Back in January, I wrote a piece about how Jeffrey Gundlach was wrong about Puerto Rico’s default risk — “I don’t care if [Puerto Rico] securities flop around,” Gundlach said, they will find a way to pay.

The territory’s power utility, the Puerto Rico Electric Power Authority (PREPA) — which is already in forbearance for tapping its debt service reserve funds — is expected to exhaust those funds and have a monetary default on July 1st. According to the trustee, after reserves are drawn down (and trustee fees are paid), PREPA will be short $150 million. The monolines have wrapped most of the maturities coming due that day and will have to cough up the cash for investors.

According to Bloomberg:

Investors and bond insurers have tentatively agreed on a proposal for how they’d be willing to alter terms on the authority’s existing securities, according to a person with direct knowledge of the discussions.

Suspending principal and interest payments or asking bondholders to reduce the amount owed would help Prepa as it seeks to modernize a system that relies mostly on petroleum to produce electricity.

Obligations of the utility that mature in July 2042 traded Thursday at an average price of 54.6 cents on the dollar, the highest since June 2 …

Regardless of how PREPA’s commitments shift, investors in all Puerto Rico securities will be negotiating difficult terrain from this point on. This will likely be the first of many creative revisions, which will all ultimately amount to bondholders not receiving what they were originally promised.

I heard from a congressional staffer yesterday that Representative Jeffrey Duncan sent out a “Dear Colleague” letter asking for a financial control board for Puerto Rico to address its debt crisis. Establishing a federal financial control board for Puerto Rico could potentially be the best option for residents. I have started thinking through the mechanics of how such a board might work and the history of emergency interventions in the municipal market —no, this is not an unprecedented event.

Objectively speaking, any Chapter 9 legislation will be ineffective when applied to Puerto Rico

Representative Duncan’s letter was written in response to H.R. 870, the “Puerto Rico Chapter 9 Uniformity Act of 2015.” This legislation wasrecently discussed in a hearing of the House Judiciary Committee’s Subcommittee on Regulatory Reform, Commercial and Antitrust Law.

H.R. 870 has proven to be quite controversial and bondholders have spared no expense in lobbying policymakers to scrap it. The legislation should be scrapped, but not necessarily for moral reasons. As drafted, the legislation would be ineffective.

All H.R. 870 does is redefine “state” within Chapter 9 of the federal bankruptcy code to include Puerto Rico. Under Chapter 9, states may authorize their political subdivisions (municipalities) to file for bankruptcy. States themselves — which are considered sovereign entities under the U.S. Constitution — are not eligible to file for bankruptcy. The logic behind the legislation is that if Puerto Rico is considered a state, its general obligation debt would be shielded from bankruptcy. The territory’s public corporations, however, could file for bankruptcy and adjust their debts. Puerto Rico recently enacted legislation that would have accomplished the same thing — to the horror of municipal market participants, who interpreted the measure as a diminution of the government’s willingness to repay what it owed. The law was shot down when bondholders challenged it in court.

Rarely, however, does legislation that is one line long accomplish what you want. The problem with H.R. 870 is that the bonds issued by Puerto Rico’s public corporations are of a variety that other provisions in Chapter 9 protect from being impaired — that is, “special revenue” debt. Furthermore, this is an error that Congress should not resolve through amending those provisions, which were added to Chapter 9 through the landmark 1988 Amendments. The status of special revenue debt is important to the municipal bond market and municipalities’ ability to provide essential government services.

The pledge of what are considered special revenues survives bankruptcy. Special revenues are defined as:

(A) Receipts derived from the ownership, operation, and disposition of projects and systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems;

(B) Special excise taxes imposed on particular activities or transactions;

(C) Incremental tax receipts from the benefited area in the case of tax increment financing;

(D) Other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or

(E) Taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sale, or income taxes (other than tax increment financing) levied to finance the general purpose of the debtor.

(James Spiotto, from The Handbook of Municipal Bonds)

If minutiae excite you, I’d also recommend this white paper on special revenue debt from Waller Lansden — the law firm that represented the trustee for the sewer warrants in Jefferson County’s bankruptcy and the trustee for water and sewer bondholders in Detroit.

Basically, if H.R. 870 is enacted, Puerto Rico still wouldn’t be able to adjust its debts.

