Huh? Punishment for Taking Out A Loan You Couldn't Afford is... You Don't Have To Pay the Loan Back?

I really was not going to blog this week but this article exceeded by fury threshold, which is pretty hard to do nowadays.

The report, shared with MarketWatch, states that some of Puerto Rico’s debt may have been issued illegally, allowing the government to potentially declare the bonds invalid and courts to then decide that creditors’ claims are unenforceable. The scope of the audit report, issued by the island’s Public Credit Comprehensive Audit Commission, covers the two most recent full-faith-and-credit debt issues of the commonwealth: Puerto Rico’s 2014 $3.5 billion general-obligation bond offering and a $900 million issuance in 2015 of Tax Refund Anticipation Notes to a syndicate of banks led by J.P Morgan

So government officials break the law by taking out a loan they shouldn't have taken out, and the punishment is that they get to keep the money and not pay it back?  This is absolutely absurd.  That means that completely innocent third parties are essentially being fined $4.4 billion for the malfeasance of Puerto Rico's government officials.  Were the creditors truly innocent?  Well, the same report goes on to further criticize the government officials for not telling their creditors that what the government was asking for was illegal

Puerto Rico did not inform bondholders that its constitution forbids it from using debt to finance deficits. That, the commission’s report says suggests “substantive” noncompliance with the letter of the constitution

So in fact, incredibly, the creditors' very innocence is used as part of the proof that the debt was illegal, and thus that creditors should be expropriated.

I thought that this couldn't possibly be the law, except that the Supreme Court has already upheld the same outcome in other cases:

The U.S. Supreme Court has said in the Litchfield v. Ballou case and, more recently, in litigation related to Detroit’s bankruptcy that borrowing above a debt ceiling may allow the issuer to declare debt invalid and, therefore, unpayable. Detroit went to court to invalidate $1.45 billion in certificates of participation, debt issued by two shell companies called “service corporations.” The parties settled before the case went to trial, but, while refusing two initial proposed settlements, the judge stated that Detroit’s argument had “substantial merit” and that the suit would have had a “reasonable likelihood of success.”

This is they type of thing that occurs in banana republics.  No honest nation with a strong rule of law operates this way.  And what is to prevent other distressed government bodies with limited ethics (e.g. the State of Illinois) from carefully borrowing money in a way that is subtly illegal and then repudiate it a few years later?


  1. ToddF:

    "This is they type of thing that occurs in banana republics."

    Looked at Obama's America, lately? Yes, we are becoming a banana republic.

    Lesson to take from this? Never lend a backwards, deadbeat, banana republic people like the American people money. You will get burned. Guaranteed.

  2. Not Sure:

    "This is they type of thing that occurs in banana republics."

    You mean like having the cops stop you and take your cash, even though you're not charged with anything?

  3. Not Sure:

    "So government officials break the law by taking out a loan they shouldn't have taken out, and the punishment is that they get to keep the money and not pay it back?"

    Professional courtesy.

  4. DaveK:

    There's absolutely nothing to prevent this from happening again. It only stops when the money runs out (or is devalued to zero, with the same effect).

  5. jon49:

    And what is to prevent other distressed government bodies with limited ethics (e.g. the State of Illinois) from carefully borrowing money in a way that is subtly illegal and then repudiate it a few years later?

    The free market is what would prevent it. If a government does this then the interest rates will rise since it is known to be a risky investment.

  6. xtmar:

    Why should the people of a state pay for the malfeasance of their officials?

    However, it mostly seems like a huge failure by the ratings agencies and the due diligence types

  7. Andrew_M_Garland:
    Mark Twain: “No man's life, liberty, or property are safe while the legislature is in session.”

    Puerto Rico takes money from people under false pretenses, like a swindler. Then, the court says it shouldn't have happened, but the state swindler smiles and says "you should have read the fine print in the PR constitution".

    How do you know whether you live in a tyranny? Say, when the mayor of San Jose, with impunity, orders his police to avoid trouble by not defending people wearing Trump T-shirts, not defending against a mob throwing eggs and bottles.
    === ===
    In its release, SJPD said it held off in arresting people seen committing crimes because it “had the difficult task of weighing the need to immediately apprehend the suspect(s) against the possibility that police action involving the use of physical force under the circumstances would further insight the crowd and produce more violent behavior.”
    === ===

    So, when a mob acts, our modern police step back, because it might make the mob more violent. They just hope that the hospital can fix up the unlucky few who have to be injured while the police may remain uninjured. The mob notes this policy for the next time.

