The shadow bailout of Puerto Rico is underway

You may recall that the initiative in Congress to bail out Puerto Rico by allowing them to enter into bankruptcy pretty much fell flat. Of course, there wasn’t much enthusiasm for seeing the Island of 3.5 million people completely collapse into a failed territory, either. On Friday they’re going to miss another multi-billion dollar payment date so we should have known that there would be some sort of “compromise” afoot on the Hill to avoid both situations, but what would that look like? John Fund at National Review takes a peek at what’s in the works and it looks like the sort of “third way” which Washington is famous for, causing problems in the capitalist market while really pleasing nobody.

But the U.S. Senate may vote to make things worse this week by passing a rescue package that suspends the constitutional rights of bondholders in the island to collect on their debts. Debt holders will essentially have no legal means to secure repayment.

The Senate is acting on its version of a House bill that passed last month that sets up an oversight board to monitor Puerto Rican finances and the power to override some destructive laws. That’s all well and good, but the bill comes with a poison pill by allowing write-downs of bonds in which payment is guaranteed by Puerto Rico’s constitution.

As Fund notes, this is a direct violation of Puerto Rico’s constitution, which assures that bonds shall be repaid. It’s precisely that iron clad guarantee which convinced so many investors to dump significant investment capital into the territory for many years. That’s something of a double edged sword, of course, because it allows unfettered capitalism to thrive, but doesn’t allow much wiggle room if the beneficiaries of the investments can’t cover their payments such as in the situation we’re seeing now.

Why would the GOP go for this? Because it’s not technically a “bailout” as such. We’re not sending federal tax dollars to Puerto Rico to cover their markers and we’re not letting them go into bankruptcy. What we are doing is giving a legislative nod to the idea that they can violate their own constitution and stick it to the investors. The island’s formerly pristine credit rating should be well and truly in the dumpster by the time this exercise is complete and it still doesn’t provide any assurance that they’ll regain any semblance of fiscal stability even with this maneuver.

What will the bondholders do in response? Fund predicts that we (as in “we the taxpayers”) may wind up holding the bag anyway.

The irony is that if Washington passes a short-sighted Puerto Rican debt-relief bill, it may still wind up handing taxpayers the tab. There is no doubt a “takings” lawsuit will be led by bondholders claiming that Congress confiscated the value of their property by allowing Puerto Rico to shortchange tham on payment. If that lawsuit wins in the courts, you can bet Congress – meaning U.S. taxpayers – will be required to pay the bondholders whatever amount Puerto Rico didn’t pay. That would simply be a bailout by another name.

Ideally, Puerto Rico should have been able to go into some severe conservative mode of operation, cutting costs in every corner until they got back up to speed on their bond payments. Unfortunately, the time for that would most likely have been years ago and such “regressive” moves would have been highly unpopular with the locals. At this point I’m not seeing anyone with a viable solution on the table, so Puerto Rico may wind up looking much like Detroit, only with nicer weather and beaches.

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