Momentum Builds For 38 Studios Anti-Bailout Plan

Friday, June 07, 2013

Jonathan Jacobs, GoLocalProv News Contributor

 

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The writing is on the wall for many disparate political allies--no bailout for 38 Studios bond debts.

Momentum is building from all sides for the idea of abandoning repayment of the $90-million-plus dollar moral obligation debt for 38 Studios. Leading the charge: Representative Karen Macbeth (D-Cumberland), who says the bond debt should not be repaid at all. “Not now. Not ever,” Macbeth said. On the other side of the aisle, RI Republican Party Chair, Mark Smiley agreed with the Democratic Representative stating in a news release, “The taxpayers of Rhode Island should not be forced to pay for this. They never made this commitment.”

Macbeth sponsored legislation earlier this year that would prevent the corporation, the state and any subdivisions from making payment on the moral obligation bonds related to 38 Studios. Just recently she uncovered information with regard to a third party analyst hired by the state to assess the potential repercussions of defaulting versus repaying the loan. The expert, Matt Fabian, is a Managing Director for Municipal Market Analysts, an independent research firm based in Concord, MA. Macbeth said Fabian has affiliations with Assured Guaranty, Ltd, the company that stands to make $500,000 from insurance on the 38 Studios deal; as well as Charles Schwab who has $100,000 invested in the deal. “The expert is biased,” said Macbeth.

Experts Debate

Occupy Providence, which has already protested the 38 Studios bail-out, held a panel discussion with the Stephen Hopkins Center that featured six panelists including portfolio manager Robert Cusack of WhaleRock Point Partners (who has advised the state on bond topics), citizen advocate Elaine Heebner, URI Business School dean Mark Higgins, Gary Sasse, former head of RIPEC and now director of Bryant University Institute for Public Leadership, and Tom Sgouros, Policy Analyst, RI Future.

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During the debate, Elaine Heebner argued that $90 million on 38 Studios could potentially lead to having to raise taxes or cut programs such as disability on which she and others rely. Other safety net cuts of which Heebner feared included subsidized housing (Rental Assistance Program), and cuts to public transit.

Tom Sgouros conveyed the message that we shouldn't act passively. Rather we should use our strength as a state. Rhode Island shouldn't have to appease credit agencies.

Mark Higgins, a proponent of paying back the debt to the bondholders, felt it would send a good signal about Rhode Island's business climate.

Grassroots organizing has played its own part in rallying for the cause. Last week, Occupy Providence held a media event in the State House Rotunda. Holding a banner that read, “No 38 Studios Bail Out,” the group told stories of underfunded education while anonymous Wall Street bondholders stood to profit from a failed business venture. The group has also created a petition that currently has over 800 signatures. “House Speaker Gordon Fox sent his first response to our petition, brushing it off and saying that the House Finance Committee was looking into it,” Occupy's Randall Rose told GoLocal. “Suppose that the politicians, the bondholders and the insurer had been more brazen in what they did, and had simply issued what they claimed to be official state debts without consulting voters. That would be flat-out illegal. Rhode Islanders would have no legal obligation to pay these debts. We wouldn't have any moral obligation to pay these debts, either.” Rose went on to explain that the moral issue was one thing, but the legal issue was quite another. He quoted a section of the RI State Constitution, which says:

Article VI section 16:

16. The general assembly shall have no powers without the express consent of the people to incur state debts to an amount exceeding fifty thousand dollars, except in time of war, or in case of insurrection or invasion; nor shall it in any case, without such consent, pledge the faith of the state for the payment of the obligations of others.

According to Rose, this legal argument should be sufficient to negate any motion made in favor of payment. Further, the Rhode Island Progressive Democrats of America have prioritized a campaign of contacting local legislators to encourage them to press for no repayment of the debt.

Municipal Market Analysis Presents at Special Hearing

At a special session of the House Committee on Finance held Thursday night, Chairman Melo opened by saying "We are here to protect Rhode Island and the future of Rhode Island."

Matt Fabian gave an extremely detailed presentation about the nuances of potentially defaulting on the debt.

The term “moral obligation bond” has been used quite often since the collapse of 38 Studios. The difference between moral obligation bonds and general obligation bonds is best explained by defining what a moral obligation bond is. According to The Financial History of the United States, written by Jerry W. Markham: “Moral obligation bonds were introduced by Governor Nelson Rockefeller of New York in the 1960s...[The] idea was that public corporations could be created that would issue housing or other bonds backed by income from the projects being financed, rather than from the state's taxes or other revenues. This avoided the necessity of obtaining voter approval of the bonds.” Therefore, moral obligation bonds do not involve a promise by the government to use its powers of taxation to raise the necessary revenue to pay off the bondholders.

