Why are hedge funds so interested in Puerto Rico debt?

1. HEDGE FUNDS AND THE MUNI MARKET
Puerto Rico, the Outlier
Maria de los Angeles Trigo
August 2015
Hedge Funds and the Muni Market: Puerto Rico, the Outlier 1

2. IT HAS BEEN REPORTED THAT HEDGE FUNDS HOLD
30%
OF THE PUBLIC DEBT ISSUED BY ENTITIES OF
THE PUERTO RICO GOVERNMENT
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3. Why are they so interested in Puerto Rico debt?
In this presentation I discuss:
 how hedge funds started participating in the sovereign debt market,
 their absence in the US municipal debt market, and
 what makes Puerto Rico attractive to this type of investor.
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4. The Setting
 In 28-30 April 2015 the UN Ad Hoc Committee on Sovereign Debt Restructuring
celebrated its second working session. His Excellency Axel Kicillof, Minister of
Economy and Public Finance of Argentina, addressed the Committee with a
historical background of the participation of hedge funds in the sovereign
debt market since the creation of the Bretton Woods institutions. It mirrors
what has happened with Puerto Rico debt and its purchase by these investors.
 The post starts with a summary of the change in the sovereign debt market
from multilateral obligations between nations to the participation of private
creditors. It is not a summary of Minister Kicillof’s address, but his speech is
the inspiration for the post.
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5. The Setting — In the Beginning
 Countries need capital to provide for the development of its infrastructure
and economy. Debt issued by sovereigns was issued to other sovereigns in
bilateral or multilateral agreements in which countries were creditors of one
another. To help broker negotiations among creditor countries and debtor
countries, the Paris Club was created in 1956. It still serves as an informal
creditor group where parties negotiate the restructuring of debt incurred
through bilateral or multilateral agreements, among countries.
 After the Second World War the United Nations celebrated the Monetary and
Financial Conference, where mostly the US and the UK designed an
agreement to create a new international finance system. This is the Bretton
Woods Agreement.
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6.  With the Bretton Woods agreement in 1944, international entities such as the
International Monetary Fund and The World Bank were organized, and the
system that we know today came to be. Although there is still lending among
countries, it is also done by the new international organizations: the Bretton
Woods institutions.
 With the oil crisis in the 1970s commercial banks started to participate in
sovereign lending because of excess money in the system, because they
needed to recycle petrodollars deposited in the largest commercial banks.
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7.  This excess liquidity in the commercial banks, and banking system in general,
originated because of the massive amounts of money that the countries
producers of oil generated through the sale of oil (the two oil shocks of the
1970s). These transactions were denominated in dollars (hence the name
petrodollars) and were deposited in big commercial institutions.
 To make use of the huge amounts of petrodollars, commercial banks started
to participate in sovereign lending, which was done mostly at variable rates.
Therefore, when the US Federal Reserve Bank raised rates in 1979-1980 to
20% from 11%, the immediate consequence of this rate change for sovereigns
was that, proportionally, their debt burden doubled.
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8. The Setting — And You Are…?
 Coupled with the fall of commodity prices, the increase in interest rates
unleashed the external debt crisis of the 1980s, starting with Mexico in 1982,
when it defaulted on its debt.
 Since the crisis started to affect several countries in quick succession, two US
Treasury Secretaries, James Baker and Nicholas F. Brady, came up with
proposals to stop the spillover of these defaults.
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9.  The Baker Plan proposed the postponement of debt payments, the granting of
new loans, and changes in the policies of debtor countries; there was no
forgiveness of debt. The main problem with the plan was that many
commercial banks didn’t want to increase their exposure to sovereign debt.
The situation was critical for banks, since the loan exposure in the US banks
was in average 130% of the banks’ capital and reserves. Eventually, banks
established debt reserves against these loans, which made it harder for them
to extend loans under the Baker Plan, but easier to participate under the
Brady Plan, restructuring the debt at less than face value, since they had
already taken a loss.
