Vulture investors have descended on the commonwealth, taking advantage of a debt crisis that has impoverished citizens and created massive unemployment.
by David Dayen
The American Prospect (Winter 2016)
“This is a distress call from a ship of 3.5 million American citizens that have been lost at sea,” Puerto Rico Governor Alejandro García Padilla said on December 1, begging the Senate Judiciary Committee to help protect his homeland from an unspooling disaster. After issuing bonds for over a decade on everything not nailed down, Puerto Rico now carries $73 billion in debt, a sum that García Padilla had termed “not payable” in June. Successive governments have enacted punishing austerity measures to service the debt, despite a stubbornly depressed economy and poverty rates near 50 percent. Now, after defaulting on smaller loans, it’s likely that much of the $957 million due January 1 will go unpaid, bringing more chaos and suffering at the hands of Puerto Rico’s creditors.
In many ways, the Puerto Rico situation is sui generis, resulting from a patchwork of laws and obligations on an entity that is not really a country and not really a U.S. state. But looked at another way, Puerto Rico is just the latest battlefield for a phalanx of hedge funds called “vultures,” which pick at the withered sinews of troubled governments. In Greece, Argentina, Detroit, and now Puerto Rico, vultures have bought distressed debt on the cheap, and then used coercion, threats, and legal action to secure a massive windfall, compounding the effects on millions of citizens.
The legal wrangling masks an irony: As creditors demand that Puerto Rico pay back everything it owes, hedge fund managers have used the island as a tax haven to avoid their own responsibilities. Wealthy investors don’t just want to make money in Puerto Rico; they want to use their leverage to effectively buy an island playground.
PUERTO RICO HAS LABORED under colonial rule since Christopher Columbus arrived in 1493 and claimed it for Spain. After the Spanish-American War in 1898, the United States acquired Puerto Rico in the Treaty of Paris, and ruled it as a territory. Since then, Puerto Ricans are considered natural-born citizens, but must abide by U.S. laws without a voting member in Congress.
For decades, the island was a jewel of the Caribbean, with the highest per capita income in Latin America. But in his December 1 testimony, García Padilla pinpointed the beginning of Puerto Rico’s troubles: 1996, when a Republican Congress and the Clinton administration agreed to a ten-year phase-out of Section 936, a tax exemption for U.S. manufacturing on the island. Clinton supported it as a deficit reduction measure, promising it would save the federal Treasury $10.5 billion over ten years. But Congress did not replace Section 936 with an economic development plan for Puerto Rico to offset the impact.
Nelson Torres-Ríos, an attorney and professor at the City University of New York’s Hostos Community College, believes that letting Section 936 go was a political gambit. Puerto Rico’s political parties are aligned with options for future status, with pro-commonwealth and pro-statehood parties being the dominant factions. In the 1990s, the pro-statehood party then in power thought shedding Section 936 would eliminate the economic viability of the commonwealth arrangement and increase support for their position.
“In actuality, the opposite happened,” says Torres-Ríos. Washington had no interest in taking on a 51st state, especially one in economic crisis. In an era of massive off-shoring to destinations with even cheaper labor, Section 936 expiration led to recession, as manufacturers fled Puerto Rico, leaving few job-creating industries behind. According to World Bank data, after Section 936 was established in 1976, Puerto Rico enjoyed 28 out of 29 years of economic growth. Since 2005, as the tax credit faded away, the island has experienced negative growth eight out of ten years, with its gross national product falling 10 percent.
The recession, combined with the broader economic downturn (Puerto Rico, like warm-weather U.S. states, experienced a housing bubble and collapse), exposed structural problems derived from the island’s unique status. Though Puerto Ricans pay the same payroll taxes as mainland workers, the island receives sharply lower reimbursement rates for Medicare and Medicaid. Its poorest citizens are ineligible for the Earned Income Tax Credit. A monopolized power company derives nearly all its electricity from diesel oil, despite trade winds and sun being the most plentiful resources on the island. With few exploitable natural resources, Puerto Rico has to import oil (giving itsome of the highest electricity rates in the United States and loads of unpaid bills) and most of its goods. And a 1920 law called the Jones Act restricts cargo carriage between two U.S. ports with a foreign-flagged ship. This means that foreign ships carrying U.S.-bound goods must stop at a U.S. port, transfer goods headed to Puerto Rico to a separate U.S. ship, and send them along. These shipping costs result in an exorbitant cost of living. The Virgin Islands, a U.S. territory near Puerto Rico, have an exemption from the Jones Act; Puerto Rico doesn’t.
As unemployment soared and the economy crashed, Puerto Rico papered over problems by issuing debt. Wall Street asset managers and investors egged them on, because Puerto Rican municipal bonds are free from federal, state, and local taxes. Usually Americans must reside in the state whose bonds they purchase to get “triple tax-exempt” status. But anyone from Arizona to Maine can buy triple tax-exempt Puerto Rican bonds.