    Do you live in a tyranny? Say, when El Presidente can do anything he wants, subject to court decisions years later, and then can ignore those decisions or test the law again.

    Say, when there is much chin pulling over the knotty issue of whether the Congress has legal standing (!) to restrain the borrowing and spending of El Presidente. And more chin pulling about whether any minority in Congress can do anything at all.

    Yes, a tyranny. The US economy is adjusting nicely to the new reality. Slow growth (if lucky) and restrained investment is the result of tyranny. Ask Venezuela about the later stages of rule by El Presidente.

  8. Roy_Lofquist:

    Well, this is one way to handle it.

    Hello? J.P. Morgan? This is Antonio in San Juan.

    So solly, Wrong number. This Golden Lotus Restaurant and Steam Laundry.

  9. jdgalt:

    There is precedent for this, depending on how much the judge believes the lenders knew. Making a loan to someone you know, or should know will probably default has always been considered fraud.

  10. irandom419:

    I wonder if that is what Trump will say about America's debt?

  11. jdgalt:

    I certainly don't consider myself bound by my ancestors' foolishness.

  12. jdgalt:

    The big banks will be happy to buy it. They know the government will bail them out, or just give the Fed permission to pull more trillions out of its ass.

  13. John Moore:

    Errr... due diligence? It looks to me like the villains are also those who sold those bonds to investors - the middlemen. Did nobody due their due diligence? The provision is a fact that should have been discovered by analysts. I'd say any bond holder who bought through any middleman has a case against someone. As other commenters say, why should the residents of Puerto Rico pay for malfeasance by their officials and negligence by investors?

  14. herdgadfly:

    Then there is the illegal bankruptcy proceedings involving GM and Chrysler whereby the bondholders, stockholders, dealerships and other debtors had to eat shit for the benefit of the UAW. The presiding judge ignored the bankruptcy law as written at the behest of the Obama regime. Subsequently, sweet deals were worked by the Congress to funnel lots of taxpayer money to Fiat and the new GM, including freedom from income tax and virtually all financing for the failed Chevy Volt and its flaming battery.

  15. chembot:

    Replace "creditors" with "grandma's pension fund" or "little Johnny's Savings bond" and you begin to see the problem. "The People" (TM) are still paying for it one way or another. It may seem a trite way to put it, but a bond is a contract and people (and institutions) buy them assuming that the issuing agency is acting in good faith. If morality and/or justice ruled the day, these people would be made senior creditors first in line to get their funds back when assets get liquidated. (Now, if your argument is that the corrupt officials should be held personally liable, I can see some justice in that. However, that is not how these things generally work in gov't)

    If this type of activity were committed by a citizen, there is a good chance they would end up like Bernie Madoff or Ken Lay. (Or perhaps Martin Frankel is more appropriate here...)

  16. chembot:

    If you were to go to your local bank to purchase a T-bill, how much "due diligence" are you doing? Do you feel compelled to ask the institution if these bonds are free of any constitutional/legal infirmities? Do you delve into the arcane legal framework and say "Ahh, hah! Why, these bonds are being used to finance deficits! Illegal!" I suppose that is what institutions pay the legions of lawyers for, but an awful lot of general obligation type bonds are bought by individuals looking for "risk free" fixed income.

    (Additionally, thank you federal reserve. In a more normal interest rate environment this might be less of an issue. Anybody close to retirement age is being forced way out on the risk curve, maintaining a heap of junk debt among other things just to get a real return to use as fixed income.)

  17. chembot:

    unfortunately, the foolishness is eternal in the form of rolled over debt. Whether or not you personally feel bound by it, it is almost certain you will get caught up in it. The expanding price of our welfare state will eventually give us a Greece style economic meltdown, and thanks to the 14th amendment we will all wind up paying more than our share for foolish promises.

  18. Kurt Droffe:

    Now just imagine the outcry if a private company behaved this way: "crooks, duplicity, corporate greed, at the expense of retired bondholders, capitalisms dark side ..." etc. But oh wait, it's a governement, so it cannot do wrong.