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10.  The Brady Plan was directed to developing countries and the proposal was to,
in practice, privatize the sovereign debt. The plan, carried out during the
1990s, refinanced the loans the sovereigns owed commercial banks with
instruments that the banks could easily trade, and thus, creating a market for
sovereign debt.
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11.  With the early restructurings under the Brady Plan new types of investors and
broker dealers entered what they called the “emerging markets”, and
transformed sovereign debt to a bond market. An important feature of the
plan was that these instruments issued to the commercial banks were to be
guaranteed by investments in US Treasuries.
 Commercial banks eventually started trading the debt instruments, and
countries started refinancing debt with bonds issued in the international
capital markets, instead of taking loans from banks, bank syndicates, or other
sovereigns.
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12. Minister Kicillof
 The Brady Plan was a process of privatization of sovereign debt, and also its
atomization, by breaking it up in small parts. This new reality has given
private parties power over the economies of debtor countries. The hedge
funds’ apogee started in the 1990s when the sovereign debt turned into bond
debt, without any institutional control or regulation.
 The funds started their litigation strategies in the late 1990s against African
countries, getting victories in different courts [I add, mostly European] to
“collect” precedents. The result has been that now they can block almost any
kind of restructuring.
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13.  Hedge funds are not the typical investor that invests in the development and
the future of a country. They just buy title to the debt, and are converting
sovereign debt into a commercial transaction not under the debtor country’s
sovereignty.
 Capital needed by countries to promote their development is provided by the
financial markets. But if the market can turn into a system of appropriation of
national assets, then the system is a parasite and not a participant in the
development of the countries.
 And the situation is still pertinent, since if interest rates go up, the debt
burden for developing countries will increase, since there is sovereign debt
issued at variable rates.
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14. Municipal Debt? No, Thank You
 Subnational governments (State and local) in the US can issue debt as
prescribed under the State laws, and in the US capital market under federal
law. They are provided with a restructuring process through Chapter 9 of the
US Bankruptcy Code. State governments cannot file for relief, but their local
issuers can, if they have been authorized by State law.
 States don’t have access to Chapter 9, but have political clout in the US
Executive Branch and in Congress — which counts for something.
 This availability of Chapter 9 makes the municipal debt issuers of the US
unattractive to hedge funds: when your business strategy is to buy cheap and
collect all the amount due, at face value and all arrears, it doesn’t make
sense to buy the debt of an issuer that has been provided with a framework to
restructure that has been “blessed” by the US Constitution.
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15.  That leaves sovereign debt, especially debt issued under foreign law (usually
New York and UK) as the most attractive for distressed credit investors.
Sovereigns have no framework within which to restructure debt issued under
foreign law, since this debt is subject to foreign interests, courts, and
interpretations.
 On the other hand, debt issued under national law is better managed, since
the applicable law is the debtor’s law, and purchasers of the debt have
accepted the jurisdiction of, usually, national courts.
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16. Puerto Rico, Here We Are
 Hedge funds are not the typical investor in the municipal debt market in
which Puerto Rico issues its debt. It is the first time distressed credit
investors are so heavily invested in a US municipal issuer.
 Even when Puerto Rico debt has been almost in its entirety been issued under
and subject to Puerto Rico law, it is also subject to the US Constitution and US
Federal Courts interpretation, factors over which Puerto Rico has no control.
 It is the quite an interesting position to be:
 not a sovereign with absolute control over the debt issued under and
subject to its national law
 not a US municipal debt issuer with access to the restructuring regime
of Chapter 9
 Puerto Rico has the worst combination of factors: a “sovereign” that issues
debt under its own law but cannot control how it restructures its debt
because it is also subject to foreign law (the US Constitution).
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17. Where’s My Money
 For distressed credit investors, on the other hand, it’s a wonderful
combination, with debt that:
 is not subject to a composition where the majority of creditors
decides on new terms
 is subject to foreign law (the US Constitution, even if not necessarily
the US courts)
 For the last 20 years hedge funds have been quite active in the sovereign
debt market, buying distressed debt at very discounted rates and then
litigating for the repayment of the totality of the debt. In the most famous
cases this strategy has meant earnings of 400% (Perú), 540% (Zambia), 1,400%
(Congo), and 1,600% in the case of Argentina (no, those numbers are not
typos). In all of these cases the debt had been issued under foreign law:
either NY or UK law, considered to be the most creditor-friendly jurisdictions.
