Puerto Rico's Debt Crisis

Puerto Rico Clearinghouse's Cate Long, former Lieutenant Governor of New York State Richard Ravitch, and CFR's Brad W. Setser join the Wall Street Journal's Aaron Kuriloff to discuss the factors that led to Puerto Rico’s crisis, the options for restructuring its more than $70 billion debt, and solutions for helping fix the island’s economy. The panel additionally considers the origins of the debt crisis and outlines scenarios for the island's future.

KURILOFF: All right. Welcome, everybody, to this discussion on what’s happening in the Puerto Rican debt crisis.

I’m Aaron Kuriloff. I’m a reporter at The Wall Street Journal, where I’ve been covering this for going on three years now. I’d like to introduce the other panelists. This is Cate Long. She’s the principal of the Puerto Rico Clearinghouse, which is a research service for bondholders. To her left is Richard Ravitch, you know, who has had many hats in this city an elsewhere—former lieutenant governor and MTA chair, I mean, I shan’t guild the lily there. And then we have Brad on the far left, who is a member of this august body and a former Treasury Department official who has experience in sovereign debt and other related areas.

I think you’ll find the discussion spirited. I know the pre-discussion was. And without further ado, I will open it up to the panelists and just say: Broadly speaking, what’s happening in Puerto Rico right now? And I’m just going to pass it to Cate and we can go on down the line.

LONG: So Puerto Rico governor declared on June 29^th of 2015 that the debt was unpayable. And since that time, they have paid $4.5 billion of debt service. They’re looking at a May 1 payment for the Government Development Bank of about $400 million. The Government Development Bank is insolvent. And in July 1, they have a $600 million, or slightly higher, general obligation debt service payment. So Congress is working madly to—or, working somewhat hard to—(laughter)—create some legislation to give them some tools to address this.

KURILOFF: Dick, is that your read on what’s happening?

RAVITCH: Yeah, I would amend it, to put it in a little more context. What Puerto Rico has been doing for some time is not unique. It’s what Illinois, Chicago, New Jersey, what New York City did in the early ’70s, no distinction. They borrowed vast sums of money in a market that was either willing to lend without regard to the use, without regard to anything other than the rating agencies. And they borrowed billions of dollars in order to cover operating deficits. The previous gubernatorial administration borrowed $17 billion. And that former governor is now lobbying vigorously on behalf of the payment of all this debt, but borrowed 17 billion (dollars), most of which was used to cover operating deficits.

So I have no—I have nothing but the same rectitude that others have about these practices. But there are 3 ½ million U.S. citizens there. And the question is, what’s going to happen to them? What’s going to happen to all the obligations, not only the debt obligations but the obligations to pay pension benefits and the obligations to maintain a level of stability in the island so that there’s a chance of re-growing the economy.

KURILOFF: Brad, do you agree with that? And how did we get to this point?

SETSER: So, Puerto Rico is now, roughly speaking, in the tenthyear of a recession. That recession started in 2005, 2006. It is commonly attributed to the expiration of the Section 936 of the tax code, which favored pharmaceutical manufacturing in Puerto Rico. And it was phased out over the preceding 10 years. I think in addition to the challenges created by the loss of the 936 tax benefits, Puerto Rico’s decline stems from the bursting of a residential and commercial real estate investment boom. If you look at the level of investment in the housing stock, it went from, say, 4 percent of Puerto Rico’s GNP to 1 percent of Puerto Rico’s GNP. And it left a legacy of bad debts in the banking system.

So during this period of sort of sustained decline, and an increasing divergence between Puerto Rico’s economic trajectory and that of the United States, Puerto Rico, broadly speaking, ran sustained deficits, all the while, in effect, pretending to pass balanced budgets. But the stated balanced budget never truly balanced, partially because revenues were consistently overestimated—never once did Puerto Rico hit its budgeted revenue target—and partially because the stated budget left both a lot of debt service and a lot of spending outside of its scope. So the true underlying deficit was much bigger than it appeared—hence, the over 15 billion (dollars) in debt accumulated under the previous government—governor. And while the pace of debt increase has slowed recently, largely because Puerto Rico has lost market access, assets have been drawn down to sustain ongoing fiscal deficits, notably in the pension system.

And I think we should recognize—you know, and Cate’s provided the basic facts—but that the ability of the governor to continue to avoid default on the big sets of debt—the sales tax-backed bonds, the general obligation bonds—has come as a result of a series of ever-more complex financial maneuvers—failing to pay tax refunds, running up your accounts payable, borrowing or advance selling your pension assets, not making payments on many of your junior debts. And I think the issue is reaching a point because it’s quite reasonable to think that the scope for further financial gymnastics is very limited. And, as a result, we are heading towards a world where there will be a default on the Government Development Bank in May, with near certainty, and absent agreement—

RAVITCH: Or sooner.

SETSER: Or sooner. Default on the general obligation bonds in July. And that will set in process a set of litigation, both against Puerto Rico and between the holders of the general obligation bonds and other categories of debt that, at least in my view, could trigger another down-leg in Puerto Rico’s economy.

KURILOFF: Right. And for those who don’t follow the ins and outs of the municipal bond market, Puerto Rico has made efforts to protect its most sacrosanct levels of debt, the stuff that they are constitutionally obligated to pay, or that have provided what they call a statutory lien on a revenue stream. That appears to be coming—their ability to do that appears to be coming to an end, I think is fair. And then why is sorting that out hard, then, posed to the panel? Cate, why can’t they just restructure?

