By Ted Nesi
PROVIDENCE, R.I. (WPRI) – In a battle pitting Rhode Island against Wall Street, Wall Street will win.
That was the emphatic message Thursday from top aides to Gov. Lincoln Chafee, who warned the state would risk “severe” consequences if lawmakers refuse to pay bondholders roughly $90 million they loaned the R.I. Economic Development Corporation to fund Curt Schilling’s bankrupt video-game company, 38 Studios.
“The governor is emphatically opposed to not paying this obligation,” Richard Licht, Chafee’s director of administration, told reporters. Chafee was a vocal critic of the 38 Studios transaction as a candidate for governor.
“The governor was adamantly opposed to the loan – if we’d listened to him we wouldn’t be here today,” Licht said. “But we are, and it’s better to work with a known risk than an unknown risk that could be much more harmful to the state. … We believe the risk of not paying significantly exceeds the risk of paying.”
Licht’s comments came amid a full-court press by the Chafee administration to ensure wavering state lawmakers don’t balk at including $2.5 million in the 2013-14 budget to cover state taxpayers’ first payment on the 38 Studios bonds, which were sold in 2010 to a number of major investment firms.
‘The good name of Rhode Island’
“This isn’t about the bondholders. This isn’t about an insurance company. This is about the good name of Rhode Island and the credit we have now,” Licht said, pointing to other state policies the financial markets have welcomed, such as the 2011 pension overhaul, the Central Falls bankruptcy and the first-lien bondholder law.
Chafee spokeswoman Christine Hunsinger added that the governor hopes the state’s lawsuit against the architects of the 38 Studios deal, as well as the eventual sale of the company’s intellectual property, could yield money that could be used to help repay the bonds.
The House Finance Committee heard testimony later Thursday from Matt Fabian, managing director at Municipal Market Advisors, a Massachusetts-based consulting firm whose clients include Assured Guaranty, the company that insured the 38 Studios bondholders against losses in the cast of default.
Fabian was the only witness invited by legislative leaders to testify on the issue. A House spokesman said he wasn’t paid to offer his opinions.
“I know there are people who are upset and very angry about this whole thing, and I share this feeling,” House Finance Committee Chairman Helio Melo, D-East Providence, said at the hearing. “There is no appetite whatsoever here to protect the bondholders in any way, shape or form. We are here to protect Rhode Island and the future of Rhode Island, and we need to weigh out some options.”
First time since the 1800s
Fabian told the lawmakers if Rhode Island failed to repay the 38 Studios bonds it would be the first time a U.S. state had “walked away” from a bond obligation since after the Civil War. Others who have defaulted, such as Arkansas in the 1930s, were unable to pay, which is viewed differently, he said. Arkansas eventually repaid the debt.
Fabian pointed out that the original disclosure documents in the 38 Studios deal contained relatively little information about Schilling’s company but provided reams of details about the state’s financial condition, which would have suggested to bondholders that this was Rhode Island’s debt as much as the company’s.
Fabian said he surveyed more than a dozen bond investors to get their opinions on how Rhode Island would be treated if the state defaults. “There is really a wide variety of opinions,” he said. “Some say there could be a minimal impact. Some say there could be a large impact. And some just wave their arms about catastrophe.”
He suggested the state should take a slower approach to making any decision about whether to pay the 38 Studios bonds, perhaps by commissioning an outside study of the potential impacts and seeking to renegotiate the repayment terms with Assured Guaranty or the bondholders.
“The state has done an amazing job improving its reputation with Wall Street and the rating agencies, with pension reform, with changes to the law involving local governments, including Central Falls,” Fabian said, adding: “Why drag your name through the mud just to save a little bit?”
‘A dog-and-pony show’
The committee members listened to Fabian’s comments closely, but more than one expressed skepticism about the lack of hard data about the impact of a default.
“I say we get out of this now, have these insurance companies pay this bill, and then we negotiate with the insurance companies if they want to ‘morally’ come after us,” said Rep. Ray Hull, D-Providence.
Melo replied that the 38 Studios insurance policy was paid for out of the bond proceeds, not by the state.
House Minority Leader Brian Newberry, R-North Smithfield, called the hearing “a dog-and-pony show” designed by top leaders to push rank-and-file members to support repayment. He also noted that Fabian said he could have done a more thorough analysis of the state’s options had they approached him sooner.