It should likewise be noted that proponents of H.R. 870 are not the only ones with weak arguments. One of the claims frequently made by opponents is that Congress cannot (or should not) pass legislation that would retroactively alter the terms of outstanding debt. This is absolutely possible and how Chapter 9 came into existence in the first place.

Returning to Spiotto:

Prior to 1934, federal bankruptcy legislation did not provide a mechanism for municipal bankruptcy, insolvency, or debt adjustment. During the period 1929 through 1937, there were over 4,700 defaults by governmental bodies in the payment of their obligations. In 1934, the House and the Senate Judiciary Committees estimated that there were over 1,000 municipalities in default on their bonds.

Units of local government were dependent upon property tax. During the Depression, there was widespread nonpayment of such taxes. Bondholders brought cases for accountings, secured judgments and obtained writs of mandamus for levies of further taxes. The first municipal debt provisions of the Bankruptcy Act of 1898 as amended from time to time (the Bankruptcy Act) were enacted as emergency legislation for the relief of such municipalities …

Legislation permitting the adjustment of debt does not arise from thought experiments. It is born out of desperation and relates to existing contracts.

It is also difficult to make a moral argument in support of Puerto Rico’s bondholders. Investors have never purchased Puerto Rico’s debt based on the territory’s credit fundamentals, although some investors with large exposures are now trying to suggest otherwise. They purchased the debt because Puerto Rico’s bonds are the only bonds in the market (of any real size) that are triple exempt. And recently, Puerto Rico has attracted a surfeit of market tourists, who could care less about Puerto Rico’s fate. They are reaching for yield in a yield-less environment, where there is a lack of distressed debt opportunities in corporate bonds.

It is not the federal government’s responsibility to redeem opportunistic investment decisions or to reinsure the monolines. Fortunately, the monolines have taken to citing Puerto Rico and Detroit as cases that demonstrate the value of bond insurance. Who would have imagined that, following the financial crisis, the monolines would be advertising that that they continue to wrap toxic debt? But I digress.

Political hurdles to overcome

It is inevitable in the bond market that some governments will over-borrow and some investors will over-lend. Neither side is particularly virtuous and there has to be a process for resolving the conflicts that arise.

The practical wisdom behind Chapter 9 is the observation that if a government cannot honor its obligations, it is best for everyone involved if it at least does so in a fair and organized manner. A government’s raison d’être is to provide services to residents in perpetuity and it cannot do so effectively if it is fending off lawsuits from every direction. Value is also lost to investors as such situations suck resources from the government that could otherwise be used to offset its debts. Even if Chapter 9 cannot successfully be applied to Puerto Rico, this practical wisdom still abides.

Puerto Rico has two major political hurdles in the mainland U.S. to overcome as it advocates for such a process. The first is that the territory is literally no one’s constituency. Puerto Rico officials have tried to impress upon policymakers the gravity of their situation to little avail. Three congressmen appeared for the initial hearing on H.R. 870.

Some token technocrats from the U.S. Treasury Department have been dispatched to Puerto Rico to provide “technical advice” — but considering that the Puerto Rico government is contemplating raiding its state insurance funds and legalizing black market slot machines for operating cash, they probably aren’t getting very far on the advice front. Of course, I jest — everyone knows “technical advice” is code for “we aren’t giving you a dime, but we need to look like we did something.”

Federal policymakers likely will care about Puerto Rico if there is a string of major defaults. Such defaults might not have much of an impact on the municipal market as a whole, although they will be the largest the market has ever seen. However, large defaults could potentially produce a humanitarian crisis if they upend the territory’s financial system and interrupt the government’s ability to provide essential services. By then, providing something more than a symbolic gesture and avoiding a legacy of shame will be considerably more expensive. Policymakers can moralize all they want, but it’s remarkable how many man-made crises derive from simply waiting.

Puerto Rico’s other political hurdle is that it has an old school debt crisis but schizophrenic legal status/organization, which precludes the obvious solutions (like Chapter 9) and makes Puerto Rico easy to bully in court. Granting Puerto Rico statehood — and the federal resources that brings — could potentially be a good option in the future, but the territory requires immediate financial relief.

So what options does Puerto Rico have left?

Establishing a federal financial control board

This is not the first time the United States has had to grapple with a financially distressed entity that is stuck in not-quite-a-state limbo. Something similar happened with Washington D.C. in the 1990s. The federal government responded with the Revitalization Act, which was folded into omnibus legislation along with the Balanced Budget Act of 1997. By the time the legislation was enacted, it had broad bipartisan support.

