors. And so the drumbeating for intervention by Congress has been loud and uninterrupted for many months, as the central component of an effort by commonwealth politicians and their allies to force the creditors to accept terms far less favorable than those that negotiations less distorted by political pressures would produce.

Ask and ye shall receive: Congress has been unwilling to resist the temptation to butt in, with various proposals for retroactive Chapter 9 bankruptcy eligibility and other schemes being considered. The latest trial balloon is a draft bill produced by the House Natural Resources Committee, the most important detail of which is a provision that would allow a federal oversight board to send a debt-restructuring proposal to a court, which then would use it to impose a “fair and equitable” solution — that is, a forced allocation of debt write-downs among the creditors.

A “fair and equitable” solution, of course, would be imposed without a requirement for agreement through negotiations, and would assume the answer to the difficult underlying question. Without prior conditions specified in the bond instruments, and without current agreement resulting from a negotiation process, the “fair and equitable” solution in truth is an imposed solution, that is, a debt write-off “crammed down” upon the creditors.

And so we must ask whether it is a cram-down process or negotiation that is more likely to satisfy five relevant policy goals. First, a cram-down might be better than negotiations at reducing the immediate problem of debt service costs; after all, by its very nature, coercion is better than agreement in terms of extracting concessions from adversaries. But that is hardly an argument in favor of the former; the whole point of voluntary market processes is the creation of mutually beneficial solutions to problems.

And, second, the re-creation of fiscal discipline decidedly is not a goal consistent with the cram-down approach; if current creditors can be strong-armed, why not future ones as well? Everyone agrees that enforcement of fiscal discipline is the only plausible route to a positive fiscal future for Puerto Rico, and only the fear of future pain can further that end.

Third, future incentives for investment in Puerto Rico bonds must be eroded as little as possible so that large future investments in needed infrastructure and other capital requirements can be made in an orderly and efficient process. Such large investments will be needed by the Puerto Rico Electric Power Authority (PREPA), the Aqueduct and Sewer Agency, and several more. Will future investors, having lived through a cram-down, have warm thoughts about investing in the Commonwealth again? The question answers itself.

Fourth, the process should encourage compromise rather than holdout behavior. A cram-down is utterly inconsistent with this objective by definition — it is the opposite of compromise — and why should future creditors opt for good-faith negotiations when they believe that any concessions will be taken and then abused in a future cram-down process?

Finally, political favoritism must be avoided. Only negotiation can achieve that end, and a forced solution inevitably will be used to transfer wealth from creditors to concentrated political interests. That is a reality illustrated well by the previous bankruptcy outcome in Detroit, celebrated as a “success,” but the specifics of which were far less salutary. Pension costs were the single largest outlay in the city budget, but the bankruptcy in effect paid pension obligations in full while the bonds that were issued to fund those payments received from Detroit less than 10 percent of what was owed. City officials were able to avoid the adoption of almost all major cost efficiencies, such as those recommended for the Department of Transportation. Not one of Detroit’s 28 agencies was closed. To this day, infrastructure planning has not been adjusted to reflect a population decline of almost two-thirds. And so on.

In short, a cram-down process will penalize those not responsible for the fiscal problems confronting Puerto Rico, will weaken commonwealth incentives to adopt fiscal and governance reforms, will increase future borrowing costs for the island and for the municipal bond market writ large, will encourage future intransigence on the part of everyone, and will increase rather than reduce the politicization of the municipal bond market.

In contrast, under a reasonable compromise solution, a collective action provision would be implemented for each class of claims. Under such a compromise, the commonwealth would have the power to bind holdouts within a given creditor class once a majority or supermajority of the creditors in that class (weighted by the value of holdings) agrees to a proposed restructuring of the debt. Such collective action approaches have proven effective at driving competing interests toward reasonable compromises in debt restructurings, but the commonwealth has resisted this approach thus far because it does not involve the sort of cram-down that bestows huge advantages upon the debtor.

Why is Congress meddling in this problem? The recent agreements between PREPA and its creditors demonstrate that negotiation without federal involvement is a viable solution. (Note that PREPA, with its $9 billion in debt, is the largest debtor among the commonwealth entities.) It is obvious that the prospect of federal involvement has made negotiations more difficult, in particular by reducing the willingness of the debtors to compromise: Why do so when Uncle Sam might impose a cram-down process upon the creditors? But even if Congress now cannot induce itself to back away, a fiscal control board able to impose fiscal discipline, but not allowed to interfere with the negotiation process over the commonwealth’s existing debts, is the option likely to do the least damage currently, and to preserve the soundest incentives over the longer term.

Zycher is the John G. Searle scholar at the American Enterprise Institute.