Puerto Rico Does Not Need A Financial Control Board – It Needs A Governor

09/14/2015 | Filed under: Economía | Posted by: Francisco

Puerto Rico Does Not Need A Financial Control Board – It Needs A Governor

Sep. 11, 2015 9:18 A http://seekingalpha.com/

Daniel Irvin

Analysis

On September 9, 2015, Puerto Rico’s Governor Padilla released a Fiscal Adjustment Plan, which purports to provide a road map for the Commonwealth to achieve fiscal balance and a return to economic growth. The plan and Governor Padilla’s speech to the Island’s residents the same day seem to be part of a campaign strategy to deflect blame from his administration’s fiscal mismanagement. He uses this platform to blame tax and rate increases on his predecessors and the Commonwealth’s bond investors, including fund managers whom he convinced a mere 18 months ago to purchase a $3.5 billion bond issue and whom members of his administration have referred to as vultures.

His government is quickly running out of cash, in large part as a result of his having spent 3 years leading his Administration and the Legislature down a series of blind alleys, that distracted them from the vital work of cutting costs and improving revenue collections and squandered time, resources and political capital. According to a cash flow projectionprepared by an outside consultant to the government, the Commonwealth’s cumulative cash shortfall will reach $205 million in December of this year, then return to a positive balance and fall again to a deficit of $512 million in June 2016. The liquidity to bridge a cash shortfall of this magnitude would likely have been available from investors, had the Governor not also squandered the government’s credibility by failing to provide transparency in its dealings with investors.

El 99.9% de los Puertorriqueños está en contra del IVA

As discussed at the end of this article, the Administration has crafted its response to the crisis to deflect blame for any bond default on a combination of the acts of previous administrations and the investors in the Commonwealth’s bonds. This populist appeal to blame the financial chaos on greedy investors has some chance of succeeding, but it will likely impose a significant cost on the Commonwealth’s taxpayers for many years.

A history of 11 key policy decisions and initiatives the Padilla Administration has pursued in response to Puerto Rico’s fiscal challenges is presented below to help explain how the Commonwealth reached this point and why his Fiscal Adjustment Plan is likely to fail.

1. No Layoffs

One of the Governor’s few reliable promises has been not to lay off a single government worker. According to the Bureau of Labor Statistics, about 15% of U.S. workers are employed by Federal, state and local governments (21.9 million workers out of 145.4 million total employed). By comparison, in July of this year, 24% of Puerto Rico’s workers were employed by the government (233,800 workers out of 992,000 total employed). This is a significant voting block that reliably turns out in Puerto Rico’s elections.

The sheer number of Puerto Rico’s public sector employees has been recognized for years as an obstacle to serious fiscal reform. Most governments have tried to address the problem by limiting new hires and hoping to reduce the numbers by attrition over time, so as not to alienate this voting block.

In 2010, Padilla’s predecessor, Luis Fortuno, made the courageous decision to lay off 30,000 government workers. Padilla beat Fortuna by 11,285 votes (896,060 to 884,775). Presumably, some of Fortuno’s laid-off workers were in Padilla’s column.

To get Puerto Rico’s government workforce in line with the U.S. average would require laying off 100,000 public employees. Having learned from Governor Fortuno’s experience, Governor Padilla has steadfastly avoided any risk of alienating this base of voters. Instead, the Governor proposes offering government employees the opportunity to retire early and receive 60% of their current compensation every year until they retire and then begin collecting their pensions. It is not clear if the cost of this program is to be shifted to the pension system to keep it off the current budget, only to aggravate the severity of the unfunded pension liability.

It might be easier to sympathize with the Governor’s lack of courage on this issue, were it not for his rhetorical appeals to opponents for «selflessness», «setting aside political considerations» and «keeping our sons and daughters in mind» as the Commonwealth faces its fiscal challenges.

This issue highlights why some students of the fiscal crisis have called for a Federally-appointed emergency manager or control board that can act without fear of re-election. Of course, one can also hope for elected officials who really can set aside political considerations.