From Jon Bouker of Arent Fox (Brookings):

When Congress granted home rule to the District of Columbia in 1973, Rep. Charles C. Diggs, Jr., then chair of the House D.C. Committee, declared that Washington’s residents had become “masters of their own fate.” …

However, a mere two decades later, the District’s limited home rule was in crisis. As the District government’s financial position reached its nadir in the mid-1990s, residents’ frustration and anger mounted as the District was unable to deliver efficiently the most basic services to its citizens, and the city’s congressional overseers began calling for a partial or even complete elimination of home rule.

After enjoying relative financial stability for most of the 1980s, the District began operating at a deficit in 1994 and by 1995 the accumulated deficit had ballooned to $722 million. To make matters worse, Wall Street dropped the District’s bond ratings to “junk” levels, prompting Moody’s to brand them as risky and “speculative.” As a result, the city was unable to pay its vendors, to render basic services, or to obtain a simple line of credit. District residents, tired of dealing with ineffective and inefficient services, underachieving schools, and high crime rates, fled to Maryland and Virginia suburbs in droves — 53,000 District residents, representing 22,000 households, left between 1990 and 1995. This flight contributed to the erosion of the District’s tax base and exacerbated shortfalls. It was a vicious cycle that was driving the city toward insolvency.

The Revitalization Act established a financial control board for D.C. with virtually unlimited powers and clear financial and economic objectives. The control board essentially replaced the local government until its finances stabilized.

Could a financial control board improve Puerto Rico’s situation? Is a highly polarized Congress capable of assembling a financial control board that is skilled, independent, and has the territory’s best interests in mind? Would a highly polarized Puerto Rico accept it? Financial control boards have historically only been utilized for local governments with far smaller debt burdens and far less complex organizational issues than Puerto Rico — can the Revitalization Act model be scaled?

Respectfully restoring accountability

It is possible that the federal government could create a financial control board without the consent of Puerto Rico’s government. If policymakers were to proceed down this path, however, it would be best to make any legislation contingent upon the Puerto Rico government enacting companion authorizing legislation because: (1) this is respectful; (2) such a provision would mirror the discretion given to states in authorizing municipal bankruptcy; and (3) the reform process will be a lot easier with the government’s cooperation than without it.

Under the financial control board, Puerto Rico would temporarily forfeit control over its finances, but it would gain financial aid contingent upon meeting specific economic and operational milestones. The control board would be able to represent the territory in court with creditors, if necessary, with the weight of the federal government and economic necessity behind it.

Providing affordable liquidity

The first step to curing Puerto Rico’s problems is to provide the territory with affordable liquidity. Obviously the political constraint here is that most Americans have a visceral reaction to the idea of a bailout. Having already covered Chapter 9, another Depression-era response to fiscal crisis provides useful guidance — when Arkansas defaulted on its highway debt in 1933 — which is to structure assistance as a loan.

A history lesson from Joe Mysak:

When Arkansas defaulted on its bonds in 1933, the politicians and investors talked about the same things we would talk about today. The state blamed underwriters for allowing it to sell too many bonds. Investors compared the willingness to repay debt with the ability to pay, and weighed the advantages of bonds backed by a pledge of taxing powers to those secured by a specific source of revenue …

The municipal market was a much different place in the 1920s and 1930s. States and localities borrowed about $1 billion in long-term debt each year … credit research was in its infancy, and the practice of bond law was only about 50 years old. The 10-year bond call wasn’t as common as it is today, and there were no prohibitions on the number of times issuers could refund their bonds. The market was less codified and more contentious …

“We have a state ranking 46th in per-capita wealth in 1929, ranking first in per-capita indebtedness,” was how state Senator Lee Reaves summed up the matter in a 1943 article for the Arkansas Historical Quarterly. “Under the best of circumstances it would have been difficult to meet payments on the mounting debt.”

Arkansas ended up with a debt burden of this magnitude when it assumed the debt of its many local road districts in 1927 to prevent them from defaulting. As the state’s borrowing costs climbed, the Arkansas General Assembly had the genius idea essentially to impair the debt through a refunding transaction and replaced bondholders’ first lien on automobile and gasoline taxes with … a general obligation pledge.

As you can imagine, the full faith and credit of a government that already could not service its debt was not what bondholders had in mind. (Hedge funds didn’t exist back then.) So they went to court, received an injunction blocking the use of said taxes for anything besides repaying the outstanding debt. And so the state’s financial woes persisted, albeit with some short-lived pockets of optimism.

