Why Puerto Rico’s bonds are moving to New York

March 3, 2014

Puerto Rico, which is already junk-rated and which is facing yet another downgrade to its credit rating, is in no position to call any shots when it comes to raising new debt. If it wants to borrow new money — and it looks like it wants to borrow a hefty $3.5 billion in the next few weeks — then it’s going to have to make whatever concessions its lenders want. That means paying a very hefty interest rate in the 10% range, of course. But it also means changing the governing law of the bonds, from Puerto Rico to New York.

Notably, the Puerto Rican government was very careful to ensure that it would not waive its sovereign immunity, except as regards “legal proceedings with respect to such bonds”. The result is that Puerto Rico seems, on its face, to be setting itself up for a nasty, drawn-out stalemate a la Argentina, where bondholders sue a sovereign nation in New York, trying to claim all the principal and past-due interest that they’re due, while the sovereign in question responds that all of its assets are immune from attachment. That’s definitely not the kind of fight that the hedge funds lending Puerto Rico money would ever want. So why are they insisting on New York law?

The answer is that the hedge funds lending to Puerto Rico basically look at bond contracts, and New York law, in much the same way that Argentina does. In fact, they would be very upset if Puerto Rico treated its new debt in the way that Argentina’s opponents — and a number of New York federal judges — like to think.

At stake, of course, is the fate of Puerto Rico’s bondholders if and when the territory ever defaults on its obligations. Already, some Puerto Rican lawmakers are saying that’s exactly what should happen, and there’s no obvious fiscal track to debt sustainability, so default is a very real risk, and the main thing that lenders want to protect themselves against.

Historically, default protection has come mainly in the form of asset-backed bonds. Most of Puerto Rico’s debt is backed by some revenue stream or other: even if the government defaults, the state-owned utilities and the like will still have revenues which can be attached (at least in theory) by bondholders. But here’s the problem: if I held one of those revenue bonds today, I would not feel particularly confident in my ability to continue to get my coupon payments, even in the face of a government default.

The problem is precisely that so much of Puerto Rico’s debt is collateralized in this way. If we reach the point at which Puerto Rico needs to default in order to get its fiscal house in order, then it will have to restructure (which is to say, default on) its revenue bonds. If those are untouched, then the problem doesn’t get solved, and there’s really no point in defaulting in the first place. No one knows exactly how Puerto Rico would do such a thing, but legislation would probably be involved — if Greece can do it, then there’s a decent chance that Puerto Rico can, too. The idea is to pass a law which, in effect, makes it legal to default on your debts. And since those debts are issued under domestic law, there might not be much that bondholders can do about it.

Conversely, if Puerto Rico defaults with a relatively small quantity of New York-law debt outstanding, it’s probably easier for Puerto Rico to just continue to pay the coupons on that debt, rather than try to restructure it. Again, Greece is the precedent here: while debt under Athens law was restructured, debt under London law continues to be paid in full. Puerto Rico could default on its New York-law debt, of course — but doing so would severely cripple the island’s ability to do business with the mainland; would involve paying massive legal fees for years to come; and probably wouldn’t move the needle very much when it came to debt sustainability.

The point here is that the concept of seniority doesn’t really make a lot of sense when you’re not operating in the context of a formal bankruptcy regime. A bankruptcy judge can ensure that a debtor pays senior creditors first, and junior creditors last. But in a sovereign context — which includes Puerto Rico — there is no such thing as bankruptcy. In the Argentina case, the New York courts are trying to enforce an idiosyncratic reading of the formerly-obscure pari passu clause to try to bring back some semblance of seniority into the sovereign debt world, but it’s a knock-down, drag-out fight, and no one knows how it’s going to end. The overarching principle in sovereign debt remains the principle that has governed Argentina’s behavior ever since it defaulted well over a decade ago: a sovereign government can and will pay whomever it likes, whenever it likes, wherever those people think that they might stand in terms of some theoretical seniority chart.

As a result, creditors in Puerto Rico aren’t looking for de jure seniority; they’re looking instead for de facto seniority. And the way to get that is to be part of a small group of bonds which is more trouble than it’s worth to restructure.

That strategy generally works very well. When most of Latin America was busy defaulting on its sovereign loans in the 1980s, for instance, the countries in question generally stayed current on their sovereign bonds — just because the loan stock was big, and mattered, while the bond stock was small, and didn’t. Similarly, when Russia defaulted on its debt in the late 1990s, it defaulted on its large stock of domestic bonds, but stayed current on its much smaller stock of international-law bonds, for exactly the same reason.

So when you see hedge funds demanding that their new Puerto Rico bonds be issued under New York law, don’t kid yourself that they particularly value the protections that New York law gives them, or that they think that New York courts will allow them to recover most of their money in the event of default. Rather, they’re just hoping that Puerto Rico won’t bother defaulting on those bonds in the first place. And they might well be right about that.


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