The Securities Litigation Expert Blog

The hedge funds that constitute a large portion of Puerto Rico municipal bond holders are signaling initial acceptance for a restructuring of the island's debts.  Last week, The New York Times reported the following:

... the exchange would involve rolling up most of the island's current debt and restructuring it into a new "superbond," according to people briefed on the plan.  As part of that new bond, general obligation holders would have the first claim on government revenues, giving them the highest priority in the superbond structure.  Holders of other forms of the government's debt would have lower priority.

 

 

 

 

 

General Obligation Bonds Drink Your Milkshake

General Obligation bonds were always going to come out ahead in any restructuring because they are constitutionally protected and they have first claim on many of the revenue streams that support various Puerto Rico agencies.

Most noteable are the Highway Transportation Authority bonds, of which there are roughly $6.5B outstanding.  Infrastructure Funding revenues are also pledged to support GOs.

It is not clear if the superbond structure would broaden these claims to other agency revenues not currently pledged to support Commonwealth GOs.  However, don't be surprised if additional straws appear.

Puerto Rico CDO

In effect, the superbond debt restructuring would create a Puerto Rico CDO with GO bonds as the super senior tranche, and many equity tranches (all named after various Puerto Rico agencies).  It could look something like the chart below.

Chart 1:  Potential Puerto Rico "Superbond" CDO Structure

For a higher resolution version of this chart, click here.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

This blog post continues our expert analysis of complex investments and their regulation.

A new paper from Alp Simsek of MIT makes an argument that financial innovation always increases market risks.  (See the WSJ article on the paper here, and the paper here.)  Essentially, the argument boils down to this:

1. New financial products create new disagreements about valuations and outcomes;

1. These products are new and therefore disagreements are bound to be wide;

1. New products amplify speculation on existing disagreements;

1. They also allow traders to purify their bets (and speculate on more narrow outcomes) or in economic terms, the traders opportunity set has increased;

1. When traders are able to make purer bets, they make larger bets

The traditional argument for financial innovation is that it allows for risk sharing, and that those who don't want to take certain risks can trade them to others who want them.  This paper is interesting because it shows that aggregate risks are increased by the endogenous introduction of new financial products (by amplifying old disagreements and introducing new disagreements).

A paper published in the Journal of Finance shows that AAA tranches were inflated 12.1% over published guidelines and that, on average, the AAA tranches analyzed were structured to BBB support levels.  (JoF)

For implications of this rating inflation (by S&P), see this Bloomberg article.

See our previous coverage on CDOs here and here.