Why were Puerto Rico’s economic and financial troubles not reflected in its bond yields prior to its 2016 default? A Stigler Center working paper explores the possibility that this puzzle is related to government involvement in financial markets.
In the summer of 2015, the Commonwealth of Puerto Rico began to default on some of its bond commitments; bankruptcy was effectively declared (under Title III) on May 2, 2017. At that time, its outstanding liabilities were approximately $68 billion of debt, as well as $45 billion of unfunded liabilities. These two figures totaled to more than 100 percent of Puerto Rican GDP.
That Puerto Rico defaulted on its liabilities was unsurprising. Macroeconomic conditions had been deteriorating for many years. Between 2005 and 2016, population declined by 11 percent, the employment/population ratio declined by 14 percent, and GDP declined by 9 percent. Effective 2006, a very favorable tax subsidy for US firms operating in Puerto Rico was terminated.
Fiscal conditions were equally precarious. The operating deficit was persistent and growing. In 2002, it was a little over 1 percent of GDP; in 2014, it rose to 6 percent. These burdensome deficits are tied to Puerto Rico’s limited debt capacity. In 2016, the Puerto Rican median household income was $19,606. This figure is about half as large as that of Mississippi, the poorest US state.
The age composition of the population is also a debilitating factor. Puerto Rico has a much older population than most countries with similar incomes. The out-migration of younger workers has been facilitated by the fact that all Puerto Rican citizens hold US passports, and thus they can migrate to and work in the US with no restrictions. As reported in the New York Times, “[a]fter years of propping up a struggling economy with unsustainable borrowing, Puerto Rico’s financial reckoning was inevitable.”
As reported in the New York Times, “[a]fter years of propping up a struggling economy with unsustainable borrowing, Puerto Rico’s financial reckoning was inevitable.”
That borrowers—municipalities, corporations, or households—occasionally get into financial difficulties is not surprising. Financial markets are well-equipped to handle such situations. In well-functioning financial markets, deteriorating financial conditions raise the risk premium assessed on borrowed funds, thus making capital more expensive and restricting its flow to the beleaguered entity. In the extreme case, credit is completely cut-off.
An August 2012 article appearing in Barron’s stated that [Puerto Rico’s] “economic and financial woes don’t appear to be reflected in its bond yields.” Why did “smart money” investors in New York and other financial centers continue to purchase Puerto Rican debt with only a modest risk premium? In early 2016, one major bond mutual fund had 50 percent of its assets in Puerto Rican government securities. Taken together, bond mutual funds and hedge funds owned $26.3 billion dollars of Puerto Rican debt, approximately 38 percent of Puerto Rico’s total outstanding debt. Pricing and allocating capital are the primary tasks facing financial markets. What went wrong in the case of Puerto Rico?
“Why did “smart money” investors in New York and other financial centers continue to purchase Puerto Rican debt with only a modest risk premium?”
In a recent working paper (“What Went Wrong?: The Puerto Rican Debt Crisis and the ‘Treasury Put’ “), Ryan Chiu, Shana Henderson, and I explore the possibility that this puzzle is explained by government involvement in financial markets. Specifically, we ask whether investors were operating under the assumption that Puerto Rican bonds enjoyed an implicit guarantee from the US government in the case of default. We label this implicit guarantee the “Treasury Put,” borrowing the terminology from options markets for a “put,” a contract that entitles the holder the right, but not the obligation, to sell (or “put”) an asset with another party at a predetermined price.
We begin our analysis by documenting the existence of the Treasury Put. In the face of financial crises, federal financial assistance has been the norm. In 1975, New York City was on the verge of bankruptcy. Despite an initial refusal to bail out New York (President Ford’s position was encapsulated in a famous—though perhaps apocryphal—headline in the New York Daily News of October 30, 1975: “Ford to City: Drop Dead. Vows He’ll Veto Any Bail-Out”), the federal government relented. Financial assistance was authorized on December 10, 1975 in the form of loans that would be valued in 2013 at $15.5 billion (adjusted for increases in both the size of the economy and the level of prices).
Additional bailouts include Lockheed (1971; valued in 2013 at $1.12 billion), Chrysler (1980; $6.29 billion), the Savings and Loan Crisis (1986-1995; $273 billion), Brady Bonds (1989-present; no dollar figure is available), the Mexican Peso Crisis (1995; $37 billion), Bear Stearns (2008; $32 billion), and the Troubled Asset Relief Program (TARP, 2008; $508 billion). These precedents, coupled with the devastation that followed the non-bailout of Lehman Brothers, led investors to expect government support of $100+ billion in Puerto Rican liabilities.