2. A $3.5 Billion Refinancing to Bridge the Funding Gap

In March of 2014, a year and three months into his term, the Padilla Administration offered $3.5 billion of general obligation (GO) bonds (2014 Bonds) to institutional investors, since the Commonwealth and its underwriters determined the bonds were too risky to offer to individuals. The 2014 Bonds were issued to refinance maturing short-term obligations and to provide the government with additional liquidity to continue operating. Because of market concerns regarding the Commonwealth’s fiscal condition, the bonds were sold with a stated interest rate of 8% and a price of 93% of their par value. The 2014 Bonds have recently been changing hands at prices ranging from about 72% to 75%, which represents a loss of over 20% to the original investors.

Many of the buyers were hedge funds, who had not previously purchased Commonwealth bonds, but other buyers were long-time investors in Puerto Rico bonds who believed, based in part on statements made by the Administration, that the government would address its fiscal imbalances. This was the last time investors demonstrated a meaningful level of trust in the Commonwealth’s ability and intention to treat them fairly. This was also the last time the market received audited financial statements from the Commonwealth.

3. A New Bankruptcy Bill

While the Administration was marketing the 2014 Bonds, and the Governor was claiming that paying Puerto Rico’s debt was both a legal and (to him) a moral obligation, he was assembling a team of bankruptcy lawyers and consultants who have since played a central role in this drama.

The Administration hired Cleary Gottlieb Stein and Hamilton LLP (Cleary), represented by Lee Buchheit and Richard Cooper, whose experience includes negotiating bankruptcies and debt restructurings for corporations and sovereigns including Greece, Iceland and Argentina. These lawyers do not seem to have any experience with the U.S. municipal bond market or U.S. state and local government finance. Cleary’s first assignment was to write a new bankruptcy law (PRBK Law), that was apparently designed to deal with fiscal stress at the Puerto Rico Electric Power Authority (PREPA), the Highway and Transportation Authority (NYSE:HTA) and the Puerto Rico Aqueduct and Sewer Authority (PRASA); although PRASA was quick to announce publicly that it had no intention of using this avenue to restructure its debt.

The Legislature, controlled by the Governor’s party, dutifully passed the PRBK Law. The rating agencies and other members of the municipal bond investment community predictably recoiled. The Commonwealth suffered credit rating downgrades, and its bonds traded to new lows.

The Administration tried to explain that the PRBK Law was necessary because Puerto Rico is explicitly excluded from Chapter 9 of the U.S. Bankruptcy Code, which allows subdivisions of states to file for reorganization. However, given the timing of the legislation, many investors felt duped by the Administration. In addition, the law contained a number of provisions that were perceived as far more draconian than anything in Chapter 9 or Chapter 11 of the U.S. Federal Bankruptcy Code. The passage of this law marked a major shift in the attitude of Puerto Rico’s creditors toward the Padilla Administration.

The PRBK Law only applied to certain public agencies, most notably PREPA, HTA and PRASA. PRASA publicly stated that it did not need the law. As discussed below, the law’s benefits in lowering PREPA’s rates would have been extremely limited, and it was arguably superfluous for a restructuring HTA, because HTA’s revenues are explicitly subordinated to GO bonds under the Commonwealth’s constitution. It therefore struck many investors as odd that the Administration has spent so much time, money, political capital and investor goodwill to pursue this avenue.

Several PREPA bondholders immediately challenged the new law. A Federal district court ruled the law unconstitutional and an appeals court upheld this ruling. The Administration is seeking to appeal the appeals court ruling to the U.S. Supreme Court.

The Governor is also now also asking for the U.S. Congress to amend the bankruptcy code to allow Puerto Rico’s subdivisions to file under Chapter 9. That might have been a political possibility had the Governor initially worked with the Territory’s representative in Congress, Pedro Pierliusi, but Pierliusi is in the other party, and well, you know.

This would seem to have been an expensive and unproductive gambit that yielded virtually no benefit to the Commonwealth and succeeded only in alienating its investor base. Despite having their work product declared unconstitutional by two Federal courts, the Governor gave Cleary new responsibilities including negotiating a debt restructuring on behalf of the PREPA and participating in the drafting of the Fiscal Adjustment Plan.

