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Whither Market Discipline?: Lessons From The Puerto Rican Default

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Robert Chirinko
October 28, 2019 

Where was financial market discipline when we needed it? Why did investors continue to buy Puerto Rican government bonds and supply capital from 2005 onward to this economically beleaguered Commonwealth? A recently completed paper (“What Went Wrong? The Puerto-Rican Rican Debt Crisis, The, ‘Treasury Put,’ and the Future of Market Discipline,”) presents evidence that bond investors thought there was a government guarantee implicitly backing Puerto Rican bonds.

Unfortunately for them, these investors would be wrong. The guarantee they thought they had is dubbed a, “Put,” which in the derivatives literature is defined as a device that would allow investors to put their bonds into the government’s hands and receive a bailout in return in the event of a default.

Puerto Rico defaulted on their bonds starting August 3, 2015. Defaults, of course, are part of the bond game, just as strikeouts are part of baseball. With the benefit of hindsight, batters wish they had anticipated a curve ball and bond investors wish they had made other choices.

Most financial markets are well-equipped to handle the risks associated with defaults by adding a premium to bond yields. However, in the case of Puerto Rico, the premium added to account for risk was divorced from economic reality. For example, in April 2012, the yields from a matched pair of 10-year uninsured and insured Puerto Rico bonds implied that the risk premium was only 41 basis points higher than that on corporate Aaa bonds and, remarkably, 85 basis points lower than on corporate Baa bonds.

The level of the Puerto Rico risk premium should have depended on the likelihood that the Commonwealth would be in a position to make scheduled bond payments. But macroeconomic fundamentals had been poor for a long time. Starting in 2006, population growth turned negative (and continued to fall), real GDP began to contract (between 2005 and 2016, real GDP declined by 12%), and a very favorable tax credit for United States corporations operating in Puerto Rico was eliminated. Liabilities of the public sector (as a percentage of nominal GNP) were 62% in 2000, rising to 98% by 2010. In its July 2012 report on the Puerto Rican economy, the Federal Reserve Bank of New York concluded that, “[T]he task of putting the Island on a path of robust, sustainable and inclusive growth remains a work in progress.” Given these macroeconomic fundamentals, a risk premium less than that on Baa corporates is deeply puzzling.

Investors had good reasons to believe that the government would bailout Puerto Rican investors (i.e., the Treasury Put). Federal financial assistance to beleaguered companies has been frequent and generous, such as with Lockheed in 1971 and Chrysler in 1980, the savings and loan crisis of 1986-1995, Bears Stearns in 2008, Fannie Mae and Freddie Mac in 2008-2012, AIG in 2008-2009 and TARP in 2008-2009. Bailouts were also extended to Mexico in 1995. And perhaps most closely related to the Puerto Rican situation, in 1975 New York City was bailed-out by a fiscally conservative Republican President. Given this history, it was reasonable for Puerto Rican bond investors to have expected that they held a Treasury Put.

The Treasury Put is a plausible explanation for the exceedingly low risk premium on Puerto Rican bonds. But can this assertion be backed up by the data? Strong evidence of its existence was provided by the July 2013 bankruptcy of the city of Detroit with liabilities of $18-$20 billion, close to the $16 billion bailout of New York City (expressed in 2013 dollars). The withholding of federal assistance to Detroit indicated that the federal government was very unlikely to come to the rescue of Puerto Rico. Moreover, two pieces of federal legislation were introduced in July 2013 that prohibited the federal government from providing relief to state and local governments. The federal government’s truancy effectively extinguished the Treasury Put and allows us to estimate its magnitude by observing the Puerto Rican risk premium before and after July 2013.

The changes were dramatic. A variety of estimates (based on different assumptions about outliers and the trading window) indicates that the Treasury Put was at least 300 basis points and likely higher. The Treasury Put lowered the cost of capital for Puerto Rico and led to a misallocation of capital of approximately $14 billion to Puerto Rico.

A sizeable Treasury Put raises an important policy question: How can this implicit guarantee—which effectively is a form of regulatory forbearance—be eliminated on a permanent basis? Balanced budget amendments intended to temper debt accumulation are one possible solution, but the precarious financial situation of several states with such putative restrictions suggests that they are not very effective. Government policy during the Euro Crisis is equally worrisome.

The no-bailout clause in the Maastrict Treaty creating the European Monetary Union, coupled with explicit and emphatic statements of support of this clause by German Chancellor Kohl, were insufficient to prevent massive bailouts during the Euro crisis. How to extinguish the Treasury Put on an ongoing basis in a democratic society remains an open question.

Author: Robert Chirinko, a professor in the Finance Department, University of Illinois at Chicago, is a member of the Faculty Advisory Panel for the Government Finance Research Center (UIC). His research focuses on business behavior emphasizing financial markets, capital formation, corporate governance and finance, macroeconomics, and taxation. He has been a visiting scholar at several central banks and universities; in 2020, he will visit the Banks of Japan and Italy. Email: [email protected]



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One Response to Whither Market Discipline?: Lessons From The Puerto Rican Default

  1. Cate Long Reply

    November 1, 2019 at 3:09 pm

    I was the first to publicly predict the insolvency of Puerto Rico in 2012. See here > > http://blogs.reuters.com/muniland/2012/03/08/puerto-rico-is-americas-greece/ No one that I am aware of ever assumed US Treasury would bail out PR and I explicitly cautioned investors against it. The last state to default was Arkansas in the 1930’s and the federal govt gave no support. The prior state defaults were in the 1800’s and the federal govt did nothing at that time. I honestly know of no investor that assumes that Congress will backstop municipal bonds.

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