Puerto Rico's debt situation has the potential to significantly rattle financial markets and banks need to take notice.
At a recent Senate hearing, Antonio Weiss, a counselor to the Treasury secretary, unveiled a plan to allow Puerto Rico to restructure all of its debts. Puerto Rico's financial challenges are well-documented, but the plan introduced by Weiss is unprecedented and dangerous, particularly for the banking industry. It would allow sweeping bankruptcy powers that aren't currently available to any U.S. state by allowing Puerto Rico to restructure debt that must be repaid under the territory's constitution.
Treasury's plan, called "Super Chapter 9", would require congressional approval, which is far from certain. That's a good thing because allowing Puerto Rico to restructure its constitutional debt would undoubtedly lead to high-spending states like Illinois wanting the same authority. If that happened, debt markets would be chaotic. The entire notion that full faith and credit debt for territories, states and even the federal government are sacrosanct would be called into question. Banks, as major holders of government debt, would be affected severely.
Current Gov. Alejandro Garcia-Padilla spooked markets recently when he declared Puerto Rico's debts unpayable. Moreover, former Detroit bankruptcy judge Steven Rhodes, who serves as an advisor to Puerto Rico's government, said recently that the U.S. territory could run out of cash by the end of November. According to Rhodes, Puerto Rico has "no choice" but to default.
There's a key question that seems noticeably absent from the discussions in Washington which relates to how Puerto Rico violated its constitution by taking on so much debt in the first place. How did Puerto Rico rack up $73 billion in debt when the island's constitution mandates a much lower debt limit?
Each year since taking office in 2013, Garcia-Padilla submitted budgets that increased spending. Making matters worse, Puerto Rico's government routinely exceeds these budgets even as it misses the revenue projections on which they are based. Garcia-Padilla's fiscal policy seems oblivious to the fact that over the last decade, Puerto Rico lost 7% of its population as its economy contracted by 13%.
But Puerto Rico's debt mess is deeper than the wasteful policies of its current government. At one point U.S. law actually banned Puerto Rico from borrowing in excess of 10% of the island's real property. That changed in 1961, when Congress allowed Puerto Rico to set its own debt limit. Puerto Rico's constitution currently limits the debt backed by the commonwealth's "full faith and credit" to 15% of the average tax revenue collected in the previous two years.
This 15% cap on "General Obligation" bonds should have prevented Puerto Rico from amassing huge debts, but it didn't. As Puerto Rico's economy began to collapse in the early 2000s, it quickly reached its debt limit.
The government of Puerto Rico responded by issuing revenue-backed debt, culminating in the creation and issuance of a new type of bond — known as COFINA bonds — in 2006. The new bonds, developed for Puerto Rico's government by Wall Street traders, are backed by sales tax revenues. COFINA bonds are not guaranteed by Puerto Rico's constitution and they enable the territory to circumvent the constitutional debt limit. Puerto Rico's government even referred to COFINA bonds as "extra-Constitutional debt."
COFINA debt was issued to pay existing debts, allowing the government to avoid tough political choices and postpone an eventual day of reckoning.
In a full-page advertisement placed last month, Puerto Rico's government claimed that it had done everything possible to address its challenges. But how can we take the government's claim seriously when it has circumvented its constitution as a means of forestalling desperately needed fiscal reforms? Let's be clear: by creating COFINA, rather than making necessary reforms, Puerto Rico allowed its debts to spiral out of control. Now it wants Washington to come to its rescue by giving it unprecedented bankruptcy powers, which would undoubtedly lead to high-spending states wanting the same.
To be sure, helping Puerto Rico avoid a disorderly default should be a priority, and there are existing mechanisms in the U.S. bankruptcy code to do this. Giving Puerto Rico access to established Chapter 9 bankruptcy for its public corporations and municipalities, and not Super Chapter 9, would be a good start. It would signal that Congress is committed to dealing with Puerto Rico's crisis with the same level of seriousness that would be afforded to a state.
But any action taken by Congress must protect the sanctity of constitutional debt for the territories, the states, and the federal government. The banking industry has an enormous stake in the outcome of this debate and cannot afford to sit passively on the sidelines. The industry needs to get in the arena and insist that Puerto Rico make real fiscal reforms and honor its constitutional debt.
William Isaac, a former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting. He and his firm provide services to many clients, including some who may have an interest in the subject matter of this article. The views expressed are his own.