How Hedge Funds Hurt Puerto Rico

November 30, 2017   Michelle Celarier

In the wake of Hurricane Maria's devastation, hedge funds holding Puerto Rico debt are fighting with the government — and each other — to get paid. But hedge funds may have themselves to blame for the mess they’re in.

  Photograph by Justin Metz.

Outside of Spring Studios, an event space at 50 Varick St. in downtown Manhattan, a small group of protesters held up a handmade Puerto Rican flag sign, then began to chant. "Cancel the debt . . . shame, shame, shame," they called out to Baupost Group CEO Seth Klarman, who was getting ready to address the annual Robin Hood Investors Conference being held there on October 19.

A soft-spoken hedge fund manager who is one of the most revered and reclusive in the so-called value investing community, Klarman was no doubt mortified to find himself at the red-hot center of perhaps the ugliest financial debacle in nearly a decade, the $74 billion bankruptcy of Puerto Rico. Given the impact of its crushing debt load, the commonwealth of 3.4 million U.S. citizens was already facing a catastrophe before Hurricane Maria imperiled their lives, leaving the vast majority still without electricity and clean water more than two months after the hurricane hit on September 20. Official death tolls have varied widely, but recent reports suggest that hundreds of people had perished as a result of the storm.

The destruction was so severe that President Donald Trump, upon visiting, made an offhand comment to Fox News that the debt would be "wiped out," and bond prices immediately plummeted. Puerto Rico’s general-obligation bonds fell from 44 cents on the dollar the previous day to what was then their lowest level, around 32 cents, since the debt turmoil hit in the summer of 2015. Even though Trump’s administration tried to walk back his words the next day, those bonds have continued to slide, falling to 27 cents by early November.

Klarman’s $31 billion hedge fund firm Baupost owns more than $925 million in face value of another type of Puerto Rican bond, called Cofinas, securitizations of a slice of the island’s sales tax revenue designed by Goldman Sachs that the fund bought through an alias called Decagon Holdings. Given their securitization, Cofinas, recently trading in the high 30s, have held up slightly better than the GOs. But protesters aren’t the only ones wanting that debt to be canceled. The GO bondholders — led by Mark Brodsky’s Aurelius Capital Management — along with union pension funds and even the commonwealth itself have sued Cofina bondholders like Baupost, arguing the debt is illegal and should not be paid.

"I don’t like to be attacked," Klarman told the crowd, according to an audio recording of his off-the-record remarks obtained by Alpha. The hedge fund titan also admitted that he "hid" his firm’s ownership of the Puerto Rico debt through Decagon (only recently unmasked by The Intercept) because "the world tends to follow us and copycat us."

Klarman also acknowledged the protesters’ pain and said the hurricane that had devastated Puerto Rico had also torpedoed the value of his already defaulted bonds. "People have died," he said solemnly, "and protesters are very angry that the island is in debt at all. It’s got to be incredibly frustrating. Your friends and family are in a life-or-death situation, and there’s financial pressure on top of that."

Warning that principal writedowns were ahead, a humbled Klarman added, "Almost certainly we’re going to collect less; whatever the settlement was going to be, it’s going to be less. Inevitably there will be less debt, and the coupons will be lower."

Baupost’s stake, which the firm first took in 2015, is the second largest among what was once calculated to be 60 hedge fund owners of Puerto Rico debt. But it was worth only $300 million at the end of the third quarter.

Of course, Baupost isn’t the only hedge fund that would like to hide right about now.

"There are probably hundreds of people in this room who are owners of this debt," Klarman told the group of about 1,000 people at the Robin Hood conference. Given that all Puerto Rico bonds are at historic lows, it seems likely almost everyone invested in Puerto Rico is losing money, and could lose even more.