Fabian said before the committee that Moral Obligation Bonds are typically used to fund projects that are not economically viable. Municipal market does not have a lot of moral obligation bonds. Furthermore, the concept is unique to US and not typically popular with international investors. "38 Studios would never qualify for bond insurance without state back up," he said. Fabian offered extensive testimony on the long term potential ramifications of default, citing that immediately after the Civil War is the most recent incident of a state not paying back municipal bonds. (Rumor has it that some European investors still will not invest in US municipal bonds due to these Confederate state defaults.)

A more recent comparison involved a 2012 assurance bond for a Chinese sucralose factory that turned out to be a scam and resulted in default and a credit downgrading of 9 points. Fabian predicted in a worst-case scenario resulting in a triple B credit rating. Furthermore, all future rates of interest could be negatively affected, he said.

Challenges

During the hearing, Representative Agostinho Silva (D-Central Falls) asked, "Why did the state purchase insurance if it was not going to use it?" Fabian answered, "The issuer of the bond is the insured party, not the purchaser. Insurance was purchased to lower interest rate but does not protect state. The insurer would act as proxy for bond holders and can choose to exercise all remedies to pursue payment. There could be a case, but additional collateral is likely in that the insurance company would do damage to the state's reputation and interest rates."

Chairman Helio Melo (D-East Providence) asked Fabian if there would be "concern and effect" due to simply a discussion of default in the municipal bond market. "Not so far," Fabian said, "but it could occur opportunistically in the market."

Fabian's ultimate recommendation was to pay back the debt, as it would be the least expensive means, in the long term, of solving the problem. However, he did admit to Representative Brian Newberry (R-North Smithfield, Burrilville) that this situation was unprecedented and his opinion was informed but not based on previous experience with this type of situation. Therefore he could only speculate on a potential outcome.

Alternative Ideas

Representative Charlene Lima (D-Cranston) sponsored her own bill that proposes yet another approach by placing a caveat on repayment requiring that any and all bondholders reveal themselves before payment could be considered. Representative Lima told GoLocal, "The biggest obstacle to the State’s economic revival is the total lack of transparency in legislative dealings. We will never turn around our state’s faltering economy if we continue to do business behind closed doors where the only goal is to enrich special interests for personal gain.” Lima went on to explain the General Assembly’s vote. She said, “If the behind-the-scenes dealings were known before the 38 Studio vote, the General Assembly would have never voted to approve the $75 million dollar sweetheart deal for 38 Studios. Now the public interest demands full disclosure of all parties who have made a profit from the sale of the 38 Studio bonds so we can trace their potential legislative ties driven solely by special interests.”

Edward Mazze, Distinguished Professor of Business Administration at URI, had a different take. Mazze summed it up very clearly by saying, "A moral obligation by a state should be honored and the bondholders should get paid the principal and interest owed to them if we were playing on a 'level field.' In Rhode Island, there is no level field. The real question is where will Rhode Island get the funds to pay the bondholders. The funds will come from taxpayers. There is insurance to pay the bondholders." This more practical approach minimizes the impact as much as possible while taking a forward looking at RI's economy. Mazze continued, saying, "Make the decision and get it over with. Use the insurance. Let's not let this issue hang over our heads for the next six years. The downside is that the insurance company will go after the state and claim it was duped, and file a complaint with the U.S. Securities Exchange Commission, if they have not done so already."

Republican Agreement

It is not just Democrats who support withholding taxpayer dollars going to repay the moral obligation bonds. GOP Chair, Smiley’s news release said, “I am calling upon the General Assembly to not pay the 38 Studios bond. The bondholders purchased an insurance policy as part of this bond and stand to be made whole if the state chooses not to pay it off. Additionally, the bond's rate of return was much higher because it was more likely to default than general obligation bonds. This is not a guaranteed bond and carries with it a higher risk.”

Smiley continued in his news release, “I don’t really see the taxpayers taking the hit, because this isn’t a general obligation bond, it is a moral obligation bond. It shouldn’t be looked at by bond rating institutions as the same thing. Whatever the ramifications would be to our credit rating, they should be stacked up against the actual cost of paying off this bond and not to preserve the ability to issue this type of bond in the future.”

RI Looking Forward

Representative Lima thought about her own constituents as well as all of Rhode Island when she said, “I feel the money being used to pay these bonds could be better used for property tax relief for the citizens of Cranston and the citizens of the other 38 cities and towns.”

Fabian, in response to Representative Newberry's cross-examination style questioning concluded that it is true that the moral obligation bonds provide less recourse for legal claims by the insurance company. "But that doesn't mean they can't make your life hell," he said.

Professor Mazze concluded his expert opinion on the topic by saying, "If the state does not honor the moral obligation, we assume our bond rating will go down a small amount. The state will not issue moral obligation bonds in the near future. By not honoring the obligation, we will save about $112 million. The financial impact to the state will be minimal, the impact on our reputation will be minimal and over time, this matter will be an historical footnote. We need begin to put more attention on the future and make Rhode Island a better place to live and work.... then you will have real economic progress."

 

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