Q&A: S&P’s lead RI analyst on the 38 Studios bond debate

standard_poors_logoA heated debate has picked up once again over whether Rhode Island lawmakers should put $12.5 million into the state budget for the fiscal year that starts July 1 in order to make the next two payments on the bonds sold to lure 38 Studios to Rhode Island.

On Monday, Standard & Poor’s Ratings Services downgraded its rating on the 38 Studios bonds from A to BBB, and put a negative watch on all of Rhode Island’s bonds, including its general-obligation debt. Henry Henderson, director in the U.S. public finance group at S&P and its lead credit analyst for Rhode Island, co-authored the report.

Henderson spoke with WPRI.com on Tuesday about the 38 Studios bonds and how S&P makes its decisions. The following is a transcript of the interview, which has been lightly edited for length and clarity.

Last June, Standard & Poor’s kept the rating and outlook on these bonds unchanged and said they were unaffected by the debate. Yesterday you dropped the rating sharply and put them on a negative watch. What changed from 11 months ago in your view?

Well, as you said, we’ve been looking at the rating for a while. We’ve been monitoring the legislative debate. And we have noted the continuing debate, and also that we have not heard clear support for honoring this debt. That was what was reflected in our rating.

Do you think the situation has changed significantly since last year? It seems like you noted with interest that the debate has continued so much this year.

They did make the payment last year. There was debate last year – they did end up making the payment. And now it’s been a whole year, and it’s still the same debate. So we focus on the ability and willingness to honor the obligations, and we haven’t heard clear support for doing that.

How uncommon or common is the debate that you’re watching in Rhode Island right now, about paying a moral obligation bond like this?

These moral obligations, they are a type of obligations that Rhode Island has issued in the past, and many other states have issued. We have seen situations where the project revenues have fallen through, and states have stepped up to pay the payments per the moral obligation pledge that they put on the bonds. So I would say it’s not common that there’s this level of debate about paying on any type of obligation at the state level.

How significant was yesterday’s rating action?

Most ratings that we have are stable outlook – I’m not sure the exact percentage, but I would say probably about 80% of ratings do have a stable outlook. There are some with negative or positive outlooks. So a CreditWatch by itself is definitely a less common type of outlook to have on a rating.

In retrospect, do you think the original bonds were rated too high, since there was a lot of political controversy around this project and the public polling showed it wasn’t particularly popular back when it was done?

Well, the bonds were properly authorized by an act of the legislature for economic development, and all the points that we look for in our moral obligation criteria were in place. So we rated them based on the moral obligation that was being pledged by the state. We rated them based on that.

These 38 Studios bonds are insured by Assured Guaranty, and as far as I know they’ve indicated they would pay the bondholders in full even if Rhode Island declines to appropriate the money, though of course I’m sure something would happen between Rhode Island and Assured Guaranty. I was wondering, why is it that the rating changed when there is an insurer standing behind it, saying that bondholders will get their payments even if the issuer – in our case the legislature on behalf of the EDC – might not put the money up?

Again, we’re focused on the ability and willingness to honor obligations, so the state would not be honoring the obligations per the bond documents. Obviously, the ability and willingness to pay obligations in full and on time would not be in place, whether it’s to Assured or to bondholders.

You of course didn’t limit yesterday’s rating actions to the 38 Studios bonds. There was, as you said, a negative watch put on all of Rhode Island’s other bonded debt. Why did you take the action impacting all of the bonds when the debate is very much focused on this one?

We did lower the 38 Studios bonds because we felt that there was a higher level of risk with those bonds. But in general, to choose to not pay on one obligation does cause us to take into question the state’s – again – ability and willingness to pay on its debt in general.

You said yesterday a multiple-notch downgrade for all those bonds, including Rhode Island’s general obligation debt, is likely if the 38 Studios bond payment isn’t appropriated. Would you take those ratings below investment grade, to “junk” status?

