What Went Wrong?: The Puerto Rican Debt Crisis, The “Treasury Put" and the Failure of Market Discipline
AbstractWhat 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? Given gloomy macroeconomic fundamentals and relatively low risk premia, investors were either stunningly myopic or Puerto Rican debt was implicitly insured by the U.S. Treasury. The rational investor model rules out the former hypothesis.
This project 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, especially the prior bailout of the city of New York. Evaluating the Treasury Put hypothesis with a minimal set of assumptions is possible given two fortuitous features – a unique characteristic of Puerto Rican bonds and a “seismic shock.” Puerto Rico issued both uninsured and insured general obligation bonds. These bonds were issued on the same day and, in many cases, with the exact same maturity. These features allow us to compute accurately the risk premia on Puerto Rican bonds. The second feature was 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 documenting the existence of a sizeable Treasury Put and a significant misallocation of capital to Puerto Rico.