LONG: Well, basically because the advisors to the government, both at the Treasury level—U.S. Treasury level and Millstein and Cleary that advise them, have gone all-in on this full restructuring package, where they want every class of debt to be merged into one sort of giant pile, regardless of the security and the lien of those individual classes, and to emerge as a super bond, which would be securitized in some form and have a greater level of legal security, they say. And I’m just—I don’t think that’s really a great approach. You know, I think every one of these classes of debt has a specific source of revenue repayment. Some are insolvent, clearly, and some are solvent. And you know, we’ll see what path we get to after we fight a lot more. (Laughs.)

KURILOFF: I was going to say, our other panelists may have some views on that.

RAVITCH: If I can say, Cate raises a very important question. But there are two kinds of obligations that we have to be concerned with. We have an unfunded pension liability to the retirees of the government that’s estimated at a value of about $45 billion. And as I’ve been interested in the general subject, as many of you know, for a number of years, I’ve never been able to figure out what the moral distinction is between a promise to pay interest to somebody who lends you money and a promise to pay a benefit to somebody who worked for you for 20 years. And the obligations that the commonwealth has occurred because of the fact that there is nothing that prevents a commonwealth, let alone a state or a city, from borrowing any amount of money that they—that the market’s willing to lend them, there’s no—there’s no systemic regulation that protects the people in the jurisdiction where their political leadership has abused it as clearly as both Cate and Brad have said.

But the only relevant question, without getting into the macro issue of what’s happening—for a while I thought that Brad was talking about New Jersey or Illinois. And I was reminded he was talking about Puerto Rico. So there are broader issues. But right now you have, as I said, a problem of 3 ½ million Americans. They have the highest sales tax, 11 ½ percent sales tax. And they have an economy that’s very shaky. There are now more Puerto Ricans living in Florida than there are in New York. About 100,000 Puerto Ricans left last year. And they are now suggesting that that exodus is increasing because people don’t see economic opportunity. The professional class also is leaving. And I don’t think that’s—I don’t think the United States government can stand idly by. You know, I think the Treasury is trying to—they’re not telling the governor what to do. They are telling the governor that they will try to help get the statutory power, under Article 4 of the Constitution, to restructure the debt so that they can deal with all the obligations they have in a rational, fair, and decent fashion.

And that’s, in my view, far more important than whether you technically violate a pledge of the GO debt, which was, in effect, violated when the very same people issued billions of dollars of debt backed by the sales tax, which the GO bondholders thought they had every right to believe belonged to them to begin with.

KURILOFF: Let me stop you there, for a sec, Dick. And Brad had this hand up on this point too. And before we wanted, I wanted to hear what he had to say on this.

SETSER: So I think there are three basic impediments to reaching agreement on a restructuring. The first is that there isn’t any analog to the International Monetary Fund, or an International Monetary Fund program that is spelling out, in a way that the market broadly accepts, the amount that is available to pay in aggregate all of Puerto Rico’s tax-supported debts. So therefore, Puerto Rico’s capacity to pay is still being contested.

Second, Puerto Rico has one of the most complex debt stocks, I think, in the municipal market—although, Dick would know better than I—certainly a far more complicated structure of debt than is typically the case when an emerging market needs to restructure its debt. Why does that matter? It matters because each subgroup of Puerto Rico’s debts would rather be protected and see the other groups take the concessions. And each group can make a plausible claim for being protected. And at least in my judgement, if everybody tries to put themselves off the table the numbers will not add up.

And then third—perhaps the one—the most obvious difficulty, is that Puerto Rico’s contractual bonded provisions do not provide for voting. So each bondholder has to agree individually to the restructuring. And Puerto Rico and its public entities—so neither the commonwealth itself, nor any of its public instrumentalities or public corporations—has access to Chapter 9 of the Municipal Bankruptcy Code. So the typical legal mechanisms that are put in place to facilitate a restructuring are not available. So that combination, to me, is why it has been so difficult to resolve.

KURILOFF: And hence, the concerns of the various classes of debt, and your concerns about lawsuits. Cate, I think wanted to respond to that second point.

LONG: Right. And Brad and I have discussed this before in public. And the—you know, bondholders have clearly indicated through trading of these classes of debt, these 18 classes of debt, where they believe seniority-wise. And the bonds trade at the top as a general obligation—at the top of the stack. You know, 65 cents all the way down to 15 cents on the lowest class of debt. So the market has already sorted the debt stack to say where seniority lies, where security lies. And it’s not legally possible for groups of creditors to go after each other. If there’s a default—if the government defaults, then the creditor sues the government. They don’t sue another class of debt. So this idea that this legal chaos is going to erupt if one of these classes or two of these classes of debt are defaulted on, I think is somewhat misleading.

KURILOFF: Brad.

RAVITCH: You know, I have to say, I don’t come out of the world of markets, but when somebody says in total honor that markets are coming to these various judgements, I say to myself: On what basis do they have for making these judgments? And I mean, do they really understand what’s happening economically and socially in the entity that is the underlying obligor in all of this? Is this really just a market determination? Why do they get paid 9 percent in 2014 to lend money to the Commonwealth of Puerto Rico? And why did they buy that debt? What do they know about it? And so we can spend most of our time talking about promiscuous borrowers, but we also ought to talk about promiscuous lenders and the absence of anywhere in our economic and social and political system in which people are protected.

