To:

From:
Date:
RE: The Federal Reserve and Puerto Rico

I. Background
Between 1996 and 2005, a tax incentive that had subsidized business investment in Puerto Rico
for two decades phased out. Ever since, the territory has struggled with business flight, declining
tax revenues, and repeated periods of recession. Today, the unemployment rate has risen to 14
percent, hundreds of thousands of workers have stopped looking for work altogether, and nearly
half the population of 3.6 million lives below the poverty line. Alongside Puerto Ricos
downward economic spiral, its debt has ballooned to $72 billion more than all but two U.S.
states (New York and California).1
In late June, Puerto Ricos Governor Alejandro Garca Padilla told the New York Times that the
territory was unable to pay its debts and called for restructuring. Padillas interview stoked
concerns of looming default and sparked a new period of crisis.2 In contrast to U.S. cities and
municipalities, Puerto Rico is unable as a U.S. territory to file for Chapter 9 bankruptcy
protections under current law.3 The result has been great uncertainty for Puerto Rico, its
bondholders, and the broader economy.4
In July, the Obama Administration called on Congress to extend bankruptcy provisions to Puerto
Rico to allow for an orderly restructuring of the territorys debt.5 The extension of bankruptcy
For general background, see: James Surowiecki, The Puerto Rican Problem, The New Yorker,
http://www.newyorker.com/magazine/2015/04/06/the-puerto-rican-problem (April 6, 2015); Matthew Yglesias, The Puerto Rico
Crisis, Explained, Vox, http://www.vox.com/2015/7/1/8872553/puerto-rico-crisis (July 7, 2015); Puerto Rico on the Brink,
The New York Times, http://www.nytimes.com/2015/04/30/opinion/puerto-rico-on-the-brink.html?ref=topics&_r=1 (April 29,
2015).
2 Michael Corkery and Mary Williams Walsh, Puerto Ricos Governor Says Islands Debts are Not Payable, The New York
Times, http://www.nytimes.com/2015/06/29/business/dealbook/puerto-ricos-governor-says-islands-debts-are-not-payable.html
(June 28, 2015). See also: Gillian B. White, Whats Really Happening in Puerto Rico? The Atlantic,
http://www.theatlantic.com/business/archive/2015/06/puerto-rico-debt-crisis/397241/ (June 29, 2015); Max Ehrenfreund, Things
in Puerto Rico Are Getting Really Bad: What You Need to Know, The Washington Post,
http://www.washingtonpost.com/blogs/wonkblog/wp/2015/06/29/things-in-puerto-rico-are-getting-really-bad-what-you-need-toknow/ (June 29, 2015); Sophia Yan, Governor: Puerto Rico Near Death Spiral, CNN,
http://money.cnn.com/2015/06/29/news/economy/puerto-rico-default/index.html?iid=surge-stack-dom (June 29, 2015).
3 See: Broke And Barred From Bankruptcy, Puerto Rico Seeks Outside Cash, NPR,
http://www.npr.org/2015/06/05/411710928/broke-and-barred-from-bankruptcy-puerto-rico-seeks-outside-cash (June 5, 2015);
Aimee Picchi, 5 Things to Know About Puerto Ricos Debt Crisis, CBS News, http://www.cbsnews.com/news/5-things-toknow-about-puerto-ricos-debt-crisis/ (June 30, 2015).
4 See, e.g., Laura Barron-Lopez and Adriana Usero, The Curious Case of Puerto Rico, And Why Default Poses a Risk to the
U.S., Huffington Post, http://www.huffingtonpost.com/2015/06/30/puerto-rico-default-us_n_7692006.html (June 30, 2015)
5 Rodrigo Ugarte, Treasury Secretary Jacob Lew Says Obama Administration Cannot Help Puerto Rico, Calls for Bankruptcy
Protections, Latin Post, http://www.latinpost.com/articles/69048/20150731/treasury-secretary-lew-explains-administration-cando-nothing-for-puerto-rico-calls-for-bankruptcy-protections.htm (July 31, 2015). Secretary Clinton has similarly called for
bankruptcy protection. S.A. Miller, Hillary Clinton Backs Bankruptcy for Puerto Rico, The Washington Times,
http://www.washingtontimes.com/news/2015/jul/7/hillary-clinton-backs-bankruptcy-puerto-rico/ (July 7, 2015). See also:
Helping Puerto Rico Prosper, Bloomberg View, http://www.bloombergview.com/articles/2015-02-25/let-puerto-rico-gobankrupt (February 25, 2015); James Surowiecki, Why Congress Should Let Puerto Rico Declare Bankruptcy, The New
Yorker, http://www.newyorker.com/business/currency/why-congress-should-let-puerto-rico-declare-bankruptcy (July 1, 2015);
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protections, however, has been opposed by Republicans in Congress, a number of hedge fund
bondholders, and others who argue that bankruptcy would insufficiently penalize the territory for
mismanagement and overly penalize creditors.6 Many of these critics have instead called for
harsher austerity measures, including further tax increases, government layoffs, and funding cuts
to the public education system.7 In this political context, it is unlikely that Congress will act to
extend the protections.

