May 2, 2019

Six Lessons

Mr. Chairman, Ranking Member Bishop, and Members
of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a senior fellow at the R
Street Institute, and these are my personal views.  I have spent almost five decades working in
and on the banking and financial system, including studying the recurring
insolvencies of municipal and sovereign governments.  I have personally experienced and studied
numerous financial crises and their political aftermaths, and have authored
many articles, presentations, testimony and two books on related subjects.  Prior to R Street, I was a resident fellow at
the American Enterprise Institute 2004-2016, and President and CEO of the
Federal Home Loan Bank of Chicago 1991-2004.

In my view, there are six key lessons about PROMESA,
the massive insolvency of the government of Puerto Rico, and the role of the
Oversight Board we should consider. 
These are:

  1. The fundamental bargain of PROMESA was
    sound.  But it could be improved.
  2. In such situations, a lot of conflict and
    controversy is unavoidable and certain.
  3. The Oversight Board should have more power: in
    particular, it should have the same Chief Financial Officer provisions as were
    so successfully used in the Washington DC reforms.
  4. Oversight boards are likely to last more than
    three years.  In Puerto Rico, all the
    problems were of course made more difficult by the destructive hurricanes, and
    the flow of federal emergency funds into the Puerto Rican economy now makes the
    financial problems more complex.
  5. Large unfunded pensions are a central element in
    these situations and set up an inescapable conflict between the claims of
    bondholders and pensioners.
  6. Progress must operate on three levels of
    increasing difficulty:
  7. Equitable reorganization of the debt (including
    pension debt)
  8. Reform for efficiency and reliability in the
    fiscal and financial functioning of the government
  9. Reforms which allow a growing, enterprising
    successful market economy to emerge from the historic government-centric

  1. The fundamental bargain of PROMESA was sound.  But it could be improved.

As it considered PROMESA, the Congress was faced with a
municipal insolvency of unprecedented size. 
As one analyst correctly wrote, “There is no municipal borrower remotely
as insolvent as Puerto Rico.”  Indeed,
adding together its $70 billion in bond debt and $50 or $60 billion in unfunded
pension debt, the government of Puerto Rico has debt of more than six times
that of the City of Detroit, the previous all-time record holder, as it entered

The fundamental bargain Congress constructed in PROMESA to
cope with Puerto Rico’s financial crisis made and makes good sense.  It may be described as follows:

     -To the Puerto
Rican government:  We will provide
reduction and restructuring of your unpayable debts, but only if it is
accompanied by fundamental financial and government reform.

     -To the
creditors:  You will get an appointed
board to oversee and reform Puerto Rico’s finances, but only if it also has
debt reduction powers.

This is a sound bargain. 
The resulting Oversight Board created by the act was and is, in my
judgment, absolutely necessary.  But its
members, serving without pay, were as we all know, given an extremely difficult
responsibility.  So far, significant
progress has been made, but much remains to do.  Let us hope the Senate promptly confirms the
existing members of the Board, so that its work may continue uninterrupted.

In the negotiations leading to PROMESA, it was decided to
create an Oversight Board, less powerful than a control board.  I thought at the time, and it seems clear in
retrospect, that it would have been better—and would still be better–for it to
have more of the powers of a financial control board, as discussed further
under Lesson 3.

Two well-known cases of very large municipal insolvencies in
which financial control boards were successfully used were those of New York
City and Washington DC.  In 1975, New
York City was unable to pay its bills or keep its books straight, having relied
on, as one history says, “deceptive accounting, borrowing excessively, and
refusing to plan.”  In 1995, Washington
was similarly unable to pay its vendors or provide basic services, being mired
in deficits, debt and financial incompetence. 

Today, New York City has S&P/Moody’s bonds ratings of
AA/Aa1, and Washington DC of AA+/Aaa.  We
should hope for similar success with the financial recovery of Puerto Rico.

Nothing is less surprising than that the actions and
decisions of the Oversight Board have created controversy and criticism, or
that “the board has spent years at odds with unhappy creditors in the mainland
and elected officials on the island.”

As one Oversight Board member, David Skeel, has written, the
Board “had been sharply criticized by nearly everyone.  Many Puerto Ricans and economists…argued that
our economic projections were far too optimistic….  Creditors…insisted that the economic
assumptions in the fiscal plan were unduly pessimistic and…provided too little money
for repayment.”