4. PREPA Restructuring

Ostensibly, a principal objective of passing the PRBK Law and subsequently seeking Chapter 9 was to restructure PREPA’s debt to lower the Island’s electric bills. What the Administration and its advisors apparently failed to recognize is that PREPA’s debts are not the reason it has high electric bills. At 15% of it annual budget, PREPA’s debt service is actually quite low, and even a severe restructuring of these obligations would not result in significantly lower rates. PREPA’s high rates are the result of high fuel and operating costs related to it being on an island, along with a certain amount of mismanagement.

In this light, the Administration’s relentless pursuit of a «sacrifice» from PREPA’s bondholders seemed to many market participants as if the Administration had an irrational desire to punish creditors. As discussed here, the sustainable reduction in electric rates that would result from the Administration’s recently announced tentative settlement with about a third of PREPA’s creditors is about 6/10ths of a cent per kwh from an average rate of 27 cents and an estimated funding gap of 8 cents to achieve financial viability.

Given this tiny benefit to ratepayers of a PREPA debt restructuring, creditors and even some legislators began to suspect that this process was either being driven by political considerations or a blind reliance on consultants whose advice might be influenced by their interest in participating in a long, expensive, high-profile restructuring. None of the members of the Administration’s restructuring team seems to be well-positioned to weigh the long-term cost of alienating municipal market investors against the benefits of restructuring. Cleary’s experience with sovereign borrowers who have access to the IMF, may not have given them much perspective on the impact of these decisions on the municipal market.

The tentative settlement was reached after over a year of negotiations and millions of dollars in fees to its lawyers and consultants. Given the very small sustainable decrease in debt, the principal motivation seems to have been to defer payments for 5 years, and this seems to be a common theme of the Administration’s debt negotiations. However, these payment deferrals are not free, as they merely cause future administrations to deal with higher payments principal and interest. See here, here and here for other articles that discuss PREPA’s restructuring.

For some market participants, PREPA’s effort to restructure its debt had the appearance of gratuitously punishing PREPA’s bondholders for a problem, which they had no role in creating and which the restructuring could not solve. As a result, this initiative further alienated investors, many of whom have come to view the Commonwealth as extremely unpredictable.

5. The Petroleum Tax Bonds

Puerto Rico has an unusual institution known as the Government Development Bank (GDB), which is not a real bank but a state agency that is the government’s «financial advisor» and sometimes lender. The conflict of interest in these two roles is becoming more apparent as the financial crisis unfolds and is illustrated by another of the Padilla Administration’s failed initiatives.

In 2014, GDB announced that in order to provide «liquidity» it needed to refinance certain loans on its books from the Highway and Transportation Authority. By way of background, HTA’s debt is supported by certain taxes and fees that are subject to a constitutional provision that they must be «clawed back» to pay the Commonwealth’s GO bonds, if there is a budgetary shortfall that would result in a GO default. Thus, HTA bonds are effectively subordinated to Commonwealth GOs.

To accomplish this refinancing, the Administration asked the Legislature to increase the tax on petroleum imports from $9.25 per barrel to $15.50 per barrel, and to allow it to pledge the tax to new bonds (Petroleum Tax Bonds) which would be issued to refinance GDB’s loans to HTA. In response to the Administration’s representations that this initiative would solve the Commonwealth’s fiscal challenges, the Legislature again complied with Padilla’s request. However, this time, the Legislature put some limits on the debt issuance (e.g., limiting the interest rate), likely because its members had begun to lose some confidence in the Administration. Because bond investors had begun to share the misgivings exhibited by some of the Commonwealth’s lawmakers; they also put some conditions on the sale–specifically, the delivery of a balanced budget and a delivery of a credible plan to resolve the fiscal imbalances.

The Administration developed a narrative that the bondholders’ demands were unacceptable, but it is not clear which bondholders’ demands were unreasonable, since the issue was never formally offered to investors. The failure to access the market for this deal has been billed as a major cause of the Commonwealth’s current liquidity crunch. However, there is a somewhat more interesting back story to all of this that has received little or no attention.

