How a Broke Little Island Beat the Hedge Funds

Puerto Rico got the debt relief legislation it wanted while some of the most powerful forces in finance got stiffed. What happened?

People protest outside of Wall Street against cutbacks and austerity measures forced onto the severely indebted island of Puerto Rico on December 2, 2015 in New York City.
People protest in December outside of Wall Street against cutbacks and austerity measures forced onto the severely indebted island of Puerto Rico in New York City.

Spencer Platt/Getty Images

In 2015, the hearts of hedge funders fluttered when former Treasury Secretary Larry Summers wrote, in a Washington Post op-ed on Puerto Rico’s debt crisis, “How things play out from here will be an important test of whether Washington is, as some allege, controlled by financial interests.” For anyone with deep pockets and an interest in maintaining leverage over the Puerto Rican government, killing congressional debt relief legislation must have looked like a slam dunk. To give Puerto Rico the option to legally restructure its debts, Congress would need a groundswell of bipartisan action—all to help poor, nonvoting quasi-citizens in an ugly election year. How would you have bet?

Yet, on June 30, Obama signed into law the Puerto Rico Oversight, Management and Economic Stability Act (or PROMESA, which means “promise” in Spanish), handing a rare loss to a group of powerful hedge funds—along with banks and public mutual fund companies Franklin Templeton and OppenheimerFunds Inc.—that saw in Puerto Rico’s slow-burn fiscal crisis an opportunity for profit.* In doing so, Congress preemptively decided what was shaping up to be a multiyear war between Puerto Rico and its creditors, giving leverage to Puerto Rico’s previously overmatched government and pulling the rug out from under the funds doing the financial equivalent of turning the commonwealth upside down, shaking hard, and collecting the coins that fell out of its pockets. How did such a thing happen? How did some of the most powerful forces in American finance lose to a broke little island?

A quick refresher on government borrowing: Public authorities, towns, cities, states, our federal government, and sovereign states the world over frequently issue debt (i.e., borrow money from investors) for needs ranging from, say, building an aqueduct to bridging budget gaps between now and tax day. Once public entities decide when and how much they want to borrow, a bank steps in to underwrite the bonds, determining how to sell them, and how to fill in the blanks in the book-length prospectuses that accompany every bond issuance. The bank finds customers for the bond sale—anyone from labor union pension funds looking for a safe place to invest members’ dues, to hedge funds using municipal bonds to balance complex, algorithmically risk-weighted portfolios—and the bonds continue to trade on the secondary market just like stock, with the issuing government’s fiscal health driving the undulations in a bond’s price.

Apart from some legal quirks (no taxes!), Puerto Rico’s bonds were no different. What does make Puerto Rico’s bonds different from the bonds of every state-level issuer since 1933—when Arkansas defaulted—is that Puerto Rico mostly isn’t paying them back. The commonwealth’s government told the world mid-2015 that it couldn’t pay its debt and proved it over the intervening year, defaulting on select issues of bonds on multiple occasions before July 1, the day after PROMESA passed, when it managed to make principal and interest payments on just over half the $2 billion that had come due that day. The latest budget proposed for Puerto Rico’s next fiscal year includes no allotment for debt service payments. The Treasury estimates that hedge funds own about $23 billion, or more than one-third, of Puerto Rico’s external debt. That sound you hear is teeth grinding in midtown Manhattan and Greenwich, Connecticut.

The congressional debt relief bill puts a stay on litigation stemming from the defaults on Puerto Rico’s bonds: Those hedge funds and mutual funds, who before PROMESA and after informal negotiations failed, raced to court to argue Puerto Rico was legally required to pay its debts. It also creates a federally appointed fiscal oversight board to oversee Puerto Rico’s budgeting for the next few years and mediate a period of negotiations with creditors, in which Puerto Rico will ask the parties that lent it money—or the parties that acquired the debt securities that represent those loans—to accept significant haircuts and extended repayment schedules. (Think new loans worth 50–60 percent of original face value with principal repaid in 2065 instead of 2035.)