KURILOFF: Brad, you had a response, I think, to the other point.

SETSER: Let me note that I agree with Mr. Ravitch that, you know, the market bears some responsibility for not insisting on more credible fiscal numbers over an extended period of time from Puerto Rico. There is one critical legal risk that we should all be completely aware of. Puerto Rico has set aside—there are two key categories of debt, the debt backed by the sales tax pledge, which has been exempted from a constitutional provision called clawback, and the general obligation bonds, which are protected constitutionally. And one of the ways in which they are protected is Puerto Rico’s right to claw-back other revenue pledges to pay the general obligation bonds.

The core problem that Puerto Rico faces is that it has set aside, because of the structure of the bonds, and I apologize if this gets kind of detailed, the funds to make payments on the sales tax-backed bonds. So those payments will be made. The money has already been set aside. It has not set aside money to make payments on the general obligations bonds. And on July, absent a miracle, there will not be payments made on the general obligation bonds.

At that point in time, the general obligation bonds will litigate for enforcement of their constitutional priority against the government of Puerto Rico. And I’m fairly confident they will also challenge the constitutionality of the exemption from clawback of the sales tax-backed bonds, which will be litigation from one group of bonds to another, which will force a decision about the ability of Puerto Rico to continue to set aside money to pay the sales tax-backed bonds when it’s not paying other categories of debt to the full. I could go on and on—(laughter)—but there are other possible sources of litigation that are quite likely to happen when there is a broad default.

RAVITCH: And some of this debt has to be litigated in the New York courts, some of it going on the New York courts and some of it in the Puerto Rican courts at the same time. You can imagine what’s going to happen to both investment and local confidence, and people’s willingness to say there, particularly since they’re all absolutely free to come here, the Medicaid benefits they’ll get here will be greater than what they get in Puerto Rico. And probably, from what I hear, the heath care will be significantly greater. And therefore the inducements for people to leave in that state of chaos increases enormously. And is that in our collective interest? I don’t think so.

LONG: I’d just like to mention that three bond insurers are already suing Puerto Rico in the federal court in San Juan in a case that was filed in early January. And no government services have stopped. You know, litigation is not—it stinks. It’s terrible. And it’s time-consuming for the government. But the government of Puerto Rico will continue providing services, police and education. And bondholders have rights. And they want to litigate in many cases. And it’s fair. That’s the way the law in the U.S. is written.

SETSER: I think the problem is that if every creditor pursues to their final legal resolution all of their possible remedies, the net result will be a much weaker Puerto Rico economy, and less funds available for everyone, both across the different classes of debt and amongst and within each class of debt, if there are holdouts on any potential deal.

LONG: But that’s also a myth, because the first default that the Puerto Rican government made was last July on public-financed corporation debt, for about $93 million. No one litigated that. Everyone realized that was a moral obligation. The Puerto Rican government has no security, no means to litigate that in court, and it’s ever been litigated.

SETSER: Of course.

LONG: And that’s the case with many classes of those debt.

SETSER: I’m quite confident that the general obligation bondholders have a much stronger legal case against the government of Puerto Rico than the holders of the moral obligation appropriation-backed bond, where the bond indenture says: You have no legal capacity to enforce. (Laughter.)

LONG: That’s absolutely right.

SETSER: The issue is not whether or not you will litigate on the PFC bonds, which are small and have no enforcement rights. The issue is what is the impact of the litigation that will arise from the constitutional bonds, from the constitutionally guaranteed bonds, on the constitutional challenge to COFINA, and the very complex litigation that will arise with the resolution of the Government Development Bank. So I’m pretty confident there’s going to be litigation and more disruptive litigation than we’ve seen.

KURILOFF: COFINA, by the way, is the Spanish acronym for the sales tax bonds. And they—the reason they get so much attention with the general obligation is because that is the most obvious and direct oppositional—those two groups are the most obvious and direct opposition.

I want to move into some possible solutions, since we’re running low on time here. And I think we all have varied ideas about the ability and willingness to pay issue. This is in Washington now. And what might come out of there? I’m going to turn to Brad for that first.

RAVITCH: Well, if I—

KURILOFF: Or Dick.

SETSER: There’s only one of us who’s served elected office. (Laughter.)

RAVITCH: No, I have occasionally talked to a number of on the Hill, and I’ve testified before the Senate Judiciary Committee. And I would say there are three strains. But the most important thing I have to tell you is that the creditors are quite legally, probably, spending a lot of money lobbying. And they have a very receptive audience in a certain part—amongst a certain number of the members of Congress, who have listened to them very, very thoroughly. There’s nothing wrong with that, but that’s just a fact of life. To most people, Puerto Rico isn’t—the problems that you came to hear about today don’t rise in significance in the minds of 95 percent of the members of Congress, compared to all the other issues they’re facing, particularly it being an election year. So getting people’s attention is problem number one.

Problem number two is there are a lot of people, quite understandably, like Senator Hatch, who are extremely concerned about the problem of the growing underfunding of public pension fund obligations in the United States, Puerto Rico being one illustration, but there are many others, and a focus on that issue and a desire to make sure that the burden of Puerto Rico’s insolvency is shared by everyone. I think that you have a traditional situation which labor unions—and I think some of you know, I was involved in the bankruptcy of Detroit as an advisor to the judge—the labor unions are very concerned about bankruptcy because under our judicial decisions the only way you can modify a pension benefit, given the contract impairment clause or other specific constitutional guarantees of public pensions, is in a bankruptcy.

