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

What went wrong? Why did seemingly rational, forward-looking 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 weak 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," by examining a rare situation where the put was extinguished. 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 through the Global Financial Crisis. 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 an exogenous "seismic shock." The latter 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 350 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.