Back in 2013, markets tumbled (if briefly) on the news that Detroit would file for bankruptcy, at the time the biggest municipal bankruptcy in US history with over $18 billion in liabilities. Yesterday, algos barely even bothered to look up when Puerto Rico's governor announced that the US Commonwealth would submit Title III (aka bankruptcy) protection, despite a debt load of more than $70 billion, or nearly four times greater than Detroit's.
So does that mean that there are no losers or casualties (metaphorically speaking for now) from the bankruptcy filing? The answer is that in addition to the citizens of Puerto Rico of course, more than half of whom live in poverty and who are about to be crushed by even more austere financial conditions (that said, nobody ever complained when Puerto Rico was raking in the billions in debt), the biggest losers are a handful of hedge and mutual funds, all of whom were attracted by the island's high yields forgetting that yields were high in the first place for a reason.
Here's a list, courtesy of the WSJ:
- At the top of the pile are plain vanilla mutual funds, which held about $14 billion of Puerto Rico’s outstanding bonds as of March, according to Morningstar Inc. Two fund families, OppenheimerFunds and Franklin Templeton Investments, held most of the debt. About 7% of Franklin’s debt was insured as of mid-March, the WSJ calculates, which also means that 93% was not and will suffer impairments.
- General Obligation bondholders include: Aurelius Capital Management, Autonomy Capital and Monarch Alternative Capital LP,
- Sales tax revenue-backed (Cofinas) bondholders: Scoggin Capital Management, GoldenTree Asset Management, Merced Capital, Tilden Park and Whitebox Advisors have held Cofinas.
- Bonds insurers: roughly $12 billion of the island’s $70 billion in outstanding debt is insured. It will be up to the bond insurers to fill the gap when interest and maturity payments are missed. Insurers backed a wide swath of bonds from Puerto Rico, complicating the island’s ability to prioritize payments. Among the companies with the biggest exposure to Puerto Rico debt include Ambac Financial Group, National Public Finance Guarantee Corporation, Assured Guaranty Ltd. and Financial Guaranty Insurance Company
Some creditors put a positive spin on yesterday's events: one senior bondholder on Wednesday said Puerto Rico’s placement into bankruptcy protection was a positive development because it stayed litigation by competing groups of bondholders and was likely to clear the way toward a settlement.
Unfortunately, optimism may be premature: if Puerto Rico’s record bankruptcy follows the template of other municipal restructurings, general obligation bondholders may be in for a long ride, despite constitutional guarantees on their debt.
As Reuters points out, the island's constitution guarantees the debt of GO, or General Obligation, bondholders, while other debt, known as COFINA, is backed by revenue streams from tax proceeds. But in past bankruptcies, that has not meant much.
In five of six recent public bankruptcies in which the debtor defaulted on bonds, pensioners walked away with full recovery, while bondholders took haircuts, according to data from Moody’s Investors Service. Some case studies:
- In Harrisburg, Pennsylvania, bondholders took a 25 cents on the dollar haircut
- In Stockton, California, the haircut was 50 percent.
- In Detroit, where pensioners suffered losses of about 18 percent, bondholders were slapped with a 75% haircur, taking home just 25 cents on the dollar
“If the market hasn’t taken this dynamic into account by now, you can imagine they will after Puerto Rico, given its enormous scale,” said bankruptcy expert Drew Dawson, a professor at the University of Miami School of Law.
When calculating recoveries there is another potential quirk .
Among Puerto Rico creditors, GO and COFINA debt are viewed as the two safest bets for decent recoveries. In theory, GO holders seemed to have an advantage out of court, where constitutional debt is seen as sacrosanct. Puerto Rico offered a restructuring that favored GO bonds over COFINAs.
But the opposite may be true in bankruptcy court, which prioritizes debt backed by a revenue stream, like COFINA, ahead of unsecured debt. “Bankruptcy totally changes the priority for those two bonds,” said George Schultze, hedge fund manager and head of Schultze Asset Management, which does not hold Puerto Rican debt.
Moody rates PR's GO and COFINA debt on equal footing, forecasting recoveries for both between 65 and 80 cents on the dollar, ahead of debt from Puerto Rican agencies like the Government Development Bank, which it sees as recovering less than 35 cents. “There is no precedent to really resolve which one is the stronger between GO and COFINA,” said Tim Blake, a managing director at Moody’s, noting that Title III was uniquely created under last year’s Puerto Rico rescue law, PROMESA.
Dawson said it is a tough call, but negotiating leverage “seems to have shifted, in the context of bankruptcy, to favor COFINA.”
Furthermore, contrasting statements by lawyers for the two creditor groups give a sense of each side’s confidence in the bankruptcy process.
Susheel Kirpalani, a lawyer for a COFINA investor group, on Wednesday called the filing “sound public policy.” All along, COFINA holders have favored the bankruptcy route.
But Andrew Rosenberg, a lawyer for a GO bond group, said “the economy of Puerto Rico will be put on hold for years” in a bankruptcy.
GO creditors could appeal to the court claiming that the the Title III bankruptcy was filed without meeting are requirements, although that route is unlikely to yield results.
Reuters also notes another key issue that remains in limbo for debt holders is what the island defines as an "essential service." Under Puerto Rico's constitution, it cannot cut repayments to GO creditors except to maintain essential services.
All told, “this will be a field day for litigation, including over who has priority and whether the bankruptcy is even authorized,” said Schultze. “It could even go to the Supreme Court.”
Meanwhile, muni creditor of other distressed territories may be starting to sweat. Just this week, the Pennsylvania Department of Revenue said that April’s tax collections came in $537 million below expectations, or 13.5% below expectations. That means the state’s overall shortfall 10 months through the fiscal year is more than $1 billion. Could Harrisburg, or Philadelphia, be next?
And could Meredith Whitney's forecast of mass municipal defaults - now nearly 7 years old - finally start to materialize?