So the unions generally don’t like bankruptcy. And it’s very interesting. The Republicans’ approach to the AFL-CIO in this instance, in saying we should have common—or, some Republicans—we should have a common—we have a common issue here. And in this case, the AFL-CIO said, no, we’re sorry. In the case of Puerto Rico, you’re going to have a human tragedy unless we can restructure all the debt. But that issue is present and is a very sensitive issue to a large part of the Democratic Party’s constituency.

 And third of all, there is a question about what kind of discipline is going to be put in place if there is a resolution of the existing obligations. So there’s a discussion about what kind of oversight board or what kind of control board would be useful here. No rational person believes that you don’t need some kind of oversight board. And it should be federally created. But some argue that it should have more power than others, and not just have the power to approve what the commonwealth proposes, but should have ultimately the power at a federal level of restructuring the debt.

And that issue, and I don’t know where it currently stands because Jack Lew and his team are very involved in that and I’m not privy to everything that’s going on. But, I mean, those are the issues that are being discussed. So, I believe that there will, at the very least, be a stay. There will at the very least be some kind of oversight mechanism. But if there isn’t the power ultimately to file—two things—or do the equivalent of filing—two important things to remember. If you are eligible, or if you actually file, you’re eligible for debtor-in-possession financing. So at that point in time any bank, or even the Federal Reserve system, would lend money and would therefore avoid a cash flow calamity, because the DIP lender has the first priority. That’s what’s covering the costs in Detroit today is, in effect, a securitized DIP loan that took place when they filed under the bankruptcy law.

So that would solve the liquidity problem, and it would give the time for a process of arguing, and ultimately a judgement of our court system, which we have faith in, that the plan of adjustment is—or, the equivalent—is a fair, equitable way of dealing with the fact that there are five times as many dollars owed as—or whatever the percentage is—as we have available if we’re going to continue to provide essential services. Well, I can’t think of a better way than ultimately the court system. We use that in every other aspect of our life in this society to adjust competing claims. And I have a lot of confidence that the judicial system will ultimately make the right decisions.

KURILOFF: It is—

RAVITCH: Sorry to be so long. (Laughter.)

KURILOFF: Brad, do you have any further thoughts on that before I go to questions from the members?

SETSER: Well, just to provide the basic context. The Treasury put forward a proposal last fall that provided an outline of how one might design both oversight and a mechanism to facilitate restructuring. But it also put forward some suggestions for how the fiscal bargain between the U.S. government and the commonwealth of Puerto Rico might need to be adjusted to make it a little bit more fair, addressing some of the inequities in medical funding and the absence of an Earned Income Tax Credit.

Speaker Ryan has indicated that he would like to see legislation emerge by the end of March. And the chairman of the House Natural Resource Committee is now working quite diligently to try to come up with a proposal. I think it should cover those three areas. Obviously, the ones that cost money—the Medicaid, the EITC—will be very difficult, but you could imagine a compromise around the design of oversight and the design and the scope of debts that would be covered in the restructuring to possibly emerge in the next several weeks.

KURILOFF: All right. So now we should open the floor up to questions from the members. There are folks with microphones circulating. If you want to put your hands up.

Q: Hi. Thank you very much. I’m David Malpass with Encima Global.

I wonder if each of you could give a sense of, while Dick raised the idea of the unfunded pension liability, 45 billion (dollars), I’m wondering about the outlay side of that, meaning putting aside the projected inflows, are there projections of the outlays from those?

RAVITCH: About a billion two—about a billion two a year.

Q: For 30 years? So, I’m interested in the details and how—

RAVITCH: Well, obviously, it depends on longevity and how many—and how many people get hired in the interim. I served on—

Q: Will that number go up year by year for 50 years, or?

RAVITCH: Well, I would hope that perhaps the size of the government might shrink, and it might actually go down. I would say that they are saddled with an expense of over a billion dollars a year for a long time to come.

Q: And I’m—in finishing the question—so the $45 billion is based on an assumption about outlays? And where is that available? And I wonder if all three could answer. Thank you.

LONG: Just let me say the pension system has been a really complex problem. And the 2014 financials for the Puerto Rican government are not released—the audited ones. And what’s holding it up, the going concern on the Government Development Bank and the pension systems. And unfortunately the pension systems there have made a lot of personal loans to members for what they call cultural trips, and mortgages, and all kinds of things. And the status—they’ve been selling those loans off—but the status of those loans and the evaluation of those loans kind of feeds into valuing the pension system.

So we don’t really have any recent actuarial numbers. They did release an annual report for 2014 which is available on EMMA. But those numbers are about right. But the other thing to know in Puerto Rico, very unusually, is that employees pay a massive amount of their income—their pay into the pension system. It’s now 12 percent, going up to 20 percent over the next eight years. So they have—they carry a heavy—you know, they do a lot more heavy lifting, Puerto Rico employees, than most mainland government employees do.

SETSER: I would just add a couple of things. One, the size of the future pension outlay depends on whether you combine all three of the pension systems. If you combine all three, I think it’s about 2 billion (dollars). It does not increase over time because there was a very significant series of reforms that have been passed and the system is transforming into something called a defined contribution plan, which effectively will reduce future pension benefits relative to the legacy-defined benefit plan. So there isn’t an escalator.