If the purpose of the Petroleum Tax Bonds was to provide the Commonwealth with additional liquidity, why the complication of refinancing HTA loans to GDB? Why not simply refund Commonwealth debt payments coming due in the current fiscal year. The answer seems to be that at least part of the motivation for this financing was for GDB to get out of the way of an imminent restructuring of HTA debt to preserve its own finances.

During the passage of the PRBK law, HTA was openly discussed as the most likely candidate for a restructuring after PREPA. Since GDB was a major lender to HTA, it would have suffered along with other creditors if such a restructuring were to occur, especially in a Chapter 9 proceeding that would not give GDB the control it had in the PRBK Law. If the Petroleum Tax Bonds had been issued and HTA were to subsequently default, GDB would have gotten out in the nick of time.

Since the Petroleum Tax Bonds were to be guaranteed by the Commonwealth, the effect would also have been to refinance HTA debt, which is effectively subordinated to GOs, with new debt that had both a GO and special tax pledge. GDB would have been bailed out of a bad loan at the expense of Commonwealth taxpayers and GO bondholders; while holders of HTA bonds would be left behind to fend for themselves.

GDB’s holdings of bonds that are legally subordinated to GOs may have influenced its advice to the Commonwealth in other ways. The Fiscal Adjustment Plan seems to focus on restructuring GOs, which are constitutionally protected and senior to most tax-backed bonds. Since GOs provide the most credible security under Puerto Rico’s Constitution, this financing vehicle would likely be the most viable borrowing vehicle as the Territory emerges from financial distress. Presumably any long-term view of the Commonwealth’s interests would regard defaulting on GOs as a last resort. This logic has led many legislators and others to question the wisdom of members of the Administration talking openly about defaulting on GOs.

In contrast, the Fiscal Adjustment Plan contains no explicit discussion of a restructuring or payment moratorium for HTA bonds or other tax-backed bonds. GDB and other Administration officials do not seem to be publicly discussing this possibility; even though the subordination of these obligations to GOs would seem to make them a more likely candidate for restructuring.

GDB’s institutional interests would seem to have at least the potential to be in conflict with the Commonwealth’s interests, and its seems that GDB’s role as financial advisor to the Commonwealth and its agencies should be re-evaluated.GDB is itself clearly a candidate for restructuring. As the Commonwealth evaluates the impact of various restructuring alternatives on its long-term financial interests, GDB’s institutional interests could color its advice on this issue.

Another little twist to all of this is that GDB’s budget is much less constrained by appropriations than the Commonwealth’s general fund. The hiring spree on consultants and lawyers has been greatly facilitated by the fact that GDB does not need to go to the Legislature for appropriations to pay these bills, but can pull the funds from cash flows being paid on its portfolio of loans to the Commonwealth and its agencies. To some extent, this payment reality also raises the question as to whether the consultants and lawyers represent the Commonwealth’s interests or GDB’s.

6. Reorganization of Public Schools

Because its student population has been in decline and school teachers have not been laid off, Puerto Rico has one of the highest ratios of teachers to students in the developed world. The Commonwealth also has too many schools to serve the current student population. Of course, Governor Padilla’s pledge not to lay anyone off precluded doing anything to adjust the number of teachers, but he did have the courage to propose closing some schools. However, rather than calling the leadership of the school system in and telling them they needed to identify savings, he reportedly paid the Boston Consulting Group $15 million to recommend which schools to close.

7. No Cuts to the University of Puerto Rico

The University of Puerto Rico is one of the most heavily subsidized public higher education systems in the U.S., receiving approximately $900 billion in annual appropriations from the Commonwealth. It offers all students extremely low tuition, regardless of financial need. The Padilla Administration has considered cuts to the University’s annual appropriation, but in the face of student protests has reduced those proposed cuts to zero. The Krueger Report, discussed below, which the Governor commissioned to tell him that he needed to achieve fiscal balance, recommended cutting as much as $500 million from the University’s annual appropriation, in part by needs testing student subsidies. In response, the Fiscal Adjustment Plan proposes to reduce appropriations to the University by $200 million – five years from now.

