Observations on Another Bailout: a “Super-Bond” For Puerto Rico

by Victor Sperandeo with the Curmudgeon

Disclaimer: Victor has been in Puerto Rico for the last week. All opinions expressed herein are his.

Introduction:

The U.S. Treasury is talking to Puerto Rico (PR) about saving them from default on $72 Billion of debt they can't pay. According a 10/15/15 WSJ article titled: Puerto Rico, U.S. in talks Over Debt, the U.S. Commonwealth would issue a "super-bond" to help restructure $72 billion in debt. It would be administered by the U.S. Treasury Dept. which would swap $72 billion of non-payable debt for this "super bond” guarantee.

Victor's Opinion: This looks like something between the Greece bailout and the horror movie "Friday The 13^th." Expect more of these horror bail-outs to come to save large institutional investors. Hedge funds bought PR bonds, in some cases with an 18% effective- tax free -yield, and those "investors" are smiling today. While there is talk of a “haircut,” the details are not clear or concluded.

Isn't this restructuring of non-payable debt what bankruptcy courts are for? Previous talk of resolving PR's debt crisis was to permit it to go bankrupt, like Detroit did. What law permits the US Treasury Dept. to guarantee PR’s “super bond?” (I can’t find that definition in my financial dictionary!)

Curmudgeon Notes & References:

• An inability to collect all the taxes owed is widely seen as contributing to Puerto Rico’s debt crisis. The island faces more than $18 billion in debt-service payments alone between 2016 and 2020, according to a recent report from a working group set up by Governor Alejandro Garcia Padilla. Best case, with reforms and a return to growth, the island would still face a $14 billion funding gap, according to a Barclay’s review of the group’s findings.
• Over 20% of bond mutual funds own Puerto Rican bonds, according to data from Morningstar (the exact numbers are 377 funds out of 1,884 United States bond mutual funds). Hedge funds also own PR bonds, but the total is not known.
• While federal law allows municipalities to restructure their debts under Chapter 9, that option is unavailable to states or US territories (like PR). Fortune columnist Amilcar Antonio Barretorote in a blog post: “A more realistic short-term solution is amending federal law to allow the Commonwealth of Puerto Rico to file for Chapter 9. In the long haul the island’s economy cannot recover to the point where it can repay its debts without a restoration of tax incentives that attracted industries there in the first place.”
• Without addressing the proposal directly, officials from the Treasury said in a statement that it had “no plans to provide a bailout to Puerto Rico.” Source: Treasury Considers Plan to Help Puerto Rico.
• Kevin Allison wrote a great summary and conclusion in a Breaking News Blog post: “The Treasury Dept.'s super-bond is a poor substitute for a financial control board or Chapter 9 bankruptcy…..Even if super-bond was to be implemented, it would leave needed institutional reforms to Puerto Rico’s finances unaddressed. That makes it a partial solution at best.”
• Reference: Puerto Rico’s Debt Crisis and How U.S. Government Could Help

SIDEBAR: Washington Post writer Charles Lane’s editorial: Puerto Rico’s crisis illustrates the risks of minimum wage hikes:

"Greece’s impending bankruptcy is dominating the headlines right now, but between that financial catastrophe and the one facing Puerto Rico, the latter probably deserves more attention in the United States — or at least more attention than it’s getting. After all, whether “contagion” from a default by the Caribbean island’s government is great or small, almost all of those affected by it would be U.S. citizens, from the holders of Puerto Rican bonds to the island’s people themselves.

“What’s more, the Puerto Rican predicament results in large part from policy mistakes by the US federal government — with directly relevant lessons for the economic debate on the U.S. mainland.”

Take the minimum wage. Right now, progressives around the country are campaigning to raise it to $15 an hour — more than double the current $7.25 minimum and even higher than the $10.10 supported by President Obama. Advocates confidently assert that this huge increase in the price of labor could be imposed with no significant job-killing impact, or at least that any such consequences would be outweighed by reductions in income inequality. Puerto Rico’s economic ruin, however, is partly a story of the damage an ill-considered minimum wage hike can do.

Prior to 1974, Congress held Puerto Rico’s minimum wage below that of the mainland, a sensible policy given the commonwealth’s lower level of economic development and labor productivity. Then, with the best of intentions, lawmakers ordered Puerto Rico to equalize its rate with the federal figure; this was phased in by 1983, and the Puerto Rican minimum wage has moved in lock-step with the federal minimum ever since.

