Congress Shouldn’t Provide A ‘Super Chapter 9’ Escape For Puerto Rico

Arturo C. Porzecanski
Dr. Porzecanski is a distinguished economist in residence at American University.

Puerto Rico Governor Alejandro Garcia Padilla wants to default on all of the island’s debt. (AP Photo/Ricardo Arduengo)

Puerto Rico Governor Alejandro Garcia Padilla wants to default on all of the island’s debt. (AP Photo/Ricardo Arduengo)

Puerto Rico’s Governor, Alejandro García Padilla, confirmed everyone’s worst fears recently when he testified before a Senate committee that “Puerto Rico will have no choice but to default. Nobody wants this, but it is a reality, and the consequences will be grave.”

Indeed, with each passing week, it is looking more and more likely that Puerto Rico will run out of funds before year’s end, becoming the first major U.S. jurisdiction to default on all its bonded debt. Such a widespread and indiscriminate default could have a damaging effect on the U.S. municipal bond market, given that the island is the third-largest issuer in the country after the states of California and New York. Moreover, such a default will make it extremely hard for Puerto Rico to return to the capital markets after the current financial storm eventually passes.

As someone who was involved in multiple restructurings of government debt in an earlier career on Wall Street, and as a keen academic observer of fiscal crises during the past decade, I fail to understand the governor’s preemptive surrender to the forces pushing him downriver into an all-out bankruptcy.

The importance of respecting the seniority structure

In workouts involving corporate or government entities, it is standard procedure to observe the established hierarchy of creditors. Each security issued, whether debt or equity, has a specific seniority or ranking which determines the order of repayment in the event of a reorganization or bankruptcy. Everybody knows that preferred stock is higher-ranking than common stock, and that senior debt must be repaid before subordinated debt.

Even sovereign governments in financial difficulty prioritize their payments, though they do not operate under a formal bankruptcy regime. For example, governments will keep servicing debts to official multilateral agencies such as the International Monetary Fund and the World Bank, widely regarded as senior creditors, even as they stop paying their bondholders or bank creditors. This is what Greece did in 2012, and even what Argentina has done in the past dozen years in which it has been in and out of default to bondholders.

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