Puerto Rico Crisis: It's Not About the Debt, It's About the Politics

SAN JUAN, PUERTO RICO - JULY 01:  The Puerto Rican flag flies near the Capitol building as the island's residents deal with t
SAN JUAN, PUERTO RICO - JULY 01: The Puerto Rican flag flies near the Capitol building as the island's residents deal with the government's $72 billion debt on July 1, 2015 in San Juan, Puerto Rico. Governor of Puerto Rico Alejandro García Padilla said in a speech recently that the people of Puerto Rico will have to make sacrifices and share the responsibilities to help pull the island out of debt. (Photo by Joe Raedle/Getty Images)

When the Puerto Rico debt crisis burst into the news, Puerto Rico Governor Alejandro García Padilla pronounced that the Commonwealth's debt crisis "is not about politics." Of course, to paraphrase H.L. Menken, when a politician says something is not about politics, chances are it's all about politics. That is not to say that Puerto Rico's massive debts are payable or that the math is not suffocating, but long before the debts were massive, and long before the math became intractable, there were the politics. To put in place a plan to address Puerto Rico's debt crisis without taking account of the long simmering witch's brew of island and federal politics and policies that led us to this point would be folly.

While federal and island officials alike are loath to use the "c" word, Puerto Rico has been a colony of the United States for just over 100 years. Like colonies across the globe that traded hands among European powers as the spoils of one war or another, Puerto Rico was ceded to the United States -- along with Guam and the Philippines -- by Spain in 1898 after its defeat in the Spanish-American War.

Americans are generally not comfortable with the notion that we are a colonial power. Global hegemon or imperial nation perhaps, but not colonial overlord. Maybe it is because we were once a colony ourselves. Perhaps our struggles to overcome our legacy as a slave power left us uncomfortable with the idea that through much of the 20th century we ruled over Caribbean sugarcane plantations where the descendants of slaves continued to toil.

The Founders set forth the terms of America's dominion over its colonies under Article Four of the Constitution -- aptly known as the Territories Clause -- and directed that full plenary power and responsibility over America's territories was to be vested in Congress. For the better part of the century that Puerto Rico has remained an American colony, a series of legal cases have explored and defined the relationship of U.S. territories to the United States, but over that time little has fundamentally changed. As set forth in the Territories Clause, and as confirmed repeatedly by the Supreme Court, Puerto Rico remains an unincorporated territory of the United States for which Congress remains fully and unambiguously responsible.

It is notable, then, that throughout the public discussion and debate over the past several months about the insolvency of Puerto Rico, there has been little or no discussion of the ultimate responsibility of Congress for events that have transpired. Congress has never been shy about exercising its oversight powers in areas that offer political opportunity -- Benghazi and the IRS are recent examples -- and is often swift to demand full accountability and point the finger of blame at others for any manner of controversy or scandal that might come up, but with respect to the territories, where the responsibility of Congress is clear, we have heard a deafening silence.

There is no Committee on the Territories in either the House and the Senate through which it might have exercised its responsibility over the years, and none of the Tea Party members who carry a copy of the Constitution in their breast pocket have been seen thumbing through it in front of an assembled gaggle of reporters demanding that Congress that it be held accountable for its own failure of duty as the Puerto Rico crisis has escalated.

The economic and fiscal crisis now confronting Puerto Rico has been building for years, and is a direct outgrowth of political and policy decisions made at the local and national level. It was two decades ago that Congress -- with the support of then-Governor Pedro Rossello of the pro-statehood party -- legislated the end of the Section 936 tax benefit program that for decades had been the basis for a thriving manufacturing sector on the island and a domestic capital market that provided low cost funding for infrastructure and other purposes. And it was in the same timeframe that Puerto Rican activists demanded the curtailment of missile testing on the island of Vieques, which ultimately resulted in the closing of the Roosevelt Roads naval base on Puerto Rico.

The end of the 936 program and the closing of Roosevelt Roads both came to a head around 2006, which is generally viewed as the beginning of the long slide in employment on Puerto Rico, the outmigration of Puerto Ricans to the mainland, and the growth in debt that Governor García Padilla now deems to be unpayable. The end of the 936 program and the closing of Roosevelt Roads were political decisions for which Congress and Puerto Rican officials each bear culpability and that together laid the groundwork for the current crisis.

Puerto Rico politics have long been defined by differences over the preferred political relationship with the United States. Governor García Padilla's Popular Democratic Party stands for continued Commonwealth status while the New Progressive Party of former Governor Rossello stands for statehood. The third force in local politics, representing those who favor independence, has historically had a far smaller share of the vote -- though Puerto Rican "nationalism" remains a powerful political and cultural force.

Much to the chagrin of the United States, the United Nations Special Committee on Decolonization -- created to support self-determination for colonized peoples -- instigated several plebiscites on the political status of Puerto Rico, beginning in 1993 when the Puerto Rico electorate voted 45 percent, 45 percent and 10 percent for statehood, current status and independence, respectively. Over the years, the preference for statehood has grown, with the most recent plebiscite showing a 60-plus percent preference for statehood over the current territorial status, and just last month the Puerto Rico non-voting delegate to Congress, Pedro Pierluisi -- a member of the statehood party -- published an op-ed in the New York Times arguing that statehood is the only solution for what ails the Commonwealth.