Wall Street also covets the bonds because of a1984 Congressional amendment denying Puerto Rico’s municipalities access to Chapter 9 bankruptcy protection. Plus, under the territorial constitution, general obligation debt gets a senior position above virtually all other items in the budget. So investors receive all the upside benefit of tax-free bonds with little downside risk-except, of course, the risk of default.
The commonwealth’s government created 18 different vehicles to issue Puerto Rican debt. They linked bonds to nearly every available revenue source, from the Highway and Transportation Authority to the Electric Power Authority (PREPA) to the Aqueducts and Sewer Authority to a government-owned corporation called COFINA, which links bonds to sales-tax receipts. “They [the government] haven’t come up with any solutions besides issuing more debt for the past 15 years,” says Carla Minet, a reporter with the Center for Investigative Journalism in Puerto Rico.
Public debt increased every year since 2000, according to a government report from former World Bank chief economist Anne Krueger. Debt levelsexpanded from $25 billion in 2000 to $73 billion today, totaling more than 100 percent of the island’s gross national product. One-third of all Puerto Rican revenue now goes to debt service.
To pay back the debt, Puerto Rico has delayed tax refunds and payments to suppliers, cut back on health care and public transportation services, fired 30,000 public-sector workers, closed 100 schools, increased the sales taxby more than 50 percent, and even forced community credit unions to take IOUs in exchange for cash. The poverty rate on the island is around 45 percent, and only 40 percent of the labor force has a job. Trapped in an economic death spiral, the tax base has eroded, amid massive out-migrationto the U.S.: Puerto Rico has lost 300,000 citizens since 2006. “In Puerto Rico today, the hardest thing to find is a suitcase,” says Eric LeCompte of the faith organization Jubilee USA. “They can’t keep them on the shelves.”
PUERTO RICO’S CREDITORS initially consisted of traditional municipal bond investors; mutual fund managers like Oppenheimer and Franklin Templeton remain major bondholders (one Franklin Templeton fund is actually called the “Opportunistic Distressed Fund“). But starting in December 2012, credit rating agencies began to downgrade Puerto Rican debt, leading to a fire sale, with many investors heading for the exits. For the last year, Puerto Rico has been locked out of international credit markets. Benchmark bonds currently trade as low as 30 cents on the dollar, with interest rates up to 11 percent.
This was when “vulture” hedge funds like Fir Tree Partners and Appaloosa Management and Och-Ziff made their move. “They started to buy debt on the secondary market at 30, 40, 50 cents on the dollar, and tried to get a complete dollar [repayment] plus interest,” says Manuel Natal, an at-large member of the Puerto Rican House of Representatives. “They see Puerto Rico as an opportunity for huge earnings, just like in Greece.” Poor performance by other recent hedge fund plays makes them even more desperate for a payday from Puerto Rico.
Hedge funds also became the sole investors willing to lend to the commonwealth, making up nearly all the participants in the 2014 sale of $3.5 billion in low-rated, 8.7 percent general obligation bonds, the biggest U.S. municipal junk bond sale in history. Hedge funds were prepared to lend even more to Puerto Rico in the summer of 2015, until the governor warned about inability to pay. But vulture funds DoubleLine Capital and Avenue Capital were still buying up discounted debt as recently as November. Jeffrey Gundlach of DoubleLine recently called Puerto Rican debt his “best idea” for investors.
The situation is similar to vulture investors who bought Argentina’s discounted debt and tried to force repayment. Argentina refused, despite a U.S. court order, creating a stalemate. But a newly elected conservative government in Argentina will likely renegotiate a debt deal, giving the vultures their windfall of close to full valuation of debt bought for pennies on the dollar.
Unlike Argentina, Puerto Rico has scant opportunity to avoid its creditors. Because of the constitutional guarantee on general obligation bonds, vulture funds could secure a claim on Puerto Rican revenues. The commonwealth must follow orders from the U.S. judiciary, where vulture funds could appeal to recoup their money. Puerto Rico’s municipalities and public corporations cannot access Chapter 9 bankruptcy, and they have no alternative lender available to sovereign nations, like the International Monetary Fund. Talk of a federal bailout elicits laughter in Washington. And an out-of-court settlementwould require wide participation from creditors; even if vulture funds control a fraction of the debt, they can hold out for better terms and upend negotiations. Marc Lasry of Avenue Capitalrecently said about Puerto Rican debt, “It’s hard to get hurt now.”
It’s nearly impossible to get good information about the magnitude of this scheme; hedge funds don’t have to report their bond purchases to the Securities and Exchange Commission, whether bought directly from the issuer or traded on the secondary market. In August 2014, the Fitch ratings agency claimed hedge funds owned 24 percent of the debt; a June article in Fortuneput the number closer to 50 percent. “This is a $3 trillion industry that operates largely in the shadows,” says Democratic Representative Nydia Velázquez of New York, who has introduced legislation to bring more transparency to hedge fund operations.
