What Went Wrong?: The Puerto Rican Debt Crisis, the 'Treasury Put,' and the Failure of Market Discipline

61 Pages Posted: 21 Mar 2019

See all articles by Robert S. Chirinko

Robert S. Chirinko

University of Illinois at Chicago, Department of Finance; CESifo (Center for Economic Studies and Ifo Institute)

Ryan Chiu

University of Illinois at Chicago

Shaina Henderson

University of Illinois at Chicago

Date Written: 2019

Abstract

What went wrong? Why did seemingly rational bond investors continue to purchase Puerto Rican debt with only a modest risk premium, even though the macroeconomic fundamentals were dismal? Why did financial markets fail to exercise market discipline and restrict capital flows to Puerto Rico? Given gloomy macroeconomic fundamentals and relatively low risk premia, investors were either stunningly myopic/misinformed, or Puerto Rican debt was implicitly insured by the U.S. government. This paper examines the latter hypothesis, which we label the “Treasury Put.” The expectation of a federal bailout was perfectly reasonable given past behavior by the federal government, starting with the prior bailout of the city of New York. Evaluating the Treasury Put hypothesis with a minimal set of assumptions is possible given three unique features – the dire fiscal and economic conditions in Puerto Rico, a fortunate characteristic of Puerto Rican bond issuance, and a “seismic shock.” Regarding the second feature, Puerto Rico issued both uninsured and insured general obligation bonds on the same day and, in many cases, with the exact same maturity. The associated bond price data allow for an accurate computation of the risk premia on Puerto Rican bonds. The third feature is the non-bailout of the city of Detroit in 2013 that effectively extinguished the Treasury Put. Puerto Rican risk premia were stable before the Detroit bankruptcy and bracketed by the risk premia on Corporate Aaa and Baa bonds. However, after the Detroit bankruptcy, risk premia rose dramatically, thus identifying a sizeable Treasury Put of at least 300 basis points and a significant misallocation of capital to Puerto Rico. In effect, the Treasury Put was a form of regulatory forbearance. Institutional reforms that would eliminate the Treasury Put are considered, but none are found satisfactory.

Keywords: Puerto Rican debt crisis, government guarantees, capital misallocation, bond interest rates

JEL Classification: H810, H740, G180, G010

Suggested Citation

Chirinko, Robert S. and Chiu, Ryan and Henderson, Shaina, What Went Wrong?: The Puerto Rican Debt Crisis, the 'Treasury Put,' and the Failure of Market Discipline (2019). CESifo Working Paper No. 7558. Available at SSRN: https://ssrn.com/abstract=3357135

Robert S. Chirinko (Contact Author)

University of Illinois at Chicago, Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States

HOME PAGE: http://tigger.uic.edu/~chirinko/

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Ryan Chiu

University of Illinois at Chicago ( email )

1200 W Harrison St
Chicago, IL 60607
United States

Shaina Henderson

University of Illinois at Chicago ( email )

1200 W Harrison St
Chicago, IL 60607
United States

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