We should not repay'moral obligation'of 38 Studios bonds

With the release of the state budget, I thought this would be a good time to discuss the whole issue of repaying the 38 Studios bonds. There has been so much misinformation and so many misconceptions in the public sphere that I thought it important to try to clarify what the actual issues facing the Assembly are at this time.

To recap, in 2010 the legislature passed a bill authorizing EDC to issue loan guarantees in a collective amount up to $75 million to assist small businesses in obtaining financing during the depths of the financial crisis and recession. As it turns out, EDC planned to use the entire $75 million to guarantee a loan in the form of bonds to 38 Studios. Had the General Assembly membership known this at the time, the bill never would have been approved but Gov. Carcieri and former House Speaker Fox, who both knew about the plan, kept that information to themselves and pretended that the bill was intended for other purposes. The result is the very public lawsuit by the state against the EDC, the ongoing House Oversight hearings and who knows what type of federal and state investigations, topics for another day.

Once the bill became law, within two months the EDC announced the 38 Studios venture. A total of $75 million in "moral obligation bonds" were then issued by 38 Studios to raise capital. For about 18 months the company was in operation but as we all know it eventually ran out of money and collapsed. By the time of the collapse, even though annual bond payments were due to be made by the company for a total of nine years, only one year had been paid in full and a partial amount had been paid in year two. Year two required an additional $2.5 million in payment. This was the amount authorized by the Legislature in 2013 after a rancorous debate. I voted against that payment largely because no due diligence had been done by the prior Speaker and the whole thing felt like something being forced through the legislature to forestall too many questions being asked about the original deal. Now, in year three, 2014, a payment of $12.5 million is due with six additional annual installments of $12.5 million each running through the next several years.

Besides the obvious chicanery involved in the passing of the original legislation, the reason this has become so controversial has to do with the nature of moral obligation bonds versus general obligation bonds and the State's credit rating. To put this simply, the 38 Studios bond offering documents make it expressly clear that while the State is pledging a "moral obligation" to repay the bonds in the event the company itself fails to do so, the State has no legal obligation to do so. In other words, the State cannot be sued for nonpayment. In addition, an insurance policy was purchased from a company known as Assured Guaranty. This company, which insures bond offerings around the country, was paid a little over a half million dollars - by 38 Studios not the State - to pledge insurance in the event bond payments were not made.

Why was this structured this way? There is a history to moral obligation bonds that dates back to New York State in the early 1970s. To put it as simply as possible, general obligation bonds pledge the full faith and credit of the state (or city or whatever) toward repayment and also expose the state (or city etc.) to lawsuits for failure to pay, the same as any ordinary debtor. Most state constitutions, however, including Rhode Island's, require any general obligation bond issue to be approved by the voters in an election. Moral obligation bonds were created as a financial instrument over 40 years ago as a way to avoid the need to obtain voter approval. The trade-off, however, is that in exchange for forgoing voter approval, such bonds are not a legal responsibility of the state, city etc., rather they are merely a "moral" responsibility. The other trade-off, because the full faith and credit of the state is not pledged behind the bonds, is that the bonds are sold at a higher interest rate than normal general obligation bonds. The point is that there is more risk to purchasing these bonds precisely because they are not legal obligations of the state. The bondholders exchange additional risk that they will not be paid for higher rates of return. In addition, the purchase of bond insurance also helps mitigate the risk to the bondholders but costs additional money to the entity issuing the bonds, in this case 38 Studios.

What makes the 38 Studios payment issue so galling is that the State of Rhode Island is essentially being extorted by the Wall Street ratings agencies, Standard & Poor's, Moody's and, to a lesser extent mainly because they have not said anything publicly, Fitch. In essence, the ratings agencies have, through subtle and not so subtle public signals and in private conversations, including in meetings with the new Speaker of the House and the advisory firm, SJ Advisors, hired by the state to provide an analysis, that they will treat the failure by the State to repay these moral obligation bonds exactly the same as they would treat a failure by the State to repay general obligation bonds. From what I can tell, treating these two very different kinds of bonds as the same thing with the same consequences for failure to pay is a direct violation of the published ratings criteria these agencies allegedly use to make their decisions, not to mention that it makes one wonder why moral obligation bonds, at higher rates, are ever issued to begin with. To me, it smacks of an antitrust situation and collusion.