Even as hedge funds became a fixture on the island, meeting with lawmakers and suggesting policies to free up funds for debt repayment, their names remained secret. “We started doing interviews with public officials and legislators,” says journalist Carla Minet, whose Center for Investigative Journalism devoted several months to identifying the hedge funds. “They said, ‘We have been meeting with them, we had them in our offices.’ But when you ask who they were, they say they couldn’t recall their names.”
Minet and her colleagues discovered that the Puerto Rican government contracted a private company called BondCom to identify debt holders, but the government refused to give up the information. The Center for Investigative Journalism sued the government in July to release the names; the case is under appeal. In the meantime, between press reports, off-the-record conversations, and an inadvertently released document that named all PREPA (the electric power utility) bondholders, the center verified 36 firmswith some share of Puerto Rican debt. Since then, additional media reports
uncovered eight others involved in Puerto Rico, for a total of 44 known firms.
Incredibly, 22 of the center’s 36 named hedge funds had additional holdingsin other distressed countries and cities, like Argentina, Greece, and Detroit. Three hedge funds-Aurelius Capital Management, Monarch Alternative Capital, and Canyon Capital-bought debt in all four cases. So lending to Puerto Rico is no accident; it’s an investment strategy. Michael Novogratz, formerly of Fortress Investment Group, active in Puerto Rico, Greece, and Argentina, calls the countries they invest in “so bad, they’re good.”
Several informal creditor groups have formed, based on the debt they hold. The Ad Hoc Group of reportedly 34 hedge funds owns about $4.5 billion, mostly in constitutionally guaranteed general obligation bonds. The PREPA Group has holdings in the Electric Power Authority. There are also groups for the Government Development Bank and bondholders in COFINA. Three vulture funds have acquired almost all of the debt of the Aqueduct and Sewer Authority, believing that high water costs on the island assure profits.
In public, the hedge funds claim that Puerto Rico’s problems are manageable as long as they repay the debt. “It’s a willingness to pay problem, not an inability to pay problem,” Knighthead Capital Management co-founder Tom Wagner recently told Bloomberg. In fact, Puerto Rico could pay only by destroying what’s left of its economy.
Behind the scenes, creditors have prepared for war. They have hired high-powered law firms, like Davis Polk, Quinn Emanuel, Venable, Gibson Dunn, and Robbins Russell, which won the Supreme Court case on Argentina’s debt. This signaled that the vultures would sue to compel repayment, using favorable debt terms to their advantage.
The PREPA Group successfully overturned a Puerto Rican law that would have allowed public corporations to restructure their debt. BlueMountain Capital Management, active in the Ad Hoc and PREPA Groups, filed the suit; they hired Ted Olson of Bush v. Gore fame to argue the case. BlueMountain and other firms, including Marathon Asset Management and Angelo, Gordon & Co., have also lobbied to stop Congress from allowing Puerto Rican municipalities to access Chapter 9 bankruptcy to restructure a portion of their debt.
Ad Hoc Group leaders include Aurelius Capital Management, one of the largest holders of general obligation bonds. Founder Mark Brodsky has been nicknamed “The Terminator,” because he just keeps coming after distressed debt. Brodsky was one of the biggest holdouts in Argentina negotiations, and made a side deal with Ukraine that paid back his bonds at 100 percent. With skills honed by working with noted vulture fund manager Paul Singer, Brodsky is known for his unyielding approach, refusing to compromise or even negotiate.
The vultures have deep political ties, amplifying their voice in Washington. Most hedge fund managers are major donors to both parties. Former Obama Treasury official Lee Sachs runs an asset management firm funded by BlueMountain; one of their lobbyists is Republican ex-Representative Connie Mack. Obama/Clinton economist Larry Summers used to work for D.E. Shaw, a member of PREPA Group and Ad Hoc Group. Chelsea Clintonworked previously at Avenue Capital, which recently walked away from negotiations. Chris Christie’s wife worked for Angelo, Gordon & Co. Centerbridge Partners owner Mark Gallogly sat on President Obama’s Economic Recovery Advisory Board. Summers, now away from D.E. Shaw, ominously referenced the hidden power of the hedge funds in The Washington Post, arguing that the Puerto Rican case represents “an important test of whether Washington is, as some allege, controlled by financial interests.”
PUERTO RICO HAS ALREADY defaulted once,missing a $58 million payment on Public Finance Corporation bonds in August. A more consequential $354 million payment on December 1 included constitutionally guaranteed Government Development Bank bonds. Puerto Rico made the payment, but only after anexecutive order redirected money earmarked for$7 billion in non-guaranteed public corporation bonds, including those for highway, general infrastructure, and the convention center. The January 1 payment will almost certainly not be paid in full. “In simple terms we have begun to default on our debt,” García Padilla told the Senate Judiciary Committee on December 1.
