Does RI Have a Moral Obligation on 38 Studios?
Monday, June 02, 2014
It seems an appropriate time to revisit the issue of 38 Studios and the Moral Obligation bonds which I wrote about in GoLocalProv one year ago “Is the Obligation Legitimate and Should We Honor It?” (May 20, 2013) This may be a perennial discussion for the remaining six years of the life of the bonds. It’s striking to see how much more we now know, but also to realize how much remains to be uncovered. The political establishment seems to have accepted the Manichean view put forth by the proponents of an annual 12.5 million appropriation. If we don’t do it, it would be financially catastrophic, we would be punished severely for decades, our GO bonds would fall to junk status, planes will fall from the sky, cats will lie with dogs, etc.. This is largely based on a $75,000 study by SJ Advisors, a Minnesota research firm the Chafee administration retained to do the study.
One year ago, Matt Fabian of Municipal Market Advisors in testimony before the House Finance Committee, also cautioned that there would be consequences for not budgeting the 2.5 million dollar payment which was then at issue. Fabian said that it is unlikely that the state’s general obligation rating would be lowered below investment grade, but it could be knocked down one, two or three notches. He said “It could go down to a BBB, the lowest investment grade rating … it is a scenario but not most likely.” He thought it could result in an interest penalty on future borrowings of 50 to 100 basis points (½ to 1 percent), a far cry from the junk status suggested by SJ Advisors.To be fair, he was just opining based on his years of experience in the municipal market, he hadn’t done any extensive financial modeling to come his conclusion.
Fox's Office Raid
GET THE LATEST BREAKING NEWS HERE -- SIGN UP FOR GOLOCAL FREE DAILY EBLASTIn the last year Rhode Island has lost its Speaker after an extraordinary State House raid by federal and state law enforcement. The deep involvement of Michael Corso in the 38 Studios plan has begun to be realized. Former Speaker Fox has wed his partner Marcus LaFond, who was a commercial tenant of Corso, and the Fox/LaFonds are entitled to the Marital and Spousal testimonial privileges afforded to all married couples, which could be significant depending on the eventual result of the investigation into Gordon Fox.
Christianity has the secrets of Fatima, Islam its “Hidden” Imam and Judaism the mysteries of Kabbalah. Rhode Island’s Economic Development Corporation also has its foundational secrets. We still don’t know who bought the 38 Studios bonds at the time of their issuance in November 2010. The buyers of approximately 68 million of the 75 million have been identified, but the purchasers of the remaining 7 million remain unknown (at least to the general public). This despite the fact that buyers were required to execute and return to several parties to the transaction letters of risk disclosure and acceptance, which EDC was unable to produce a year ago. Do those letters not exist? Were they deliberately omitted or suppressed to hide the identity of the unknown buyers? If so, whose fault is that, and does it cloud the bond insurance? Note: there was a $7,440,000 redemption (call) of the five year tranche on November 1, 2013, so the amount outstanding has been reduced accordingly. Do not confuse that with the unknown $7 million at original issuance.
Governor Chafee is leaving office in January with a 1.41 million debt still owed to him in the form of a loan he made to his election campaign. He has no electoral future and few apparent sources of political contributions as a lame duck with strong competition from other politicians in this campaign year. He casts his strident support for the paying of the bonds in terms of fiscal necessity and responsibility, and that may be true. But forgive me if I observe that there are lots of financial advisers, lawyers, contractors, politicians and others - in state and out - who would dearly love to see 38 Studios go away, and might be inclined to fond feelings toward anyone who facilitated that.
There is at least one truth in the 38 Studios saga which I believe no one would dispute. The issue could never have been done without bond insurance. One of the rationales for the added cost of bond insurance is that it allows for a lower more favorable rate of interest, because the buyers know the Insurer ultimately stands behind the debt both to principal and interest. This does not appear to have been particularly effective in 38 Studios. The bonds carried rates of 6%, 6.75% and 7.75%, for five, six and ten year periods, nobody’s idea of cheap financing. The truth is that this highly speculative business prospect could never have gotten debt financing at any rate, it could only be done, if at all, with equity investors, and those investors would have insisted on large ownership stakes, something that Schilling was unwilling to do.
Assured Guaranty, the bond insurer, has been in business since 1985, first through its predecessor company, Financial Security Assurance, which was acquired by Assured Guaranty in 2009. It insured 1697 issues in 2010, with a par value of 27 billion, and had claims paying resources of 12.6 billion. The question has to be asked. How much underwriting and due diligence did Assured actually do before writing this policy on a highly speculative venture which exposed them to potential liability of 112 million in principal and interest for a one time premium of less than 600,000 dollars? Assured claims expertise in addition to the aforementioned credit, underwriting and due diligence in the areas of negotiation, surveillance and remediation. I have no doubt that this is true.
Did EDC Suit Go Far Enough?
Assured is not a defendant in the EDC suit filed by the Chafee administration. Its interest are not necessarily inimical to ours, and there is no reason why our dealings with them have to be conducted in an atmosphere of hostility, even though at first glance it might seem so. Detroit has spent the last year negotiating a billion dollar bankruptcy evidently with some success. We have done nothing but sit back, assume the EDC lawsuit will cure all our problems and compensate our losses. The Loan and Trust Agreement governing this issue gives total veto power over any attempt at settlement or renegotiation to the Insurer. We need to explain the situation to them with all its byzantine layers of cronyism and negligence and enlist them as partners in a fact finding process which should ultimately mitigate whatever losses both parties might incur. With apologies to Attorney Max Wistow, there is no need to needlessly incur losses, simply to keep our damages high for an eventual recoupment. Attorneys always know there is a risk of a case settling out from under them, and he can be appropriately compensated for his efforts.
Finally, on the question of credit availability, consider the recent statement of William Conway, co-founder of the Carlyle Group. He said, "The world continues to be awash in liquidity, and investors are chasing yield seemingly regardless of credit quality and risk." The 38 Studios bonds are not actively traded, but the last reported sale I saw was last summer for 114 cents on the dollar. Rhode Island has never shirked from meeting any honest, ethical obligation and never will, but that is no reason to play the patsy and succumb to the financial hyperbole and histrionics of those attempting to sweep this mess under the rug.
C. Kevin McCarthy is a Guest MINDSETTER™. He is a resident of Lincoln, Rhode Island.
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