The settlement of defaults, reorganization of debt and
creation of fiscal discipline is of necessity passing out losses and pain,
accompanied by intense negotiations.  Of
course, everyone would like someone else to bear more of the loss and
themselves less.  It is utterly natural
in the “equitable reorganization of debt” for insolvent debtors and the
creditors holding defaulted debt to have differing views of what is

If only one side were critical of the Oversight Board, it
would not be doing its job.  If it is
operating as it should, both sides will complain, as will both ends of the
political spectrum.  In this, I believe
we must judge the Oversight Board successful.

The financial control boards of New York City and Washington
DC are now rightly considered as a matter of history to have been very
successful and to have made essential contributions to the recovery of their
cities.  But both generated plenty of
complaints, controversy, protests and criticism in their time.

In Washington, for example, “city workers protested by
blocking the Control Board’s office with garbage trucks during the morning rush
hour.”  In the board’s first meeting,
“protesters shouted ‘Free D.C.’ throughout the meeting, which was brought to an
end by a bomb threat.”  Later, “in one of
its most controversial actions, the Board fired the public school
superintendent, revoked most of the school board’s powers, and appointed its
own superintendent to lead the system.”

In New York, the board “made numerous painful, controversial
decisions that the administration of Mayor Abraham D. Beame was unwilling or
unable to make.  It ordered hundreds of
millions of dollars in budget cuts above those proposed by the administration
and demanded the layoffs of thousands of additional city workers.  It rejected a contract negotiated by the
city’s Board of Education…it also rejected a transit workers’ contract.”

What did this look like at the time?  “In the eyes of many people in the city, it
was most distasteful,” said Hugh Carey, then Governor of New York State.  “They saw the control board as the end of
home rule, as the end of self-government.” 
Another view: “The city of New York was like an indentured servant.”

In restructurings of debt and fiscal operations, it has been
well observed that a “key factor is making sure that the sacrifice is
distributed fairly.”  But what is fair is
necessarily subject to judgment and inevitably subject to dispute.

As PROMESA came into effect, as has been observed, “The most
obvious obstacle…was that no one really knew what Puerto Rico’s revenues and
expenditures were.” This financial control mess, stressed by expert consultants
at the time, highlights the central role in both creating and fixing the debt
crisis, of financial management, reporting and controls.  Progress had been made here with efforts of
both the Oversight Board and Puerto Rico, as the certified fiscal plan has been
developed.  But the government of Puerto
Rico still has not completed its audited financial statements for 2016 or 2017,
let alone 2018.

Of the historical instances of financial control boards in
municipal insolvencies, there is a key parallel between Puerto Rico and
Washington DC:  in both cases, there is
no intervening state. The key role played by New York State, or by Michigan in
the Detroit bankruptcy, for example, is missing. The reform and restructuring
relationship is directly between the U.S. Congress and the local government.

The most striking difference between the Washington DC board
and the Oversight Board is the greater power of the former.  This was true in the initial design in 1995,
but when Congress revised the structure in 1997 legislation, the Washington
board was made even stronger.  Most
notably, the Washington design included the statutory Office of the Chief
Financial Officer, which answered primarily to the control board and was
independent of the mayor.  Puerto Rico
has created its own Chief Financial Officer, as good idea as far as it goes, but
it lacks the reporting relationship to the Oversight Board and the independence
which were fundamental to the Washington reforms. 

Today, long after Washington’s financial recovery, the
independence remains.  As explained by
the current Office of the Chief Financial Officer (OCFO) itself:

“In 1995, President Clinton signed the law creating a
presidentially appointed District of Columbia Financial Control Board…. The
same legislation…also created the position of Chief Financial Officer, which
had direct control over day-to-day financial operations of each District agency
and independence from the Mayor’s office. 
In this regard, the CFO is nominated by the Mayor and approved by the DC
Council, after which the nomination is transmitted to the U.S. Congress for a
thirty-day review period.

“The 2005 District of Columbia Omnibus Authorization
Act…reasserted the independence and authority of the OCFO after the Control
Board had become a dormant administrative agency on September 30, 2001,
following four consecutive years of balanced budgets and clean audits.”