The results were sharply disruptive, according to a 1992 National Bureau of Economic Research analysis. They included “substantially reduced employment on the island” and mass migration of suddenly unemployable lower-skilled workers to the U.S. mainland. Puerto Rico did post a short-term increase in real earnings, but the causal factor was the out-migration, which shrank the labor supply. Without the exodus, the authors noted, “it would have been virtually impossible to impose the U.S.-level minimum on the island.”

Is the U.S. Constitution still Relevant?

A "minimum wage "is not a right written in the US Constitution, nor one of the 18 things the government was allowed to do as written in Article 1 Section 8. PR's minimum wage isn't the cause of the non- payment of debt. Indeed, saving the bond holders by a bail-out doesn't solve the same mandated minimum wage problem from recurring in the future.

The U.S. Constitution - Article One/Section 1: "All legislation Powers herein granted shall be vested in a Congress of the US, which shall consist of a Senate and House of Representatives."

The very first sentence of the "law of the land" says where laws are created. The Department of the US Treasury isn’t mentioned! Therefore, it does not have the right to create law or bail out anyone. Also, I don't see an exception for Hedge Funds?

It seems the "US Constitution" is really just a retired ship these days, as the trashing and unconstitutional changing of the law is the cause of virtually all of the problems of today. It will cause greater destruction in the future, in my view.

The U.S. Debt Limit Ceiling Must be Raised - Yet Again:

Ironically, Treasury Secretary Jack Lew wrote Thursday in a letter: “The U.S. debt limit will be exhausted Nov. 3^rd, two days before previously estimated. At that point, we expect Treasury would be left with less than $30 billion to meet all of the nation's commitments — an amount far short of net expenditures on certain days, which can be as high as $60 billion. Operating the United States government with no borrowing authority, and with only the cash on hand on a given day, would be profoundly irresponsible. As I wrote previously, we anticipate that a remaining cash balance of less than $30 billion would be depleted quickly."

Secretary Lew knows he is negotiating $72 Billion of effective guarantees, which will turn into spending as the PR bonds can't be paid by the Commonwealth. Why didn’t he see mention this issue in the debt limit proposals?

Note that under Dodd Frank-II, the U.S. government can’t bail-out U.S banks. Please see Dodd-Frank Title II is Incomplete and Misleading? Somehow, U.S. territories don't count in Dodd Frank-II??

It gets better ... also reported 10/15/15 by Terence P. Jeffrey in an article titled: $3,248,723,000,000: Federal Taxes Set Record in FY 2015; $21,833 Per Worker; Feds Still Run $438.9B Deficit:

“The federal government took in a record of approximately $3,248,723,000,000 in taxes in fiscal 2015 (which ended on Sept. 30), according to the Monthly Treasury Statement released today."

So the U.S. "stated debt" (not including unfunded liabilities, or off balance sheet debt plus estimated bad debts on the Fed and government agencies books) as of September 30th indicates the budget deficit was $438.9 billion. That’s with record tax payments received. The federal government is yet again out of paper money, and needs to borrow more at the same time that the U.S. Treasury Dept. is considering ~ $72 billion more in effective potential spending guarantees for PR without consulting Congress or suggesting they pass a bail-out bill? This is blatantly unconstitutional!

Without the Rule of Law the U.S. is in Big Trouble:

Allan H Meltzer, highly regarded Professor at the Tepper School of Business at Carnegie Mellon University, said in a "Real Vision TV" interview:

There are two axioms of nations:

· No nation has ever remained rich without the rule of law, and

· No nation ever became rich without the rule of law.

This is an example why any close analysis of the U.S. debt and breaking of the laws of the land to allow debt issuance is a real problem which most people have not considered. Unfortunately, it may result in hyperinflation sometime in the future.

Hyperinflation Sequence:

First comes the recession/depression causing the national debt to explode. That causes a run from the dollar, which leads directly to a substantial decline in the dollar's purchasing power and thereby hyperinflation.

The clue for hyperinflation to take hold is a "substantial decline" of the dollar along with the price of the 10 and 30 year U.S. debt. If you see this unfold, gold will rise to levels you cannot imagine.

Selected Quotes on Gold:

Hans F. Sennholz wrote “When paper money systems begin to crack at the seams, the run to gold could be explosive.”

He also wrote: “The history of fiat money is little more than a register of monetary follies and inflation. Our present age merely affords another entry in this dismal register."

Dr. Franz Pick wrote: “Gold bears the confidence of the world’s millions, who value it far above the promises of politicians, far above the unbacked paper issued by governments as money substitutes. It has been that way through all recorded history. There is no reason to believe it will lose the confidence of people in the future.”

Good luck and till next time…

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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