EXPERTS: State Should Consider Defaulting on 38 Studios Bonds

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Thursday, June 28, 2012

Stephen Beale, GoLocalProv News Contributor

State officials have promised that they won’t default on the $75 million loan guarantee to 38 Studios, but now some of Rhode Island's leading figures in law, economics, and public policy are saying that the state should consider doing just that.

In the first place, experts point out that the state isn’t even legally obligated to pay the bonds, which, including interest, total about $112 million. Taxpayers may be on the hook for most of that—but they don’t have to be, experts say. That is because the state only has a ‘moral obligation’ to back up the bonds, meaning that the Governor is obligated to ask the General Assembly to put it in the annual state budget.

But they certainly don't have to. And, some experts aren’t so sure that they should.

‘Money down the rat hole’

Bob Flanders, the former Central Falls receiver and state Supreme Court justice, said the state should “absolutely” consider defaulting.

“The important thing is, legally, there is no legal obligation. It’s an appropriation. It’s a policy decision that needs to be made,” Flanders said. “This is serious money. This is a hundred-plus million dollars that if it goes here isn’t going to education, isn’t to job creations. It’s really going down the rat hole. I think before we willy-nilly just go ahead and pay here, I think that other options need to be at least considered.”

 

The former state administration and revenue director, Gary Sasse, says the state actually has three options—defaulting, paying back the bonds, or negotiating a better deal with bondholders. “Until you do your due diligence, don’t preclude any option,” said Sasse, who served in the Carcieri administration.

Sasse said the state needs to do a rigorous analysis of all the costs and benefits of a default, including what the cost would be to spending in other areas of the budget. “We’ve been starving public higher education,” Sasse said. “So there are the tradeoffs.”

Some say the state should default because it simply can’t afford not to. “While the state has a moral obligation to pay, the state has more moral obligations than it can afford, which is why the state discharged about $2 billion in pension liabilities last year,” Bloomberg columnist Josh Barro said in an interview yesterday. “I don’t know how the state can then say that it can afford to pay $100 million to bondholders when it’s not legally obligated to pay.”

And momentum seems to be building for the default option.

 

Yesterday, a local libertarian-leaning institute, the Stephen Hopkins Center for Civil Rights held a policy forum probing the state’s legal options, featuring Flanders and Barro as panelists. In advance of the forum, the center issued a press release comparing the obligation to paying 38 Studios bonds to the obligation to pay retiree pensions. The release was distributed on the e-mail list for the Ocean State Tea Party in Action.

Even economist Leonard Lardaro—who ultimately believes that defaulting is probably not a good idea for the state—said he thinks state leaders should nonetheless carefully evaluate that option rather than ignoring or dismissing it outright.

State officials publicly committed to paying bonds

So far, every indication is that the state is committed to avoiding a default. At the end of May, Moody’s Investors Service said it had received assurances to that effect from top officials. “Gov. Chafee, Treasurer Raimondo, Senate President Teresa Paiva-Weed and House Speaker Gordon Fox have recently expressed to us directly their support for the moral obligation commitment based on the state’s credit,” the report stated.

State officials are concerned that a default would have a negative effect on the state’s bond rating and reflect poorly on the state in the investment community—all of which could affect its ability to borrow money in the future, according to Thomas Mullaney, the state budget officer.

It’s easy to see what’s driving such concerns. The state has more than $357 million in outstanding moral obligation bonds, according state records obtained by GoLocalProv. The state Economic Development Corporation alone has issued $117 million in moral obligation debt, a figure which includes the $75 million loan guarantee to 38 Studios.

 

A spokeswoman for Lincoln Chafee yesterday said the Governor has not changed his position: she said he believes the state should honor its moral obligations.

But behind the scenes, some believe that state officials are already exploring their options. “I think what you’re hearing is the executive is saying that we know you intend to honor this, but it’s ultimately a decision the legislature has to make as to whether to do the appropriation and so I think behind the scenes there’s probably going to be some exploration of what other options do we have, if any,” Flanders said.

Economist Leonard Lardaro is less optimistic. “They probably aren’t, but in a more capably run state they would be looking at all options and running different scenarios,” he said.

