Puerto Rico announced a historic restructuring of its public debt on Wednesday, touching off what may be the biggest bankruptcy ever in the $3.8 trillion U.S. municipal bond market. While it was not immediately clear just how much of Puerto Rico’s $70 billion of debt would be included in the bankruptcy filing, the case is sure to dwarf Detroit’s insolvency in 2013. The move comes a day after several major creditors sued Puerto Rico over defaults in its bonds. Bankruptcy may not immediately change the day-to-day lives of Puerto Rico’s people, 45 percent of whom live in poverty, but it may lead to future cuts in pensions and worker benefits, and possibly a reduction in health and education services.
The island’s economy has been in recession for nearly 10 years, with an unemployment rate of about 11.0 percent, and the population has fallen by about 10 percent in the past decade. The bankruptcy process will also give Puerto Rico the legal ability to impose drastic discounts on creditor recoveries, but could also spook investors and prolong the island’s lack of access to debt markets.
BANKRUPTCY UNDER PROMESA LAW
The debt restructuring petition was filed by Puerto Rico’s financial oversight board in the U.S. District Court in Puerto Rico on Wednesday, and was made under Title III of last year’s U.S. Congressional rescue law known as PROMESA.
The Title III provision allows for a court debt restructuring process akin to U.S. bankruptcy protection. Puerto Rico is barred from a traditional municipal bankruptcy protection under Chapter 9 of the U.S. code.
The filing includes only Puerto Rico’s central government, which owes some $18 billion in debt backed by the island’s constitution.
On paper, it does not include $17 billion of sales tax-backed debt, known as COFINA debt, or debt from other agencies.
But those debts are likely to be pulled into the bankruptcy, or included in separate bankruptcy proceedings in coming days, Elias Sanchez, an adviser to Governor Ricardo Rossello, told Reuters on Wednesday.
Puerto Rico’s massive pension debts will also likely get restructured in the bankruptcy.
“Title III was especially compelled by the commonwealth’s need to restructure $49 billion of pension liabilities,” the oversight board said in Wednesday’s filing.
BIGGER BANKRUPTCY THAN DETROIT
The previous largest U.S. public bankruptcy, Detroit’s in 2013, covered some $18 billion in debt. The city was able to reach an agreed debt restructuring with stakeholders, in part by soliciting huge contributions from philanthropic foundations so it did not need to sell the city’s art collection.
But “unlike Detroit, there isn’t billions of unencumbered artwork to fund a restructuring” in Puerto Rico, said David Tawil, whose fund, Maglan Capital, held Puerto Rico general obligation debt but has since sold it.
The legal proceeding does not mean negotiations toward a compromise must stop, Governor Rossello said in a statement on Wednesday.
“It is my hope that the Government’s Title III proceedings will accelerate the negotiation process,” the governor said in the statement.
Rossello’s fiscal plan for the island, approved by the oversight board in March, forecasts Puerto Rico having only $800 million a year to pay debt, less than a quarter of what it owes. The low figure alienated creditors and negotiations toward an out-of-court restructuring foundered.
Andrew Rosenberg, a lawyer for the general obligation bondholders, criticized the Title III filing, saying in a statement a consensual deal could have been reached.
“Just as a deal was within reach [on Tuesday], we understand that the oversight board intervened to block it,” Rosenberg said in a statement. “For months, the oversight board has made every effort to sabotage consensual negotiations.”
Francisco Cimadevilla, a spokesman for the board, denied the allegation, saying in an interview, “I can understand that might be a narrative on the other side, but it’s just not the case.”
Conversely, Susheel Kirpalani, a lawyer for COFINA bondholders, called bankruptcy “sound public policy,” saying in a statement it “enables Puerto Rico to freeze numerous lawsuits” and “maintain essential services.”
Analysts and experts agreed the case is likely to take time.
“It will be an orderly process that should be better for creditors in the aggregate than a chaotic and uncertain period involving proliferating lawsuits,” said Moody’s Investor Services analyst Ted Hampton.
Some expect creditors to challenge the filing, arguing the board did not meet requirements under PROMESA to conduct good faith negotiations out of court.
“We would agree there is a case to be made here,” said Keefe Bruyette & Woods analyst Chas Tyson, who follows Puerto Rico.
Factbox: Puerto Rico vs Detroit – What’s different?
Puerto Rico on Wednesday filed for a form of bankruptcy protection, bumping aside Detroit for the title of the largest municipal insolvency case in U.S. history.
While the Caribbean Island and MoTown share comparable histories of economic malaise, ballooning debt and fiscal mismanagement at the heart of their distress, several important differences distinguish the two proceedings.
Here are some key distinctions and similarities:
SIZE OF THE PROBLEM
Puerto Rico’s overall debt burden is nearly seven times larger than Detroit’s was when it entered bankruptcy.
The Motor City had $18 billion of debt, including outstanding bonds and unfunded liabilities for its worker pensions and retiree healthcare, when it filed for Chapter 9 municipal bankruptcy in July 2013.
By contrast, Puerto Rico is struggling with a public debt burden totaling $74 billion of outstanding bonds and $49 billion owed for pensions.
DIFFERENT KIND OF ‘BANKRUPTCY’
Detroit’s case occurred under Chapter 9 of the U.S. Bankruptcy Code, which is reserved for state and local governments.
Puerto Rico, as a U.S. territory, is barred from filing for the same kind of creditor protection, but Title III of the so-called PROMESA law, enacted by Congress last year, allowed it to pursue a court-supervised, bankruptcy-like proceeding to restructure its obligations.
Detroit exited Chapter 9 in December 2014 after a 17-month restructuring that allowed it to shed about $7 billion of debt. Bondholders and bond insurers reached agreements that resulted in recoveries of 74 percent for unlimited-tax general obligation bonds and 34 percent for limited-tax GO bonds.
It is unclear at this stage how much Puerto Rico’s creditors can expect to recover.
POVERTY AND FLIGHT
Heading into bankruptcy, both Detroit and Puerto Rico were plagued with population declines, high unemployment rates, sinking housing values and a large portion of local residents living below the poverty line. Chronically late financial audits were common for both, and severe budget problems adversely affected the delivery of government services.
LOSS OF LOCAL CONTROL
Both Puerto Rico and Detroit had been effectively stripped of local control over their finances by the time each sought protection from creditors.
Detroit’s finances had been turned over to an emergency manager tapped by Michigan Governor Rick Snyder. Kevyn Orr, a corporate bankruptcy attorney from Jones Day, retained day-to-day control over city operations until the city emerged from bankruptcy.
Under PROMESA, Congress imposed an oversight board charged with fixing Puerto Rico’s finances and devising an economic recovery plan. It also armed it with the use of a court-supervised process to restructure the territory’s debt.
Both bankruptcy filings followed bond defaults.
Detroit’s emergency manager skipped a payment on $1.43 billion of pension bonds in June 2013. As of Sept. 30, Puerto Rico and its various bond issuing authorities had missed nearly $1.5 billion in debt service payments.
WHERE’S THE ART?
Perhaps the most unique element of Detroit’s bankruptcy was the role played by its local art museum.
The Detroit Institute of Arts was home to city-owned works from masters such as Claude Monet, Henri Matisse and Pieter Bruegel that were at risk of being sold to help settle Detroit’s debt. A so-called grand bargain involving $816 million pledged by foundations, the institute and the state of Michigan saved the art from sale, while providing money for pensions.