8. A New Value-Added Tax

Governor Padilla commissioned a study from KPMG to evaluate the introduction of a new value-added tax to replace the Commonwealth’s reliance on income and sales taxes. The principal motivation appears to be to achieve higher rates of compliance, as one of Puerto Rico’s most significant challenges is a very high rate of tax evasion. This initiative was highly controversial and was opposed by a large percentage of the population, including many business owners. Several economists warned that shifting to a new tax regime during an economic downturn was extremely risky, and KPMG even cited this risk in its report. This time members of the Governor’s party balked and refused to pass the bill. The Governor eventually assembled a slim majority to pass a 4 cent increase in the sales tax from 7 to 11 cents to be replaced by the value-added tax in April of 2016. The legislature apparently had the wisdom to note that the Governor’s people have been unable to accurately project revenues from taxes that the Commonwealth has been collecting for many years. They were right to be skeptical that Padilla’s Treasury department could estimate and collect this new tax. This remains a major risk on the revenue side of the Commonwealth’s budget.

9. The Krueger Report.

Ann O. Krueger, a former official with the IMF, was hired by Cleary to develop a plan for Puerto Rico to resolve its fiscal imbalances. The timing of the report’s release was odd.

The Legislature struggled to meet a June 30, 2015, deadline to pass a balanced budget (based on the Administration’s revenue estimates) that was essentially in line with the Governor’s submission to them. Within days of the Legislative leadership announcing the first «balanced budget» in many years, the Governor released the Krueger Report and announced that three years into his Administration he was shocked to learn how difficult the Commonwealth’s financial challenges really were and that fiscal balance had not been achieved after all.

Ms. Krueger and her team did a credible job of delineating the financial challenges facing the government and providing concrete, actionable responses to these challenges. There is a somewhat limited reference to renegotiating the Commonwealth’s GO debt, and Ms. Krueger does not purport to be an expert on the Commonwealth’s financing structures or municipal bond law in general. Yet, from the Padilla Administration’s use of the Krueger Report, one might conclude that debt restructuring is its central recommendation. The Administration has chosen to ignore many of the Krueger Report’s most important and politically difficult recommendations to focus instead on debt restructuring.

Ostensibly to implement the Krueger Report’s recommendations, the Governor convened a committee to develop the Fiscal Adjustment Plan. However, as discussed in 11 below, this plan appears to be more of a cover for a default on Commonwealth debt than a serious set of reforms.

10. Defaulting on Public Finance Corporation Bonds

As part of the 2016 budget, the Administration requested an appropriation for certain bonds of the Public Finance Corporation (PFC), as they are required to do under the PFC bond contract. The Legislature first included the appropriation in a draft budget, then set the funds aside in an account that required GDB to come back and request further legislative action–an apparent reaction to a history of disappointment and distrust over the Administration’s handling of the fiscal crisis. To the Legislature’s apparent surprise, GDB and the Administration decided to use the ambiguity of the Legislature’s appropriation to default on the PFC bonds. They announced that since the appropriation was not made explicitly to pay the PFC bonds, they could not pay them. When individual legislators objected that the funds were appropriated, but that GDB just needed to identify the purpose, the Administration changed its rationale for the default to the Commonwealth’s lack of liquidity. This was after rolling out a talking point likely prepared by the Administration’s litigation team that the nonpayment of principal and interest on these bonds was not a «default» under the bond contracts.

The PFC bonds were sold primarily to residents of the Island, and it is estimated that over 60% are still held by Puerto Rico residents. This points to a larger issue. Estimates of the amount of Puerto Rico debt held by citizens of the Commonwealth range from 20% to one third of all bonds of the Commonwealth and its agencies. There is, in any case, little doubt that Puerto Rican citizens hold a large amount of this debt. The Administration does not seem to have given much consideration to the impact (economic or moral) of impoverishing its own citizenry by impairing investments they previously considered to be the safest of their holdings.

11. The Fiscal Adjustment Plan: Defaulting on Commonwealth Bonds.

In response to the «new» crisis suddenly revealed by the Krueger Report 3 years into his administration, the Governor resorted to a familiar pattern: he appointed a committee of government officials and an army of very high priced consultants to develop the Fiscal Adjustment Plan. After a one week delay (attributed to a tropical storm) and strategic leaks to gauge public reaction to the plan’s details, it was released on September 9.

