Defaulting on 38 Studios Bonds May Not Hurt State Finances

Thursday, April 18, 2013

Stephen Beale, GoLocalProv News Contributor

 

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Defaulting on the $112 million owed for the 38 Studios bonds—as some lawmakers now want to do—may not have the harmful impact on state finances as some top state officials are warning, according to several finance experts.

UPDATE: A former top state official today says there is "zero evidence" a default would have long-term harm on the state.

A former member of the Rhode Island Public Finance Management board, William Fazioli, says he doesn’t think there would be an “automatic downgrade” in the state’s credit ratings—the feared outcome of a 38 Studios bond default, which would increase borrowing costs for more basic public needs, such as new roads, schools, or housing projects.

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Fazioli, a senior managing consultant at the PFM Group, said credit rating agencies most likely would react by issuing a credit watch on the state, taking a harder look at state borrowing, and asking local officials to explain their rationale behind not paying the 38 Studios bonds—adding that a default certainly wouldn’t help state finances either.

Other experts are also unconvinced that a default on the 38 Studios bonds would have wider repercussions for state finances. “I think that’s an open question,” said Josh Barro, a Bloomberg columnist.

He suggested that it could even have a positive impact. Barro said the state would have to see how the market for general obligations bonds reacts to news that lawmakers have submitted bills to stop or reduce payments on the 38 Studios debt. An increase in projected yields for state-issued general obligation bonds is a sign that those are now viewed as riskier investments—in other words, a negative reaction, he said.

On the other hand, if the markets for state debt remain calm, Barro said that would indicate that it is in the state’s best interest not to honor the so-called moral obligations bonds associated with 38 Studios.

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In a previous interview, Barro has said the state has given itself room to maneuver by taking a harder line on other kinds of debt it has by enacting a law in 2011 strengthening the obligation of cities and towns to pay their bondholders.

Moody’s spokesman: impact of default uncertain

A spokesman for Moody’s yesterday said it would be premature to say that a default would affect the state’s credit rating for general obligation debt. “Too early to tell what the impact would be on the GO rating—it would depend on the specific decision and circumstances,” said Moody’s spokesman David Jacobson. “But it would be a credit consideration and goes to the question of a bond issuer’s willingness to honor their debts.”

The fact that top state policymakers can’t come up with any solid evidence that defaulting would hurt state finances is itself enough of a reason to pass the bill blocking state payments on the bonds, said state Rep. Karen MacBeth, D-Cumberland, and the sponsor of the measure, H5888.

She said the only formal opposition to the measure came in the form of an April 9 letter from the state Economic Development Corporation.

“This would negatively affect all of the state’s market ratings, and would make financing economic development projects very difficult and expensive,” the letter stated. However, it did not elaborate on that assertion or provide any data or other evidence to support it, MacBeth noted.

But an economist who has been critical of the 38 Studios deal in the past said he believes it’s a bad idea for the state to renege on the bonds. “Even though this is a moral obligation in terms of the way the financial deal is set up I still feel the state has an obligation to the bondholders, to make good on their payments,” said Ed Mazze, a noted business professor at the University of Rhode Island.

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Mazze did not specifically say that he expected the bond rating to be downgraded. But he said the default would have an effect on the state’s long-term ability to borrow and further tarnish the state’s already lackluster reputation as a business-friendly state. “We’re in a state with an extremely dark cloud over the state—and that’s not going away,” Mazze said. “We’re stuck in neutral.”

Few, if any, clear precedents

There are few, if any, precedents for a state default on a moral obligation. The last time a state defaulted on a general obligation bond was during the Great Depression, according to Liz McNichol, a senior fellow for the Center on Budget and Policy Priorities. Texas defaulted in 1930, and South Carolina followed suit in 1932. Arkansas and Louisiana were the last states to have bond defaults in 1933.

In 1975, the New York State Urban Development Corporation defaulted on short term notes, but the state legislature soon appropriated $90 million to cover the debt.

