Puerto Rico's debt crisis and the siren song of after-the-fact bankruptcy

Sometimes debt burdens become deeply burdensome.  And if you’re the debtor, wouldn’t it be nice to find a way to avoid hard decisions by reneging on past agreements on repayment, that is, to change the rules after much of the game has been played?  A bill before Congress, the “Puerto Rico Chapter 9 Uniformity Act of 2015” (H.R. 870), would allow Puerto Rico to do exactly that, which is why it should be defeated resoundingly.

Unless some sort of fraud was involved, ordinary bankruptcy by individuals and businesses cannot be criticized as a rule-changing exercise, as the lenders and creditors knew from the beginning that there was some likelihood that a given borrower might not be able to honor its commitments.  That is what it means to say that the possibility of future bankruptcy increases the risks faced by creditors, and it is obvious that the agreed interest rate and other terms applied to the debts would reflect that reality.

Not so for those borrowers explicitly prohibited under the U.S. Bankruptcy Code from filing for debt relief under chapter 9 (municipal bankruptcy).  The fact that they may not resort to bankruptcy means that their debts ostensibly are safer for creditors---they may not be repudiated---and it is that increased safety, among other factors, that allows them to borrow on terms and at interest rates more favorable than those available to other borrowers.

Puerto Rico’s borrowing needs over the not-distant future are substantial. Prepa will need to make large investments in equipment and infrastructure in order to satisfy new environmental requirements now being finalized by the Environmental Protection Agency, and to move away from the use of expensive oil.

That is the case with Puerto Rico, with respect to which legislation enacted by Congress in 1984 prevented it and its various municipal agencies and bureaus from using chapter 9.  Accordingly, this has had the effect of reducing the interest rates that they have had to pay.  And there is a broader benefit: It creates efficient incentives for public officials because they have political time horizons---the next election---shorter than the economic horizons shaping business decisions.  Municipal bankruptcies would have adverse effects down the road, but those would be borne by future officeholders rather than those currently incurring too much debt.  The prohibition on municipal bankruptcy imposes a useful constraint in the here and now.

Moreover, Puerto Rico and its various borrowing units have been granted a nationwide tax exemption for their bonds---a preference bestowed upon no U.S. state---thus reducing Puerto Rico borrowing costs even more.  It is no accident, therefore, that Puerto Rico is the third-largest issuer of municipal bonds in the U.S., with debt now totaling about $73 billion, borne by a population of only 3.7 million.  That is almost $20,000 per person.

And that brings us to the Puerto Rico Electric Power Authority, the island’s electric utility.  It has enjoyed those favorable borrowing terms and has amassed almost $9 billion in debt.  But Prepa also is woefully mismanaged, with about $1 billion in accounts receivable, most of which is owed by other units of Puerto Rico government.  This is despite the fact that its basic electric rates have not increased in 25 years (other than for increased fuel costs).

So, proponents of H.R. 870 would allow Puerto Rico generally and Prepa in particular to use chapter 9 bankruptcy to repudiate much of its debt, thus changing in their favor the agreed terms applied to past borrowings.  Voila!  Electric rates would be reduced by about 4 cents per kWh, which is large or small depending on one’s point of view.

Sadly, there are no free lunches.  This legislation would violate past lending agreements, with adverse effects on Puerto Rico’s future borrowing costs due to the obvious increase in perceived risks, both from the narrow threat of bankruptcy and from the larger increase in the likelihood that agreed contractual terms might not be treated as actual commitments.

And Puerto Rico’s borrowing needs over the not-distant future are substantial.  Prepa will need to make large investments in equipment and infrastructure in order to satisfy new environmental requirements now being finalized by the Environmental Protection Agency, and to move away from the use of expensive oil.  The Puerto Rico Aqueduct and Sewer Agency---the debt of which already is below investment grade---has investment needs over the next few years of well over $1 billion, of which about $400 million alone is needed to satisfy consent decrees with the EPA.  And so on.

If Prepa’s commitments can be repudiated after the fact, why not those represented by other debts in the muni market?  If enacted, H.R. 870 promises to increase borrowing costs for all municipal debt across the country, an outcome that would serve the interests of no one except borrowers with political incentives to acquire debts that cannot be sustained.

And it is not as if Prepa has no options.  Rates can be increased; why is it, after all, that almost all other municipal (and investor-owned) utilities charge rates sufficient to pay their bills?  A far more effective system for collecting receivables, emphatically including those owed by other units of government, can be implemented, and Prepa’s customers---above all, again, other government agencies---can be pressured much more effectively to pay their power bills.

Recent news reports on waste and bankruptcy in the electric power sector have focused heavily on the subsidized boondoggles prominent in the wind and solar sector, as represented by the Solyndra debacle.  But it is not only renewables that can display such outcomes.  Irresponsible behavior over time, designed to bestow economic benefits upon favored constituencies, can yield highly adverse outcomes in conventional generation as well, particularly as political pressures to mortgage the future prove irresistible.  Adhering to the agreed rules of the game---the contractual arrangements under which resources are provided and debts are honored---is a crucial bulwark against the incentives of politicians and bureaucrats to weaken economic markets.  The special favor for Puerto Rico that is H.R. 870 should not move forward.

Benjamin Zycher is the John G. Searle scholar at the American Enterprise Institute in Washington, D.C.