By Sal Bommarito
Too big to fail is now being applied to more than struggling financial institutions, but the new moniker should be “too important to fail.” Consider the bailout of Detroit and the impending financial disaster in Puerto Rico, both municipalities.
The key aspect of any bailout involving a municipality is the renegotiation of debt that is always the most important element of the process. Without getting too technical, this means that existing debt holders agree to forgive a significant percent of their loans. Since municipalities have no equity, the debt holders receive nothing in kind from the debtor.
This is in contrast to corporations like AIG and General Motors where creditors could exchange some portion of their debt for equity ownership in the companies. The federal government received warrants to buy GM stock at a low price for the loans it made to bailout these entities.
Municipalities are much more complicated to reorganize than corporations. One reason is that they cannot cease to exist or liquidate to repay their debt. Puerto Rico borrowed $70 billion and is on the verge of defaulting on several outstanding obligations. The U.S. government is intimately involved in the current negotiations, although there is little agreement within Congress and with the Obama administration about a solution for the Commonwealth.
Creditors may ultimately forgive part of their loans, but only if Puerto Rico agrees to take certain actions that will make it financially more secure and able to service the residual debt. Complicating the process is the fact that there are many different categories of creditors, some of which are guaranteed by the Puerto Rican government, some of which are secured by specific sources of income (such as taxes) and some that are unsupported by anything other than the general credit of the island.
Creditors will be looking for concessions that will increase the free cash flow of the government. The greatest areas of relief will be derived from decreasing services provided to the citizens of Puerto Rico including basic things like energy, water, police, fire departments, etc. Decreasing payments to municipal pension funds would be another major source of cash.
The people on the island are protesting vehemently. They say decreasing basic services is unfair, and they are dependent upon their pensions for their retirement. At some point, the federal government will likely step in to defray some of these cuts in services and pensions, thereby transferring some percent of Puerto Rico’s financial responsibilities to the American taxpayers.
Puerto Rico’s dilemma is more problematic because the government sponsored Government Development Bank is the repository of billions of dollars of Puerto Rican investments by island residents. The likely default by the Bank will have serious repercussions for one million families. The government does not guarantee the Bank’s obligations, so when it defaults, many investors will lose money.
Much of the Bank’s debt is held by Puerto Ricans through credit unions. Local investors have invested billions in these credit unions, which in turn have financed municipal securities.
The point that needs to be made from all this is that there are hundreds of municipalities across the country that will probably encounter serious financial problems in the near future. They will be deemed too important to fail. Millions of people living in these places are dependent upon services provided and the jobs offered by the local government.
This scenario will occur for a number of reasons. Some of the most important ones include:
- Costly municipal pension agreements negotiated years ago that will never be funded.
- The migration of undocumented immigrants and the stress they have put on state and local governments for health care, education and jobs.
- Unwarranted and costly projects for which municipalities have borrowed billions.
- Out of control health care benefits to municipal workers.
The chickens have come home to roost. Tax receipts have not kept pace with inflationary costs and all the expenses mentioned above. City dwellers have resisted higher taxes and so the deficits in cities and states continue to skyrocket.
More bailouts of municipalities will continue to put financial stress on the economic stability of the U.S. The problem is that the federal government will not allow municipalities to go bankrupt and abandon citizens dependent on their services.