  19. kidmugsy:

    The State of Illinois presumably has sovereign immunity and can rat on its debts anyway. Does that apply to Puerto Rico?

  20. Orion Henderson:

    Maybe I'm being naive, but doesn't this essentially prevent PR from ever issuing bonds again? Or at the very least, this means they cannot issue bonds with any kind of reasonable interest rate. Who, in their right mind would, buy the bonds going forward?

    Seems like it's a nuclear option for them. And whatever other state might choose to do this.

    Now, this is a government. So the current admin in PR simply doesn't care that this will hobble their finances for decades. As the phrase I learned on this blog goes: To politicians, the discount rate on future pain is infinite.

  21. jdgalt:

    That was a dirty deal, but as I recall, Congress enacted a private bill making it legal.

  22. jdgalt:

    I expect it to take the form of Weimar-style runaway inflation within a decade from now. I'd love to be wrong about that.

  23. xtmar:

    I don't know, I think it's like making a contract with a minor. If you erroneously give money to somebody who can't legally contact for it, like a minor with a credit card, why should the courts allow you to recover what shouldn't have been summer in the first place? If you rant to go after the other party for misrepresentation, that's fine, but I dying think there court should allow you to recover on improperly contacted debts.

  24. Mr. Generic:

    Of course, the people are still going to pay. No one is going to buy Puerto Rican bonds without an interest rate premium now. They've also removed any future ability to cover a deficit with bond debt. So any cash shortfall will now result in service cuts.

  25. johnson85:

    It's bad, but at the same time, it's been clear for a while that Puerto Rico isn't going t pay back its debts without a bailout from the US. Seems like making creditors scared to loan to governments like Puerto rico's, Illinois', and soon if not now, the US isn't he worst thing. The government official that signed off on the repps and warranties needs to go to jail though.

  26. kidmugsy:

    If they were all Dems O will pardon them.

  27. chembot:

    I would argue that it is more similar to a situation where people put money down for a purchase, say a car or a house that has yet to be manufactured. If the the manufacturer then welches on the delivery and further states that the product will never be made, usually you are entitled to get your money back.

    In the situation you describe, the roles are rather reversed. The credit companies are either a) knowingly extending credit to a minor, in which they committed the crime and shouldn't profit from it, or b) the minor committed fraud in obtaining the card and likely the credit companies will go after the guardians for recovery. Here, it looks like the gov't committed fraud in issuing the notes, promising in the manner of Madoff and Ponzi to repay with future revenues, and gleefully sucked up the cash. Why should they profit from fraudulent activity?

  28. GoneWithTheWind:

    The problem is that the courts are acting in an ex post facto manner. How as an investor, banker or middleman can you foresee this? The only logical solution would be for investors and banks to stay away from government paper.

  29. John Moore:

    If it is against the Constitution of Puerto Rico, that is a discoverable fact.

  30. John Moore:

    No, because I understand T-bills. I would be more leery of Puerto Rican bonds. I just took a peek at that Constitution and the debt issuance rules are right out in plain sight - Article 6, Section 2.

  31. xtmar:

    What are they paying all the due diligence types for, if not to discover this sorry of information?

  32. xtmar:

    Okay, but that's a legitimate result. Nobody has a right to credit.

    Also, I think there is enough money running around looking for returns that they actually wouldn't be frozen out for very long.

  33. xtmar:

    Apparently something similar happened back during the railroad boom, and the creditors got stiffed then as well.

  34. jdgalt:

    The problem with that view is that governments don't suffer if required to pay money. The taxpayers suffer.

    Now if a court were willing to haul in every politician who voted to issue the bonds and make them pay out of their own pockets, I'd be all for it.

  35. chembot:

    Fair enough, that article does indeed feature the escape hatch. If only the average investor would read the constitutions and charters of the issuing jurisdictions and applicable law and court precedent... Incidentally, I wonder how many people as part of their due diligence in this case keep tabs on the 15% rule and how often the debt sloshes over 15% and gets repudiated. I suppose this is yet another example where if you got beef with a corporation, you've got some options for redress (usually). If your beef is with gov't, you get a sore ass.