Back to Mysak:

On April 1, 1941, $90.1 million of outstanding highway bonds was callable, an additional $45 million was callable on July 1. The state made plans for another, this time uncontested, refunding.

A syndicate of 250 banks said it would bid on the new Arkansas refunding bonds, in conjunction with the Reconstruction Finance Corporation, a new entrant in the municipal market and a creation of Herbert Hoover’s administration.

On February 27, 1941, to Wall Street’s shock, the RFC bought the entire issue single-handed.

Pause for a moment and consider this in the context of Puerto Rico. The federal government provided assistance to an issuer that represented over one-tenth of the market at the time. This is equivalent to multiple Puerto Ricos now.

The Reconstruction Finance Corporation’s intervention provided financing to Arkansas when the state would have otherwise had to pay punitive market interest rates, and it was structured to accomplish a variety of federal interventions. The RFC was modeled on the War Finance Corporation of World War I and kept in place from 1932 to 1957. (Kind of difficult to wrap your head around a Depression-era agency surviving until Elvis Presley, eh?) It supported everything from state and local governments to railroad companies.

Anyway, according to Mysak, “the RFC bid, which averaged 3.2 percent, saved Arkansas $28 million over the life of the bonds. The [RFC] later sold the securities to Wall Street banks at a profit of $4 million.” This strategy of structuring emergency government assistance as a loan was repeated with Washington, D.C. and with other local governments that have received state-level assistance.

When municipal bonds are involved, it is the U.S. Treasury — and not the Federal Reserve — that has to serve as lender of last resort. The Federal Reserve is only authorized to pick up short-term municipal debt, and financial support for Puerto Rico would likely need to be amortized over the medium term. This isn’t any different than it was in 1932 — in fact, the independent RFC was the brainchild of Eugene Meyer, who lead the Federal Reserve at the time.

A possible solution then would be for policymakers to establish and capitalize an independent agency for the purpose of purchasing notes from Puerto Rico’s government as a bridge to restructuring the territory’s overall debt with federal oversight. The debt could be refinanced later if desired.

Untangling the government’s existing liabilities

One of the advantages of Chapter 9 is that it allows a government to address its liabilities holistically, rather than one-by-one in a process that could drag out for several years. Something similar has to occur for Puerto Rico’s finances to stabilize.

The first project of Puerto Rico’s financial control board would be to figure out a comprehensive strategy. This will involve evaluating the territory’s tax structure; government operations (efficiently eliminating bloat and corruption); economic performance and the like. No more betting the house on municipal market tourists’ half-baked economic development fantasies. New policies cannot imperil the provision of government services, although they may include privatizing government activities.

This strategic plan will provide a rudimentary framework for evaluating the territory’s liabilities. For the sake of returning the territory to a genuinely structurally balanced budget, the financial control board will likely be in the position of demanding concessions from bondholders. The control board should be able to reverse-engineer approximately what the scope of these concessions needs to be. The ranking of Puerto Rico’s liabilities should probably follow the same requirements as Chapter 9. The federal government has an advantage in negotiating with bondholders in that it controls the tax status of the debt. There are many routes to a restructuring.

Puerto Rico’s unfunded pension liabilities cannot be addressed in the same manner as Washington D.C. Under the Revitalization Act, the federal government assumed the cost of the district’s pension liabilities. The municipal landscape was very different back then than it is now. The district’s financial problems peaked in the late 1990s, when most state and local government pension systems were either adequately funded or over-funded. The precedent doing so would set in the current environment is untenable, both practically and politically. The trade-off between funding pensions and retiring debt would have to be made by the control board.

This risk exists for bondholders with or without the financial control board. It will take strong leadership to broadcast to stakeholders that everyone will recover more through an impartial arbiter than from ad hoc restructurings.

Conditions for returning control to Puerto Rico’s government

As indicated earlier, returning control to Puerto Rico’s government should be conditioned upon the territory meeting certain financial and economic objectives. These could include: (1) a structurally balanced budget and manageable debt position; (2) market access at investment grade rates; (3) an expanding economy; and (4) a restructured government that is capable of stable, continuous management.

I hope Congress considers this alternative. Being connected to the United States of America should have some advantages.

A Financial Control Board Proposal for Puerto Rico — Medium.