Solving the Puerto Rico Electric Power Authority debt problem

Puerto Rico and its various government entities owe creditors $72 billion, an enormous debt that Gov. Alejandro García Padilla has described as “unpayable.” Over 11 percent of that total is owed by the Puerto Rico Electric Power Authority (PREPA), now in negotiations with its creditors to reduce and to stabilize its debts over the long term, about which more below. The latest development in the Puerto Rico debt saga was the failure of the Public Finance Corporation (PFC), a subsidiary of the Puerto Rico Government Development Bank (GDB), to make a $58 million bond payment due on Aug. 3. Somewhat amusingly, the payment was due on about 20 “moral obligation” bonds that financed school construction and other infrastructure projects.

{mosads}A bit of background is useful. The GDB financed the projects initially, and then refinanced them through the PFC, thus removing the debts from the GDB accounts. One — but not the only — legal interpretation of the repayment terms for these bonds is that given payments are required only if there is a budget appropriation for that purpose. On the other hand, the bonds were sold with an irrevocable letter of credit — a guarantee — from the GDB, which said that in the event that the PFC failed to make a payment, the bondholders would be able to get the dollars owed them from the GDB.

Alas, there seem to be some wording differences among the various documents describing the bonds with respect to how and under what circumstances the guarantee can be implemented. But the central reality is straightforward: The $58 million was due and the PFC failed to pay it. Accordingly, an unsophisticated type (like me) would conclude that the debt is in default.

But there is a more sophisticated view among many officials in Puerto Rico, referring back to the supposed requirement for a budget appropriation: If there is no such appropriation, then the given payment cannot not be made, and so there is no “default,” strictly speaking. Moreover, threaten some of those officials, suppose that the creditors file suit in a Puerto Rico court so as to obtain a default judgment, and then fail to convince the court to agree, due to the disputed issue of a required appropriation. Then maybe the commonwealth will sue the creditors on the grounds that their default accusation had harmed the credit worthiness of Puerto Rico, causing financial harm! One rather doubts that public officials in Puerto Rico advertised these nuances when they were marketing the “moral obligation” bonds, obviously preferring to make them appear as riskless as possible so as to pay the lowest interest rates.

That, of course, was then. In the here and now, the Puerto Rico debt saga has entered a version of bizarro world that only the lawyers could love, in which the repayment of debts is not an actual obligation unless politicians decide to honor them with a budget appropriation. That any such appropriation must be taken from other spending priorities benefiting actual constituents does not yield political incentives consistent with long-term creditworthiness. And in bizarro world, it is neither a failure to make required payments nor the parsing of words with respect to the letter-of-credit “guarantee” that will have harmed Puerto Rico’s credit worthiness. That harm comes instead from the claim by the creditors — utterly true on its face — that they are owed money and that it has not been paid. It is their fault! Is it actually possible that officials in Puerto Rico are making this argument with straight faces?

It gets better. The Puerto Rico government is lobbying Congress to allow it to resort to Chapter 9 (municipal) bankruptcy, notwithstanding the fact that it is prohibited explicitly from doing so under the U.S. Bankruptcy Code, and many of the bonds that would be affected — including PREPA’s — were marketed with that constraint up front and center. This meant that those bonds were safer than those of other public-sector borrowers — the debts could not be discharged through bankruptcy — which yielded an important benefit for the commonwealth, again in the form of lower borrowing costs, which Puerto Rico and its various entities were happy to enjoy.

One constant in this saga is the apparent blindness of the Puerto Rico political establishment with respect to the effect of their arguments on the island’s future creditworthiness. The need for Puerto Rico to borrow over the long term for ongoing infrastructure investment and similar endeavors is obvious; but who will buy their future bonds once they have been made permanently riskier by ongoing efforts to define away current debt obligations? It is obvious that fewer lenders will be willing to do so, thus increasing future borrowing costs and reducing the public investments needed to modernize the island economy. This adverse effect will be borne by ordinary citizens of the commonwealth, a reality that politicians focused on the next election are simply ignoring.

Another constant has been the open willingness of the creditors to face the reality that the debt is “unpayable” fully as a practical or political matter. In the case of PREPA’s creditors, they have offered to:

• Accept a 10-20 percent haircut in the present value of the repayment stream over time;
• Reduce the interest rate on the PREPA debt by 22 percent, from over 5 percent to just over 4 percent, thus reducing the ratepayer payments needed to service the debt, saving $2.5 billion for investment in modernized equipment;
• Use new securitized (“rate reduction”) bonds to defer principal payments on about 70 percent of the outstanding debt for three years, and both principal and interest payments on the remaining 30 percent for up to 19 years; and
• Accept a charge to electricity consumers for servicing the securitized bonds that would allow a 9 percent rate reduction for PREPA ratepayers from about $259 to about $236 per megawatt-hour. That lower rate is 15 percent less than PREPA’s August 2014 rate and 39 percent lower than the 2012 average of those paid in (ascending order): Guam, Hawaii, Haiti, St. Lucia, Grenada, the Dominican Republic and the Virgin Islands.

Given that Congress is unlikely to make bankruptcy a viable option, and given that the outcome of a suit over default even in a Puerto Rico court is a risky proposition, and given the long-term needs of the people of Puerto Rico for access to credit markets, one would think that the concessions offered by the PREPA creditors would be enough to induce public officials in Puerto Rico to make a deal and move forward.

And one would be wrong. Negotiations have dragged on for over a year, during which time the creditors have sweetened the pot by increasing the size of the securitized bond offering. Will the politicians accept this so as to minimize the future damage to Puerto Rico’s credit standing? Stay tuned.

Zycher is the John G. Searle scholar at the American Enterprise Institute.