Hedge Funds and the Muni Market: Puerto Rico, the Outlier

HEDGE FUNDS AND THE MUNI MARKET

Puerto Rico, the Outlier

Maria de los Angeles Trigo

August 2015

Hedge Funds and the Muni Market: Puerto Rico, the Outlier 1

IT HAS BEEN REPORTED THAT HEDGE FUNDS HOLD

30%

OF THE PUBLIC DEBT ISSUED BY ENTITIES OF

THE PUERTO RICO GOVERNMENT


Why are they so interested in Puerto Rico debt?

In this presentation I discuss:

how hedge funds started participating in the sovereign debt market,

their absence in the US municipal debt market, and

what makes Puerto Rico attractive to this type of investor.


The Setting

In 28-30 April 2015 the UN Ad Hoc Committee on Sovereign Debt Restructuring

celebrated its second working session. His Excellency Axel Kicillof, Minister of

Economy and Public Finance of Argentina, addressed the Committee with a

historical background of the participation of hedge funds in the sovereign

debt market since the creation of the Bretton Woods institutions. It mirrors

what has happened with Puerto Rico debt and its purchase by these investors.

The post starts with a summary of the change in the sovereign debt market

from multilateral obligations between nations to the participation of private

creditors. It is not a summary of Minister Kicillof’s address, but his speech is

the inspiration for the post.


https://www.linkedin.com/pulse/front-end-puerto-rico-debt-maria-de-los-angeles-trigo?trk=prof-post

http://www.economia.gob.ar/ministerio/ministro/

http://www.economia.gob.ar/

http://webtv.un.org/meetings-events/general-assembly/watch/8th-meeting-ad-hoc-committee-on-sovereign-debt-restructuring-processes-general-assembly-2nd-working-session/4204723517001

The Setting — In the Beginning

Countries need capital to provide for the development of its infrastructure

and economy. Debt issued by sovereigns was issued to other sovereigns in

bilateral or multilateral agreements in which countries were creditors of one

another. To help broker negotiations among creditor countries and debtor

countries, the Paris Club was created in 1956. It still serves as an informal

creditor group where parties negotiate the restructuring of debt incurred

through bilateral or multilateral agreements, among countries.

After the Second World War the United Nations celebrated the Monetary and

Financial Conference, where mostly the US and the UK designed an

agreement to create a new international finance system. This is the Bretton

Woods Agreement.


With the Bretton Woods agreement in 1944, international entities such as the

International Monetary Fund and The World Bank were organized, and the

system that we know today came to be. Although there is still lending among

countries, it is also done by the new international organizations: the Bretton

Woods institutions.

With the oil crisis in the 1970s commercial banks started to participate in

sovereign lending because of excess money in the system, because they

needed to recycle petrodollars deposited in the largest commercial banks.


This excess liquidity in the commercial banks, and banking system in general,

originated because of the massive amounts of money that the countries

producers of oil generated through the sale of oil (the two oil shocks of the

1970s). These transactions were denominated in dollars (hence the name

petrodollars) and were deposited in big commercial institutions.

To make use of the huge amounts of petrodollars, commercial banks started

to participate in sovereign lending, which was done mostly at variable rates.

Therefore, when the US Federal Reserve Bank raised rates in 1979-1980 to

20% from 11%, the immediate consequence of this rate change for sovereigns

was that, proportionally, their debt burden doubled.


The Setting — And You Are…?

Coupled with the fall of commodity prices, the increase in interest rates

unleashed the external debt crisis of the 1980s, starting with Mexico in 1982,

when it defaulted on its debt.

Since the crisis started to affect several countries in quick succession, two US

Treasury Secretaries, James Baker and Nicholas F. Brady, came up with

proposals to stop the spillover of these defaults.


The Baker Plan proposed the postponement of debt payments, the granting of

new loans, and changes in the policies of debtor countries; there was no

forgiveness of debt. The main problem with the plan was that many

commercial banks didn’t want to increase their exposure to sovereign debt.

The situation was critical for banks, since the loan exposure in the US banks

was in average 130% of the banks’ capital and reserves. Eventually, banks

established debt reserves against these loans, which made it harder for them

to extend loans under the Baker Plan, but easier to participate under the

Brady Plan, restructuring the debt at less than face value, since they had

already taken a loss.


