Russell Moore: 38 Studios Taints RI House Budget

Monday, June 24, 2013

 

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Is it finally reckoning time for the 38 Studios moral obligation bonds? Can RI walk away from this fight or not?

The House Finance Committee budget holds the line on spending, doesn’t raise taxes, and actually boosts aid for education and local cities and towns. What’s more, the budget creates a $10 million revolving fund to improve the state’s infrastructure.

If only it weren’t for 38 Studios, this would be a responsible budget. That’s the poison pill.

There’s always a catch on Smith Hill.

The budget appropriates $2.5 million for a an initial payment to the bondholders who thought it was wise to invest in the now-bankrupt video game company led by retired baseball star Curt Schilling. It also appropriates another $50,000 to study the consequences of a strategic default by the state on the bonds.

Allow me to offer some advice free of charge on these column inches—do not pay someone a debt you don’t legally owe, especially when you’re spending someone else’s money. That’s immoral.

This is a terrible idea, and if an initial payment is made by the state taxpayers, a court could potentially look at the appropriation as an admission of liability.

The more I hear about the 38 Studios fiasco, the clearer it becomes that the state must not spend one dime to back these ill-fated bonds. Last week, in particular, the developments bordered on absurd.

Moody’s downgraded the 38 Studios bonds two notches, acknowledging they’re more risky then they thought they were in the first place. This should be no surprise to anyone; the bonds were a gamble, at best, from the beginning.

Then the real fun started. Moody’s had the nerve to tell Rhode Island’s state legislators that if they even had the courage to consider not paying a debt that they legally are not obligated to pay, they would downgrade all of Rhode Island’s debt. Standard and Poor’s were no better. They basically told the state, “We know you’ll do the right thing for our clients,” which was nothing but a thinly veiled threat.

Richard Licht, a former investment and insurance company lobbyist who now serves as Governor Lincoln Chafee’s Director of Administration, argued to a Senate caucus last week that Moody’s is some powerful, respected organization that has the power to single-handedly destroy Rhode Island’s borrowing capabilities.

To quote Vice President Joe Biden, “That’s malarkey.” Unlike Licht, the proper response to the ratings agencies should be, "Do your worst." We don't have to answer to them.

The truth is, in the wake of the financial crisis that the ratings agencies aided and abetted, they have very little (and I’m being generous here) credibility. Most large investment firms hire their own analysts to perform risk assessment on financial instruments and products before they invest. They know better.

The reason: because the rating agencies are paid by the organizations selling the financial products. Here’s the dirty little secret, when a broker approaches an analyst at one of the agencies, and the analyst doesn't give the financial product the rating the broker wants, he then runs upstairs and argues to the analyst’s boss that he doesn't agree with the methodology. And guess what, the customer is always right!

The result is that worthless financial products, like the AAA rated mortgage backed securities that caused the financial crisis, get rated very high and are easier for the brokers to sell. The ratings agency is paid by the broker and can expect continued business.

Everyone is happy, except for the people that have been fooled by putting any stock in the ratings agencies' recommendations to begin with. Those people lose money.

Wise investors, however, know better and therefore put very little stock into the ratings agencies analysis.

Let’s not forget that this past April, these two rating (Moody’s and Standard and Poor’s) agencies settled a lawsuit against them filed by groups of institutional investors for roughly $200 million. The two agencies were accused of conspiring with Morgan Stanley to defraud investors throughout the mid to late portions of the last decade. Basically, they’d say financial products were safer than they were, tricking investors into losing money. That looks looks a lot like fraud to my eyes.

Michigan Senator Carl Levin was quoted in an excellent article by Rolling Stone’s Matt Taibbi this past week as saying “It’s like one of the parties in court paying the judge's salary”, referring to ratings agencies.

The truth here is that while the ratings agencies make recommendations, the end result is that the bonds sell for whatever investors are willing to pay for them. At the end of the day, if investors think they’ll get paid a decent interest rate for lending the state money, they’ll lend the money.

Markets are amoral, for better or worse. Contrary to Licht’s argument, they don’t have the ability to punish entities intentionally—only naturally.

Look at what happened to US Treasuries after the Standard and Poor’s downgraded the USA’s sovereign debt. One would think that that Treasury rates would have increased, but instead the exact opposite happened. Treasury interest rates went down. Unlike the agency, investors still thought Treasury notes were a good deal, and bought them at a lower interest rate.

Also, we can’t forget that Rhode Island has defaulted on the equivalent of a moral obligation before. As Stephen Beale reported last week, the developer of the American Express building in downtown Providence went bust, and then Governor Donald Carcieri was called on to make the holders of those bonds—the state pension fund—whole. The Governor balked.

Nothing else happened.

Isn’t it interesting that we didn't hear a big hue and cry from these ratings agencies at that point? Apparently, there’s nothing wrong with welching on a debt owed to state workers and retirees, but not the big shots on Wall Street.

Rhode Island would do well to ignore the biased warnings from ratings agencies that lack credibility in the first place. There’s no way the state would lose more than the $112 million it would save by refusing to pay the 38 Studios bonds we’re not legally obligated to pay in the first place.

State legislators should remove the appropriation for the 38 Studios bond repayment, and if they’re not successful in doing do, vote against the full budget. Say no to bailing out Wall Street at the expense of Rhode Island taxpayers and tell the rating agencies to take a hike.

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A native Rhode Islander, Russell J. Moore is a graduate of Providence College and St. Raphael Academy. He worked as a news reporter for 7 years (2004-2010), 5 of which with The Warwick Beacon, focusing on government. He continues to keep a close eye on the inner workings of Rhode Islands state and local governments.

 
 

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