If PROMESA were ever to be revised, for example trading
additional financial support for additional reform and financial controls, as
happened in the Washington DC case in 1997, I believe the revision should
include structuring an Office of the Chief Financial Officer for Puerto Rico on
the Washington DC model.

As we come up on the third anniversaries of PROMESA and the
Oversight Board, we can reflect on how long it may take to complete the
Oversight Board’s responsibilities of debt reorganization and financial and
fiscal reform.  More than three years.

The New York City control board functioned from 1975 to
1986, or eleven years.  There was a
milestone in 1982, which was the resumption of bank purchases of its municipal
bonds. That took seven years.

The Washington DC control board operated from 1995 to 2001,
or six years.  (Both boards still remain
in the wings, capable of resuming activity, should the respective cities
backslide in their financial disciplines.)

Everything in the Puerto Rico financial crisis was made more
uncertain and difficult by the destruction from the disastrous hurricanes of
2017.  Now, as in response, large amounts
of federal disaster aid are flowing into the Puerto Rican economy. 

How much this aid should be is of course a hotly debated
political issue.  But whatever it turns
out to be, this external flow makes the formation of the long-term fiscal plan
more complex.  Whether the total disaster
relief is the $82 billion was estimated by the Oversight Board, the $41 billion
calculated as so far approved, or some other number, it is economically a large
intermediate-term stimulus relative to the Puerto Rican economy, with its GDP
of approximately $100 billion.

There are significant issues of how effectively and
efficiently such sums will be spent, what the economic boost will be as they
generate spending, employment and government revenues, whether they can result
in sustainable growth or only a temporary effect, and therefore how they will
affect the long-term solvency and debt-repayment capacity of the government of
Puerto Rico.  Even if none of these funds
go to direct debt payment, their secondary effects on government revenues may.  How to think through all this is not clear
(at least to me), but a conservative approach to making long-term commitments
based on short-term emergency flows does seem advisable.

The Oversight Board will have to come up with some defined
approach to both long and short-term outlooks, as it continues its double
project of debt reorganization and fiscal reform.  That is yet another difficult assignment for
them, requiring time and generating controversy.

Puerto Rican government pension plans are not only
underfunded, they are basically unfunded. 
At the time a PROMESA, a generally used estimate of the pension debt was
$50 billion, which added to the $70 billion in bond debt made $120 billion in
all.  It appears that there is in
addition $10 billion in unfunded liabilities of government corporations and
municipalities, making the pension debt $60 billion, and thus the total debt,
before reorganization haircuts, $130 billion. 
As I learned from an old banker long ago, in bankruptcy, assets shrink
and liabilities expand.

How are the competing claims of bondholders and pensioners
equitably to be settled?  This is an
ever-growing issue in municipal and state finances—very notably in Illinois and
Chicago, for example, as well as plainly in Puerto Rico.  The bankruptcy settlement of the City of
Detroit did give haircuts to pensions—a very important precedent, in which the
state constitution of Michigan was trumped by federal bankruptcy law.  But the pensions turned out in Detroit, as
elsewhere, to be de facto senior to all unsecured bond debt. This reflects the
political force of the pensioners’ claims and needs.

On April 30, the Oversight Board demanded that the government
of Puerto Rico act to enforce required contributions to pension funds from
several public entities and municipalities. 
It is “unacceptable to withhold retirement contributions from an
employee and not immediately transfer that money into the individual retirement
account where it belongs,” wrote our colleague on the panel, Natalie
Jaresco.  She is right, of course.  Except that it is worse than
“unacceptable”—it is theft.

Pensions as a huge component of municipal insolvencies will
continue to be a tough issue for the Oversight Board, as well as for a lot of
other people.

Three years into the process, the first of these
requirements is difficult and controversial, but well under way.

The second is harder, because it is challenging government structures,
embedded practices, power, and local politics. 
Relative to addressing insolvency, the most important areas for reform
are of course the financial and fiscal functions.  Reform would be advanced by the creation of
an Office of the Chief Financial Officer on the Washington DC model.

The third problem is by far the most difficult.  Solving the first two will help make solving
the third possible, but the question of how to do this is not yet answered,
subject to competing theories, and major uncertainty.  We all must hope for the people of Puerto
Rico that it will nonetheless happen.

Thank you again for the chance to share these views.

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