The Brady Plan was directed to developing countries and the proposal was to,

in practice, privatize the sovereign debt. The plan, carried out during the

1990s, refinanced the loans the sovereigns owed commercial banks with

instruments that the banks could easily trade, and thus, creating a market for

sovereign debt.


With the early restructurings under the Brady Plan new types of investors and

broker dealers entered what they called the “emerging markets”, and

transformed sovereign debt to a bond market. An important feature of the

plan was that these instruments issued to the commercial banks were to be

guaranteed by investments in US Treasuries.

Commercial banks eventually started trading the debt instruments, and

countries started refinancing debt with bonds issued in the international

capital markets, instead of taking loans from banks, bank syndicates, or other

sovereigns.


Minister Kicillof

The Brady Plan was a process of privatization of sovereign debt, and also its

atomization, by breaking it up in small parts. This new reality has given

private parties power over the economies of debtor countries. The hedge

funds’ apogee started in the 1990s when the sovereign debt turned into bond

debt, without any institutional control or regulation.

The funds started their litigation strategies in the late 1990s against African

countries, getting victories in different courts [I add, mostly European] to

“collect” precedents. The result has been that now they can block almost any

kind of restructuring.


Hedge funds are not the typical investor that invests in the development and

the future of a country. They just buy title to the debt, and are converting

sovereign debt into a commercial transaction not under the debtor country’s

sovereignty.

Capital needed by countries to promote their development is provided by the

financial markets. But if the market can turn into a system of appropriation of

national assets, then the system is a parasite and not a participant in the

development of the countries.

And the situation is still pertinent, since if interest rates go up, the debt

burden for developing countries will increase, since there is sovereign debt

issued at variable rates.


Municipal Debt? No, Thank You

Subnational governments (State and local) in the US can issue debt as

prescribed under the State laws, and in the US capital market under federal

law. They are provided with a restructuring process through Chapter 9 of the

US Bankruptcy Code. State governments cannot file for relief, but their local

issuers can, if they have been authorized by State law.

States don’t have access to Chapter 9, but have political clout in the US

Executive Branch and in Congress — which counts for something.

This availability of Chapter 9 makes the municipal debt issuers of the US

unattractive to hedge funds: when your business strategy is to buy cheap and

collect all the amount due, at face value and all arrears, it doesn’t make

sense to buy the debt of an issuer that has been provided with a framework to

restructure that has been “blessed” by the US Constitution.


That leaves sovereign debt, especially debt issued under foreign law (usually

New York and UK) as the most attractive for distressed credit investors.

Sovereigns have no framework within which to restructure debt issued under

foreign law, since this debt is subject to foreign interests, courts, and

interpretations.

On the other hand, debt issued under national law is better managed, since

the applicable law is the debtor’s law, and purchasers of the debt have

accepted the jurisdiction of, usually, national courts.


Puerto Rico, Here We Are

Hedge funds are not the typical investor in the municipal debt market in

which Puerto Rico issues its debt. It is the first time distressed credit

investors are so heavily invested in a US municipal issuer.

Even when Puerto Rico debt has been almost in its entirety been issued under

and subject to Puerto Rico law, it is also subject to the US Constitution and US

Federal Courts interpretation, factors over which Puerto Rico has no control.

It is the quite an interesting position to be:

not a sovereign with absolute control over the debt issued under and

subject to its national law

not a US municipal debt issuer with access to the restructuring regime

of Chapter 9

Puerto Rico has the worst combination of factors: a “sovereign” that issues

debt under its own law but cannot control how it restructures its debt

because it is also subject to foreign law (the US Constitution).


Where’s My Money

For distressed credit investors, on the other hand, it’s a wonderful

combination, with debt that:

is not subject to a composition where the majority of creditors

decides on new terms

is subject to foreign law (the US Constitution, even if not necessarily

the US courts)

For the last 20 years hedge funds have been quite active in the sovereign

debt market, buying distressed debt at very discounted rates and then

litigating for the repayment of the totality of the debt. In the most famous

cases this strategy has meant earnings of 400% (Perú), 540% (Zambia), 1,400%

(Congo), and 1,600% in the case of Argentina (no, those numbers are not

typos). In all of these cases the debt had been issued under foreign law:

either NY or UK law, considered to be the most creditor-friendly jurisdictions.