II. The Federal Reserve Has the Authority to Act and Should Act
A. The Federal Reserve Should Exercise its Emergency Authorities Under Section 13(3) of the
Federal Reserve Act to Pave the Way for an Orderly Restructuring of Puerto Rican Public
Corporation Debt
i. The Federal Reserve Has Immense Emergency Lending Authorities under 13(3)
Under Section 13(3) of the Federal Reserve Act, the Federal Reserve has the authority,
in unusual and exigent circumstances, to lend to individuals, partnerships, and
corporations outside the banking system that are unable to secure adequate credit
accommodations from other banking institutions.8 During the 2008 financial crisis, the
Federal Reserve used this authority to provide emergency, discounted loans to AIG and
Bear Stearns.9 In commencing emergency lending under this provision, the Federal
Reserve must:

Laura Barron-Lopez, Senate Democrats Warn Puerto Rico Default Would Trigger Humanitarian Crisis, Huffington Post,
http://www.huffingtonpost.com/2015/07/15/puerto-rico-crisis-schumer_n_7804390.html (July 15, 2015); Danica Coto,
Economists say Puerto Rico's debt-laden government needs option of declaring bankruptcy, U.S. News and World Report,
http://www.usnews.com/news/business/articles/2015/06/30/puerto-rico-wants-bondholders-to-postpone-debt-payments (June 30,
2015).
6 See: Michael Corkery and Mary Williams Walsh, Puerto Rico Debt Crisis Splits Congress on Party Lines and Draws Muted
Response From White House, The New York Times, http://www.nytimes.com/2015/06/30/business/dealbook/puerto-ricosbonds-drop-on-governors-warning-about-debt.html (June 29, 2015); Steven Mufson and Michael A. Fletcher, Puerto Rico Urges
U.S. to Help Save It from Default, Washington Post, http://www.washingtonpost.com/business/economy/puerto-ricos-leadersays-washington-must-help-with-staggering-debt/2015/06/29/dbb99b6e-1e83-11e5-aeb9-a411a84c9d55_story.html (June 29,
2015); Norbert Michel, Changing U.S. Bankruptcy Law Will Not Help Puerto Rico, Forbes,
http://www.forbes.com/sites/norbertmichel/2015/06/01/changing-u-s-bankruptcy-law-will-not-help-puerto-rico/1/ (June 1, 2015).
7 See: Rupert Neate, Hedge funds tell Puerto Rico: lay off teachers and close schools to pay us back, The Guardian,
http://www.theguardian.com/world/2015/jul/28/hedge-funds-puerto-rico-close-schools-fire-teachers-pay-us-back (July 28, 2015);
Nathaniel Parish Flannery, How Bad is Puerto Ricos Economic Crisis? Forbes,
http://www.forbes.com/sites/nathanielparishflannery/2015/07/29/how-bad-is-puerto-ricos-economic-crisis/ (July 29, 2015); Ed
Morales, The Roots of Puerto Ricos Debt Crisis- And Why Austerity Will Not Solve It, The Nation,
http://www.thenation.com/article/the-roots-of-puerto-ricos-debt-crisis-and-why-austerity-will-not-solve-it/ (July 8, 2015); Roque
Planas and Adriana Usero, Why Every American Should Care About Puerto Ricos Austerity Crisis, The Huffington Post,
http://www.huffingtonpost.com/2015/05/20/puerto-rico-austerity_n_7345662.html (May 20, 2015); Elias Isquith, The 1 percent
declares war on Puerto Rico: The austerity push that unmasks neoliberalism, Salon,
http://www.salon.com/2015/07/29/the_1_percent_declares_war_on_puerto_rico_the_austerity_push_that_unmasks_neoliberalis
m/ (July 29, 2015).
8 12 U.S.C. 343 (3)(a).
9 See: Fed Invokes Unusual and Exigent Clause Again, The Wall Street Journal,
http://blogs.wsj.com/economics/2008/09/16/fed-invokes-unusual-and-exigent-clause-again/ (Sept. 16, 2008).

1) Establish by regulation, in consultation with the Treasury Secretary, policies and

procedures governing the lending;10
2) Establish procedures to ensure that the borrowing entities are not insolvent (i.e.,
not currently in bankruptcy, in resolution under the Dodd-Frank Act, or subject to
any other insolvency proceedings);11
3) Obtain approval from the Treasury Secretary;12 and
4) Provide a report to Congress including the justification and specific terms of any
emergency lending and subsequent written updates on that lending every 30
days.13