If those negotiations aren’t fruitful—and the complex creditor voting process laid out in PROMESA almost guarantees Puerto Rico won’t come to a consensual agreement with all of its sundry creditors—the fiscal oversight board will commence a bankruptcy proceeding in a U.S. District Court. In Detroit’s court-supervised bankruptcy, some creditors walked away with just 14 percent of their original loans. To avoid that outcome, Puerto Rico’s creditors will either have to swallow their pride and come to a painful agreement with the commonwealth, or gamble on the inventiveness and tenacity of their lawyers to convince the presiding bankruptcy judge that their loans should take priority over Puerto Rico’s pension system and public services.

Puerto Ricans aren’t happy with the oversight board, calling it the latest in a long history of colonial intrusions on Puerto Rican sovereignty. They’re not wrong: The unelected fiscal oversight board will in many ways supplant the island nation’s elected officials, and instead of simply bailing out Puerto Rico or canceling its debts, PROMESA gives the commonwealth the tools to negotiate with creditors, keeping it reliant on well-heeled lawyers and consultants for the foreseeable future—all without contemplating the new revenue needed to pay for them. Equally, if less sympathetically, aggrieved are the financial heavyweights that needed Puerto Rico to stay in what Supreme Court Justice Ruth Bader Ginsburg called federal bankruptcy law’s “never-never land.”

Before PROMESA, Puerto Rico was considered a state-like entity with regard to bankruptcy law. The 11th Amendment’s prohibition on federal interference in interstate disputes has long been interpreted to preclude state bankruptcies, as states are inevitably in hock to parties from other states—for example, when a retail investor in Minnesota owns shares in a mutual fund invested in California debt. The dynamic duo of Jeb Bush and Newt Gingrich wrote a Los Angeles Times op-ed in 2011 arguing states should be permitted to declare bankruptcy, but somehow the movement never got off the ground. However, municipalities within states—like Detroit or your local water utility—can declare bankruptcy. Except in Puerto Rico, for reasons dating back to an obscure and maybe accidental 1984 legislative amendment.

This legal ambiguity proved disastrous for Puerto Rico but created an opening for what we’ll call nontraditional opportunistic investors. As Puerto Rico’s debt mounted and fears began to form about its ability to repay creditors—solidified by a 2013 Barron’s article and a ratings-agency downgrade of Puerto Rico’s general obligation bonds—many long-term, low-risk mutual funds that held Puerto Rico’s debt as part of a portfolio from issuers all over the country reduced their exposure to the suddenly dicey bonds as fast as they could. Big hedge funds like Marc Lasry’s Avenue Capital, Jeffrey Gundlach’s DoubleLine, D.E Shaw, Paulson and Co., Davidson Kempner, Farallon, and others sensed an opportunity. Puerto Rico’s debt became relatively cheap as traditional investors fled, yet Puerto Rico had no legal way to avoid repaying the debt.

Specialized high-yield funds at Oppenheimer and Franklin Templeton also increased their positions in Puerto Rico’s debt, evidently confident that yields on the bonds—between 8–12 percent depending on the issuer over the last two years, spiking to much higher rates when things looked iffy—adequately compensated them for the risk that Puerto Rico would default on, or even completely repudiate, its debt.

These funds were betting on two things: a long-term turnaround for Puerto Rico, premised on the notion that Puerto Rico’s finances and its instrumentalities were simply in better shape than its government had claimed; or, failing that, successful legal action to recover the full face value of debt originally purchased for much less.

Hedge funds that bought Puerto Rico’s debt on the cheap hoping a turnaround would increase its value worked hard to make it happen (or at least briefly inflate the value of their holdings). The New York Times reported in 2014 that a group of 28 hedge funds and other investment firms were dispensing advice, providing public relations support, and offering to lend to Puerto Rico, on the theory that helping to paint a rosy picture of Puerto Rico’s finances would lead their bonds to appreciate. They also advocated for austerity in Puerto Rico’s budgets, commissioning a 2015 report arguing for increasing taxes, loosening labor laws, and cutting subsidies for health care and education.