    Anyway, Moral Learned: If the rubes were foolish enough to get snookered by invalid debt, they should consider it tuition, not fraud.

  36. Kurt Droffe:

    Thank you, didn't know. Do you have a hint, or where do I have to look for it?
    Anyway, I didn't say that such behaviour wouldn't exist in the private sector (which is not morally superior, only more constrained by market forces and by the rule of law, normally), only that people are quite indulgent if it's a state (e.g. Argentina defaulting on it's bonds) and quite upset if it's a company, which shouldn't make a difference, IMO.

  37. chembot:

    I understand the argument you making, and I even believe there is some merit to it (especially regarding personal liability). However, there is a certain aspect of defending the hostage taker here that is unsavory. By that logic, we can't ever ask for monetary redress from government on just about any issue because it is the moral equivalent of running a drive-by on the taxpayer. I would call it the ultimate limited liability corporation, but even LLCs are held to a higher standard than this.

  38. jdgalt:

    This is one of several reasons why taxes should not be used to pay for anything except police, courts, and defense.

    The unjust enrichment went to some project that lawmakers spent the bond funds on, but you can be sure it's not something most of the taxpayers wanted or needed, since if it were, we'd have been willing to pay for it without the government protection racket forcing us to.

  39. MJ:

    Incidentally, I wonder how many people as part of their due diligence in
    this case keep tabs on the 15% rule and how often the debt sloshes over
    15% and gets repudiated.

    Bingo. It's more than coincidental that, now that the Puerto Rican government has run itself into beggary and bankruptcy, it starts casting about for technicalities that allow it to repudiate the debt that has grown to unsustainable (and unconstitutional) levels.

  40. MJ:

    Why should the people of a state pay for the malfeasance of their officials?

    Because they enabled the officials by not only allowing them to issue huge amounts of debt, but actively encouraging them by returning them to elected office when they did so.

  41. LoneSnark:

    I'm somewhat sympathetic to the idea of not paying such debts. It always seemed absurd that one corrupt legislature was able to tie the hands of all future legislatures. As such, I'm in favor of the idea that any legislature has the right to pass a law releasing itself from current obligations. The alternative is often unworkable. The U.S. is ungodly wealthy, with plenty of room for taxation, yet our governments have promised to pay all future medical costs of current government retires regardless of how costly future medical advances become (swapping out organs isn't going to be cheap). Luckily local governments have the right to default if the state government lets them. But state governments and the federal government don't currently have that right.

    The only downside I see is some businesses will insist on payment up front when dealing with long-term projects, which is not much of a downside. Overall, I don't think government interest rates will be much higher, since it still takes an act of congress to discharge it. It may already be this way, since the constitution doesn't speak to Congress' ability to prioritize obligations, so I believe Congress already has the right to repudiate debts without amending.

  42. jdgalt:

    14th Amendment, Section 4: "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. ..."

    It is unclear whether this applies to debts of a US Territory. It depends on whether the territory really exists as an entity separate from the federal government, a question I don't think the courts have answered.

  43. LoneSnark:

    Hmm, Puerto Rico is not the United States in that sentence, so in plain language that section does not apply to Puerto Rico or any other state or territory.

  44. stevewfromford:

    Public officials being held personally liable for illegal acts would certainly slow this kind of crapola down.

  45. antiquarian:

    The fact that I believe in capitalism makes it hard for me to sympathize much with the bondholders. The PR Constitution is, I would imagine, in the public domain and on the Internet, and P.R.'s ability to repay all this debt and propensity to borrow even more after the purchase of your bonds, making repayment even less dicey, are pretty easy to see. They were chasing yield, and got burned.

    That said, I agree with you, Warren, that letting P.R. skate on this sets a terrible precedent that fosters future moral hazard.

  46. madeline cruz:

    I concurd

  47. John O.:

    This is an old precedence that goes back to the Pre-Civil War era. Internal Improvements were a big thing in many states and in the south they often bankrupted the poorer states; and a few Southern States had illegal bonds issued for a fraudulent state improvement project declared null and void because the case law assumed that it was duty of the bond purchaser to know if the debt was legal or not. And these cases were very important in the aftermath of the Civil War as much of the debt issued in the name of the states operating under the Confederacy were made unenforceable costing those who purchased the bonds considerable losses.