Realistic versus sentimental perspectives on bondholder protections
So, Puerto Rico defaulted on a relatively minor bond payment last Monday, and it is a truth universally acknowledged that a government default must be in want of an avalanche of hot takes. Although it is difficult to absorb all of the instant authorities out there, these events do provide an interesting opportunity to observe how various money managers form opinions about different securities.
Brian Chappatta’s article, Puerto Rico Shows Perils of Muni Bonds Backed by Empty Promises, quoting a number of market participants and observers hyping the risks of appropriation-supported bonds versus other bond structures, has compelled me to write something about realistic versus sentimental perspectives on bondholder protections.
The plural of anecdote is not data
Municipal-bond investors are learning that when cash gets tight, promises are made to be broken.
Puerto Rico’s default Monday on bonds sold by its Public Finance Corp. underscored the risks of debt backed only by a legislature’s pledge to repay. Two days later, Chicago’s Metropolitan Pier and Exposition Authority’s rating was cut to near-junk from AAA by Standard & Poor’s because Illinois hasn’t appropriated the money to pay its bonds amid a stalemate over the budget.
Unlike with general obligations or debt that has a claim to specific revenue, buyers have little recourse if politicians walk away from appropriation bonds, a $197 billion niche of the municipal market. Vadnais Heights, Minnesota, and Menasha, Wisconsin, have already done so. In bankrupt San Bernardino, California, investors may recover one cent on the dollar.
“Appropriation debt is scarier than people want to think it is,” said Matt Dalton, chief executive officer of Rye Brook, New York-based Belle Haven Investments, which manages $3 billion of munis. He said his firm tends to avoid the securities.
Legislators “have to come around the table and appropriate each year, and as you can see, if they’re not on sound financial footing, you’re taking a lot of risk,” he said.
So S&P formerly rated Chicago’s Metropolitan Pier and Exposition Authority higher than it rates the United States of America, then noticed that (1) Illinois policymakers sometimes have difficulty agreeing on spending, and (2) the bonds are already in technical default — and the news story there is about the underlying debt structure? Come on, the super-downgrade is Onion material, not Bloomberg material.
First of all, there is not $197 billion of appropriation-supported debt outstanding. To arrive at this figure, one would have to count a lot of debt that does not truly fit into this category. I’d submit to you that some of the examples cited in the article do not count.
Second, even if that were true, defaults by issuers like Vadnais Heights — population 12,302 — and Menasha, Wisconsin — population 15,144 — are not exactly terrifying precedents for the marketplace. Both examples are more cautionary tales on economic development projects than an indictment of appropriation-supported debt in general.
One of the key considerations for investors in Vadnais Heights, which defaulted in 2012, should have been that bond proceeds were being used to finance the construction of a controversial, non-essential project. These factors used to be central to credit analysis, and now no one cites them. Why is that?
Did a city with a population slightly over 12,000 need a giant sports complex with two ice rinks and Minnesota’s second-tallest dome, covering a 100,000 square-foot turf field? (“If you build it, they will come. If you build it, they will come…”) I don’t know about you, but I am not particularly surprised by this default and more than a little reluctant to lump this example in the projects governments typically finance with general fund dollars.
Menasha defaulted on bond anticipation notes that the city issued in 2005 and 2006. Bond anticipation notes are a form of short-term debt that are supposed to be taken out through the later issuance of long-term debt. The primary investors were a Maryland retirement complex, a life insurance company, and a community bank.
These investors ultimately ended up with higher recoveries on their notes than the general obligation bond investors Chappatta cites later in the article. So Menasha is actually a counterexample, not an example, of Chappatta’s argument here.
Menasha’s largest employers are paper mills. In order to help the large corporations that operate these mills cut costs, the city decided to convert its utility from an electric plant to an industrial steam plant, thereby reducing the cost of power. (“If you help us cut costs, we will not downsize employment and your little village will survive.” Probably how discussions went, no?) The project was supposed to cost $12.7 million and be completed within one year, but was plagued by cost overruns. The city ended up borrowing $40 million, including general obligation bonds and the notes. Given the scope of cost overruns and mechanical problems with the facility, the city ended up not issuing bonds to take out the notes and closing the plant.