But neither the United Nations nor Puerto Rico politicians can make Puerto Rico a state. That can only come about through an act of Congress, and Congressional approval of a new state that would more likely than not send two new Democrats to the U.S. Senate and a half dozen or so new Democrats to the House of Representatives -- projected to come primarily at the expense of red state delegations -- is unlikely to win approval in a Republican-dominated Congress. Nonetheless, the political status of the former Spanish colony that would be the 17th largest state if admitted to the Union remains the dominant political subtext even as Puerto Rico careens into insolvency.

Today, Congress and the White House are largely speaking with one voice as they argue against a "bailout" for Puerto Rico. Instead -- as evidenced by the support of both Hilary Clinton and Jeb Bush -- the magic bullet that many support is to allow Puerto Rico to seek protection under the federal Bankruptcy Code, which is not currently available for U.S. territories. Bankruptcy seems like a neat solution, though advocates conveniently ignore the fact that allowing Puerto Rico access to bankruptcy protection would also be a form of bailout, but one that would place the cost of the bailout on the backs of the millions of Americans that currently own Puerto Rico bonds -- directly or through mutual funds -- that would take a significant haircut in any debt restructuring mandated by a bankruptcy court.

The presence of hedge funds -- a category of opportunistic investors that is quite different from mutual funds -- as owners of a share of Puerto Rico debts is going to complicate any proposed resolution. Puerto Rico bonds have been purchased by mutual funds for years, if not decades, and they are now among the most widely held securities in Americans' savings accounts. Hedge funds only became significant buyers of Puerto Rico debt over the past two years, most notably in 2014 when Puerto Rico issued $3.5 billion of bonds to pay operating costs and push the advent of the current insolvency crisis a year down the road.

At that time, Puerto Rico's traditional mutual fund investor community declined to participate in the new financing. That was the moment when the decade-long decline in Puerto Rico fiscal affairs had become fully evident and a tipping point had been reached. At that time, when access to capital looked to be precluded -- forcing the Puerto Rico administration to come to grips with its fiscal problems -- the hedge fund community saw an opportunity and purchased nearly all of the multi-billion dollar financing.

The $3.5 billion bond issue purchased by the hedge fund community seemed like a blessing at the time for the Puerto Rico administration of Governor García Padilla. It not only allowed the inevitable collapse to be pushed down the road, but more specifically it allowed the crisis to be deferred to a presidential election year, when a politically friendly solution would be more likely due to the large Puerto Rican representation in key electoral college states. Governor García Padilla showed his cards with respect to the deeply political calculus involved when he bluntly threatened both political parties if they fail to support Puerto Rico's preferred solution of achieving access to the bankruptcy courts: "Puerto Ricans decide the elections in Florida. That's very important. By deciding the election in Florida, we can decide [who is the next] president of the United States."

Hilary Clinton and Jeb Bush have read the electoral map, and are now each on record supporting Governor García Padilla's demand that Puerto Rico be allowed access to bankruptcy protection. And they are not alone. National publications from the New York Times to the Weekly Standard have made similar arguments, and the Obama administration seems to be heading in that direction.

Bankruptcy sounds like such a reasonable solution. After all, municipal governments across the country are allowed to use bankruptcy as a tool for renegotiating debts that have become unaffordable. Puerto Rico leaders believe that they have sufficient leverage over the national political parties to secure the legislative changes necessary to allow them to use bankruptcy as a means to renegotiate their outstanding obligations, while leaving their powers of self-governance -- as enshrined in the 1952 Commonwealth Constitution approved by Congress -- largely unaffected going forward. For their part, Democrats and Republicans in Congress seem to be embracing bankruptcy as a path of least resistance, one that allows them to wash their hands of the problem while others pay the bill.

But despite the appeal of bankruptcy as an easy solution for Puerto Rico, it is unlikely to play out that way over time. The mutual fund community -- the trustees for the millions of Americans that own Puerto Rico bonds -- has indicated that it will fight efforts in Congress to change the bankruptcy code on an after-the-fact-basis. But it is the hedge fund managers -- individuals with their own money on the line -- who constitute the greatest threat to the easy solution envisioned by politicians in Puerto Rico and Washington. Those investors -- whose money Governor García Padilla eagerly accepted when it seemed politically advantageous to do so -- who will take the fight all the way to the Supreme Court to demand adherence to the law as well as Congressional accountability.

It may be appealing given the anti-Wall Street mood in the country to place some share of the burden on the backs of hedge fund managers -- after all, they are highly compensated opportunists who bought Puerto Rico bonds after the insolvency was evident -- but there will be considerable political blowback against that line of argument once it becomes apparent that the tens of billions of dollars that a Puerto Rico bankruptcy bailout is going to cost would primarily be seized from the retirement savings of tens of millions of ordinary Americans.

Ultimately, the problem with bankruptcy as a solution is that it will not solve the problem. The insolvency of Puerto Rico is not simply a fiscal crisis but is a constitutional one. Since the approval of its constitution in 1952, Puerto Rico has enjoyed significant powers of self-government, but as the Supreme Court has ruled, none of those powers has removed Congress from its position of ultimate responsibility, and like a parent that has ignored its responsibility for a wayward child, Congress may have looked the other way, but at the end of the day it remains responsible for the welfare of the all of the U.S. territories.

If the failure of duty is placed on Congress -- as the Constitution suggests that it must be -- then at the end of the day the price of the Puerto Rico debt crisis is one that we all will be forced to pay, and Puerto Rico and the Congress will have to recraft their relationship going forward so that the current problems are not repeated in the future.