The basic problem, though, is that contributions fall far short of current benefits. So assets are currently being sold to pay current benefits. And those assets will be exhausted in a couple of years. And therefore, the amount that the government needs to contribute to the pension system will go up quite significantly. And even with those very high levels of contributions, there is a gap. And so they’re phasing into a higher level of contributions, but that will not be enough to move to an effectively pay-go system.

KURILOFF: Right there, sorry.

Q: Good afternoon. Brian O’Neill with Lazard.

Brad, I think you mentioned it, but I’d like everybody’s comment on it, that there is no IMF role, there are no numbers, nobody agrees either historical numbers or projections on ability to pay. And it seems to me that until there is a set of numbers that all of the constituents can get around and agree to as to reasonable numbers with regard to ability to pay, it’s very hard to restructure the debt. It’s very hard to get the tough decisions that are needed by all parties until there’s a set of numbers. I understand even U.S. Congress is unsatisfied—or, at least elements within Congress are dissatisfied with the quality of the numbers, and that we’re dealing with unaccountable accounting. What does it take to remedy that? And what’s the time frame to come up with that kind of remedy?

LONG: So I would just say, as part of federal litigation, Wal-Mart is suing the Puerto Rican government now for discriminatory tax treatment. And in that federal trial, the head of the Government Development Bank said, and the Treasury secretary by the beginning of April, that the audited numbers—KPMG would have the audited numbers done. So we’ll see. I mean, we’ve been hearing that for over a year that, you know, within a month or two the numbers would be ready. I think in my view, it really does come down to the insolvency of the Government Development Bank, and the willingness of them to put a going concern letter in those 2014 financials. And you know, you lay that up against the May 1—the big May 1 GDP debt service payment. And they have to do something one way or another. But the numbers are just not there.

RAVITCH: Yeah, two things in response. One is, yeah, one would prefer to make decisions based on credible data, but it doesn’t exist. It’s the most messed up system in the world, except for the system that existed in New York City in 1975—(laughter)—where the governor—I happen to have been involved. The governor and I were told on the day after the banks told us they would no longer underwrite the notes and bonds of the city of New York, having very profitably underwritten $7 ½ billion of short-term paper for the previous eight years, with no way whatsoever of repaying it, except by issuing more and more every year. And we were told that the only way we could get budget information was on the cuff of the New York City budget director. There was no system in place whatsoever.

So one of the first things that we did was to pass a law that required the city of New York to have a budget system, to budget in accordance with generally accepted accounting principles, and have this in place within four years. Hired a very talented guy from OMB to come to New York and be the budget director. And we had a very talented group of people who did just that. But the chaos of New York City’s budget and the, if I may say so, profligacy of the lending that had been gone on under Governor Rockefeller and Mayor Lindsay, was at least as egregious as what has been going on in Puerto Rico. And whereas we never had to file, because we had the threat of filing we were—and because the leadership of the business community and the labor community, ultimately behaved very, very well, and we had great leadership at the state level, the problem got resolved. But it was only because they knew if it wasn’t, the next day we’d file bankruptcy. As a matter of fact, on October 17^th the city almost filed—two hours away from filing.

KURILOFF: Mr. Setser, do you have any further response her?

SETSER: So I think the possible tragedy in Puerto Rico is that we won’t reach agreement on Puerto Rico’s capacity to pay before Puerto Rico runs out of money to pay, and we will enter in the risk of chaotic litigation, when the right solution would be before this date certain, July 1^st, to reach agreement and try to avoid that outcome. I think that it will be difficult to get consensus on capacity to pay for a lot of reasons. The absences of audited financials for fiscal year ’14 is not the most important. The unaudited financials are now available. My guess is the audited financials will not be substantially different. The unaudited financials show that in fiscal ’14 Puerto Rico was running very large deficits.

The problem with all that, is that’s fiscal ’14. We’re about, in four months, to start fiscal ’17. And what matters for the debt restructuring going forward is agreement on how much Puerto Rico can pay on a forward-looking basis, not full accounting for how it got into its current predicament. My guess is, and I think this is where the debate should focus, that you could resolve this through federal legislation, which provide, you know, a stay and create some kind of fiscal oversight body, which would be charged with producing a forward-looking fiscal plan that everyone could agree on. That seems to me the best outcome.

Alternative, maybe consensus could be reached that—and I know this would be hard—but I don’t think the numbers is Puerto Rico’s fiscal and economic growth plan are actually that far off. I think they show that this year Puerto Rico will run a very small primary surplus, but not a primary surplus big enough to pay 5 percent of GNP, which is the contracted debt service on tax-supported debt on an ongoing basis. So to me, the constructive way forward is to start to talk about what the right level of primary surplus, or the excess of revenues, compared to non-interest expenditure, is. And then figure out, amongst the creditors, how to get the debt service down to that number, and put in place some credible mechanism for assuring the Puerto Rico on a forward-looking basis delivers on its forward-looking fiscal commitments.

LONG: Just, if you don’t mind, I’ll make one point to the Krueger Report, which is used often as a rationalization for pretty extensive debt haircuts. And that is when you look at—they’ve now projected out 10 years—they basically flat-lined the revenues, rising slightly, but they’ve massively up-ticked the expenses over that period of time, with no rationalization in the government. So of course there’s no room to pay debt service. So, you know, basically, again, we just have a disagreement on the numbers. The Krueger Report, you know, is useful, but it was commissioned by the government of Puerto Rico.