Personally, because moral obligation bonds are far more common around the country than people realize, I believe the ratings agencies are taking such a strong position because they are afraid that if Rhode Island does not pay these moral obligation bonds, other entities all around the country will follow suit for reasons of their own, causing the entire moral obligation bond industry to collapse. In essence, not to overstate things, but it appears to me as though "Wall Street" has created a financial instrument (which is not entirely without value in the right circumstances), has gotten used to downplaying the risks of this financial instrument over the years and now, faced with the unusual political situation in Rhode Island revolving around the 38 Studios scandal, is terrified that the Emperor will be shown to have no clothes.

As legislators we are faced with making a decision as to whether to repay these bonds or not. We have no legal obligation to do so. Rhode Island cannot be sued. If Rhode Island does not pay the bonds the insurance company will be forced to pay the bonds but the insurance company cannot sue Rhode Island either. That is because the only rights the insurance company has are for subrogation, which in essence means they step into the shoes of the bondholders. They have no more rights than the bondholders have and since the bondholders cannot sue the State of Rhode Island neither can the insurance company; though the insurer (and the bondholders) can sue the EDC and the legal and other professional firms that are currently defendants in the civil suit brought by the State.

Failure to pay these bonds would certainly make it almost impossible for Rhode Island to issue any moral obligation bonds in the near-term future and that would not be an unfair result for obvious reasons. However, not paying the moral obligation bonds should, in a fair world, have little or no impact on the rates of interest Rhode Island has to pay for general obligation bonds. Indeed, many respected financial and bond analysts have argued that the threats to Rhode Island's credit rating and potential cost structure for general obligation bonding are vastly overblown and that even if the 38 Studios bonds are not repaid by the State, the financial impact on future state borrowing will be minimal. The ratings agencies, however, are using their financial muscle and clout to extort and intimidate both the Rhode Island legislature and the voters of Rhode Island into making the decision to pay these bonds. Essentially they are holding a proverbial gun to the head of the legislature and daring us to call their bluff.

From a pure business perspective, that is a high risk to take. It is therefore no wonder that the various chambers of commerce, various business people etc. are urging the legislature to repay the 38 Studios bonds. In their view, the seven additional years of payments in the range of $12.5 million in taxpayer money are worth it to prevent the risk, however small, of a catastrophic rate increase on general obligation bonds. Governments, however, despite the fact that I believe they often should be run more like private-sector businesses, are, in the end, not a business. Governments serve the people that elect them and carry out the wishes and will of the people and, further, have an obligation to stand up for what is right and wrong in society and to push back against Wall Street bullies. In short, the legislature is an impossible position between doing the "prudent" thing versus doing the "right" thing and there probably is no "correct" answer.

Beyond this, I believe the Attorney General is failing the State. I realize that my criticism may seem politically motivated. After all, this is an election year, the Attorney General is a Democrat up for reelection and I am not only a supporter but a friend of his Republican opponent Sen. Dawson Hodgson. But my criticisms are not intended to be political. I served with Peter Kilmartin in the General Assembly and I consider him an honorable and decent man. But I am amazed at the timidity that he is showing in the current situation. The State of Connecticut successfully sued the same Wall Street ratings agencies for improper practices relative to Connecticut's bond rating. CalPERS, the California state pension system, has also sued those ratings agencies. The Attorney General has said that it is "premature" to start filing lawsuits but the Attorney General has far more power at his disposal than simply a lawsuit. He should step up and defend the people of Rhode Island against Wall Street extortion. At least make the effort.

Unfortunately, because I do not see that happening and because even if he had a change of heart, time has essentially run out given the imminence of the budget decision, the legislature will have to make the Hobbesian choice and each member of the General Assembly is going to have to look themselves in the mirror and do what they feel is the right thing to do for their constituents.

- Newberry is a Republican who represents North Smithfield and Burrillville.