That strategy will not work in Puerto Rico.

The debt is issued under Puerto Rico law, and the courts will most probably be

(and in some cases must be) Puerto Rico courts. It is not a country having to

litigate its sovereign debt in a foreign jurisdiction, even if it is still subject to

the US Constitution.

I don’t see a litigation strategy that will guarantee earnings of that

magnitude, even in the long term.


Close to You

Although there would be a payoff in the long term when Puerto Rico’s

economy starts growing again, the hedge funds interest may also be in the

shorter term. A country with liquidity problems and a pressing need to invest

in infrastructure may decide to go on a privatization spree. That could

provide a benefit to hedge funds and their partners, with contracts signed for

at least 30-40 years, requirements of guaranteed minimum income, and

repayment secured by specific assets. They could even receive negotiable

instruments representing the repayment obligations — a “Bradyzation” of the

obligation.

It brings to mind a preliminary offer investors made to PREPA (the electric

service company), with a team of investors, developers, administrators, and

operators already in place.

But even this “privatization strategy” is long-term, since the investor would

still need a growing and eventually robust economy for the initial investment

to pay off, and to generate enough recurrent income.


Together… Forever?

The hedge funds’ strategy with other sovereigns has been successful in part

because other sovereigns have been able to partially restructure their debt,

and receive additional investment from international organizations such as

the IMF and the World Bank.

The money freed by the negotiations reached with other creditors may help a

country improve its economic conditions, which then makes it easier for the

hedge funds to litigate for the payment of the instruments they hold; after

all, the debtor country’s economy is improving.


That doesn’t apply to Puerto Rico either. The US court held that Puerto Rico,

because of the US Constitution, cannot implement a composition of debt in

which the majority of creditors decides on new terms. And what use is a

restructuring that knowingly creates hold-outs?

Second, Puerto Rico doesn’t have access to any international organization to

request aid, either financial or advisory or of any other kind. The US has

historically quite actively opposed any attempt by Puerto Rico to reach to

these entities. So, who will take the loss now so that these investors may

eventually collect the totality of the debt?


We’ll See

I see only two alternatives: either

the US stands aside while Puerto Rico reaches out to international

financial organizations, or

the US takes their place.

Although… there’s always a third one: leave Puerto Rico to manage its debt

under its laws and its courts.


Extras

The recording of Minister Kicillof’s address can be seen here (starts at 1:25).

The Emerging Markets Traders Association (EMTA) has a brief summary on the

Brady Plan here and here.

El Confidencial published an interesting take on the hedge funds’ interest in

Puerto Rico and Greece.

Important to note that in the hearing before the Subcommittee on Regulatory

Reform, Commercial and Antitrust Law of the Judiciary Committee of the US

House of Representatives for the H.R. 870 (Puerto Rico Chapter 9 Uniformity

Act of 2015), the main reason given by investors for their opposition to the

bill was that creditors didn’t fare well in the Detroit bankruptcy.


http://webtv.un.org/meetings-events/general-assembly/watch/8th-meeting-ad-hoc-committee-on-sovereign-debt-restructuring-processes-general-assembly-2nd-working-session/4204723517001

http://www.emta.org/template.aspx?id=32

http://www.emta.org/template.aspx?id=35&terms=brady+plan

http://www.emta.org/template.aspx?id=34

http://www.elconfidencial.com/mercados/2015-06-12/los-buitres-sobrevuelan-las-dos-grecias-en-busca-del-beneficio_879963/

http://judiciary.house.gov/index.cfm/2015/2/hearing-h-r-870

Originally published in LinkedIn

Hedge funds and the muni market: Puerto Rico, the outlier

22 June 2015 This presentation has been edited from the original post.

Maria de los Angeles Trigo, an attorney and certified public accountant, helps clients understand

Puerto Rico’s public finance market. She advises financial institutions, investors, law firms, and

government institutions on Puerto Rico debt’s legal and regulatory framework. Maria de los Angeles

worked for 16 years in the Government Development Bank for Puerto Rico and was the highest-

ranking career legal officer as Director of the Compliance Department and Acting Deputy Director of

the Legal Division.

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Hedge Funds and the Muni Market: Puerto Rico, the Outlier

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