Most of the details of this plan are irrelevant, as they include proposals that are beyond the Administration’s or the Legislature’s control.

Possibly the most egregious example is the proposal to extend a 4% excise tax on corporations which represents 20% of the Commonwealth’s general fund revenues.The corporations paying this tax have been treating it as a direct offset to their Federal tax liability and have therefore been indifferent to paying it. The IRS is temporarily allowing corporations to continue this practice while it promises to study the issue and provide a ruling. Few tax experts seriously believe the IRS will ultimately rule in favor of the current practice and many believe the IRS is simply looking the other way because the tax is set to expire in 2017. The Fiscal Adjustment Plan assumes an extension of the tax, but states it will only be extended if the current practice of offsetting it against Federal tax payments is approved the IRS–a highly uncertain, if not unlikely, event.

The Fiscal Adjustment Plan also proposes a fiscal control board to be appointed by the Governor. Apparently, this new committee is intended to assuage the fears of bondholders whose trust in the Commonwealth has been shattered by the various gambits described above. This board would be «empowered» to enforce the financial «reforms» outlined in the report. In addition to not fooling anyone, this silly contrivance has a major constitutional flaw: a constitutional officeholder cannot delegate powers it does not hold, nor can an entity be created which violates the delegation of powers among executive, legislative and judicial branches. So this board cannot have any powers other than those the Governor already holds. A member of the Legislature recently commented that the Commonwealth does not need a fiscal control board, it needs a governor.

As discussed in 1, above, a true emergency manager or fiscal control board like the ones used in New York, Detroit and DC might ultimately be necessary in Puerto Rico. However, most of Puerto Rico’s creditors are likely to see this proposal as another attempt to dupe them.

Other than the many other silly assumptions, impossible-to-execute proposals, and weak «reforms» dressed up as austerity measures, two things stand out about this report:

A. Most of the revenue and expense initiatives are significantly back-loaded, with little or no impact until after the 2016 election and most of the projected benefits occurring five years out, at the end of the next administration’s term. Essentially, the Administration is not requiring itself to deliver much, if any, results until after the 2016 election, and even then to produce only gradual financial improvement. Immediately below are examples of some of the initiatives proposed in the plan.

(click to enlarge)

The Governor cannot be held accountable by voters in the next election for the success or failure of these initiatives. Moreover, bondholders who are being asked to «sit at the table of sacrifice» before December of 2015, would have no apparent mechanism to ensure any of the these initiatives are implemented. Below is a summary of the projected impact of revenue and expense initiatives contained in the plan.

(click to enlarge)

B. Virtually all of the proposed pain in the next 1-3 years is imposed on bondholders.Aside from the fact that most of the initiatives underlying the table above cannot be achieved in the timeframe described, the Administration is using these projected budget enhancements to justify requiring bondholders to commit in 2015 to forgo $14 billion of principal and interest payments over the next five years. Here things get a little sketchy. Is he asking them to give this amount up forever or to merely defer most some or all of this amount? Either way, this does not seem like good public policy. The bondholders are unlikely to allow this amount of their capital to be wiped out without a protracted, expensive and extremely disruptive legal battle. To the extent it is merely a deferral of debt service, it will eventually be repaid with interest. This merely shifts the burden to a future administration and increases it by the interest that would accrue.

One contribution to the size of this $14 billion funding gap is an Administration proposal to spend several billion dollars to promote economic growth. Why anyone would trust this government to choose the right set of expenditures to finally promote real private sector economic growth is not explained.

The Proposed Default

The mechanics of the sacrifice by bondholders would apparently involve current bondholders exchanging their various securities for a new security similar to the Governor’s other recent settlement with some of PREPA’s bondholders (discussed here). The Governor darkly proclaims that if bondholders do not come willingly to this exchange, his government will have to do something bad–presumably default. The Governor:

If creditors are not willing to partake in this, Puerto Rico will have no alternative but to proceed without them. That path doesn’t suit us nor them and will result in years of litigation and defaults and a major humanitarian crisis, forcing us to choose between paying a creditor, a teacher, a policeman or a nurse. A decision I’d prefer not to make, but that I’ll make if I have to, always looking out for the best interests of our country.

