Puerto Rico at the Brink

The GOP may muff a chance to clean up the island’s debt mess.

The Puerto Rican flag flies in front of the Capitol in San Juan in 2015. PHOTO: ASSOCIATED PRESS

The Puerto Rican flag flies in front of the Capitol in San Juan in 2015. PHOTO: ASSOCIATED PRESS

THE WALL STREET JOURNAL – Hillary Clinton plans to run against Congress’s dysfunction, and some Republicans are helping her case by blocking legislation to fix Puerto Rico’s debt morass. The GOP abdication threatens to blow up a reform opportunity and exacerbate the island’s woes while conceding Florida to Democrats.

The House Natural Resources Committee is trying to move legislation to create an independent oversight board and debt restructuring for the commonwealth. The bill is needed to help Puerto Rico recover from a lost decade and prevent a humanitarian disaster that could ripple onto U.S. shores. Since 2006, employment has shrunk by 12%. Florida is now home to about a million PR exiles, and the exodus is accelerating.

The commonwealth recently passed legislation authorizing a moratorium on its $72 billion in debt, signaling a default by the insolvent Government Development Bank on a $422 million payment due May 1. Barring federal intervention, public services will erode or worse as creditors race to the courthouse. Democrats will blame Republicans and demand that Congress appropriate billions of dollars to protect the island’s 3.5 million citizens.

Legislation introduced by Rep. Sean Duffy and backed by Speaker Paul Ryan offers a political prophylactic, though the ingredients still need fine-tuning. The bill creates a seven-member oversight board appointed by the President from the nominations of congressional leadership. One member would be required to live on the island.

The board is modeled on the Washington D.C. control board that imposed discipline on the capital city in the 1990s. Puerto Rico’s watchmen could reject budgets, contracts and regulations that don’t comport with its fiscal plan. The board could also use its veto to impel economic and government reforms. The GOP should welcome this political supervision.

A five-member supermajority would be required to authorize a global debt restructuring, similar to Chapter 11 of the U.S. bankruptcy code, that would be overseen by a federal district court judge. This process would be a last resort if voluntary agreements and creditor collective-action clauses similar to those used in eurozone debt restructurings fail.

The cumbersome collective-action mechanism, which would require two-thirds approval of each creditor class to redo bond contracts, needs tinkering. As currently written, attempts at forcing collective action by creditors of all 18 debt issuers would have to fail before the oversight board could approve a court-supervised restructuring for public agencies.

This could take years—by which time the legislation’s nine-month stay on litigation would expire—since many creditors have interrelated claims. Eleven of the commonwealth’s 18 debt issuers depend on tax revenues that finance the government’s general fund. Pensions also couldn’t be impaired.

The ostensible goal is to deter an adversarial court restructuring in which a judge could impose a plan on dissenting creditors. However, as bankruptcy attorney Susheel Kirpalani explained to Congress, the collective-action provision “would retroactively change individual creditor rights, without judicial supervision and accepted notions of due process of law” and the “‘takings’ jurisprudence of the United States.”

The better idea is a court-supervised restructuring in which the oversight board would develop a plan of adjustment—including pensions—that would be voted on by creditors grouped by the seniority of their claims. A judge could “cram down” a plan on dissenting classes only if it is “fair and equitable” and in “the best interest of creditors” (i.e., better than they would have otherwise received).

Some Republicans—egged on by hedge-fund lobbyists—complain that the legislation would retroactively impair bond contracts, though this will occur regardless if Puerto Rico defaults. The options now are an orderly restructuring governed by U.S. law or a chaotic default dictated by the island’s politicians.

Others putatively worry that a debt restructuring—which is now inevitable—will hurt U.S. retail investors, unnerve bond markets and raise municipal borrowing costs. But as Nuveen Asset Management director John Miller told Congress, less than 50% of municipal bond mutual funds own Puerto Rican securities. Hedge funds have recently been buying Puerto Rican debt at a steep discount. Mr. Miller also pointed out that the municipal bond market “has actually strengthened” and “Puerto Rican bonds valuations specifically did not move down” after the draft legislation was released.

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There are also Republicans who oppose any federal intervention. “We didn’t cause the problem. Puerto Rico caused the problem,” said Louisiana Rep. John Fleming. Good luck holding that line as the tales of woe mount.

Congress will have to act eventually, and if too many Republicans wig out, Democrats will demand a weaker control board and more welfare spending as the price of support. Or Republicans can do nothing, watch Puerto Rico default and slide into a deep recession while Democrats exploit the issue. Adios to Florida’s 29 electoral votes and Marco Rubio’s Senate seat.

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