The Equity Factor

What U.S. Cities Can Learn From Puerto Rico’s Crisis

Beware the municipal version of a payday loan.

(Photo by Oscar Perry Abello)

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Wherever there’s a budget crisis, from Detroit to Chicago to California to Puerto Rico and beyond, communities aren’t just losing public services. City employees also get salaries frozen or cut, put on furlough, or laid off entirely. For unions, which still represent around 35 percent of public sector employees, budget crises can be a huge existential threat.

In the aftermath of the 2008-2009 foreclosure crisis, Saqib Bhatti was looking into the roots of budget crises as a researcher for the Service Employees International Union (SEIU). “Members had been severely impacted by the financial crisis both because they directly in many cases were losing their homes or having their hours cut because cities and states were facing severe budget crises,” he says.

Bhatti says he began looking at the ways in which Wall Street both helped cause the foreclosure crisis by peddling predatory loans, “and then ways in which Wall Street was then able to additionally make money off budget crises by swooping in with predatory deals to try to help cities make ends meet.”

Today, Bhatti continues his research as director of the ReFund America Project and a fellow at the Roosevelt Institute. In its latest report, “Puerto Rico’s Payday Loans,” the ReFund America Project shines a light on a specific type of predatory deal called a capital appreciation bond, which it argues is the municipal version of a payday loan.

“Why do working-class families take out payday loans? It’s not because they think it’s a good loan, it’s that they have to put food on the table,” Bhatti says, and it’s the same for Puerto Rico, Chicago, California and all over the country.

It’s no coincidence that state and local governments issued more capital appreciation bonds in 2009 than any other year before or since, according to EMMA, the official repository for information on municipal securities.

By focusing attention on capital appreciation bonds, Bhatti thinks unions, community-based groups and other allies fighting for public sector jobs and vital services may find a powerful leverage point to get at least some of municipal or state debt canceled.

ReFund America’s report found that Puerto Rico has $37.8 billion in outstanding debt from capital appreciation bonds. But the underlying principal, or how much Puerto Rico actually borrowed, is only $4.3 billion. The remaining $33.5 billion in debt is interest, which is nearly half of Puerto Rico’s $72 billion in debt.

The reason why the interest on capital appreciation bonds is so high is the same reason why the bonds are so attractive to cash-strapped state and local governments. With a capital appreciation bond, rather than making payments throughout the life of the bond, the issuing agency or municipality usually makes only a single payment of principal plus interest upon the bond maturity date, which can be years or even decades away. Interest compounds the entire time.

“Public officials are looking at it saying we’ve got to put food on the table, and maybe in 30 years when we have to pay this back, something will change,” says Bhatti. “Or at the very least, I won’t be in office anymore. It’s kicking the can down the road so it’s somebody else’s problem.”

According to documentation available on EMMA, Puerto Rico issued a capital appreciation bond in 2011 for $62.5 million, which is tied to a full repayment of $342.4 million, due in 2039. “In a traditional 30-year bond, you pay roughly equal amounts principal and interest,” Bhatti explains.

The ReFund America report proposes three ways to restructure Puerto Rico’s debt. First, the $33.5 billion in interest should be canceled.

“If no one lent Puerto Rico that $33.5 billion, if that’s just investor profit, well at the very least we can’t afford investor profit in the midst of a humanitarian crisis,” says Bhatti.

Second, current bondholders should not receive more than what they paid for to buy the bonds. Since Puerto Rico’s economy has taken a turn for the worse, many of the original Puerto Rico capital appreciation bond investors have already written off the losses and resold the bonds at a discount to other investors. According to ReFund America’s report, some of the investors have bought the equivalent of one dollar of debt for just five cents.

“In a humanitarian crisis, Puerto Rico should not have to pay investors back more than they put in,” says Bhatti.

Because the debt can be bought so cheaply, Bhatti points out, it’s also an opportunity for a solution — someone or a group of someones could buy all capital appreciation bonds from Puerto Rico or other places, and simply cancel all or part of the debt. John Oliver made headlines doing just that on his TV show for personal medical debts, and groups like Rolling Jubilee and American Homeowner Preservation have been doing that for other forms of predatory personal debt.

Lastly, ReFund America is also advocating that Wall Street banks should have to return the fees they charged to put together the capital appreciation bond deals. ReFund America found that Wall Street banks charged Puerto Rico $221 million for just a subset of Puerto Rico’s capital appreciation bonds, with potentially hundreds of millions more for the rest.

“The banks made a lot of money putting deals together that they knew were predatory, that they knew were unsustainable, they designed them to fail, they should have to return that money,” Bhatti charges.

To advocate for this approach to restructuring Puerto Rico’s debt, ReFund America works with an assortment of community-based groups on and off the island. In other places, such as Illinois or California, where agencies have issued large numbers of capital appreciation bonds, unions remain active partners for ReFund America.

“There’s different partners in different places that are really active on these issues, that have been working, engaging in budget fights for a long time, but are now really looking at what are the underlying causes of budget crises, who’s making money off of it, and how do we hold them accountable to get money back to put into our communities,” says Bhatti.

Bhatti has also been exploring the idea of the equivalent of a Consumer Financial Protection Bureau for state and municipal governments, which would help regulate the issuance of capital appreciation bonds and other predatory public debt in the future. But for now, there is plenty of work to do getting some of this debt canceled. Four-hundred and forty-seven capital appreciation bonds have maturity dates this year across the U.S., some of them issued as far back as 1984. Nationwide, another 411 capital appreciation bond transactions already took place in 2016.

The Equity Factor is made possible with the support of the Surdna Foundation.

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Oscar is Next City's senior economic justice correspondent. He previously served as Next City’s editor from 2018-2019, and was a Next City Equitable Cities Fellow from 2015-2016. Since 2011, Oscar has covered community development finance, community banking, impact investing, economic development, housing and more for media outlets such as Shelterforce, B Magazine, Impact Alpha and Fast Company.

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Tags: city hallbudgets

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