After acknowledging the years of litigation, uncertainty and economic turmoil a default would impose on the Island’s citizens, the Governor insists he is willing to impose this hardship on his fellow citizens if necessary. It brings to mind Cleavon Little in Blazing Saddles holding himself hostage by pointing a gun to his own head. Some of the Administration’s maneuvers would indeed be comical, were it not for the costs they are imposing on Puerto Rico’s 3.5 million citizens over the next decade. After New York City defaulted in the 1970s, it took about 8 years for the City to return to the capital markets and many more years before it could borrow money at pre-crisis interest rate levels. This administration has embarked on a path that is likely to impose much greater hardship on its citizens.

In a rhetorical flourish presumably designed to foreclose opposition to his plan the Governor goes on to warn

We will be publicly attacked by outside interests who will want to force us to pay without thinking about the consequences that will have on the wellbeing of our people. They’ll attack us because they’ll want to see us on our knees. To avoid these consequences in Puerto Rico, unity of purpose and will is needed. This must not become another battleground ahead of next year’s elections. This crossroads requires seriousness, commitment and selflessness.

The last line is a bit ironic in that it seems likely that at least some amount of attention to next year’s elections and selfishness by the private sector authors of the Plan played a role here. The Governor’s advisors must know the plan is highly unlikely to achieve the stated objective of financial stability. Perhaps the advisors have understated the risks to their client in an effort to perpetuate an income stream. Alternatively, the Governor may have been fully apprised of the risks and has accepted them on behalf of the people of Puerto Rico in an effort to preserve his candidacy for re-election in the face of dismal approval ratings.

Alternatively, the Administration and its advisors may have collectively decided that a default will buy them the time it takes for bondholder responses to wind their way through the courts? If so, this is an extraordinarily expensive approach to achieve short term liquidity, as the higher cost of capital will be born by Puerto Rico’s citizens for most of a generation at least a decade.

Perhaps the most cogent explanation of the Administration’s actions can be found in the words of Lee Buchheit, their lead counsel at Cleary:

The principle skill of a sovereign debt restructurer is the ability to persuade perfectly sensible people to do something – reduce or stretch out their claims – that no sensible person would ever think of doing. The required talents? An ability when speaking to creditors to slip effortlessly between an imperious tone and a cooing, let the little children come to me intonation. A sense of theater. And, when dealing with large creditor committees, a familiarity with the basic principles of animal husbandry.»

–Lee Buchheit and Rosa Lastra, Sovereign Debt Management

This kind of cynicism and gamesmanship may suit Padilla’s near term political objectives. It may even be acceptable practice for a borrower like Ecuador or Argentina that periodically defaults and is unlikely to become top tier credit any time soon. However, Puerto Rico has, for many decades, enjoyed ready access to capital at extremely low interest rates. To squander that for these short term political considerations seems reckless in the extreme.

The Fiscal Adjustment Plan is unlikely to achieve its stated objectives because the Administration has squandered its credibility with investors, the purpose of the proposed restructuring seems to be to allow the Administration to go on spending in an election year, and the Administration’s legal position is extremely weak.

Cleary’s maneuvering might be well-suited to jurisdictions deficient in the rule of law, but its benefits seem less clear as it encounters a court room. The Commonwealth’s Constitution is clear on the priority of GO debt service over any other government expenditure. Holders of other government credits like COFINA and bonds secured by various other Commonwealth revenue streams are likely to vigorously contest the government’s assertion that it cannot afford to pay them.

The Commonwealth’s litigation experience with the PRBK Law that Cleary drafted and defended in court should provide some note of caution. Though the current strategy may serve Cleary and Buchheit well, the cost to the people of Puerto Rico could be exponentially higher than Cleary’s fees.

The Austerity Narrative

In his speech unveiling the Fiscal Adjustment Plan, Governor Padilla lists the history of austerity imposed on Puerto Rico’s citizens:

Our people have been asked to make many sacrifices.

