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Dealing in Bad Faith

Monday February 8th, 2016   •   Posted by Craig Eyermann at 6:00am PST   •  

Watching U.S. territory Puerto Rico’s debt crisis is a lot like watching a train derail from its tracks in slow motion. Except with one important difference—it’s a train wreck where the locomotive operators’ best idea for dealing with it involves making it worse by setting the crashing train on fire.

With that image in mind, here is the latest update to the story of Puerto Rico’s growing default on its government’s debt from Reuters:

Puerto Rico asked its creditors to take a huge “haircut” that would slash its total outstanding debt by about $23 billion in an opening salvo to resolve a crippling debt crisis, but creditors reacted with frustration, calling the offer “not credible,” “not serious” and a “trial balloon.”

With $70 billion in debt, a 45 percent poverty rate and a steady exodus of its population to the mainland, the U.S. territory is trying to crawl out of an economic swamp before substantial debt payments come due in May and July. Puerto Rico has already defaulted on some debt and is trying to persuade its creditors to take concessions.

“We do not view this proposal as a serious effort,” said Nader Tavakoli, president and chief executive officer of bond insurer Ambac, which insured $2.2 billion net par, or original face value, of bonds as of the end of November. Ambac recently sued Puerto Rico over a debt default.

Why don’t the people who lent money to Puerto Rico’s government and public entities believe the government’s offer to have them be forced to take a 46% loss on the money they loaned to the U.S. territory is serious?

It is because the $26.5 billion haircut they are being asked to accept on a base bond would be paired with an empty promise that they can make up $22.7 of that $26.5 billion gap by sharing in the U.S. commonwealth’s potential future economic growth through additional bonds linked to the territory’s GDP.

Reuters quotes Height Securities’ analyst Daniel Hanson on what that means:

Height Securities analyst Daniel Hanson said there was no mechanism to ensure the commonwealth upholds its end of the deal and that growth is pursued along the lines envisioned, noting that these bonds were likely “not worth the paper they’d be printed on.”

While in theory investors could recover par on their bonds “if the plan works out under the rosiest of assumptions,” in practice the payouts from the growth bonds would be extraordinarily low, he said.

Hanson compared the plan to Ukraine’s 2015 debt restructuring, which used growth warrants, “now widely acknowledged to be a pipe dream.”

Greece’s government attempted a similar strategy that was ultimately rejected by its creditors during its third default crisis in 2015. To our knowledge, the only place it has worked, to a limited extent, is Argentina following its fiscal crises in the 2000s.

However they reason why it worked there can be chalked up to unique circumstances. Bloomberg describes the unique factor that applied in the South American nation and why similar limited success is not likely to be repeated in Puerto Rico.

While it worked in Argentina because the commodities boom helped the nation quickly recover from its fiscal crisis, Puerto Rico faces a very different set of circumstances. Not only has the economy contracted in the past decade, its prospects remain bleak. That’s raising questions about whether the offer is credible enough to win over bondholders as they kick off negotiations over how to restructure its debt.

“It’s hard to see any meaningful economic growth coming out of Puerto Rico in the foreseeable future,” said Matt Fabian, a partner at Municipal Market Analytics, a research firm based in Concord, Massachusetts. “Those securities would essentially have no value. The most likely outcome is that they never receive a payment.”

Would you ever put your own money at risk given those extremely long odds of ever getting 46% of your money back?

At the very least, it explains why Puerto Rico’s offer to settle its debt liabilities is not considered to be serious and really represents bad faith bargaining. Since the territory is now limping toward its next scheduled debt default event, the lack of good faith bargaining on the part of the commonwealth’s political leaders is not only not helping their situation, it is making it worse because it is damaging what remains of the Puerto Rican territorial government’s credibility.

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February 2016