Before proceeding to the remainder of our analysis, we note that government intervention on behalf of investors has a long tradition and, interestingly in light of recent events, foreign interference in US politics is not solely a 21st century phenomenon. In the aftermath of the debt default by eight US states and one territory circa 1840, British financial interests aggressively lobbied for intervention by the US federal government (Jenks, 1938, pp. 105-106):
Baring Brothers [a British merchant bank] began an agitation to persuade the federal government to assume the responsibility for the state debts. … London merchants easily gathered the impression that Whigs of the Webster school [a faction of a U.S. political party at the time] were likely to carry out this policy. And so the Whig cause in the campaign of 1840 received generous support from England.
Despite this assistance, the non-Webster faction of the Whigs won the election and then enacted the Bankruptcy Act of 1841, which was detrimental to the interests of British bondholders.
The next step in our analysis measures the risk premium that compensates for the possibility of default. In general, this task is quite difficult because one must take account of a host of factors that affect the expectation of default, such as all relevant macroeconomic factors (some of which were listed above), government political constraints, and the regulatory and legal environments. Fortunately, this task is made easy in the present case because Puerto Rico issued both insured and uninsured general obligation bonds on the same day, on nearly the same terms. With a few minor adjustments, we need only take the difference in yields on the two classes of bonds to measure the risk premium. For all bonds issued since 2000, we find the average risk premium is 167 basis points. This figure is only 68 basis points greater than the comparable risk premium on Corporate Aaa bonds and 31 basis points less than the comparable risk premium on Baa bonds. Given the macroeconomic and financial difficulties facing Puerto Rico, this risk premium is puzzlingly low.
While the expectation of a bailout was well-founded, it became clear in the summer of 2013 that the Treasury Put had been extinguished. On July 18, 2013, the city of Detroit filed for bankruptcy. No federal assistance was forthcoming, an event that was totally unexpected. Detroit Mayor Dave Bing discussed the need for assistance with the Obama administration. Rollcall reported that “[s]oon after Detroit filed for protection under Chapter 9 of the bankruptcy code, the Obama Administration made it clear it would not seek a bailout similar to the $2.5 billion [sic] New York City loan package enacted in 1975” (Ota, 2013, p. 2). The Obama Administration’s reluctance was echoed in proposed legislation in Congress prohibiting bailouts for the financial liabilities of sub-national governments.
The impact on the Puerto Rican bond market was dramatic. As shown in Figure 1, the price differences between uninsured and insured bonds widened sharply immediately after the Detroit bankruptcy and the federal government’s truancy regarding financial assistance:
The extinguishing of the Treasury Put in the summer of 2013 led to an increase in the risk premium on Puerto Rican uninsured bonds of approximately 350 basis points. While this increase in the cost of capital is sizeable, the resulting misallocation of capital was not fully responsible for Puerto Rico’s financial woes. According to our calculations, capital markets, aided and abetted by the Treasury Put, directed about 15 percent too much capital to Puerto Rico. This extra indebtedness may have created a tipping point for default, but default may be more deeply rooted in internal political failures.
However, if the financial situations of beleaguered states continue to deteriorate and federal assistance reemerges as a possibility, the Treasury Put may continue to misallocate capital. The five most troubled states—Illinois, New Jersey, Massachusetts, Connecticut, and Kentucky—have outstanding liabilities of $745 billion. The scope for misallocating capital is very large.
How can the Treasury Put be extinguished on a permanent basis? One procedure might follow the legislative route followed by balanced budget amendments, which have been adopted by 49 US states. Unfortunately, these have proven largely unsuccessful in constraining profligate governments and the possible need for a bailout. An equally bleak picture emerges when examining the ineffectiveness of policies adopted in Korea and the Euro area to eliminate bailouts. In the end, there is an unresolved tension between restrictive policies that are beneficial and political influences that are pervasive (Rajan and Zingales, 2003; Morck, Wolfenzon, and Yeung, 2005). How to extinguish the Treasury Put on an ongoing basis in a democratic society remains an open question.
… there is an unresolved tension between restrictive policies that are beneficial and political influences that are pervasive…. How to extinguish the Treasury Put on an ongoing basis in a democratic society remains an open question.
Barron‘s, “State of the States,” Barron’s (August 27, 2012).
Jenks, Leland Hamilton, The Migration of British Capital To 1875 (New York and London: Alfred A. Knopf, 1938).
Morck, Randall, Wolfenzon, Daniel, and Yeung, Bernard, “Corporate Governance, Economic Entrenchment, and Growth,” Journal of Economic Literature 43 (2005), 655-720.
New York Times, “Hurricane-Torn Puerto Rico Says It Can’t Pay Any of Its Debts for 5 Years,” (January 24, 2018).
Ota, Alan K., “Detroit’s Woes Put New Spotlight on Pension Overhaul Proposals,” Rollcall (July 24, 2013).
Rajan, Raghuram G., and Zingales, Luigi, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (New York: Crown Business/Random House, 2003).
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