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Puerto Rico Collapse Shows Debts Seen as Ironclad May Not Be (2)

(Bloomberg) -- Puerto Rico’s decision to use a U.S. court to escape from its debts cast few ripples in the state and local bond market, where prices rose Wednesday. But the action -- once inconceivable for a territory that didn’t have authority to file for bankruptcy -- sets a precedent that could resonate with struggling states in the decades ahead.

The island was extended the bankruptcy-like powers by Congress as a way to end an intractable crisis, despite the assurance once given to investors that it couldn’t be done. While state finances are largely on the mend and officials have dismissed any suggestion they would ever push lawmakers for the same legal recourse, the path ceded to Puerto Rico has fostered speculation it may one day look attractive to governments at the end of their financial ropes.

“There’s a cautionary tale here across the board,” said Jim Millstein, founder of Millstein & Co., which served as financial adviser to Puerto Rico under former Governor Alejandro Garcia Padilla. “Municipal debt, state debt, federal debt, sovereign debt is not without risk. The truth is that bondholders get paid based on the health of the economy of the issuer.”

Puerto Rico’s restructuring will be the biggest in municipal-bond market history, vastly larger than Detroit’s $18 billion record bankruptcy, and will mark the first time a state-level issuer has had debt written off in federal court. It comes after years of borrowing to pay bills as the economy shrank and residents left for the U.S. mainland, leaving the government without enough revenue to repay what it owes.

The island had been expected to resort to such a step ever since Congress enacted legislation last year that allowed for it. There was no discernibly negative impact from the news on the financial markets, with yields on an index of top-rated 10-year municipals slipping to 2.15 percent. Nor did it have a big effect on Puerto Rico bonds: a commonwealth general obligation with an 8 percent coupon, one of the island’s most-actively traded securities, changed hands for an average of 65.2 cents on the dollar Thursday, up from 64.7 cents on Tuesday, ahead of the court filing.

“Puerto Rico’s just been in the news for so long we know it’s in default,” said Matt Dalton, chief executive officer of Rye Brook, New York-based Belle Haven Investments, which oversees $5.7 billion of municipal bonds, including insured Puerto Rico debt. “We know it’s a problem.”

Municipal bankruptcies are rare, given that governments have the power to raise taxes to satisfy their debts. Even after the Great Recession, only a few local governments did so. And the scale of Puerto Rico’s debts is far larger than any other major American government, exceeded only by those of the more populated and wealthier New York, California and Massachusetts.

While some issuers can solve their fiscal challenges over time, investors will be watching states and localities with mounting financial problems, said Robert Amodeo, head of municipals in New York for Western Asset Management Company.

“Each issuer faces different circumstances, and some can fix their imbalances over time, but new negative information will heighten concerns for any one of them,” Amodeo said.

Pension Woes

Puerto Rico’s collapse also shows the pressure than can emerge when retirement systems run out of cash. States such as Illinois and New Jersey are under increasing fiscal strain as their unfunded retirement liabilities grow. The gap between U.S. state pension assets and benefits promised to public employees climbed to $1.1 trillion in 2015, Pew Charitable Trusts said in a report last month.

Illinois is grappling with more than $129 billion of retirement debt, leaving the state with the worst credit rating in the nation. Efforts to shore up its retirement systems have fallen victim to partisan gridlock as Republican Governor Bruce Rauner and the Democrat-led legislature have failed to agree on a spending plan for almost two years.

Even so, the possibility of petitioning Congress to allow for bankruptcy isn’t being discussed, and Democrats have roundly ruled out allowing even the Chicago school district to do so. The idea for opening bankruptcy to states was briefly raised in the Republican-led U.S. House of Representatives after the recession, only to be dismissed by governors who said it would cause investors to demand higher yields on their bonds.

Nobody should assume that a Puerto Rico-type restructuring could be applied to U.S. states: Territories and states are distinct under the U.S. Constitution, and the Tenth Amendment limits the federal government’s ability to legislate for the states, according to lawyers and legal scholars.

Virgin Islands

“If Congress acting under Article I powers were to amend the bankruptcy code to allow either voluntary or involuntary debt adjustment for U.S. states, very serious questions would be raised about unconstitutionality,” wrote Fordham University School of Law Professor Andrew Kent in a April 20, 2016 letter to the congressional committee that drafted Puerto Rico’s oversight law.

The events in Puerto Rico may have more immediate relevance to the U.S. Virgin Islands, its smaller Caribbean neighbor. Debt sold by the island is junk-rated, it faces population decline, large unfunded retirement liabilities and has a history of borrowing to fill budget gaps.

“If Puerto Rico can achieve this level of debt relief through Promesa as the initial plan suggested, it will only make sense for Virgin Islands to attempt the same,” said Matt Fabian, a partner with Municipal Market Analytics.

(Adds comment from former adviser in the fourth paragraph.)

--With assistance from Elizabeth Campbell

©2017 Bloomberg L.P.