SETSER: So revenues aren’t growing because the economy’s not growing. And without federal legislation to address some of the inequities, I don’t think one can plausibly project an economic miracle, particularly with so many Puerto Ricans leaving. Expenses are going up for two reasons. One, the pension system will run out of assets. So the amount that the—of taxes that need to go into the pension system will go up. You can debate how much, but directionally it will go up. And then second, and this is a really critical point, the Affordable Care Act provided Puerto Rico with a large pot of money to cover some of the medical—of its medical expenses. That pool of money will run out. And when that pool of money runs out, there will be a very large increase in the amount that Puerto Rico has to spend to pay for the current level of medical benefits.

RAVITCH: In that respect, Brad, you should point out, Puerto Rico was treated differently than the states.

SETSER: You pointed that out for me. (Laughter.)

LONG: Yeah. I think there’s pretty much agreement in Congress that they need to help on the Medicaid side.

SETSER: I have yet to see the Republicans agree to any extra spending. (Laughter.)

KURILOFF: Before we roam into the health care crisis, which could be another panel, I’m going to go to the next question.

Q: Hi. Kim Davis from Charlesbank Capital.

 Could you talk about how this is playing out politically in Puerto Rico? And to what extent could elections change the dynamics, either before the fact or after the fact, with respect to any solution that you all may come up with, or anybody else may come up with?

LONG: I would just say, first off, the current Puerto Rican governor, Alejandro Garcia Padilla, has about a 14 percent approval rating. So, you know, any kind of, you know, agreements that he goes into, likely to be overturned in the next election. And there’s two candidates on what is now the minority party. One is the resident commissioner in Washington, Pedro Pierluisi. And the second one is the son of a former governor, who’s very gifted, he’s actually a Ph.D. in microbiology, and as I was talking with these guys earlier, has put forward a plan to Congress to create a joint Puerto Rico and federal debt authority to start tendering some of this debt and reissuing it, without doing—going through a judicial proceeding.

So, you know, basically politics is kind of like a blood sport in Puerto Rico.

RAVITCH: Well, there’s another party, Cate. Don’t forget them.

LONG: Well, the independents, yeah.

RAVITCH: No, no, no, the—no, no, no.

LONG: Yeah, but my view, basically—

RAVITCH: The Commonwealth Party.

LONG: In Puerto Rico, government is the largest employer. And in every election, it’s the spoils of the elections. And so we tend to get these massive changes back and forth in terms of personnel and in policy. And you know, basically looks at this point that it’ll shift in November to what is now the minority party.

RAVITCH: Puerto Rican—if I may—Puerto Rican politics, as I understand it, has essentially been a Commonwealth Party and a statehood party. A lot of the statehooders are Republicans, but they don’t—not all of them are Republican. And the two candidates that Cate mentioned are competing for the nomination of the statehood party. There is another person, by the name of Bernier, who is—has no opposition to be the candidate of the Commonwealth Party. And to characterize their politics as being kind of silly and irrelevant to the problems that they face seems a hell of a comment for me to make having spent so many nights watching our politics. (Laughter.)

KURILOFF: Right here.

Q: Hi. I’m Ted Pulling from JPMorgan.

Can you—I believe that there’s about $72 billion in outstanding debt. Can you tell us who owns that debt, put it into various buckets for us? And then maybe, Mr. Ravitch, you could compare that debt ownership to your experience in the Detroit debt workout.

RAVITCH: Well, Cate knows more about this than I do.

LONG: Yeah, so they’ve driven the debt down to, like, $69 billion—excuse me. They paid it down this year, and they haven’t taken—issued any new debt. And about 20 percent of it is hedge funds. Twenty percent is owned on-island by individuals. And then the balance is owned in the U.S. retail market, either through individual investors, high net worth generally, and mutual funds.

SETSER: And then the bond insurers have substantial legacy exposure.

LONG: Yeah, there’s bond insurers, like, around 27, 28 percent, they were at.

Q: And how would that compare to the ownership of Detroit debt figures?

LONG: You know, I think that the bond insurers in Detroit were, like, 18 percent of the debt. And, you know, at the end—I don’t even know where the debt ended up at the end in Detroit. But a lot of hedge funds owned a lot of it, because it really got smashed. And you know, there was some retail. But I think a much higher percent of retail in Puerto Rico than there was in Detroit.

RAVITCH: There was more, I think—I don’t know the numbers precisely; it’s a good question—but in Detroit the big money market funds were not as important a holder as they are in Puerto Rico. And there are a lot of individuals in Puerto Rico who own a lot of this debt itself, because Puerto Rico has been unique. I mean, one of the ways that the United States government tried to help Puerto Rico was to give them the power to issue triple tax-exempt debt all over the country. So they had a broader market for their debt than anyone else in any other jurisdiction had, assuming credit quality to be the same. So there is a fair amount of individual ownership down in Puerto Rico. But I think the big money market funds are the largest holder. I’ve seen the list. It’s a publicly available list, I believe.

LONG: There’s this one sort of odd political element too to this, which is most of the weakest was sold on-island, the least-secured debt. So those people—those people on island are facing potentially the largest haircuts. The credit unions in Puerto Rico, of which there’s about a hundred, bought a lot of that debt, which they say they were forced to by the government. They own about a billion and a half of, including GDB debt, again, the weakest debt. And they’re looking at pretty severe losses, and don’t have the capital to cover it. And the legislature in Puerto Rico passed a law to suspend mark-to-market for them on the government debt. So we have this—you know, this sort of nuclear reactor sitting on the island that relates to that issue too.

