The government of Puerto Rico continues to hold the all-time record for a municipal insolvency, having gone broke with over $120 billion in total debt, six times as much as the second-place holder, the City of Detroit.

Faced with this huge, complex, and highly politicized financial mess, and with normal Chapter 9 municipal bankruptcy legally not available, the Congress wisely enacted a special law to govern the reorganization of Puerto Rico’s debts. “PROMESA,” or the Puerto Rico Oversight, Management, and Economic Stability Act, provided for a formal process supervised by the federal courts, in effect a bankruptcy proceeding.  It also created an Oversight Board (formally, the Financial Oversight and Management Board for Puerto Rico) to coordinate, propose and develop debt settlements and financial reform.  These two legislative actions were correct and essential. However, the Oversight Board was given less power than had been given to other such organizations.  The relevant models are notably the financial control boards of Washington DC and New York City and the Emergency Manager of Detroit, all successfully called in to address historic municipal insolvencies and deep financial management problems.

It was clear from the outset that the work of the Puerto Rico Oversight Board was bound to be highly contentious, full of complicated negotiations, long debates about who should suffer how much loss, political and personal attacks on the Board and its members, and heated, politicized rhetoric.  And so it proved to be.  Since the members of the Oversight Board are uncompensated, carrying out this demanding responsibility requires of them a lot of public spirit.

An inevitable complaint about all such organizations, and for the Puerto Rico Oversight Board once again, is that they are undemocratic.  Well, of course they are, of necessity, for a time. The democratically elected politicians who borrowed beyond their government’s means, spent the money, broke their promises, and steered the financial ship of state on the rocks should not remain in financial control.  After the required period of straightening out the mess and re-launching a financial ship that will float, normal democracy returns.

It is now almost five years since PROMESA became law in June, 2016.   It has been, as it was clear it would be, a difficult slog, but substantial progress has been made.  On February 23, the Oversight Board announced a tentative agreement to settle Puerto Rico’s general obligation bonds, in principle the highest ranking unsecured debt, for on average 73 cents on the dollar.  This is interestingly close to the 74 cents on the dollar which Detroit’s general obligation bonds paid in its bankruptcy settlement.   If unpaid interest on these bonds is taken into account, this settlement results in an average of 63 cents on the dollar.  In addition, the bondholders would get a “contingent value” claim, dependent on Puerto Rico’s future economic success—this can be considered equivalent to bondholders getting equity in a corporate reorganization–very logical.

The Oversight Board has just filed (March 8) its formal plan of adjustment.  It is thought that an overall debt reorganization plan might be approved by the end of this year and that the government of Puerto Rico could emerge from its bankrupt state.  Let us hope this happens.  If it does, or whenever it ultimately does, Puerto Rico will owe a debt of gratitude to the Oversight Board.

We can draw two key lessons.  First, the Oversight Board was a really good and a necessary idea.  Second, it should have been made stronger, on the model of previous successes.  In particular, and for all future such occasions, the legislation should have provided for an Office of the Chief Financial Officer independent of the debtor government, as was the case with the Washington DC reform.  This was highly controversial, but effective. Any such board needs the numbers on a thorough and precise basis.  Puerto Rico still is unable to get its audited annual reports done on time.

A very large and unresolved element of the insolvency of the Puerto Rican government remains subject to a debate which is important to the entire municipal bond market.  This is whether the final debt adjustments should include some reduction in the almost completely unfunded government pension plans.  Puerto Rico has government pension plans with about $50 billion in debt and a mere $1 billion or so in assets.

There is a natural conflict between bondholders and unfunded pension claims in all municipal finance, since not funding pensions is a back door deficit financing scheme.  General obligation bonds are theoretically the highest ranking unsecured credit claims, and senior to unfunded pensions.  But the reality is different.  De facto, reflecting powerful political forces, pensions are the senior claim.  Pensions did take a haircut in the Detroit bankruptcy, but a significantly smaller one than did the most senior bonds.  In other municipal bankruptcies, unfunded pensions have come through intact.

What should happen in Puerto Rico?  The Oversight Board has recommended modest reductions in larger pensions, reflecting the utter insolvency of the pension plans.  Puerto Rican politicians have opposed any adjustment at all.  Bondholders of Illinois: take note of this debate.

I suggest a final lesson:  the triple-tax exemption of interest on Puerto Rican bonds importantly contributed to its ability to run up excess and unpayable debts.  Maybe there was a rationale for this exemption a hundred years ago.  Now Puerto Rico’s bonds should be put on the same tax basis as all other municipal bonds.