In a new report released Thursday, Moody’s Investors Service addressed investor questions regarding the implications of the recently enacted Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) on the U.S. municipal bond market.
The report ran through what the new law means for the hierarchy of debt versus pensions. Although PROMESA contains limited direct instructions for the oversight board regarding the treatment of pension benefits, how the board interprets this mandate could be the most crucial precedent to emerge from Puerto Rico’s crisis, Moody’s said.
“If the PROMESA oversight board creates a federally sanctioned preference for unsecured pensions over bonded debt, it could have broad, negative implications for the credit quality of debt obligations of states and local governments,” said Emily Raimes, a Moody’s vice president, senior credit officer.
Moody’s also said it is doubtful Congress would enact a PROMESA-like law imposing similar oversight over a state government as it would conflict with established Tenth Amendment doctrine regarding state sovereignty. In addition, Unlike Puerto Rico, states have substantial existing powers to resolve fiscal crises, the agency noted.
“For territories like Puerto Rico, however, the federal government has clear authority to install an oversight board,” Raimes said.
“PROMESA also allows for the potential creation of oversight boards, if needed, for other territories: the U.S. Virgin Islands, Guam, American Samoa and the Northern Mariana Islands.”
Additionally, PROMESA does not alter Moody’s views on the role that legal pledges and covenants play in the credit strength of municipal debt obligations. The legislation calls for the eventual restructuring of Puerto Rico’s various obligation to “respect the relative lawful priorities or lawful liens, as may be applicable…”, consistent with the agency’s view that debt obligations with stronger legal pledges will provide better relative recovery rates in the event of default,” it noted.
The primary questions addressed in the report were:
- Does PROMESA open the door to bailouts of distressed state or local governments? We do not see PROMESA, which provides no new federal funding for Puerto Rico, as a precursor to a federal bailout either for Puerto Rico or for any other financially pressured local or state government.
- How does PROMESA change your views concerning debt security? The law does not alter our view that legal pledges and covenants are very important factors in the credit strength of municipal obligations and, in cases of default, determinants of relative bondholder recoveries. The enactment of PROMESA itself did not cause Puerto Rico to default in violation of its legal pledges to bondholders.
- What does PROMESA mean for the hierarchy of debt vs. pensions? If Puerto Rico’s debt restructuring eventually gives more favorable treatment to pension participants than to bondholders, it will mirror bankruptcy outcomes from Detroit (B2/stable) and Stockton, CA (Ba2/stable), and lend a federal seal of approval to this approach. The law itself, however, contains very limited instructions for the oversight board with respect to the treatment of pension benefits.
- Will PROMESA lead Congress to consider similar legislation for state governments? While the federal government’s clear and broad powers over the territories make a crisis oversight board feasible, it is unlikely that the federal government could pass a PROMESA-like law that imposes direct oversight of a state government, because that would almost certainly run afoul of constitutional principles.