How to Stop the Death Spiral in Puerto Rico

In late June, 2015, Puerto Rico Governor Alejandro Garcia Padilla said that the island could not meet its obligations to pay off $72 billion in the combined debt of the territorial government and municipalities.  In November 2015, the U.S. Treasury Department agreed that the territory was insolvent.  Garcia Padilla then called the situation a “death spiral” during a hearing on December 1, 2015. 

Puerto Rico ended up in this fiscal mess as the result of a growing public sector, shrinking private sector, migrating population, and failure to reduce government spending.  The government took out loans and issued bonds through the Puerto Rico Urgent Interest Fund Corporation (COFINA).  While the territory rarely garners the attention of Congress, the possibility of a bailout larger than General Motors and Chrysler combined has captured the interest of both members of Congress and presidential candidates alike.

The reason that a bailout is even being discussed is that unlike the 50 states, Puerto Rico’s municipalities cannot declare bankruptcy.  Under Chapter 9, which was created in the Municipal Bankruptcy Act of 1934, cities such as Detroit ($18 billion in 2013) and counties such as Jefferson County, Alabama ($4 billion in 2011) have declared bankruptcy.  Although this law was found to be unconstitutional, a similar bill was passed in 1937, which also included Puerto Rico and the District of Columbia in the definition of a “state.”

However in 1978, President Jimmy Carter signed into law a revision of the bankruptcy code that failed to define what constituted a “state,” leaving Puerto Rico, the District of Columbia and other territories of the United States in limbo.  In 1979, the Bankruptcy Technical Amendments Act sought to correct the “state” definition, and the Senate version of the bill included Puerto Rico and other territories.  When the House Judiciary Committee reported its version of the bill, the territories were not included as states for Chapter 9 bankruptcy.  The House version of the bill was eventually attached to the Bankruptcy Amendments and Federal Judgeship Act of 1984, which was signed into law. 

Proposed solutions to resolve the territory’s financial problems include restoring Chapter 9 protection to its municipalities and/or establishing a financial control board similar to those that helped New York City and Washington, D.C. recover from fiscal difficulties.  Many of those who support these proposals note that if nothing is done, the federal government; i.e. taxpayers, will have to bail out Puerto Rico.

Opponents of Chapter 9 or a control board argue that the government should address its financial problems solely by cutting spending and making other difficult choices on how to spend money and there is no doubt that such steps are essential regardless of any other remedies.  Creditors, including hedge funds, object to taking a “haircut” from debt restructuring, arguing that they should be paid the full amount of what they are owed after taking the risk of investing in Puerto Rico.

No one disagrees that Puerto Rico’s leadership has made poor financial decisions.  For example, the Puerto Rico Electric and Power Authority (PREPA), a government-owned corporation, provides free energy to all municipalities and its government-owned enterprises (but not citizens).  It alone has accumulated $9 billion in debt and is already in default.  The construction of the government-owned ice rink is emblematic of the authority’s rather dubious investments, since Puerto Rico is in the Caribbean, south of Cuba, and has not experienced “winter” in centuries. 

The Council for Citizens Against Government Waste wrote a letter to the House of Representatives on May 21, 2015 in support of H.R. 870, which would extend to Puerto Rico the same authority under Chapter 9 that gives states the ability to enable municipalities to restructure debts under federal court supervision.  CCAGW also supports the creation of a financial control board.

If neither of these proposals moves through Congress quickly, Puerto Rico may default on Government Development Bank debt payments of $422 million on May 1, as well as $2 billion due on July 1 by the government and several agencies.  In regard to the latter payment, $805 million is related to General Obligation bonds, which must be repaid under a constitutional mandate.

Knowing how Congress works reactively instead of proactively, perhaps the failure to make the payments in a timely manner may finally wake up legislators to the need to resolve Puerto Rico’s debt problems as a bailout looms,