In 2005, toll rates and the University of Puerto Rico’s [UPR] tuition were increased. In 2006, water and sewer rates were increased. In 2007, a legislative proposal was introduced to establish a sales tax for the first time.

In 2009, excise taxes on alcohol, cigarettes and some motor vehicles were increased. Also, a 5% income surtax was imposed to individuals, corporations and cooperatives. At that time, a surtax was imposed on real property taxes that doubled the contribution for our homes and businesses. And you’ll remember that an additional tuition fee of $800 was imposed on UPR students.In 2010, 30,000 government employees were laid off, and the employer contribution to the retirement system was increased. In 2011, a new contribution of 4% was imposed on foreign corporations with manufacturing operations in Puerto Rico. [emphasis added]

In the current term, we injected capital into the Highway Authority and the Water and Sewer Authority, we reduced by 75 percent the hiring of professional services, adjusted government spending with the passage of Act 66, we restructured the Metropolitan Bus Authority, consolidated public schools, and we extended Act 154 for foreign corporations that continue in Puerto Rico. We imposed a tax on transfers of foreign stores and are now in full transition to a VAT [value-added tax]. At the same time, we have reduced the amount of loans to finance operating expenses.

Interestingly these hardships consist almost entirely of tax increases, aside from the italicized reference to Governor Fortuno’s layoff and some obscure references to «restructuring» and «consolidation» of various operations during his administration, which we already know did not result in a single reduction in the public workforce.

The litany of tax increases might lead to the conclusion that the Commonwealth’s citizens bear an excessive tax burden. However, the reality is that Puerto Rico’s tax collections as a percentage of the Island’s economy is significantly lower than for the mainland US.

Puerto Rico’s total tax collections are about $10.2 billion per year, and Puerto Rico residents pay another $3.7 billion to the US Treasury. This total of $14 billion is 13.6% of GDP or 20% of GNP. By comparison, on the mainland, US tax revenues as a percentage of GDP are 33% (38% of GNP). In high-tax states these numbers for the mainland are even higher.

Compared to the rest of the United States, Puerto Rico is a low tax jurisdiction in aggregate. However, many of Puerto Rico’s residents may well be over-taxed, specifically, those who comply with tax laws. Puerto Rico has a large underground economy, estimated to be as high as $20 billion. Various studies have estimated that the size of Puerto Rico’s «legal» underground economy (excluding illegal activities like drug trafficking) is between 23% and 30% of the total economy compared to 6% to 8% for the US mainland. Moreover, this underground economy grew significantly from 2000 to 2009. The amount of tax revenue lost to the government as a result of this informal economy is estimated to have grown from under $600 million in 2000 to over $700 million in 2009.

See here for more on this issue and other misconceptions about the Commonwealth’s fiscal crisis.

In this light and with the lack of any near term concrete actions proposed in the Fiscal Adjustment Plan, the Administration’s calls for creditors to «sit at the table of sacrifice» seems a bit disingenuous. Creditors might be excused for worrying that they could be sitting alone at the table.

Conclusion

The Puerto Rico Aqueduct and Sewer Authority (PRASA), which is trying to manage a severe drought, provides a stark reminder of the adverse consequences of the Padilla Administration’s policies. PRASA is trying to access the capital markets to refinance short term notes and fund its capital program. Lack of access to capital has shut down PRASA’s capital improvement program, leaving contractors unpaid, idling workers and threatening to cause the Authority to raise water rates. The Commonwealth is in the surreal position of asking investors to put up money for one agency, while informing them the money they have already invested in other Commonwealth bonds will not be returned to them.

Press reports suggest the Padilla Administration has (mis)spent close to $100 million on the consultants and legal advisors who have led these hapless public officials down this road to nowhere. This late in an election cycle, it is likely too late for Padilla to admit his mistake and take a more responsible path. The creditors (and the citizens of Puerto Rico) will likely need to wait for a new governor to lead the Commonwealth out of this morass.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long bonds of the Commonwealth of Puerto Rico and its agencies