On Monday, June 29, 2015, the sovereign nation of Greece made headlines across the globe when they announced they were going to refuse a new loan from the ECB because of the strict austerity measures attached to it. But what might have gotten lost in financial news earlier this week is the situation in Puerto Rico. The US territory announced yesterday that it was unable to meet its debt obligation of $72 billion.
This caused a good amount of angst in financial markets, particularly for hedge funds that own Puerto Rican debt. American hedge funds like to undertake distressed debt. The bonds are usually sold at a tremendous discount when the investors fear a risk of default and hedge funds jump on the fire sale, presumably understanding the risks when they do.
Well, in reality, the risk might be significantly less for these hedge funds than for the traditional investor. Due to the size and influence of hedge funds, they can bully international governments and force them into fully repaying their bonds (with interest). This can cause tremendous problems for the indebted country though, often leading to resistance to the efforts made by hedge funds.
Hedge funds don’t care. They don’t care if their demand to be paid full value on these bonds pushes the country into bankruptcy. They don’t care if it screws over every other investor who might have agreed to a debt restructuring deal. All they care about is getting their money. That has had some unfortunate consequences though for foreign governments, and it may have similar consequences for Puerto Rico as we move forward.
Argentina: The Power of Paul Singer
The story of Argentina’s attempt to default on its debt obligations is perhaps a good indicator of what’s to come for Puerto Rico. It’s a story that goes back fifteen years. In December of 2001, Argentina announced to its debt holders that it couldn’t pay back the $100 billion it owed. Argentina, though, spent the next decade negotiating with bondholders and restructuring its debt like any business or individual would in the case of bankruptcy.
Ninety-three percent of creditors were willing to accept a deal Argentina put forth in 2010. In that deal, Argentina promised creditors a third of the original amount loaned with the condition that the replacement bonds would increase once the country’s economy started to rebound. The other 7%, a group of hedge funds, laughed at this proposal. Instead, the hedge funds banded together under the leadership of Paul Singer, and filed a lawsuit in US court demanding that all the creditors be paid in full or not at all.
They won – a judge in the United States in 2012 demanded that Argentina pay all of its creditors back in full, despite the fact that Argentina clearly didn’t have the capability to do that at the time. So 93% of creditors, who had been getting repaid since they agreed on the deal in 2010, stopped received payments. The deal they struck with 93% of creditors was essentially thrown out the window. This caused Argentina to default on July 31, 2014. But to the credit of Argentina, they have been fighting the United States’ hedge fund managers heavily on this matter. They view this as an issue on national pride, and feel like they are being exploited by a few vultures.
What Does This Mean For Puerto Rico?
Unfortunately for Puerto Rico, much of their debt is owned by hedge funds, even more so than Argentina. There are 35 hedge funds negotiating with the Puerto Rican government trying to ensure they don’t lose their money even if Puerto Rico defaults. They are asking for similar conditions that Paul Singer asked for with Argentina.
They want guarantees that they will be paid in full (including interest) even if Puerto Rico defaults, and they want to be paid before the Government Development Bank, the bank that handles all of Puerto Rico’s debts and obligations. Hedge funds also want the debt issued under New York law (presumably, so they have legal recourse) and they want Puerto Rico to close its budget deficit within five years.
Puerto Rico has said that these terms are completely unacceptable. The governor of Puerto Rico essentially said that creditors who took a risk buying Puerto Rican bonds are going to have to share the sacrifices with the Puerto Rican people. The governor also said that if hedge fund managers don’t come to the table with an honest proposal that works for both parties, the Puerto Rican economy is going to suffer even more, fully assuring that they don’t get their money back.
Hedge fund managers have been trying to arrange a meeting with Puerto Rico, but so far Puerto Rico has been nonresponsive.
Heads I Win, Tails You Lose
So in summation, when countries rack up too much debt and investors become nervous about future defaults, traditional municipal investors tend to sell off their bonds far below face value because the market is running away from these assets. Distressed debt investors like hedge funds then purchase these bonds at a supreme discount with the hope that the country will not default before the bonds mature. In short, they take a relatively big risk for a relatively big payoff.
This seems logical. But if the country defaults, instead of accepting the loss, the hedge fund demands that the country pay them back in full even if it strangles their local economy and is completely unfeasible. If the government refuses, then they take them to court in the United States and ask a judge to freeze any payments made by the country to any bond holder until that country agrees to pay every single bondholder in full, even if the vast majority of bondholders agreed to a completely different deal!
The court ruling over the Argentinian debt crisis seems to have set a precedent for hedge funds who rack up distressed debt from foreign governments. They are trying to cheat the market with a win-win situation, bending the legal system of the United States in their favor to squeeze every last dollar from the treasuries of any foreign government.
To be fair, not all hedge funds engage in this morally bankrupt practice, and it’s not certain that the ones negotiating with Puerto Rico will carry their demands to the extreme like Paul Singer did. That said, their initial demands indicate that we could be heading down a similar path.
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