Puerto Rico’s debt situation has the potential to significantly rattle financial markets and banks need to take notice.

At a recent Senate hearing, Antonio Weiss, a counselor to the Treasury secretary, unveiled a plan to allow Puerto Rico to restructure all of its debts. Puerto Rico’s financial challenges are well-documented, but the plan introduced by Weiss is unprecedented and dangerous, particularly for the banking industry. It would allow sweeping bankruptcy powers that aren’t currently available to any U.S. state by allowing Puerto Rico to restructure debt that must be repaid under the territory’s constitution.

Treasury’s plan, called “Super Chapter 9”, would require congressional approval, which is far from certain. That’s a good thing because allowing Puerto Rico to restructure its constitutional debt would undoubtedly lead to high-spending states like Illinois wanting the same authority. If that happened, debt markets would be chaotic. The entire notion that full faith and credit debt for territories, states and even the federal government are sacrosanct would be called into question. Banks, as major holders of government debt, would be affected severely.

Current Gov. Alejandro Garcia-Padilla spooked markets recently when he declared Puerto Rico’s debts unpayable. Moreover, former Detroit bankruptcy judge Steven Rhodes, who serves as an advisor to Puerto Rico’s government, said recently that the U.S. territory could run out of cash by the end of November. According to Rhodes, Puerto Rico has “no choice” but to default.

There’s a key question that seems noticeably absent from the discussions in Washington which relates to how Puerto Rico violated its constitution by taking on so much debt in the first place. How did Puerto Rico rack up $73 billion in debt when the island’s constitution mandates a much lower debt limit?

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