Several options exist to resolve the Puerto Rican crisis. Clearly, a bankruptcy write-down of un-payable debt-the remedy available to distressed corporations via the more familiar Chapter 11-is the sensible solution for Puerto Rico. That way, the pain would be spread around, bondholders would take some losses, and the island could begin economic recovery. But this is the one solution vulture hedge funds have united against.
The White House roadmap for Puerto Rico identifies multiple congressional actions, including giving municipalities and public corporations Chapter 9 bankruptcy authority, extending the Earned Income Tax Credit to Puerto Rican citizens, equalizing Medicaid and Medicare treatment, and instituting strong fiscal oversight. But while Democrats support the changes,congressional Republicans have been unmoved. They have mostly stressed the need for budget transparency in Puerto Rico as a prerequisite to action, in contrast to the complete lack of transparency on the part of the creditors. “In Congress, we’re hearing more posturing than solutions,” says Eric LeCompte of Jubilee USA.
Despite the White House’s focus on Congress, many believe they could use executive action or Treasury Department intervention to compel negotiations. Senator Elizabeth Warren raised this in an October hearing, relating the situation to the 2008 federal bank bailout: “I urge Treasury to be just as creative in coming up with solutions for Puerto Rico as it was when the big banks called for help.” In a December 9 speech at the Peterson Institute, Antonio Weiss, a counselor to the Treasury Department who is coordinating federal efforts on Puerto Rico, said the administration has convened an inter-agency council to develop solution, but that “resolving Puerto Rico’s crisis requires congressional action.” With each branch of government insisting that the other help Puerto Rico, the likely outcome is no help at all.
Many activists believe the Federal Reserve could extend emergency financing to Puerto Rico. Mindful of this, hedge funds have strengthened ties with former Federal Reserve officials. Ex-Fed Governors Jeremy Stein and Donald Kohn are advising BlueMountain Capital and its investment Alliance Partners, respectively. Former chair Alan Greenspan advises hedge fund manager John Paulson. The Advisory Committee of the Federal Reserve Bank of New York includes managers of five funds with bond holdings in Puerto Rico.
Puerto Rico did catch a break on December 4, when the Supreme Court agreed to hear a case that could allow the commonwealth to restructure some debts. The Puerto Rican government adopted a bankruptcy law for its public corporations in 2014, but bondholders sued, arguing that federal restrictions on Chapter 9 pre-empted the territorial statute. Lower courts agreed, but the Supreme Court will take the appeal. Conservatives who control the Court must choose between competing ideological imperatives: support for federalism and a weak central government, or support for creditors over debtors. Justice Samuel Alito recused himself from the case, because he owns tax-free municipal bond funds from Puerto Rico creditor Franklin Templeton.
Without a federal response, the only option is direct voluntary negotiations between Puerto Rico and its creditors. While the Supreme Court threat of debt restructuring could push bondholders to the bargaining table, so far talks have been scattered and unproductive. After a year of negotiations, PREPAannounced a debt exchange on $5.7 billion in bonds in November, with creditors taking a 15 percent “haircut” (capital loss) in the largest municipal bond restructuring ever. But this has not been consummated because bond insurers are still deciding whether to insure the new bonds, allowing them to achieve the required investment-grade rating. A similar debt exchange offerto consolidate general obligation, COFINA, and Government Development Bank debt into a new “superbond” yielded some positive responses from hedge funds. But COFINA bondholders, secured by sales-tax revenues, warned that any deal involving their funds would violate creditor rights.
The difficult discussions reflect divergent creditor incentives. Mutual funds like Franklin Templeton and Oppenheimer, who together own $10.8 billion in Puerto Rican debt, bought the bonds at 100 percent and want to limit any losses, whereas vulture funds with discounted debt have more wiggle room to extract profits. Bond insurers like Assured Guaranty, National Public Finance, and Ambac cannot afford payouts on a broad-based default; when Governor García Padilla called the debt “not payable” in June, bond-insurer stocks sunk. And hedge funds have different strategies. Some want to force a haircut on less-senior public corporation debt, to free up money to pay general obligation bonds. Others with larger holdings in public corporations fight any changes, even attempting to secure side deals as a condition for allowing restructuring to advance. “Everyone’s out for themselves. … They don’t really care who they take advantage of as long as they make a profit,” says Eric LeCompte. This, of course, is why bankruptcy was invented, to reconcile divergent interests in a general settlement.
The hedge funds’ main plan for a resolution appears to be sticking it to the island’s citizens. In July, they hired former IMF official Claudio Loser to