They pushed these reforms even though Puerto Ricans can—and, because of rising taxes and lagging services, increasingly do—migrate to the U.S. mainland without restriction, a population drain that makes it difficult to raise revenue or reinvigorate the economy. Promoting austerity, which could boost the commonwealth’s liquidity before the lagging effects of migration hollow out its tax base, reveals hedge funds’ medium-term interest in the Puerto Rican economy and their adherence to the one-size-fits-all distressed debt investing blueprint, where what (sort of) worked for Greece and Argentina makes sense for Puerto Rico, too.

As recently as eight months before the passage of PROMESA, some funds were arguing that prices for Puerto Rico’s bonds had bottomed out. In November, Avenue Capital’s Marc Lasry explained his decision to buy more commonwealth bonds by saying, “It’s hard to get hurt now in Puerto Rico.” (This blithe sentiment was nicely bookended by Treasury Secretary Jacob Lew’s comment after PROMESA’s passage: “For everyone who says you can’t do hard things, it’s a reminder than you can do hard things.”)

Members of labor unions march past the capitol building during a protest in San Juan September 11, 2015.
Members of labor unions march past the capitol building during a protest in San Juan, Puerto Rico, on Sept. 11, 2015.

Alvin Baez/Reuters

Some doubted this strategy from the start. Mark Taylor, who co-manages two high-yield municipal bond funds with Alpine Funds, told me he stayed away from Puerto Rico’s uninsured bonds over the past few years as the commonwealth had failed to release required financial disclosures—a red flag for junk-rated debt. David Tawil of Maglan Capital, which owned Puerto Rico’s bonds before the market “came to its senses” in late 2014, believes that the funds who stayed in Puerto Rico even as its fiscal woes began making headlines felt they knew Puerto Rico’s legal rights and their own, and that Puerto Rico would have to bend to their will sooner or later. Today, Tawil told me, “There is no positive catalyst on the horizon”—nothing will lift prices on Puerto Rico’s bonds high enough to give investors a profitable exit. Former U.N. official Jose Antonio Ocampo, who co-wrote a June report on building Puerto Rico’s economy, chalked investor confidence up to naiveté, telling me, “I really think they overestimated the capacity of P.R. to recover.”

Another investor who decided against buying Puerto Rico’s bonds at distressed prices pointed out to me that big hedge funds missed some ominous signs: In 2015, for example, the outgoing chairman of the agency that issues Puerto Rico’s general obligation bonds submitted legislation retroactively indemnifying his employees for “acts performed in good faith and within their legal authority”—a pretty good sign that he expected the commonwealth to stop making payments on its constitutionally guaranteed debt.

However ill-fated, the hedge funds’ Puerto Rico play was not without precedent. Until PROMESA, it appeared that Puerto Rico had no legal option but to negotiate with its creditors, meaning funds could gain on bonds bought cheaply either from an organic turnaround or from a lengthy court battle. Since there is no international bankruptcy court, the same dynamic has created a small cottage industry of investors in distressed sovereign debt. Argentina defaulted on over $80 billion of its sovereign bonds in 2001; shortly thereafter, multiple funds—most famously Paul Singer’s Elliott Management—acquired its bonds for pennies on the dollar and litigated for full repayment of the debt.*

The resulting 14-year saga, which saw Elliott detain an Argentine naval vessel docked in Ghana, earned Singer’s fund some $800 million on its original investment and graffiti on the streets of Buenos Aires tagging him and his ilk “vultures.”* Argentina may be the best-known and most dramatic example, but vulture funds—or, when they resort to litigation after a country’s bonds fail to recover naturally, “professional suers of sovereign states”—have found opportunities in many countries in or teetering on the brink of default since the Latin American financial crisis in the early 1980s. Vulture funds have amassed large quantities of distressed debt and litigated for repayment in countries as varied as Peru, Ukraine, Zambia, and Ireland; Hillary Clinton’s son-in-law, Marc Mezvinsky, seems to have been following a version of this strategy when he was famously wiped out in Greece.

If Puerto Rico wasn’t going to turn around, then, the task was making sure it didn’t have access to federal bankruptcy courts. In the fall of 2015, the 60 Plus Association, part of the Koch Brothers political network, ran ads calling the still-gestating debt-relief bill a “bailout” and crony capitalism, and recruited small bondholders and retirees to put a sympathetic face on the argument that restructuring would hurt average citizens.