Right now what we’ve done, as you know, is we’ve lowered the one series of bonds and we’ve put the other ones on CreditWatch, and we’re monitoring the situation. We will make the decision at the next step – whether the appropriation is made or the appropriation is not made. So as of right now, what we’re saying is there’s a potential for a multi-notch downgrade if the appropriation is not made, and we’re going to stick with what we’ve written on that.

So S&P won’t say for sure right now exactly what happens the day after the Assembly refuses to appropriate the money if that day were to come?

Other than what we said – that non-appropriation could lead to a multi-notch downgrade.

One of the things people are questioning here is why the willingness to pay a moral obligation bond for 38 Studios has any bearing on the willingness to pay the state’s general obligation bonds, because people see the 38 Studios bonds as particularly controversial – a very different thing from debt we put out for transportation or something. Why does S&P see them as correlated? Why do you see a connection with one to the other?

Again, these were properly authorized bonds that the legislature authorized. The program for the bonds to be issued under authorized the ability for the moral obligation mechanism to be in place back in 2010. And even before that, this is not the series of moral obligation bonds issued by the state, so if they were to choose to not pay one properly authorized series of debt then it would cause us to question whether they have that willingness for other series of debt that they have.

The distinction is being mentioned a lot here between a general obligation bond and a moral obligation bond, and the fact that these 38 Studios bonds weren’t voted on, they aren’t an iron clad obligation of the state the way a general obligation bond is; the moral ob just says the governor will ask the General Assembly to put the money in, but there was never a pledge that the money would actually be put forward. Is that a distinction S&P just doesn’t see – that bonds are bonds are bonds regardless of the type of bond?

We do rate various bonds under different criteria, and the moral obligation criteria that we have does say that if a moral obligation bond defaulted despite the clear original support then the state’s willingness to pay on other debt would be examined, so that’s how we see the situation. We understand there’s a difference between the pledges here, but it still calls into question the state’s willingness to honor obligations.

Some have said, what if Rhode Island said, “We’re not paying the 38 Studios bonds because of concerns about how the original deal was done, but we pledge and promise we’ll always pay our other debts, it’s just this one is weird”? Would that matter to the rating agencies? Is that something you would take into consideration?

Again, we don’t want to get into speculation about what we do in various situations. When there’s a firm decision made one way or another then we’ll analyze that situation.

Isn’t that tough, though, for policymakers, because they have no certainty about what exactly is going to happen and they can’t do a cost-benefit analysis, because they don’t know precisely what the outcome is?

That’s our stance. That’s how we rated the bonds originally under the criteria. We understand that decision-makers have a process to go through. Originally these bonds were backed with the state’s moral obligation by the state decision-makers, and right now they have a decision to make – whether to honor them or choose not to.

You mentioned in yesterday’s release that the I-195 appropriation bonds sold last year have an “acceleration provision” if the rating falls below A- or equivalent. In layman’s terms, what does that actually mean? What would happen if the rating went below there under that provision?

If the rating went below that, then – these were private placement bonds with a private entity, and the entity could choose to accelerate the bonds, which means make the bonds fully payable immediately. So the state, rather than be able to pay – I believe it was $38 million – rather than be able to pay that over the original course of time in the original agreement, the state could have to pay that immediately.

And that acceleration is at the discretion of the entity that those bonds were placed with, in that case?

Right. They could choose to trigger that acceleration.

If Rhode Island and Assured Guaranty reached some sort of settlement about reducing payments to the bondholders and told S&P about it, would that be a positive or a negative?

Similar to my other answers, we look at the ability and willingness to pay debt in full and on time, so if there was some type of situation where the state said, I’m going to default or pay you half, then that would still not be a full timely debt service payment in our view.

What do you say to those in Rhode Island who argue S&P is trying to bully the state on behalf of Wall Street insiders with this?

Again, we rate based on our published criteria. As the criteria clearly says – and this criteria was in place at the time that these bonds were originally issued, and in place at the time when the state’s other moral obligation bonds were issued – we rate things based on that criteria, and the criteria says failure to pay on this debt will cause us to question the willingness of the state to support its debt in general, its other debts.