KURILOFF: OK.

Q: Thank you. Jennifer Permesly from Chaffetz Lindsey.

This conversation about who holds the debt brings to my mind the issue that there have been some recent interesting decisions in the investment treaty arena, arising out of sovereign debt obligations going both ways. Is it possible that some of this debt is held outside of the U.S. and could be protected under, let’s say, NAFTA or any one of the U.S.’s various free trade agreements or BITs, or not sold even on the secondary market to outside of the U.S. investors?

SETSER: It really is held by Americans. The tax-exempt status is critical. And the tax-exemption is relevant to American investors, not to foreign investors. So there are various interesting international comparisons, but one important characteristic of this is that it is a—the muni market in general is not the market which has the most international participation. And there really is not an international legal angle. There are so many domestic legal angles, that I am quite grateful—(laughter)—that NAFTA, et cetera, bits are not relevant. The domestic litigation possibilities, absent some legislation to create a more coherent framework, are themselves far too complicated to game out.

KURILOFF: Anybody else?

RAVITCH: Let me add one thing, if I may, to the general discussion. And I’m reflecting a bias. And I don’t come, as I say, from the banking side of this issue generally. But when you consider the fact that there is $4 trillion of municipal debt outstanding in the United States, and until Tim Geithner created an office of state and local governments, the United States Treasury knew nothing whatsoever about any of that debt—how much there was, how much of it was creditworthy, what the proceeds were used for—had no knowledge at all. The Fed’s numbers were off by $800 million. And a friend of, I think, many people in this room, and mine, Larry Summers, who was in the White House said to me, I’m not worried about anything. Every state has a requirement to—has a constitutional requirement to have a balanced budget. And I said, the only problem is that revenue is not a defined term anywhere.

So we now have, all over this country, people are borrowing money and selling assets to fund operating expenses. And that happened so egregiously in Puerto Rico. But I just want to remind you, nobody gave a tinker’s damn and there’s was no place in the system to protect either the innocent people who directly or indirectly bought this debt, let alone the people of Puerto Rico. And I think that’s an issue that has to be considered in this context as well, because whatever happens here a lot of innocent people are going to get—whether they’re debtholders or pensioners, or just poor people dependent on essential public services. And we got to reexamine what our national responsibility is to deal with these kinds of problems.

KURILOFF: We have some follow-ups. This gentleman was first.

Q: Thank you. Dick Huber from InVina.

We do export some wine into Puerto Rico, so we do have an interest in this. But, Dick, you touched upon it. And I think underlying a lot of this discussion is the basic structure: Is a commonwealth structure sustainable? Don’t we at some point have to confront statehood or independence, which I think is probably unlikely. But it strikes me that this bizarre structure—unique structure is part of the problem. Am I wrong?

RAVITCH: Well, it certainly produces a set of sui generis characteristics and problems. I think the chances of that being resolved by—of switching to statehood, to be candid with you, are impossible at the moment because as long as the Congress is controlled by the Republicans they’re not going to admit Puerto Rico as a state, which would, at this point in time, elect two Democratic senators and, I think, seven Democratic congressmen. So it’s sort of an academic question. If you were starting all over again would you chose statehood over a commonwealth status?

You might very well, just on the grounds that if you believe that the people there are entitled to the benefits and the burdens of U.S. citizenship. They fight in our wars. They got killed in Korea and Vietnam. They can’t vote in our presidential elections. But they’re beneficiaries of many of our—many of our programs. But the tax system is a crazy system. I mean, it makes no sense whatsoever, as Cate was saying. And there’s no reason in the world if in every other regard they’re going to be treated as U.S. citizens, their taxing posture and their right to vote in presidential elections shouldn’t be—shouldn’t be comparable as well. But that’s my own view.

KURILOFF: Brad has one too.

SETSER: No, I mean, I think the territorial commonwealth status is a key issue, and that it is also, in a strange way, an opportunity. That is because, as a territory, under the territorial clause, Congress could legislate a solution that is specific to territories and that is not generally applicable to states that would create a framework for restructuring territorial debt, subject to federal fiscal oversight, that would put Puerto Rico on a more sustainable path in a way that raises fewer constitutional questions than doing something like that for a state. So I think there is an element of opportunity.

The difficulty is that the current fiscal bargain—which treats Puerto Rico worse than a state in a lot of key ways, but most notably on Medicaid—is untenable and unsustainable. So independent of whether or how the status question is ultimately resolved, a fiscal system which does not provide Puerto Rico with more medical funding for its poorest citizens will not be able to persist.

RAVITCH: It might be worthwhile taking a minute to explain the bankruptcy structure in the United States. We have, under the bankruptcy laws, a provision which permits a state to authorize any municipality within its borders to file bankruptcy. If it isn’t authorized by the state, a municipality can’t file. And 30 states out of 50 have authorized their municipalities to file. Some with some complicated restrictions. States, in the opinion of many, cannot file because the 11^th Amendment to the Constitution says that a federal court can’t have jurisdiction over a lawsuit between a citizen of one state and another state itself, which by definition would be the nature of a bankruptcy—of a contested bankruptcy.

Other people have argued that a state could waive its sovereign immunity under the 11^th Amendment, and that there probably nonetheless is constitutional power to enable states to file itself. And interestingly enough, I found in my research that Jeb Bush and Newt Gingrich wrote an article in the L.A. Times five years ago, urging the Congress to enact legislation authorizing the states to file. It’s something some of their fellow Republicans are not very happy about today, but it’s an interesting footnote.

