The Administration’s Puerto Rico Jujitsu Threatens the States’ Ability to Borrow

bankruptcy law, government debt, Puerto Rico, secured bondholders, U.S. Treasury
Robin Hood Statue in Nottingham, by Olaf1541, CC BY –SA 3.0,

Robin HoodThe New York Times reported last week on some of the details of the Obama Administration’s recovery plan for Puerto Rico, and it does not bode well for investors — or for states and municipalities that borrow money.

The island’s government is $72 billion in debt, with billions more in unfunded pension obligations.  It has been in recession for a decade during which time it has never run a balanced budget, and today it is nearly bankrupt.  The government has appealed to the federal government to help, and the Treasury has drawn up a plan.  A major feature of that plan is that it will ignore the law by putting government employee pensions in front of general obligation bondholders in the hierarchy of credits, despite the provision of Puerto Rico’s Constitution that mandates GO bondholders will be paid before all other government obligations.  The rationale for doing so is, essentially, that public sector pension holders are in greater need of the money than the investors (many of whom are retirees and pensioners themselves), so this ex post change is simply a matter of fairness.

The bondholders, naturally, do not like this. After lending money to the Puerto Rican government under the explicit assurance that they would have the highest priority in all payment scenarios, having this promise revoked seems a tad unfair, as well as blatantly illegal.

It isn’t just the Puerto Rican bondholders that should be angry.  The problems with screwing over bondholders in order to protect government pensioners goes farther than its illegality:  Doing so sets a precedent for dealing with other bankrupt states in the future.  While the Administration avers that this in no way sets a precedent, since the fifty states have recourse to use Chapter 9 of the federal bankruptcy code to reorganize, the reality is otherwise.

The Times correctly notes that Chapter 9 makes no provision for the states extricating themselves from their own general obligation debt.  No out was given for a very good reason:  Foreclosing the possibility of a default up front (at least as much as possible) makes it easier and cheaper for states to borrow money.

The Obama Administration's proposal threatens to upset this equilibrium.  By upending the law and decades of precedent, the Treasury's plan threatens to make it more difficult for the states and municipalities to borrow money as well, since their lenders see that they too, might get their promise of being first to be repaid pulled out from under them.

This administration has a long history of picking winners and losers in bankruptcy.  In the Chrysler and GM bankruptcies, the secured bondholders took a major hit being reduced to unsecured status while workers and pensioners were elevated to protected status, and the Detroit bankruptcy did the same thing.

While it may seem "fair" to help little old ladies rather than mean old hedge funds, the investors who lost money in these maneuvers weren't Wall Street plutocrats — they were regular people who invested their money into assets they thought were safe, because the law explicitly said they were. Many of them are retirees and pensioners themselves, and thousands of them will see a reduction in the value of their retirement funds.  CNN recently reported that 45% of Puerto Rico’s debt is held by “middle class Puerto Ricans” and “average Joe Americans.”  Abrogating bankruptcy law isn't akin to Robin Hood — it’s transferring money from one group of retirees to another.

A Puerto Rico bailout that punishes secured bondholders would represent a short-term political win for the Treasury but at a long-run cost to the rest of the country in the form of higher borrowing rates.  It would be a terrible precedent.  It is hard to conceive of a reason for a Republican Congress to acquiesce to such a thing, or to allow a control board to do such a thing down the road.


  1. As a matter of principle, there is a different priority in private businesses between a liquidation bankruptcy and rehabilitation bankruptcy.

    In rehabilitation, a debtor must pay its administrative expense claims (e.g. employee salary and benefits) in full in order to remain in business. These expenses will have priority over other claims. Pension costs are part of employee compensation. Try to continue to employ your workforce without making required Social Security contributions.

    Puerto Rico is not liquidating; employee costs have a valid preeminence.

    1. Not true Douglas; for a reorganization BK under chapter 11, the business entity must be able to actually survive and be able to show they can make a balanced budget, and that means employee compensation will be adjusted including the cancellation of labor contracts (and pensions), and in fact labor costs are usually the very first expense that gets a haircut as it is always the highest expense (along with real property expenses)…

  2. "…since the fifty states have recourse to use Chapter 9 of the federal bankruptcy code to reorganize…"
    States cannot use Chapter 9, and more importantly they do not need to. States are sovereign and can repudiate their OWN DEBTS, and there is nothing anyone can do about it. Not in state court, not in federal court…that pesky old 11th Amendment.

  3. "By upending the law and decades of precedent, the Treasury's plan threatens to make it more difficult for the states and municipalities to borrow money."
    Given the extent to which costs have been shifted to future generations, is this a bad thing or a good thing?
    One could make the case that federal bankruptcy laws that prohibit parents from borrowing and spending and promising repayment out of their children's future income depresses short term consumer spending. If people could sell their children into slavery, perhaps the debt driven consumption economy could keep sputtering on a little longer. There are, however, moral problems with this.
    And there are problems with the reduced level of infrastructure expenditures and increased level of state and local government debt.

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