What are the next steps for S&P in terms of watching this debate, and when will more decisions be made by S&P about this debt and the state’s other debt?

What the CreditWatch indicates is that in the near-term period – generally, 60 to 90 days – we expect that the CreditWatch would be resolved. In this case we expect it would be most likely resolved by the passage of a budget that either included the appropriation or non-appropriation for this debt service, and for all the rest of the state’s debt service.

So CreditWatch is usually a temporary thing while you wait for the outcome of something that’s leading you to put the CreditWatch on, and then once the decision is taken you decide what to do about the underlying ratings?

Right. Most ratings have an outlook on them. As I said, most ratings have a stable outlook; there are some positive or negative outlooks. CreditWatch is more of a short-term time frame, usually driven by a specific event, and so that’s the situation here. •

Ted Nesi ( tnesi@wpri.com ) covers politics and the economy for WPRI.com and writes the Nesi’s Notes blog. Follow him on Twitter: @tednesi

9 thoughts on “Q&A: S&P’s lead RI analyst on the 38 Studios bond debate

  1. Mr. Henderson’s assertion that they rated the bonds based on the moral obligation is absolutely false based on the language in the bond offer itself. The rating was based on the fact of the insurance policy not the viability of the company or the moral obligation of the State. I find it difficult to understand how this agency gave AA ratings when the internal auditor for the company, PriceWaterhouse issued an “on going concern opinion” and indicated there was no revenue and that 38 Studios may deliver the game or remain in business. S&P needs to be brought in to show how they came to this conclusion. Also, they need to explain how this document spells out numerous times that we are not obligated in any way as a State to pay this bond. How can we default on an obligation since it never was an obligation. Mr. Henderson you need to read the bond offer!

  2. What a joke. S&P was fine with the pension legislation that robbed workers of large portions of their pensions. Wasn’t that a moral obligation? Pension aren’t a gratuity, the court has already ruled on that, and workers have paid in 9.5% each year. How can this hypocritical body say that they are not shilling for WallStreet? Ted, I wish you had brought this point up, I would have loved to hear the answer.

  3. The only question for S&P, Moody’s or Fitch is why they aren’t all in Federal prison for rating GARBAGE mortgage derivatives as AAA.

    I’m okay with not paying back the I-195 bonds also. $1 billion in personal income has left the State over the last 10 or so years while the State population has risen.


  4. The people of Rhode Island were “obligated” when EDC bought the bond insurance. The mechanics of how the people get it in the neck has little to do with the moral obligation and everything to do with the insurance. It was the insurance that led to the successful floatation of the bond because the potential bond holders knew that the insurance would kick in if necessary and protect these well-healed investors. If the General Assembly renegs on the moral obligation the bond insurer simply drags the state into court and gets an order to pay. That payment would include the bond insurer’s legal expenses, by the way.

    • There is literally no reason to think that Assured Guaranty could simply get a court order to pay. The only legal obligation to pay was on the part of 38 Studios, and the state would only be directly liable for any proceeds it received from the sale of the company’s assets and from anything it could squeeze out as a result of the various investigations. There could be additional liability for particular state officials, and therefore possibly the state if they were determined to be acting in an official capacity, but I don’t think even Chafee’s sabotage was direct or illegal enough to make the state 100% liable. Even then, I have to believe that the damage to the insurer in the event of a loss would be severe enough to keep them out of the courtroom. Not that they wouldn’t try to squeeze a settlement out, mind you, and, knowing our politicians, they’d likely succeed.

      The ratings agencies are a credible threat to the state; the insurer is just posing.

  5. IMO, payment of 38 studios bondholders would violate the state constitution.

    Chafee et als want the bond paid in order to to avoid investigation into their actions (morals) or lack thereof.

    And, with respect to “the state’s willingness to honor obligations”; in RI it’s apparently moral to not honor it’s obligations to retired seniors.

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