KURILOFF: We have a couple more and we have time for about two more. So how about right here?

Q: Laurie Garrett spoke I guess about a month ago on the issue of the Zika virus. And she told us that right now the Zika virus is hibernating in the American South, and that when it comes out of hibernation we’re going to have a heck of a political problem in this country as it gets confused with the presidential election. So my question is, might it be that the Zika virus, which is also appearing in Puerto Rico, help the Congress to concentrate the money wonderfully, as another path of a solution that otherwise would not come by the natural processes of politics? Have you given any thought to that? (Laughter.)

LONG: I didn’t hear anybody mention it on the Hill. (Laughs.) But it is—

SETSER: It does illustrate why we need a public health system in all of our country, including in Puerto Rico.

LONG: The FDA is involved in shipping blood there now. And the Feds are on it quite a bit on the executive side, but not in Congress. But you’re—it’s a good point.

KURILOFF: Right here.

Q: Thanks, Aaron. I’m Bill Glasgall from The Volcker Alliance. I worked with Dick.

But I’m going to ask—it’s kind of a ringer question—I wanted you to follow-up on a point you just made. Given all the disputes over Puerto Rico’s debt, over the conditions under which Detroit was financed, under the conditions the California bankruptcy cities were financed, Harrisburg, Jefferson County, and so on, is—what’s your outlook for Congress revisiting the Tower Act exemption for municipal debt in the—in the near future?

RAVITCH: I have discussed this with members of the SEC. It’s not practical to expect it to happen, although interestingly enough I speak at many bond-buyer conferences, and I have a lot of very dear friends who are in the securities world. And they all tell me, and I believe them, that they would support it, actually. That it’s their clients who don’t want it. And that they have to complete against one another for the business. And it is the client, the issuer, who says, aha, I don’t want to make it more difficult or more expensive for me to borrow. I don’t want my credit too carefully analyzed. They don’t say it so many words. They want the guys who’ll come in and tell them, ah, we’ll get you—we’ll get the money at the lowest possible cost. So it’s the issuers that have—I’ll just tell you one interesting little anecdote.

About four or five years ago, GASB, the Government Accounting Standards Board, proposed a new regulation that would have required every state and city in their CAFRs, that’s their annual audited financial statements, to publish four-year projections of revenues and expenses. And the chairman of GASB asked me to testify on behalf of it, which I did. And I was followed at the GASB hearing by the National Association of Governors, NASBO, the National Association of State Budget Officers, the U.S. Conference of Mayors. They all testified against it. And I know the people involved. And I said to them, I don’t understand you guys. And they said, what are you talking about, Dick? They said, our clients don’t want more transparency. (Laughter.)

So I don’t think there’s a snowball’s chance in hell that we’re going to get it right now until this problem builds more and more. And I don’t know what’s going to happen in Illinois, Louisiana, Pennsylvania, New Jersey. I mean, so we’re just at the beginning of a whole new—I suspect, a whole new perspective on this.

KURILOFF: Yes.

Q: Given that wonderful projection that all of you have made about the quality and efficacy of this market, what do you predict will happen to the funds raised through tax-exempt bonds, municipal bonds generally? If there’s a suspension, and a long suspension, of these issues, what happens to the financing that’s necessary to continue to fund infrastructure investment in this country?

LONG: I just want to say, there was a really interesting letter sent by six governors to Speaker Ryan and Majority Leader McConnell saying, in their belief, that if Puerto Rico was given the right to abrogate the general obligation, the constitutional debt, that it would raise borrowing costs for them. I mean, you know, they were, like, AA rated states. And I think the general—yeah, I think if Congress starts breaking trust indentures, you know, for bonds that have been outstanding for numbers of years without some good rationale, I think—yeah, I think it will spook the municipal market a little bit. It won’t stop anyone borrowing, but is it five basis points? Is it 25? You know, is it 10? I don’t know. But, yeah, definitely. Start changing the rules on a market that has had constant rules for a long period of time I think, yeah, it raises issues.

RAVITCH: Cate maybe right about the consequence, but I have to tell you, number one, that we amortized more municipal debt in the United States this year than we have in any year since World War II, which is another way of saying that we are seriously neglecting investing in our infrastructure. We are, as I said earlier, borrowing money to pay operating expenses. We are selling assets to pay operating expenses. New York state passed a law that permits the state to make its contributions to its pension system in the form of promissory notes. Arizona, Governor Brewer, I think her name was, sold the state capitol and used the proceeds to cover an operating deficit in the state budget. New York state sold Attica Prison, used the proceeds to balance its budget. These practices have to stop.

Do I think that will hurt the market? No, I think it’ll renew the confidence. I think being able—state and local governments to be able to borrow at a tax-exempt rate is critically important to the infrastructure of this country. And I think the market would thrive if there was some discipline, if states and cities were forced to budget in accordance with generally accepted accounting principles. I don’t have to remind you, many of you people live here, New York has not had a fiscal crisis since 1975. And it’s not that we haven’t had politicians who were eager to spend. But they’ve been limited and constrained. And that has worked very effectively. And that should—that’s not a burden that makes the effective functioning of government or the investment in our infrastructure a burdensome one.

KURILOFF: And we are over time now. So I want to thank the panelists for their time and thoughts and thank you guys for coming. (Applause.)

(END)