Puerto Rico – a U.S. territory – has defaulted on more than $70 billion of debt, making it the largest municipal default in U.S. history. Despite a large amount of legal uncertainty – or perhaps because of it, vulture funds have swooped in to scoop up the troubled territory’s debt and ultimately try to enforce public spending cuts to make repayment possible. These dynamics could set an important precedent for creditors’ interactions with sub-sovereign states.

Legal Limbo

Puerto Rico is widely considered by experts to be in a state of legal limbo. Since it’s not a U.S. state, the territory is not protected by Chapter 9 of the U.S. bankruptcy code, which means that it cannot restructure its debt in an orderly fashion, like the City of Detroit did in 2013. On the other hand, organizations like the International Monetary Fund (“IMF”) and World Bank cannot provide any assistance since the territory isn’t a sovereign country.

These issues are complicated by the fact that there is no precedent for the island’s legal troubles. While several bills are emerging in Congress that would grant the territory Chapter 9 protection and weaken the hand of creditors, the potential for these bills remains uncertain given the narrative circulating that Puerto Ricans are living beyond their means and could easily pay their debt if they simply implement reforms to lower cost.

Vulture Funds

To make matters worse, a well-organized group of over 30 hedge funds scooped up the territory’s debt for pennies on the dollar and plan to make it pay.

These organizations have recruited a team of former IMF officials to support their case that the territory would be able to pay off its debt if it reduces public spending. In particular, educational spending has entered the public crosshairs, as it has increased by nearly 40% in 10 years despite lower enrollments.

These vulture funds could push for public spending cuts in order to pay off debt, while the high number of ordinary Americans holding the debt means that a full default is unlikely. In some ways, these efforts will prove to be an interesting case study regarding whether or not hedge funds and creditors can dictate terms to sub-sovereign states or whether larger governments will ultimately step in and limit their legal powers or create a moral hazard.

Austerity Risks

Puerto Rico Governor Alejandro Garcia Padilla argued that dramatic austerity would perpetuate the territory’s vicious cycle of debt. As the economy slows due to such measures, larger numbers of working class individuals would likely leave for better opportunities, creating an even larger gap in economic performance. The economy has already lost around 12% of its population over the past decade due to a lack of opportunities.

These problems are similar to those faced in Greece, which has recently accepted its third bailout, as creditors have refused to forgive debt. So far, the country’s austerity measures have only managed to further slow its economy and make repaying increasing levels of debt more difficult. The same could happen to Puerto Rico if vulture funds are permitted to legally enforce the same types of austerity measures in order to be repaid.

Takeaway Points

• Puerto Rico is in a state of legal limbo given that the U.S. doesn’t provide Chapter 9 bankruptcy protection and international organizations can’t help.
• Vulture funds have acquired a large amount of the territory’s debt on the cheap with plans to use the legal system to exact repayments.
• Austerity measures could send the territory’s economy into a death spiral in much the same way that similar measures have done in Greece.