The story does not end here though. Menasha’s creditors sued the city and the case wound its way through the courts. It was eventually settled for $17.5 million of the $22.8 million owed. This is more (percentage-wise) than the voter-approved, unlimited tax general obligation bondholders in Detroit received in bankruptcy.
Incidentally, the settlement was funded through a sale-leaseback agreement with WPPI Energy and Menasha Utilities, not city tax dollars. Detroit had similar options, but Jones Day decided to turn the city into a fee machine rather than seriously consider them.
I could cherry-pick revenue bond deals that did not end well for investors (excluding hedge funds that specialize in distressed debt) as Chappatta has done with appropriation-supported debt in this article. Remember Jefferson County, Alabama? Or Harrisburg, Pennsylvania? These were not exactly small transactions, either. And yet folks like Mr. Dalton aren’t coming out of the woodwork swearing off revenue bonds forever. Why is that?
I also find it interesting that Chappatta uses San Bernardino considering paying its pension bondholders a penny on the dollar as an example.Stockton similarly wiped out Franklin in its bankruptcy too — a secured creditor.
“Legal protection” doesn’t mean what you think it means
It makes zero sense to make sweeping generalizations about the relative safety of debt based on the specific kind of pledge involved alone. And yet this is how the majority of folks in the municipal bond market think. What Chappatta is suggesting in this article fits the traditional way of looking at risk that old-school municipal bond attorneys frequently lay out in the press. But they are not the ones litigating Chapter 9 cases now, and that is a point that cannot be emphasized enough. There is a new landscape and even general obligation bonds involve very real risks in some distressed situations.
An investor’s first question should be “what kind of legal regime am I operating under here?” The legal and political contexts in which your bonds are issued are what make your rights and remedies relevant. If there is a lesson to be taken from the recent spate of financially challenged municipalities, this is it. General obligation debt is not the same security in different states depending on whether those states authorize Chapter 9, where it is treated as unsecured debt absent a statutory lien (which very few of the states that authorize bankruptcy offer) and may be adjusted.
Chapter 9 cases are now being litigated by corporate restructuring attorneys who have far less sentimental regard for general obligation debt than attorneys who specialize in municipal debt and, it seems from the article, many institutional money managers. The reason recent bankruptcies have been devastating for bondholders is that corporate restructuring attorneys will bulldoze anything and everything, and the law permits this. By the way, many of these attorneys are advising Puerto Rico’s government and Atlantic City.
There is also a big difference here in whether you are talking about debt issued by a state or local government, both with respect to structure and risk. Local governments, as political subdivisions of state governments, are constrained by state law regarding how much debt they can assume and how much and which taxes they may levy. Tax revenue may also feed into the same fund along with funds for operations, pensions, etc. (Chicago is an excellent example of this, in fact.) This can make a tremendous difference in the amount of risk involved.
This is where it gets strange to swear off a class of debt for its own sake, especially given the diversity of appropriation-supported debt. Which would you rather have: (1) Appropriation-supported debt financing an essential government property issued by a community that has broad ability to raise revenues or (2) general obligation bonds issued by a community subject to a tax cap? (1) Appropriation-supported debt in a state that does not authorize Chapter 9, where a potential default can be litigated aggressively in state courts, or (2) general obligation debt in a state that does authorize Chapter 9, where the borrower has access to a convenient legal shield? (1) Appropriation-supported debt issued by a government with no pension problems or (2) general obligation debt in a state where pensions are severely underfunded but have constitutional protections? It’s a big, big universe.
For many state and local governments that issue appropriation-supported debt, there is solid political will to repay the debt, hence the scarce defaults. Debt service may even be legally considered a continuing appropriation and thus insulated from late budget adoption (contra the Illinois example in the article). When budgets are not adopted for some reason or another, there are usually legal determinations about which government expenditures do and do not continue to be paid, and these are not the same thing from government to government. (Except in Illinois, where they aren’t even the same from budget cycle to budget cycle — ha.)
