Puerto Rico’s Debt Crisis and the 1975 Law Complicating Matters

By MARY WILLIAMS WALSHNOV. 4, 2015

The New York Times

Senator John Tower’s 1975 bill to help resolve a constitutional disagreement let state and local governments sell bonds with less federal scrutiny. Credit George Tames/The New York Times

Senator John Tower’s 1975 bill to help resolve a constitutional disagreement let state and local governments sell bonds with less federal scrutiny. Credit George Tames/The New York Times

 

To appreciate why it is proving so hard for Washington to help debt-burdened Puerto Rico, it helps to go back to 1975, the year New York City went broke, and consider the role played in that crisis by a prominent Republican senator from Texas named John Tower.

Fearing more financial failures in other municipalities, federal securities regulators wanted Congress to force states and cities to provide truthful financial information about bonds they were going to sell to raise money. But cities were having none of it, instead rallying around the Constitution’s separation-of-powers doctrine. The fight was resolved by Senator Tower, the first Texas Republican elected to the Senate since Reconstruction. He introduced a bill that kept the feds at bay.

As a result, the Securities and Exchange Commission has no power to make states and local governments submit to the same kind of scrutiny that companies must endure before sending their securities to market — which may help explain how a small, impoverished island like Puerto Rico managed to borrow $72 billion before the markets saw that it was insolvent.

Now there are signs that some policy makers see Puerto Rico’s troubles as proof that the S.E.C.’s hands-off approach to the entire $3.7 trillion municipal bond market is part of the problem and should be changed.

“There’s just an idea that the Tower Amendment isn’t worth it, and maybe the issuers ought to come under the S.E.C. after all,” said Matt Fabian, a managing director at Municipal Market Analytics.

The lack of oversight — and transparency — is playing out in multiple ways in the Puerto Rico debt debacle. The island’s government has been unable or unwilling, or both, to provide Congress with accurate numbers that explain the island’s financial needs — a requirement for getting help from the United States government. Investors who stand to lose millions if the island defaults, or has to restructure its debt, complain that they, too, are in the dark about the island’s true financial picture.

Even Puerto Rico’s governor, Alejandro García Padilla, acknowledged at a recent Senate hearing that the absence of accurate financial information had hampered the island’s ability to get on a path to fiscal health.

Public sector workers protested last month against an austerity plan designed to lower Puerto Rico’s debt.Editorial: Save Puerto Rico Before It Goes BrokeOCT. 24, 2015
“It’s a historical problem in Puerto Rico,” he said. “We inherited such a mess there, too. It was part of the different governments, in the past, to hide information from the market, so they were able to have more access to the market.”

On Wednesday, Representative Nydia M. Velázquez, Democrat of New York, introduced a bill that would require improved disclosures from another group of players in the municipal bond market: the hedge funds and other alternative investment firms that have been snapping up the bonds of distressed jurisdictions like Puerto Rico.

The problem, she and others say, is that the funds and firms representing bondholders are maneuvering behind the scenes to protect their stakes. But unlike an investor buying up a stock of a company, they do not have to reveal the amount or the type of investment they are making. That has made it harder to come up with a coherent negotiating strategy.

 

Until just a few years ago, hedge funds showed little interest in municipal bonds, which were seen as stodgy and safe — something for widows and orphans, not sophisticated investors willing to take big risks. That has changed in the last few years, as large local governments like Detroit and Jefferson County, Ala., were crushed by their debts.

Hedge funds that might not have bothered with public finance in the past found that they could scoop up distressed municipal bonds at a deep discount, as traditional investors in the bonds bailed out. They could then participate in the restructuring agreements that followed. In some cases, market analysts said, they played a useful role when they did so, because they provided liquidity that would otherwise not have existed.

Ms. Velázquez sees it differently.

“It has become increasingly clear that hedge funds, which have purchased a sizable part of Puerto Rico’s debt, are exacerbating the crisis and profiting from the island’s misery,” she said in a statement on Wednesday after introducing her bill. In her view and that of others, the unwillingness of investors to renegotiate their bond payments is forcing Puerto Rico to lay off teachers and nurses and reduce other kinds of government services.

“Rather than working to help resolve Puerto Rico’s financial crisis in a fair, orderly fashion, these funds are lobbying to cut basic services that 3.5 million American citizens in Puerto Rico rely on,” she said.

Puerto Rico’s $72 billion debt is complex, coming from almost 20 different governmental issuers and sometimes involving guarantees or other special features. It also has different types of investors whose interests are not necessarily the same, and it is difficult, if not impossible, to determine which types of investors now hold which types of debt.

Ms. Velázquez’s bill takes aim at federal regulations that require hedge funds and other investors to file statements with the S.E.C. only after they have acquired more than 5 percent of a class of a company’s stock. Her bill would lower the threshold to just 1 percent. In addition, it would establish a quarterly reporting requirement for the purchasers of bonds — including municipal bonds — as well as stock, to bring their under-the-radar activities into the light.

Ms. Velázquez said she found it troubling that hedge funds had “enormous impact on capital markets, corporations, local governments and, ultimately, working families’ lives,” even though “they operate largely in the shadows, avoiding scrutiny.”

Her bill does not make any effort to repeal the Tower Amendment, but it would require greater disclosure for positions taken in derivatives, such as interest-rate swaps, which were a popular hedging tool for variable-rate municipal bonds in the past.

In the Chapter 9 municipal bankruptcy of Detroit, it became clear that federal laws intended to reduce systemic risk in bank failures were forcing the destitute city to keep paying its interest-rate swaps — to the tune of tens of millions of dollars — even though Chapter 9 gave it a breather from most of its other financial obligations.

Detroit’s bankruptcy judge, Steven W. Rhodes, eventually complained about the situation from the bench. Detroit managed to buy its way out of the interest-rate swap contracts at a much lower cost, and it settled the related bonds for about 13 cents on the dollar after making the unusual argument that the entire bond deal was a sham and should be voided.

Had there not been a settlement, the bond insurers were expected next to file their own lawsuits against the underwriters and blame the sham deal on them; the city would have figured in the case as a victim rather than a perpetrator.

Judge Rhodes retired after completing the bankruptcy of Detroit, and is now helping advise Puerto Rico.

Paul Volcker, the former Federal Reserve chairman, and Richard Ravitch, a former lieutenant governor of New York, called on Congress to re-examine the Tower Amendment last year, after leading a study of hidden financial weakness at the state level.

“These markets have to be sound, liquid and creditworthy,” Mr. Ravitch said at the time.

But the amendment remains intact, and officials seeking to help Puerto Rico say they will not be able to build congressional support without the kind of audited numbers that companies routinely supply to the S.E.C.

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