Labor leaders outraged at ‘total hypocrisy’

The situation has aroused outrage among labor leaders who wonder where the state’s sense of moral obligation was to workers and retirees when it slashed pension benefits last fall.

  Philip Keefe, president of the Service Employees International Union Local 580, called the situation a case of “total hypocrisy.”

 

He slammed state officials for deciding it is more important to honor a commitment they made scarcely two years ago to a video game company, over pension promises made to workers 20 years ago. “Eighteen months. Twenty years. How do you justify that?” Keefe said. “How do you brush your teeth at night, look yourself in the mirror, and justify that?”

“I think it’s absurd we have a moral obligation to a baseball player who they gave $75 million to but no moral obligation—no morals—when it comes to the people who do the day-to-day operations in the state of Rhode Island,” said J. Michael Downey, president of AFSCME Council 94. “I find it disgusting.”

Unlike Curt Schilling and 38 Studios, Downey noted, state workers held up their end of the bargain, making the required payments from their income towards the state pension fund.

“It doesn’t surprise me,” he concluded.

As the receiver in Central Falls, Flanders was in the middle of the fray on this issue. He told GoLocalProv that there is a “sort of comparison to be made between the two situations” and that the question as to whether bondholders should stand on similar footing as retirees is a valid one.

That question, in a way, has already been answered by lawmakers in a relatively new state law, which states that bondholders must be paid back by financially distressed cities before those communities meet their obligations to workers and retirees. “I don’t fault them for that,” Flanders said. “I think that was, in retrospect, a wise decision to prevent a contagion of interest rises resulting from Central Falls going under or any other city much larger having to through a fiscal distress period like the one that Central Falls has gone through. I don’t have a problem with that."

 

Default debate divides experts

Just bad the fallout of a default would be is a matter of debate among business and finance experts. Some say that the state can’t afford a hit in its credit rating. They further warn that the state not only could find it more difficult to issue bonds in the future but also it could face higher interest rates when it does. But others say the damage would be more limited.

Former state treasurer Nancy Mayer said that as “distasteful” as it may be, she believe it would be difficult for the state to default. Mayer, a Republican who was in office in the 1990s, worries that it would drive up the cost of borrowing in the future. “It just seems to me we would really suffer in our credit rating,” she said.

Such concerns were shared by Lardaro. While he does believe that all options should be considered, Lardaro doubts that defaulting will ultimately emerge as the best choice. “If we defaulted it would be really bad for us because we’re in a really precarious position in terms of our rating,” Lardaro said, adding that the compromise option of negotiation better terms wouldn’t be nearly as “severe” in its consequences for Rhode Island's standing in the bond markets.

Ed Mazze, professor of business at the University of Rhode Island, was the most emphatic in saying that the state has “no choice but to back this obligation,” warning of broad ramifications if it doesn’t.

“If the state refuses to honor this obligation it would impact future bonds and state borrowings for revenue anticipation bonds and bonds for infrastructure improvements such as projects at state colleges,” Mazze said. “It would negatively affect the state’s reputation in the financial market. It would also affect the state’s ability to attract businesses and create jobs because it would be a negative factor in talking with prospective businesses that may need state support to come and grow in Rhode Island.”

 

Both Barro and Mullaney said that moral obligation bonds would bear the brunt of the impact—not the general obligation bonds which are legally binding. “I don’t think it would affect the general obligation bonds because they have the full faith and credit of the state behind them,” Mullaney said.

So would the state’s overall bond rating actually suffer a downgrade? A spokesman for Moody’s, David Jacobson, would only say that it would have to reassess its recent report, which did not change the original rating of A2 for the 38 Studios bonds, based on the assurances it received from state officials. The spokesman said he did not know if a default would be a factor in any future changes to the state’s overall bond rating.

But Barro said the real issue is not the state’s bond rating. He said it’s the cost of borrowing, which could go up if investors demand higher interest rates. But he isn’t convinced that they will.

“My instinct is to say that Rhode Island is in a relatively good position to default on this bond while maintaining access to general obligation bond markets, because the state’s shown such a strong commitment to repaying general obligation bondholders,” Barro said, citing the state law on municipal obligations to bondholders.

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