ii. The Federal Reserve Should Use Its Section 13(3) Authority To Lend to Puerto Rican
Public Corporations for the Purpose of Coordinating an Orderly Restructuring of the
Territorys Debt Through a Reverse Dutch Auction Process
Public corporations in Puerto Rico including the electrical power authority and water
agency collectively have issued about $25 billion,14 or more than a third, of the
territorys overall debt. Under its Section 13(3) authorities, the Federal Reserve could
provide immediate, emergency loans to these corporations with conditions in place
contractually or under 12 U.S.C. 343(3)(B)(i) requiring that the territory use these loans
to pursue an orderly restructuring of its existing debt that would include bondholder
haircuts and lead to a more sustainable level of debt for the territory moving forward.
Specifically, the Federal Reserve can provide loans to the public corporations with an
accompanying requirement that Puerto Rican authorities use the money to hold Reverse
Dutch Auctions with hedge funds and other entities that own Puerto Rican bonds
forcing creditors to compete and sell their bonds.15
In a traditional Dutch Auction, a single seller offers a product or service at a high price
and incrementally reduces the offer price until a buyer is found. A Reverse Dutch
Auction is the inverse a single buyer offers a product or service at a low price and
incrementally increases the offer until a seller is found. In this case, Puerto Ricos public
corporations the single buyers could buy back debt they owe through this process,
forcing creditors to compete against each other in selling back debt. Through this series
of steps, the Federal Reserve wcould become the territorys primary creditor moving
forward, stepping into the shoes of existing bondholders and forcing haircuts that lead to
a more sustainable level of debt for the territory moving forward.
10

12 U.S.C. 343 (3)(B)(i).

12 U.S.C. 343 (3)(B)(ii).
12
12 U.S.C. 343 (3)(B)(iv).
13 12 U.S.C. 343 (3)(C)(i)-(ii).
14 Corkery & Walsh, FN 2.
15 The option of using a similar process was promoted during the financial crisis but not used by Treasury. See, e.g., Lawrence
M. Ausubel and Peter Cramton, A Troubled Asset Reverse Auction, ftp://www.cramton.umd.edu/papers2005-2009/ausubelcramton-troubled-asset-reverse-auction.pdf (October 5, 2008).
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In facilitating this arrangement, the Federal Reserve would need to develop procedures
that: 1) set an appropriate overall loan level that can lead to a sustainable restructuring of
debt (i.e., provide a loan amount substantially short of $25 billion that gives a haircut to
creditors sufficient to make outstanding debt sustainable but low enough to get them to
the table); 2) develop creative approaches to addressing possible collective action and
holdout problems by ensuring that bondholders who do not sell back their debt to the
public corporations at auction are at risk of even greater haircuts later;16 and 3) ensure the
loans would not go through unless there is a successful execution of the auctions that
includes a threshold level of debt purchased (incentivizing bondholders to go along with
this plan as a path for an orderly restructuring of debt).
Through this process, the Federal Reserve can provide the territory with more time and
tools to renegotiate its debt, diffuse the current crisis, and reduce the risk that default
poses to the broader economy. However, for this to be an effective strategy, the Federal
Reserve must force significant haircuts for hedge funds and other creditors, ensure that
Puerto Ricos level of debt moving forward is sustainable, and ensure that a portion of its
loans are used to reverse austerity and put Puerto Rico on a path to grow its economy and
repay its debts in full moving forward. It would not be acceptable for the Federal
Reserve to use this process merely as a backdoor form of creditor bailout.
B. The Federal Reserve Has Clear Authority to Buy New Bonds Issued By the Commonwealth of
Puerto Rico Under Section 14(2)(b) of the Federal Reserve Act and Should Use That Authority
To Provide the Commonwealth With the Funds Necessary to Coordinate an Orderly
Restructuring of Debt Through a Reverse Dutch Auction Process
Under Section 14(2)(b) of the Federal Reserve Act,17 the Federal Reserve has the
authority to directly purchase new bonds with a six-month maturity issued by the
Commonwealth of Puerto Rico with contractual requirements that the Commonwealth
use the loans to successfully purchase back outstanding debts using the Reverse Dutch
Auction process described above. After six months, Puerto Rico could refinance this
debt in the open market or roll it over.
The Commonwealth itself has issued about $47 billion,18 or almost two-thirds, of the
territorys overall debt. If the Federal Reserve took steps described above connecting
the purchase of new bonds with the successful execution of a reverse auction that leads to
an appropriate level of haircuts for creditors it can diffuse the current crisis, facilitate a
sustainable path forward for Puerto Rico, and reduce the risk that default poses to the
broader economy. However, for this to be an effective strategy, the Federal Reserve must
force significant haircuts for hedge funds and other creditors, ensure that Puerto Ricos
level of debt moving forward is sustainable, and ensure that a portion of its loans are used
to reverse austerity and put Puerto Rico on a path to grow its economy and repay its debts

See: Antonio J. Pietrantoni, Collective Action Clauses for Puerto Rican Bonds: Borrowing Costs, Practical Considerations
and Lessons From Sovereign Debt, Revista Juridica Upr, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2584729 (2015).
17 12 U.S.C. 355.
18 Corkery & Walsh, FN 2.
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in full moving forward. It would not be acceptable for the Federal Reserve to use this
process merely as a backdoor form of creditor bailout.