Using an appropriation-supported structure as opposed to a general obligation structure is not generally intended to provide a deliberately weaker security from the government’s standpoint. It can also be a political expedient to circumvent a constitutionally or statutorily required referendum. Many governments have extraordinarily well-established debt programs and legal protections that can be pursued in state courts. These could even include liens on a specific piece of property. That may not be the same thing as getting a court order to levy taxes, but it is not an “empty political promise” either. It is a remedy with quantifiable economic value.
How does one know these things exist? Well, relevant state law is usually summarized in offering documents.
Finally, not to point out the obvious, having debt issued under other structures/resolutions is its own incentive to appropriate funds for most borrowers. A good example of this is Rhode Island deciding to stand behindits embarrassing offer of support for the 38 Studios project.
Back to Chappatta’s article:
Detroit’s $18 billion bankruptcy illustrated the differing legal protections for investors. Buyers of its certificates of participation, which had neither the city’s taxing power nor specific revenue streams behind them, recouped 12 cents on the dollar, according to a report this week from Moody’s Investors Service. Holders of its general obligations got six times more.
Chappatta is only citing the unlimited tax general obligation bondholders, who recouped 74 cents on the dollar — and I guarantee you they felt completely and utterly screwed, not delighted, about it. The limited tax general obligation bondholders — who, last time I checked, were still general obligation bondholders — recouped only 34 cents on the dollar. Most municipal bondholders would be horrified by these recoveries.
Syncora, the insurer on the city’s pension certificates, also settled for physical assets in the city that may appreciate over time. Syncora is no stranger to project finance (Syncora acquired the operator of the Detroit-Windsor tunnel from bankruptcy), and made a somewhat clever play here in picking up assets related to those the insurer already held.
Importantly, these recoveries are the products of negotiated settlements between the bondholders and the city, which are both arbitrary and path dependent. Negotiated settlements do not say anything about legal protections. A legal precedent regarding the status of the bonds could only be created through a ruling that is upheld by an appellate court. Even then, it would be difficult for it to translate state-to-state.
Detroit’s bondholders were perversely subordinated to the city’s swap counterparties (!), which were treated as secured debt only because doing so was useful to Jones Day to have a cram down option in negotiating with bondholders and pension beneficiaries. The city could have chosen to challenge the swap counterparties’ status, seeing as how using casino revenues to secure interest rate swaps was not exactly a permissible use of casino revenues under state law. Then bondholders’ recoveries theoretically could have been higher. Such were their legal protections.
Bondholders were also practically subordinated to pension benefits, which were treated as another form of unsecured debt but arbitrarily had much higher recoveries. Such were their legal protections.
Had any of the parties settled earlier than the others, they could have received a higher amount. Had the grand bargain not have been involved, they could have received a higher amount. Had the judge not been a populist that often sided with pension beneficiaries, bondholders could have received a higher amount. The city could and often did play all groups of bondholders off of each other in the negotiation process. Theoretically, all bondholders could have been wiped out and stakeholders could still be fighting.
The bonds were the first to take the hit in Puerto Rico, where the government is reeling from $72 billion of obligations. Faced with a growing cash crunch, the legislature didn’t provide funds to cover bonds the commonwealth’s Finance Corp. sold to help keep the government afloat. When $58 million of interest and principal was due Monday, it paid just $628,000.
Let’s be intellectually honest here— Puerto Rico is already not making payments on its general obligation bonds by suspending the set-aside payments that it should be making.
The set-asides were the reason Puerto Rico’s $378 million July 1st general obligation payment was made as scheduled even though the territory was in the middle of a liquidity crisis — the trustee already had the funds on hand to make the payment.
From Puerto Rico’s perspective, resources due under both financial commitments have been diverted to operate and bondholder claims have been politically subordinated to services.
Until early July a 1976 law required Puerto Rico’s government to equally set aside its interest and principal general obligation debt service on a monthly basis. The 1976 law required the Puerto Rico to set aside each month one sixth of all interest coming due in the coming six months. It also required the commonwealth to set aside monthly one twelfth of all principal coming due in the coming 12 months. The funds were set aside in a redemption fund.
In early July Gov. Alejandro García Padilla signed a measure annulling the 1976 law.
On Monday Puerto Rico posted a statement on the Electronic Municipal Market Access site that said it had “temporarily suspended” the set asides.