"They made a bet; they got it wrong," says one hedge fund manager. Two hedge fund firms, Senator Investment Group and Stone Lion Capital, recently sold out entirely, a November 3 court filing shows. Hedge fund firm MatlinPatterson also has been selling its Puerto Rico GO bonds due to an investor redemption, according to Bloomberg. Still, hedge funds own at least $6.5 billion of the top three issuers of Puerto Rico’s debt: $2 billion out of the $18.2 billion in GO debt, $3 billion out of the $17.66 billion in Cofina bonds, and $1.5 billion of the $9 billion debt of the Puerto Rico Electric Power Authority (Prepa). None of several big Puerto Rico creditors contacted by Alpha would talk on the record about their holdings.

To be sure, Puerto Rico mismanaged its finances, and the Whitefish scandal — involving a $300 million contract with a tiny Montana company to restore electrical service on the island that was canceled after an uproar — has revived concerns about corruption. But hedge funds also bear some responsibility for the current mess, critics contend. For years, the hedge fund debt holders played hardball. They convinced the commonwealth — which already had a 45 percent poverty rate — to impose extreme austerity measures that required, for example, laying off teachers and nurses. They engaged in massive lobbying efforts to stop Puerto Rico from getting congressional approval to file for bankruptcy, which ultimately failed. And they continue to bicker among themselves about who is entitled to what. All of these efforts have worsened both the island’s finances and the bondholders’ own potential for recovery.

"It made Puerto Rico less resilient to a shock like this," says Hans Humes, the CEO of $1.2 billion Greylock Capital Management, which invests in the distressed debt of emerging markets and picked up some Puerto Rico GO debt during the downdraft from Trump’s comments. The massive layoffs austerity demanded mean that today there aren’t enough employees, like nurses, to deal with the humanitarian crisis, say local activists. In the end, by investing in what seemed a no-lose proposition, the hedge funds may find that both their reputations and their holdings have taken a serious hit.

As the hurricane’s devastation continues to take lives in Puerto Rico, and an estimated $95 billion is needed to rebuild the island, scores of lawyers representing a slew of creditors — including municipal bond insurers and the unions — are battling behind the scenes for whatever crumbs they can get. The public drama has been playing out in a federal courthouse, alternating hearings between New York City and San Juan, since May 3, when the island officially declared bankruptcy.

Today none of the bondholders are being paid. In June the fiscal board overseeing Puerto Rico’s bankruptcy nixed a sweet deal the Prepa bondholders had struck in an earlier restructuring agreement with the utility, giving them 85 cents on the dollar — much higher than the distressed prices many of them paid for the bonds in 2014, when it traded in the 40s as the prospect of bankruptcy loomed.

Hurricane Maria damaged the electric grid, which has suffered from a decades-long lack of investment. One reason: Most of the debt went to refinance older debt instead of investing in sorely needed capital improvements, according to an analysis by activist group Action Center on Race and the Economy (ACRE), which focuses on Wall Street accountability.

Following the hurricane, Prepa bondholders — which include BlueMountain Capital Management, Knighthead Capital Management, Angelo Gordon & Co., Oppenheimer & Co., Franklin Advisers, and Marathon Asset Management — offered to lend the electric utility another $1 billion and roll it up with their other debt into a debtor-in-possession (DIP) financing, which would have seniority in any restructuring. The offer was swiftly rejected. The financial board overseeing the island’s finances favors the privatization of Prepa, to bring in new capital to rebuild the system. In that case, the best Prepa bondholders can expect is that their debt will be exchanged into a new security, likely at a massive haircut.

Prepa debt has traded down into the mid-30s, and the prices of some other Puerto Rico bonds have continued to plunge into the 20s and below. Says one creditor representative involved in mediation efforts, who was not authorized to speak publicly, "The hurricane changed a lot of assumptions and called into question what the debt service capacity is. A new normal is going to set in."

The Tragic Saga of Puerto Rico’s debt nightmare is more than a decade in the making, dating at least to 2006, when the island lost the U.S. corporate tax benefits that had led mainland manufacturers and pharmaceutical companies there. When the companies fled, the commonwealth slipped into recession and tried to patch its financial hole by pledging every revenue stream it could find, from highways to sales taxes, for 18 different issuers of Puerto Rico bonds.

