By defaulting on its largest bond yet, the administration of Governor Alejandro García Padilla is ratcheting up the pressure on Puerto Rico’s creditors in a bid to force a restructuring of the island’s massive $72 billion in debt.
Puerto Rico made history on Monday when it failed to make a $367 million payment on bonds issued by its Government Development Bank. Although various governmental entities have defaulted on smaller bonds in the past nine months, the GDB default marked the first time the island, whose bonds trade in the U.S. municipal bond market, has failed to repay any debt of an entity that is backed with a constitutional guarantee.
With a further $2 billion in debt payments due July 1, including $780 million in interest payments on the government’s general obligation bonds, the default deepens the island’s financial crisis. As of April 1, the GDB’s liquidity — the administration’s main source of funds — stood at just $562 million. In Washington, where Congress has been debating proposals to give the commonwealth the authority to restructure its debt, Treasury secretary Jack Lew urged legislators to take action to prevent what he warned could be a series of “cascading defaults.”
Puerto Rico had been due to pay a total of $422 million on the GDB bonds on May 1. But in a televised address that evening, García Padilla said default was a dire but politically clear decision. “Faced with the inability to meet the demands of our creditors and the needs of our people, I had to make a choice,” he said, speaking in Spanish. “I decided that essential services for the 3.5 million American citizens in Puerto Rico came first.” The next day the commonwealth-owned bank paid $22 million in interest on the debt and swapped $33 million in debt coming due for new debt with later maturities, but it missed a remaining $367 million principal payment. By staying current on interest payments, the governor hopes to persuade creditors to agree to restructure the principal.
In early April, García Padilla sent a clear signal that Puerto Rico could be headed toward default by signing the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act and issuing an executive order under that law giving him emergency powers to deal with the fiscal crisis, including imposing a moratorium on bond payments. The law was passed just days after a group of hedge fund creditors, including Brigade Capital Management and Claren Road Asset Management, filed suit in San Juan in an effort to prevent the GDB from releasing funds to governmental bodies for anything except emergency services or ordinary operating expenses before the May 1 bond repayment date.
Since Puerto Rico was downgraded to junk status in February 2014, the government and its agencies have increasingly relied on hedge funds and distressed-debt investors to buy its bonds. Shortly after the downgrade, the government raised $3.5 billion with a muni bond offering — much of it bought by hedge funds — yielding a hefty 8.73 percent. For more than a year now, hedge funds and other creditors have been in on-again, off-again restructuring negotiations with the administration and other stakeholders after it became clear the island could not repay its debts.
Yet the vast majority of Puerto Rico’s creditors are not hedge funds. “The governor’s party line about how the Puerto Rico debt situation is all about hedge funds pillaging the unions’ pensions makes for good spin,” says Mark Palmer a financials analyst with BTIG in New York. But, Palmer says, the vast majority of Puerto Rico’s municipal bonds are still held by non–hedge fund creditors; some 65 percent of the commonwealth’s bonds are held by individual investors and mutual funds, and experts estimate approximately $15 billion, or about 20 percent, is owned by the island’s residents. A 2014 Fitch Ratings report puts hedge fund and alternative-fund managers’ ownership of the island’s debt at $16 billion. “Two thirds of U.S. pension and retirement funds hold Puerto Rico municipal debt,” Palmer adds. “So if the large haircuts the governor wants to impose on the bonds were to occur, pensioners would be harmed — just not the ones he is pointing to as victims.”
Democrat García Padilla was elected governor in November 2012 after promising to fix Puerto Rico’s financial malaise. This December, with an approval rating of just 12 percent, he announced he would not run for a second four-year term this year. Instead, he promised to focus his attention on solving the debt crises.
The governor seems to hope the GDB can set a template for a broader debt restructuring. After he announced the moratorium on the GDB payment, the development bank said Monday it had reached a tentative agreement with an ad hoc group of bondholders under which the investors would take a haircut of 43.75 percent on their bonds. Under the terms of the deal, if Puerto Rico can reach a wider restructuring of its debts, the ad hoc group will conduct a second exchange of bonds, bringing their haircut to 53 percent. The ad hoc group holds about $900 million of the bank’s total debt of $4.2 billion, as of June 30, 2015. For the proposed agreement to take place, 100 percent of GDB creditors would have to agree within 30 days.
That’s a daunting requirement. Hedge fund holdouts to a debt restructuring in Argentina, led by the New York–based Elliott Management Corp., prevented the Latin American country from accessing global capital markets for well over a decade. The new government of President Mauricio Macri agreed in March to settle with the holdouts, enabling the country to sell a record $16.5 billion in bonds last month. Jim Millstein, a lawyer who advised Argentina on a debt exchange in the past, is serving as an adviser to the Puerto Rican government.
Puerto Rico’s desire to reach a comprehensive restructuring is complicated by various categories of debt, which could provoke tensions — and litigation — between different categories of bondholders. The government’s general obligation bonds and the GDB’s bonds are protected by language in the Puerto Rican constitution, which gives them first claim on the commonwealth’s resources. But so-called COFINA bonds, those issued by the Puerto Rico Sales Tax Financing Corp., have payments that are tied to tax revenues, and investors in those bonds contend they have first right to that tax revenue.
Even if lenders take a haircut, Puerto Rico is likely to have to cut services and public sector jobs. Hedge fund investors insist such cuts could put the island back on the road to solvency. Labor union leaders counter by claiming that hedge fund managers are getting rich at the cost of jobs and benefits promised to the Puerto Rican people.
In recent months New York–based activist group Hedge Clippers has published a series of reports on hedge funds and Puerto Rico. In a March publication titled “Puerto Rico: Pain and Profit,” it alleged that the austerity cuts put in place by the administration to pay hedge fund creditors amount to a “humanitarian crisis” on the island.
“Billionaire hedge fund managers have used their power and influence in Congress to block reforms that would protect Puerto Ricans, seeking huge profits from forced austerity, like cuts to schools, hospitals and the minimum wage,” says Michael Kink, executive director of the Strong Economy for All Coalition, a union-backed body behind the Hedge Clippers. If Congress does not act, Kink says, President Barack Obama and Federal Reserve chair Janet Yellen should “use their powers to impose a fair process for debt negotiations.”
To date, Obama’s calls for action have had little effect. Now, the next 30 days will prove crucial to Puerto Rico’s future.