Last May, analysts from Moody’s Investors Service disclosed that Chafee, Treasurer Gina Raimondo, House Speaker Gordon Fox and Senate President M. Teresa Paiva Weed had all “expressed to us directly their support for the moral-obligation commitment based on the state’s credit.”
Insurer would fight the state
Licht said the Chafee administration has approached the bond insurer, Assured Guaranty, about what steps it would take if state lawmakers refuse to provide the money to pay the bonds, forcing the firm to cover the cost. “They said they expect the state to pay,” he said. “They will exercise all rights they have.”
“They don’t want to have the floodgates open,” added Peter Marino, Chafee’s Office of Management and Budget director.
Although the 38 Studios debt is a moral-obligation bond, not a standard general-obligation bond, the financial markets will not make a distinction if Rhode Island refuses to pay, he said. General-obligation bonds must be approved by voters in an election, while the moral-obligation bonds for 38 Studios were approved in 2010 by the EDC board of directors at Carcieri’s urging, just weeks after lawmakers gave them the authority to do so.
No state has ever defaulted on a moral-obligation bond, though some municipal governments have and were punished by the rating agencies for doing so, including Vadnais Heights, Minn., and Moberly, Mo. Licht argued that Rhode Island, as a small state with relatively little impact on the bond market, could be penalized.
RI would be ‘test case’
“If the first state ever to default on a moral obligation were California the market conceivably could look at it differently,” Licht said. “But we are a perfect case because Rhode Island is such a small player in the market – we’re not significant enough. If they want to set an example … if they want to say, ‘We want everyone to have pause before they ever do this,’ Rhode Island sets up perfectly.”
“The governor is not going to risk us being a test case,” Licht added.
It’s still unclear when the House Finance Committee will release its amended version of Chafee’s proposed budget and when the panel will vote on it; Melo told WPRI.com he doesn’t expect a vote next week. The new fiscal year starts July 1, and lawmakers usually vote on the budget between late May and June.
This year won’t be the last time lawmakers are asked to vote on paying the 38 Studios bonds. Repayment will require them to approve $12.5 million annually from 2014 through 2020, as well.
“Maybe we should pay this year’s payment and then do our due diligence to come up with a clearer answer,” said Rep. Frank Ferri, D-Cranston.
State bond rating could fall
Licht and Marino acknowledged that they can’t quantify exactly how much a default by the state would wind up costing directly and indirectly, but argued it would likely raise borrowing costs, hurt the state’s credit rating and potentially result in costly litigation by the insurer.
“We know that the consequences will be severe, and we believe – and we can demonstrate – that those consequences could approach $100 million or even exceed it,” Licht said.
Analysts at Moody’s have refused to tell Rhode Island officials what they would do to the state’s credit rating if lawmakers don’t repay the 38 Studios bondholders, citing legal constraints, according to Licht.
Fabian said he is skeptical that the rating agencies would reduce Rhode Island’s credit rating below investment grade if the state defaults. “Rhode Island is a state – it’s not a little city in the Midwest,” he said. But the state could see its current AA rating reduced by two or three notches, he said.
Deal protects investors’ yields
Failing to pay the 38 Studios bonds could also harm the ability to borrow of municipalities and other entities such as T.F. Green Airport’s parent agency. “There would be an assumption that the state would no longer be willing to help them, or could be willing to get in the way of them servicing their own debts,” Fabian said.
The 38 Studios bonds pay higher interest rates – between 6% and 7.75% – than most municipal bonds. Licht said there is no legal way for the state to lower the bond payments because the Carcieri administration’s advisers included a “redemption premium,” which says the investors will receive all the proceeds promised.
As the committee discussed Rhode Island’s options Thursday evening, 38 Studios founder Curt Schilling sent an unrelated message on Twitter, apparently a reference to prospect Braden Shipley in the Major League Baseball draft: “Shipley still out there, love the potential.”
Two groups opposed to repaying the bonds, Occupy Providence and the libertarian-leaning Stephen Hopkins Center for Civil Rights, organized a forum at the State House where experts including Gary Sasse, a top aide to former Gov. Don Carcieri, suggested the state should do more to study the pros and cons of defaulting.