The most ingenious feat of financial engineering to mitigate the financial crisis was the creation of the Cofina bonds. They were issued by a new entity legislated into existence in 2006 called the Puerto Rico Sales Tax Financing Corp. (known by its Spanish acronym Cofina), which collected 1.0 percent (now 2.75 percent) of the commonwealth’s sales tax revenue and used it to securitize the bonds. Puerto Rico issued 15 series of Cofina bonds between 2007 and 2011.

Cofinas were designed to be a form of low-cost financing for Puerto Rico, with a blended rate of 5.8 percent. But $5.54 billion out of $17.66 billion in total were capital appreciation (also known as zero coupon) bonds, in which interest is not payable on a current basis, but rather compounds semi-annually and is payable at maturity.

"Because of this structure, borrowers often end up paying triple-digit interest rates over the life of the bonds. In this way, a CAB is like the municipal version of a payday loan," according to a report by ACRE, which calls for Puerto Rico’s debt to be audited and any illegal debt canceled. (A source close to the Cofina senior bondholders group calls the payday description "clever.")

All of Puerto Rico’s municipal debt offered relatively high coupons, combined with a novel triple tax-free municipal bond status — meaning no local, state, or federal taxes — for all mainland investors, which resulted in a 20 percent yield. It was catnip to U.S. hedge funds searching for yield during recent years of zero interest rates.

But there was another enticement. Legally, Puerto Rico is little more than a colony of the U.S., with few rights. Its residents are U.S. citizens, but they can’t vote in U.S. elections, nor can its representative in Congress cast a vote there. Unlike other U.S. municipal bond issuers, Puerto Rico can’t file for bankruptcy protection, having lost that right in 1984. Nor does it have a sovereign’s power of immunity. To the smart money guys, it looked, at least on paper, like Puerto Rico would have to pay up, come hell or high water.

Puerto Rico’s first hedge fund booster was John Paulson. In April 2014 he suggested that Puerto Rico could become "the Singapore of the Caribbean," luring others to join him on the island paradise. Paulson gobbled up real estate and hotels on the island as well as bonds, but he sold out of the debt years ago.

Many hedge funds had already invested in Puerto Rico by the time Paulson talked it up. The month before Paulson’s speech was the last time before Puerto Rico’s bankruptcy that the commonwealth issued bonds — a $3.5 billion GO bond with an 8 percent coupon. Even though the rating agencies had finally downgraded a deeply indebted Puerto Rico to junk status earlier that year, the bond issue was scooped up by hedge funds who were also confident they could prevail in any legal battle because the bond was issued under New York, not Puerto Rican, law.

By May 2015, when the GO bonds had slipped to just under 80 cents on the dollar, bond guru Jeffrey Gundlach, the founder of DoubleLine Capital, stepped up to the plate, pitching Puerto Rico GOs at the Sohn Investment Conference.

"Puerto Rican muni bonds are my recommendation for a risky thing to buy because they have priced in a lot of problems," he said, suggesting investors could earn a tax-free yield of about 11 percent on Puerto Rico municipal bonds that mature in 2035. Gundlach assured investors that Puerto Rico was committed to paying its debt on time, and that it was unlikely to default because it would "wipe out the savings pool," a reference to the sad reality that many local Puerto Rico institutions and investors also owned its bonds.

But 80 cents on the dollar was too high for some firms, like Paul Singer’s Elliott Management Corp., which also shied away from investing in Puerto Rico bonds because of its concerns over the commonwealth’s ability to pay, according to individuals familiar with Elliott’s thinking. Those concerns were validated less than two months later by Puerto Rico Governor Alejandro García Padilla when he boldly proclaimed, "The debt is not payable." Puerto Rico, he said, was in a "death spiral."

By that time, Puerto Rico’s debt was the hottest hedge fund debt trade going. Hedge funds owned 20 percent or more of the debt and had already been unofficially counseling Puerto Rico on how to fix its economy. Some even hired former IMF economists to design an austerity-oriented blueprint to get themselves paid. The report, "For Puerto Rico, There Is a Better Way," recommended the dismissal of teachers, cuts in the subsidy granted to the University of Puerto Rico, and trims to "excess Medicaid benefits," among other austerity measures.

