Puerto Rico and the eternity of sovereign debt

July 8, 2014

Puerto Rico

Does Puerto Rico ever intend to pay its debts? Or is borrowing from the municipal market too easy? Is debt an addictive drug that politicians can’t resist?

Cleary Gottlieb Steen & Hamilton is one of the law firms hired by the government of Puerto Rico for advice on potential restructuring of some or all of its debt. Lee Buchheit is a Cleary partner who also represented the Greek government during its debt restructuring. Buchheit recently published a book, titled Sovereign debt in the light of eternity.” In it, Buchheit identified the central question, “why is sovereign debt such a pressing problem for modern democracies? And what are the alternatives?”

I excerpted some of his talk below. Although Puerto Rico is classically known as a “municipal” borrower, it is also a sovereign borrower, like a U.S. state. (Buchheit begins at 6:22):

The hard political reality of sovereign debt is that spending money helps politicians to be elected and reelected. Taxes hurt election chances. To the extent that a politician can keep providing services and can avoid taxation, borrowing is the path of least resistance. This is an inherent weakness in our democracy.

Politicians say we must have pay-as-you-go legislation or hard fiscal limits. It discredits the political class to put limits on themselves.

Debt loads have grown with a relentless, remorseless accretion. What will happen to those debt stocks? If you say that they will be repaid, that is just another way of saying that future generations will have to be taxed more or work harder or forgo services. If the debt is not paid, politicians can justify it by saying that it can be refinanced. They pass on an even larger debt to posterity. This has to have an obvious endpoint.

A sovereign debtor today from the developed world does not borrow money expecting to repay it. The expectation is that when the debt matures, the borrower will find someone else to repay the old maturing creditor, and when that matures it will find someone to repay, etc.

When an investor looks at a sovereign issuer, he is also considering whether it will be able to refinance the debt. Fifty years ago, a bank would ask what revenue would be used repay a debt. Banks would structure loans so they amortized or made incremental payments to a sinking fund so the lender would be repaid. Now we have weaned ourselves off of that behavior.

The market likes to trade bonds that mature with the assumption that the sovereign debt will be refinanced. The initial lender doesn’t have to worry about the repayment of a large bullet payment on the maturity date. This is widely true among hedge fund managers, every one of whom thinks that they are smarter than every other one. They are gambling.

Credit markets are fickle. They will cease lending to a sovereign sometimes for reasons that have nothing to do with that sovereign’s condition. Investors look around the world and see a Lehman or a natural disaster or another geopolitical event that causes them to turn away from an issuer.

Sovereigns do everything they can to avoid restructuring. Their initial instinct is to run down reserves to show the market that all is well. It is better for a sovereign to enter restructuring with some reserves than to run reserves negative. I wonder if Buchheit is referencing Puerto Rico’s March $3.5 billion bond deal, which gave the government about 18 months of reserves.

Puerto Rico

Buchheit recently offered his “philosophic reflections on our little business.” He said sovereigns discovered they could move the issue of debt restructuring to the judiciary. Now they can say to the bondholder, “Don’t come to us, you can go to a high court or federal judge and they will deal with this.”

Judges view their role as pedestrian. They get paid to apply the law. And the law in all of our countries when it comes to debts is rather pedestrian, said Buchheit. Those who borrow the money have an obligation to repay the money.

Puerto Rico

A sovereign debt crisis requires contributions from various stakeholders; the official sector, the citizens and the creditors. A judge does not have wide enough peripheral vision and cannot take into account all factors, such as how much austerity can be applied.

We all know that the sovereign debt crisis will eventually get resolved through some organized approach, but individual creditors will always be holding pieces of paper that are legal, valid, binding and enforceable under someone’s legal system. There is an absence of a mechanism similar to a bankruptcy code that would force minority creditors to follow the judgment of their fellow majority creditors.

We are trying as a community to deal with that problem by inserting clauses in sovereign debt contracts to allow the collective wishes to control the process with the minority.

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