- Blog Post
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Puerto Rico’s Oversight Board didn’t object to the terms of Puerto Rico’s proposed restructuring of the Government Development Bank bonds (and selected deposits) so it looks like the GDB restructuring will go forward if the deal gets enough creditor support.
I have mixed feelings on this.
On one hand, the proposed restructuring would make of the use of the “voluntary” restructuring tool created by PROMESA (Title VI). This tool was created by statute not contract. It was designed to mimic the “aggregated” voting provisions now used in most New York and English law international sovereign bond issuance (the ICMA standard clauses) that allow the votes of different bonds to be combined—under defined circumstances—into a single up or down vote on the restructuring terms. But fundamentally it is a statutory restructuring mechanism, not a contractual mechanism—not unlike the mechanism used to restructure Greek law bonds back in 2014.
I have a modest personal stake in the success of the voting mechanism—I participated in the working group that helped develop the aggregation clause (for more of the backstory see Mark Sobel's account), and I was part of the Treasury working group that helped develop the first version of the voting mechanism that ultimately became Title VI.
I consequently hope the legal mechanics of aggregated voting work smoothly, and that the creation by statute of a simplified voting mechanism to help address hard cases where contractual voting terms are inadequate creates a precedent of sorts. Aggregated voting is actually far better suited for sovereigns with lots of equally ranked, homogenous debt than for Puerto Rico and its highly fragmented debt stock: there is a reason why most of the Puerto Rico’s debt will be restructured through the more formal Title III process.
But I am not a fan of the actual restructuring terms that are being put up to vote.
The government of Puerto Rico is putting a more generous offer on the table than it needs to, for bonds that have a relatively weak legal hand.
And there is a real risk that the terms of the exchange—which effectively create a senior and junior bond out of the pool of assets that backs the GDB’s current stock of bonds and municipal deposits (see blog post)–will create future banking or fiscal problems for Puerto Rico.
But to understand why, you really need to understand both the fine print, and the composition of the GDB’s creditors.
There are two basic problems with the deal, in my view.
The first is that the GDB bond restructuring is effectively being subsidized by the Commonwealth government agencies that are net depositors in the GDB (e.g. they have more deposits at the GDB than loans from the GDB). These depositors are effectively giving up any return on their claim on the GDB,* and in the process raising returns for the GDB’s other depositors and its bondholders.
The subsidy here is difficult to spot. In full resolution, the government deposits would have a claim on all the GDB’s assets, including its “good” assets, not just its bad assets. And in full resolution, the other creditors of the GDB would have, in part, a claim on the GDB’s junior loans to the commonwealth. By not maximizing its recovery on an impaired financial asset (deposits in the GDB), the commonwealth is leaving a bit of cash on the table.
The second is that even with this sacrifice by Puerto Rico’s government, the deal won’t—in all probability—actually solve for Puerto Rico’s very small scale version of the bank-sovereign doom loop: the financial interconnection between the locally insured credit unions (cooperativas) and the commonwealth. The local credit unions have a sizeable position in the GDB bonds (estimated at $400 million), and significant exposure to the commonwealth generally.
Unlike the government depositors, the bonds held by the cooperativas are eligible to participate in the exchange, and thus they could in theory get a claim on the GDB’s good assets. But to do so they need to accept at least a forty percent haircut upfront—and it isn’t clear that they have the financial strength needed to do so.
Under the proposed restructuring terms, the GDB bondholders get to choose between three flavors of bonds—two senior bonds (one with a face value of 55 cents on the original dollar, the other with a face value of 60 cents on the original dollar) and a junior bond (with a face value of 75 cents on the dollar). The collateral pool backing the bonds isn’t big enough to cover payments on all the new bonds. So as a practical matter, almost all the value is going to go to those who swap into the high coupon senior bond (in return for a bit more face value debt reduction).
The low coupon junior bonds are thus real dogs, financially speaking. They will end up in the hands of those who either don’t know better or those who cannot absorb the bigger loss in face value.
That’s why, in my view, it isn’t a good deal for Puerto Rico. There is a real risk that GDB’s restructuring terms ultimately will make the cooperativa problem worse not better. They will give up their claim on the GDB’s good collateral in the exchange, while still pretending to hold a valuable claim on their books –
And I suspect that even if the GDB’s junior bonds technically have no recourse to the government, as a practical matter the government will need to step in at some stage to protect the cooperativas’ depositors from losses.
Stuffing junior debt in the hands of retail investors generally doesn’t end well: the biggest (potential) loss is held by the those least able to absorb the loss.
The deal could still fall apart: the smart thing for local creditors to do is to take the senior bonds, which will leave more senior bonds than realistically can be supported by the good collateral in the pool.
But if the deal goes ahead I suspect there is a real risk that it will ultimately leave Puerto Rico worse off than would be the case if the GDB’s assets—good and bad—were distributed equally to all of the GDB’s creditors.
One last point. If the GDB bond restructuring terms thus become a floor for what other creditors will accept, Puerto Rico (and its oversight board) has no realistic path back to sustainability. Raising the coupon while cutting face value won’t return Puerto Rico to sustainability without a really big cut in face. The GDB deal terms raise the coupon on the senior bonds to around 7.5%--from around 5%--in exchange for a 45% reduction in face, so the net reduction in the coupon is less than 20%. (The coupon reduction on the junior bonds is more like 50%--as both face and the coupon are cut).
* Deposits (technically they get a claim on the GDB’s loans to Puerto Rico’s OMB and its Treasury, but those are the most junior of all claims on the commonwealth). The details are in my previous post.