As the battle over austerity intensified, a widespread group of hedge fund creditors, calling themselves the Ad Hoc Group, broke up in 2015 over disagreements on how to deal with Puerto Rico, given their disparate holdings. Among the publicized members at the time were Fir Tree Partners and Perry Capital. (Perry is now in wind-down mode. Neither fund is involved in the current court battles.)

The Puerto Rican government soon turned to Washington for help in fashioning a bankruptcy bill for the island, which sent hedge funds into a massive counteroffensive. They spent millions of dollars and hired dozens of lobbyists, using the same types of tactics that had hardened public opinion against Argentina in a battle hedge funds finally won in 2016. The DCI Group, a conservative Washington, D.C., public relations and lobbying firm that previously worked on the Argentina hedge fund campaign, began advising the Ad Hoc Group of General Obligation Bondholders, a splinter group of the original Ad Hoc Group.

As the debate in Congress heated up, the GO bondholders put up a website called Fact Check Puerto Rico, similar to Fact Check Argentina, tracking their ongoing complaints and proclaiming Puerto Rico’s ability to pay. It also orchestrated campaigns designed to show that retail investors own Puerto Rico debt, similar to arguments made about the ownership of Argentine debt.

But Puerto Rico is not Argentina, a Latin American country ruled at the time of its hedge fund battle by an unsympathetic leader, Cristina Fernandez de Kirchner. It is a U.S. territory, and its citizens are U.S. citizens who were (and still are) moving to the mainland by the millions, to places like Florida and Texas. Lawmakers realized an influx would strain local and state governments. More cynically, some political commentators posited, Republicans feared the displaced Puerto Ricans could turn states Democratic.

In July 2016, Congress passed a compromise bankruptcy bill — the Puerto Rico Oversight, Management, and Economic Stability Act, or Promesa — which created a Washington-chosen oversight board to manage the island’s finances. In May, Puerto Rico officially filed for bankruptcy protection under the new legislation.

"The mass migration argument was the pebble that tipped the balance in getting a bankruptcy bill passed," says David Martin, a Puerto Rican attorney based in Atlanta and San Juan, Puerto Rico, who focuses on creditor rights.

When they realized efforts to stop Puerto Rico from filing for bankruptcy would likely fail, the GO bondholders took another tack to get their money back, ultimately raising the tension among rival hedge fund owners of the debt.

Last year, calling themselves Lex Claims, the GO bondholders sued the Cofina bondholders, saying the debt was structured to avoid Puerto Rico’s constitutional limits on borrowing, and siphoned off revenues that should have been available to pay the commonwealth’s GO bondholders. As a result, they claimed, the Cofinas were illegal. Aurelius, which had gained a reputation for intransigence during the battle between bondholders and Argentina, is one of the Lex Claims leaders. (Aurelius declined to comment.)

"Invalidating Cofina is, we believe, key to resolving Puerto Rico’s debt issues," says an individual close to the GO bondholders group. "Puerto Rico doesn’t have $74 billion in debt. The actual debt of the commonwealth is about $18 billion," he says, referring to the outstanding GO debt. "It is protected by the constitution, which clearly states that it must be paid before anything else."

Once Puerto Rico filed for bankruptcy, the other unsecured creditors joined the GO bondholders’ cause against the Cofinas, as did the commonwealth itself.

The battle of the bondholders has taken on even greater significance now that Puerto Rico’s finances have taken a dire turn for the worse. Sources close to the Cofina bondholders insist a "binary outcome" is not possible. "It’s not a zero-sum game," says one adviser. These bondholders are resigned to a haircut — and getting a smaller percentage of Puerto Rico’s sales tax revenue — but they don’t think they’ll get nothing. They point out that secured debt typically gets higher recoveries in bankruptcies.

Some of their opponents seem to agree that compromise is necessary. "You know that our goal is to settle this," Luc Despins, an attorney with Paul Hastings, which represents the commonwealth, told U.S. District Court Judge Laura Taylor Swain during an October 25 hearing in New York.