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18.  That strategy will not work in Puerto Rico.
 The debt is issued under Puerto Rico law, and the courts will most probably be
(and in some cases must be) Puerto Rico courts. It is not a country having to
litigate its sovereign debt in a foreign jurisdiction, even if it is still subject to
the US Constitution.
 I don’t see a litigation strategy that will guarantee earnings of that
magnitude, even in the long term.
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19. Close to You
 Although there would be a payoff in the long term when Puerto Rico’s
economy starts growing again, the hedge funds interest may also be in the
shorter term. A country with liquidity problems and a pressing need to invest
in infrastructure may decide to go on a privatization spree. That could
provide a benefit to hedge funds and their partners, with contracts signed for
at least 30-40 years, requirements of guaranteed minimum income, and
repayment secured by specific assets. They could even receive negotiable
instruments representing the repayment obligations — a “Bradyzation” of the
obligation.
 It brings to mind a preliminary offer investors made to PREPA (the electric
service company), with a team of investors, developers, administrators, and
operators already in place.
 But even this “privatization strategy” is long-term, since the investor would
still need a growing and eventually robust economy for the initial investment
to pay off, and to generate enough recurrent income.
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20. Together… Forever?
 The hedge funds’ strategy with other sovereigns has been successful in part
because other sovereigns have been able to partially restructure their debt,
and receive additional investment from international organizations such as
the IMF and the World Bank.
 The money freed by the negotiations reached with other creditors may help a
country improve its economic conditions, which then makes it easier for the
hedge funds to litigate for the payment of the instruments they hold; after
all, the debtor country’s economy is improving.
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21.  That doesn’t apply to Puerto Rico either. The US court held that Puerto Rico,
because of the US Constitution, cannot implement a composition of debt in
which the majority of creditors decides on new terms. And what use is a
restructuring that knowingly creates hold-outs?
 Second, Puerto Rico doesn’t have access to any international organization to
request aid, either financial or advisory or of any other kind. The US has
historically quite actively opposed any attempt by Puerto Rico to reach to
these entities. So, who will take the loss now so that these investors may
eventually collect the totality of the debt?
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22. We’ll See
 I see only two alternatives: either
 the US stands aside while Puerto Rico reaches out to international
financial organizations, or
 the US takes their place.
 Although… there’s always a third one: leave Puerto Rico to manage its debt
under its laws and its courts.
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23. Extras
 The recording of Minister Kicillof’s address can be seen here (starts at 1:25).
 The Emerging Markets Traders Association (EMTA) has a brief summary on the
Brady Plan here and here.
 El Confidencial published an interesting take on the hedge funds’ interest in
Puerto Rico and Greece.
 Important to note that in the hearing before the Subcommittee on Regulatory
Reform, Commercial and Antitrust Law of the Judiciary Committee of the US
House of Representatives for the H.R. 870 (Puerto Rico Chapter 9 Uniformity
Act of 2015), the main reason given by investors for their opposition to the
bill was that creditors didn’t fare well in the Detroit bankruptcy.
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24. Originally published in LinkedIn
 Hedge funds and the muni market: Puerto Rico, the outlier
 22 June 2015
 This presentation has been edited from the original post.
 Maria de los Angeles Trigo, an attorney and certified public accountant, helps clients understand
Puerto Rico’s public finance market. She advises financial institutions, investors, law firms, and
government institutions on Puerto Rico debt’s legal and regulatory framework. Maria de los Angeles
worked for 16 years in the Government Development Bank for Puerto Rico and was the highest-
ranking career legal officer as Director of the Compliance Department and Acting Deputy Director of
the Legal Division.
 If you would like to receive future posts, just click the follow button, in SlideShare and LinkedIn.
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