The New York Times would later report that the 60 Plus Association was itself recruited by the DCI Group, a Republican astroturfing firm whose clients include the decidedly non-average BlueMountain Capital, a hedge fund that held multiple forms of Puerto Rico debt. Consortiums of financial entities—ranging from banks to hedge funds to mutual fund companies—lobbied officially and informally against the restructuring bill, and in the early going it appeared Republicans would keep a full restructuring off the docket. (Ironically, it was Democrats responding to concerns from the commonwealth and its diaspora about colonialism—as well as provisions in the bill that create an unlikely scenario in which Puerto Rico’s labor laws would be loosened—that nearly delayed the bill beyond the July 1 default deadline.)

Ultimately, however, Congress seemed to understand that Puerto Rico’s fiscal situation would either require the right to restructure its debt or a Troubled Asset Relief Program–style appropriation of federal funds, as many of the lawmakers who voted for PROMESA emphasized that it “wouldn’t cost taxpayers a dime”—except, of course, Puerto Rican taxpayers. Creating a debt-restructuring mechanism for Puerto Rico affects the average congressman’s constituency in no way whatsoever, and Puerto Rico’s unique relationship with the federal government helps ensure this legislation will create few precedents for other states. These two factors permitted conservative legislators to finally shrug and vote for a bill they didn’t like, despite the hedge fund money that went toward convincing them to block it at all costs. Among Democrats, advocacy from the White House was key: In the run-up to the House vote, Treasury Secretary Jack Lew personally called even junior Hispanic lawmakers in support of the bill, and he and right-hand man Antonio Weiss met with leery senators repeatedly in advance of that chamber’s vote.

Advocates of the bill on the island also persuasively characterized the fiscal crisis as a pressing emergency and July 1 as a drop-dead date for addressing it. In April, Gov. Alejandro García Padilla told the press that Puerto Rico was struggling to pay the fuel supplier for its police cars and emergency vehicles; by June, he was telling an audience at the Center for American Progress that he would be forced to shutter parts of Puerto Rico’s government without debt-relief legislation. Here, hedge fund tactics helped justify congressional action: In April, a group of hedge funds asked a federal court in San Juan to freeze the assets of Puerto Rico’s main fiscal agent, creating the prospect of a genuine liquidity crunch that could impair needed services on the island.

Were things really this dire? Before a Senate committee, University of Puerto Rico economist Carlos A. Colón De Armas insisted that Puerto Rico’s stated inability to pay its debts was merely a strategy to force Congress’ hand. Even supporters of debt relief for Puerto Rico, like New Jersey Sen. Bob Menendez, repeatedly asserted that the July 1 debt payment deadline was irrelevant in light of Puerto Rico’s previous defaults and Congress’ power to retroactively stay litigation. Nevertheless, evidence of real hardship for the Puerto Rican people—rising utility rates, health care gaps, unemployment ticking up—went well with the Puerto Rican government’s apocalyptic communications strategy, which seeded the U.S. media with frantic reports about Puerto Rico’s burgeoning humanitarian crisis.

Thus the surreal scene of genuine, bipartisan cooperation. On the same day that funding to fight Zika died in a volley of partisan recrimination, Senate Majority Leader Mitch McConnell said of PROMESA, “We’re whipping it hard and the [Obama] administration is trying to help on the Democratic side.”

With that, Congress gave Puerto Rico an out—a burdensome and hazardous one, but still an out—and turned its back on a huge swath of benefactors who had hoped to corner Puerto Rico into coughing up the money. Over the coming months, the funds that still hold Puerto Rico’s debt will log endless hours at the negotiating table, haggling not only with Puerto Rico’s government and newly installed fiscal oversight board but with each other, as each fund argues that its bonds deserve priority. After that comes the morass of bankruptcy court, where Detroit’s restructuring wrapped up in a miraculously efficient 14 months. For funds constantly seeking to exit investments quickly and at a profit, Puerto Rico may end up a cautionary tale about investing in distressed debt—and investing in politicians.

Correction, July 12, 2016: This article misstated Oppenheimer & Co. as an investor in Puerto Rico’s debt. It’s OppenheimerFunds Inc. The story also misspelled Elliott Management. (Return.)