But the GO bondholders aren’t likely to go along, according to Puerto Rican attorney John Mudd. "Any settlement here that does not involve 100 percent of Cofina funds for the commonwealth will be challenged by the GO bondholders, leading to even more litigation," he says.

In August, before the hurricane struck, the GO bondholders made an even bolder move: They filed suit to toss out the entire bankruptcy, arguing that Promesa’s oversight board was unconstitutionally established.

Meanwhile, some GO bondholders are bailing, having sold more than $1 billion of their bonds, according to a recent court filing. Autonomy Capital, the largest owner of Puerto Rico debt with $1.06 billion — which makes up about 20 percent of its $4.8 billion in assets under management — actually bought $125 million more. But $3.5 billion Aurelius sold $23.6 million and now owns $447.4 million; Fundamental Advisors, a muni firm whose 2012 hedge fund was formed by former Goldman Sachs muni finance head Hector Negroni, sold $88 million and now owns $334 million; and $4.6 billion Monarch Alternative Capital sold $313 million — more than half of its position — and now has $272 million. Senator and Stone Lion sold all their GO bonds — $255 million and $310 million, respectively. Franklin Mutual Advisers, a unit of Franklin Resources, also dumped all its bonds, which had a face value of $294.1 million.

Some bigger hedge funds, largely distressed investors, own $3 billion in face value of Cofina senior bonds, though many also own the riskier subordinate bonds, according to a recent court filing. Baupost has the biggest stake. But the legal effort has been spearheaded by $25 billion GoldenTree Asset Management, with $852.58 million in Cofinas, including $233 million in subordinates; and $4.13 billion Tilden Park Capital Management, with $501.29 million of Cofinas, including $9.2 million in subordinates.

Other names include $23 billion Canyon Partners, with $301.66 million of Cofina seniors; $4.82 billion Whitebox Advisors, with $100 million, including $2.9 million of Cofina subordinates; and $6 billion Taconic Capital Advisors, with $128.36 million, including $8.2 million of subordinates.

Investors are understandably shy about talking about the money Puerto Rico owes them while the tragedy is still fresh. On a practical level, after U.S. government loans and aid money — none of which will go to pay back bondholders — rebuild the economy, there is a chance recoveries could improve. That said, a loan authorized by Congress to restore basic services has worried some creditors, who know it puts them further down the chain of repayment. The Cofina bondholders also recently offered a $1.5 billion zero-coupon loan, but it was rejected by the commonwealth and is now in the hands of the Promesa board.

While the battles continue, the outcome isn’t likely to hinge on legal technicalities. "More people are starting to understand in the worst-case scenario they’ll have terms dictated to them. All this legal back and forth is a lot of noise," says Greylock Capital’s Humes.

Ultimately, the fate of investors lies with the fate of Puerto Rico, which is a long way from being able to pay them anything.

"I don’t see that the island has a functioning tax base. What economic activity that’s happening right now is very marginal. Even the building where the treasury is located is not fully operable because they found asbestos there after the hurricane hit," says attorney Martin.

"We were looking at a principal haircut of a minimum 60 to 70 cents on the dollar before the hurricane," notes Eric LeCompte, executive director of Jubilee USA Network, which has attempted to resolve the impasse between Puerto Rico and its creditors. "It’s a whole new ballgame. At this point we are really looking at a writedown of 80 cents or higher."

Certainly both sides have a lot to lose — but none more so than the GO bondholders. Emboldened by their successes in Argentina and Greece, many of these creditors were sure Puerto Rico would be another win.

But they forgot that governments can change the rules of the game mid-play, says one veteran distressed sovereign debt hedge fund manager. "They screwed themselves because they didn’t know what they were doing."

Photo Credits: Photo 1 by Alex Wroblewski/Bloomberg; Photo 2 by John Taggart/Bloomberg, Residents fill containers with water at a center in Rio Grande, Puerto Rico; Photo 3 by Neenah Moon/Bloomberg, Protestors in Manhattan on October 3 call for the elimination of Puerto Rico's debt.

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