The closest parallel may be the Washington Public Power Supply System, a public utility which defaulted on $2.25 billion in municipal bonds in 1982—the largest default of its kind in the United States to date. (The bonds were for the construction of nuclear power plants.)

The default prompted Moody’s to drop the state’s overall credit rating from A1 to A in January 1982. The agency restored the state’s rating to A1 four and a half years later, according to data from the state Office of Financial Management.

Standard and Poor’s also lowered the state from AA to AA- in the same year. It too restored the rating four years later, state records show.

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No one could quite point to any contemporary parallels. McNichol said her center tracks only general obligation municipal bonds. And Jacobson said he could not answer questions about whether any other state has not paid moral obligation bonds.

Could state save money?

Advocates for not paying the 38 Studios bonds say that even if they are wrong and a default causes a government-wide bond rating downgrade, it may still be may make financial sense for Rhode Island to reject the $112 million debt for the failed video game company.

The annual debt service for the 38 Studios bonds would be $12.75 million, according to Jacobson.

Assuming a worst-case scenario—not only a bond rating downgrade, but one that affects all of the tax-supported debt issued by the state government—it is possible that Rhode Island could still save money in the short term.

The state has a current general obligation bond rating from Moody’s of Aa2. Were that to drop to the next level, it would be Aa3.

Assuming a difference of .3 percent between the interest rates associated with the two ratings means the state would pay $627,500 in additional annual interest payments if the state’s bond rating were lowered (using as principal the $209 million voters approved last year). That is notably less than the estimated $12.75 million in annual debt service for the 38 Studios bonds. (The .3 percent difference is the approximate average difference in interest rates between the top rating levels, according to Bloomberg data.)

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But over the long term, the annual cost of higher interest rates would grow. (Mazze, for one, disputed the idea that defaulting may be more cost-effective.)

For MacBeth, the state doesn’t have much of a choice: she wonders how the state could possibly claim to have the money to pay back the 38 Studios bonds after suspending retirement COLAs and making other cuts to pensions for state workers. And, if the state does have an extra $12 million on hand, she says that money should go to more urgent needs, such as its pension fund.

“You can’t have it two ways,” she said.

And the state has more than a simple do-or-default choice. Another bill, H5643, sponsored by Rep Charlene Lima, D-Cranston, would ensure the principal of the 38 Studios bonds is paid back, but not the interest, saving taxpayers about $37 million.

Is Moody’s ducking responsibility?

One local policy institute is calling on Moody’s to step in and end such speculation in a letter expected to be sent to the credit ratings agency today. In its letter, the Stephen Hopkins Center for Civil Rights takes Moody’s to task for not addressing the consequences of the state not paying the 38 Studios bonds, in its May 24, 2012 assessment of the rating for the bonds.

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“We feel a duty to point out that Moody’s analysis, to the extent that it does not contemplate the legitimate range of policies available to the state legislature provides neither state officials nor investors with guidance,” states the letter, which is signed by Matthew Fabisch, the chief counsel for the center.

The letter also raises questions about how similar a default on the so-called moral obligation bonds of 38 Studios would be to the reduction in the state’s pension obligations.

“We can find no logical reason why an agency that gave positive guidance on the state’s debt when legislators reversed statutory pension ‘promises’ could possibly allow the implication to fester that failing to back statutory ‘promises’ to bondholders that are not legal obligations should not be similarly regarded,” the letter says.

But both Mazze and Fazioli said Moody’s would not normally be expected to comment at this stage of the legislative process.

A spokesman for the ratings agency said it may respond to the legislation on the default before it is signed into law. “We’ve been hearing chatter regarding that but nothing has been determined or finalized,” Jacobson said. “Should the RI legislature pass a bill stating the bonds would not be paid we will comment, but not until that time.”

Stephen Beale can be reached at [email protected]. Follow him on Twitter @bealenews

 

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