I was an ardent critic of the “PROMESA” legislation Congress passed this summer to help restructure Puerto Rico’s debt for one primary reason: It was clear hat it would serve as a blueprint for the states that have overburdened pension funds to escape their own debts by shortchanging the bondholders—or “vultures”, as Puerto Rico officials and their Treasury Department brethren tended to refer to them.
The response to this concern, from Puerto Rico governor Alejandro Garcia Padilla, officials at Treasury, and even the Republican drafters of the bill, was that the legislation was sui generis: What was done for Puerto Rico would have no bearing at all on the actions the federal government may take in the future to deal with any state or local pension issues.
Now, three months after the president signed the bill into law, it seems many in and around Washington, including some who once claimed that this was an impossible scenario, are singing a different tune. It appears Illinois will be the first target of a state bankruptcy regime.
The state of Illinois and city of Chicago are reeling under debt and pension obligations brought on, similarly to Puerto Rico, by years of failed policies and exorbitant public employee benefit packages. They face exorbitant borrowing costs that have effectively shut them out of the markets, and have been told by courts that they cannot adjust their pension promises because of a unique clause found in the Illinois Constitution.
PROMESA signaled Congress’ willingness to rewrite rules and establish special bankruptcy powers for an entity, in this case Puerto Rico, which borrowed money under the explicit pretense that it could not force lenders into a court-ordered restructuring—even allowing Puerto Rico to renege on priorities established in its own constitution. Now many think that Illinois should ask for the same treatment.
On a panel at the Brookings Institute in July, Governor Padilla remarked that Puerto Rico is only “ahead of a curve that looms for many larger states” and that the island’s government “knocked on doors that other jurisdictions may need to approach.”
William Isaac, a former head of the FDIC, testified in front of Congress in February on the need to protect the commonwealth’s constitutionally-protected general obligation debt from bankruptcy, because of the precedent that restructuring it would set for the states. Now,
he is arguing in favor of furthering the very precedent he argued against: He wants Congress to explicitly create a mechanism by which the Illinois can access bankruptcy and restructure its own GO debt, and specifically references PROMESA as the model for doing it.
David Skeel, one of the appointees to the island’s fiscal control board, has evinced a similar sentiment, writing that general obligation debt should receive no special treatment in a bankruptcy (and indeed that it even be subordinated to some revenue backed debt), and that it is time we create a bankruptcy mechanism for the states as well. There’s a good chance that they’re going to get their wish.
As the market collectively begins to process this reality, some investors are going to be in for a rude shock. Because municipal bankruptcies are rare and states are not legally allowed to declare bankruptcy, municipal bonds have been seen as a particularly safe haven in this topsy-turvy economy; many mom and pop investors have seen them as an ideal place to put their money. But it’s starting to look like they are not so safe, and the biggest risk at the moment is that Congress has demonstrated that it will effectively change the terms of bondholders’ contracts and dispense with the promises made by local governments made when they borrowed that money.
If and when Congress or the Treasury begins discussing the need to do such a thing for their friends in Illinois and Chicago (whose mayor is a close friend of a previous, current, and the likely future president) then investors will come to realize the risk inherent in these (and other) munis and look to dump them as fast as possible.
What is to be done? A good start would be for the recently appointed Fiscal Control Board for Puerto Rico to move toward reaffirming that the legal and contractual terms that bondholders invested under still have some meaning, by ensuring that it treats the Commonwealth’s various bonds in accordance with the priorities under which they were sold.
It is more evident than ever that the Puerto Rico fiscal reform will likely serve as a template for Illinois and the other states with hopeless public pension deficits. The members of its control board should recognize this reality and consider the ramifications of their actions that go beyond the island’s finances.
Ike Brannon is a visiting fellow at the Cato Institute and president of Capital Policy Analytics.