When the idea of stopping the set asides surfaced in June, Puerto Rico Representative Rafael Hernández Montañez told The Bond Buyer that Puerto Rico would make its GO payments. Hernández Montañez is the president of the Puerto Rico House of Representatives Treasury and Budget Committee and a member of the Popular Democratic Party with García Padilla.
Since then, Puerto Rican officials have not been as definitive that Jan. 1's $375 million GO payment will be made. After the governor signed the measure allowing the set asides to be suspended, his office sent out a press statement saying that, “the suspension of these deposits does not imply a breach with the bondholders on the date of payment.”
In mid-July Puerto Rico Director of the Office of Management and Budget Luis Cruz Batista told the El Vocero news site that the GO payment was not assured. Earlier this week, Melba Acosta Febo, the president of the Government Development Bank for Puerto Rico told El Vocero that she couldn’t guarantee the GO payment but that the government was working to improve the central government’s liquidity so it could make the payment.
“We recognize the GO’s priority over other debts and its difference from other debts, but we must also recognize that there is a duty of the state to maintain health services, education services, and some security to our people — we must look at those things,” El Vocero quoted her saying. “So it is a part of a negotiating process, in which both parties are agreeing to modify certain terms and in which conditions of some payments are very difficult.”
Puerto Rico’s general obligation bonds do have strong legal protections that range from constitutional provisions to clawing back revenues from other public entities. The wild card for Puerto Rico is the question I said bondholders need to start with, which is “what kind of legal regime am I operating under here?”
Section 8 of Article VI of the Constitution provides that the public debt of the Commonwealth will constitute a first claim on the public resources. A constitutional protection is obviously a very strong legal protection, but it remains unclear what a court would do if general obligation bond payments came into conflict with basic government services or how other constitutional provisions might be interpreted if the Commonwealth used them strategically. This could work out poorly for investors in the event of default (depending upon where they jumped in, of course) or it could work out very well.
So what happens in the event of non-payment? Well, it depends on when the bonds were issued.
Puerto Rico has some general obligation bonds (dated March 17, 2014) that are governed by New York State law. In the event of nonpayment, bondholders can sue the Commonwealth to enforce the provisions of the bonds in New York courts or US federal courts sitting in the borough of Manhattan; the City of New York, New York; Commonwealth courts; or US federal courts sitting in San Juan, Puerto Rico. Puerto Rico has also waived sovereign immunity for these bonds. Of course, the fact that bondholders have the flexibility to decide which court to bring suit in doesn’t mean the court is required to hear the suit. Fun, right?
Holders of Puerto Rico’s other general obligation debt would have to bring suit in San Juan. These bonds could potentially be subject to sovereign immunity, which restricts the scope of legal actions and monetary damages involved. Puerto Rico’s general obligation bonds are not subject to acceleration, a remedy found in other forms of debt.
The lack of a clear legal regime is further complicated by the fact that Puerto Rico owes money to a lot stakeholders, who will all be asserting their rights in a web of suits against the government and each other across jurisdictions. This is not a place devoid of investment opportunity, but to believe there is a clear hierarchy among all of these stakeholders in terms of potential recoveries is naive.
Political risk works both for and against bondholders. In situations like 38 Studios, there was intense political pressure to make good on a promise to appropriate funds for debt used to finance a bad project just to maintain the state’s good credit — even though those funds could have been directed toward more responsible priorities from taxpayers’ perspective.
Where negative political risk exists, it can be divided into soft and hard risks. Soft risks are usually one-off events, and I daresay disproportionately tied to economic development. You have a government where officials long gone endorsed a project that didn’t perform and now current officials do not want to support it. These risks are actually pretty easy to predict. If a government has to finance a project that should be producing revenue on its own, it is probably a bad deal. You’re welcome.
Hard political risks are not one-off events. They are the slow-moving train wrecks — these are the situations like Puerto Rico, Detroit, San Bernardino — where the tone toward bondholders becomes increasingly adversarial and recoveries are inevitably low. The old guard way of handling these cases is to insist on the sanctity of contracts until an exhausted judge threatens to toss the case out. There are probably better ways of dealing with these situations, like resolving issues faster and being more creative about what you are willing to accept from the beginning.
