For complete video of this event see here.
The audience assembled at the Old State House, on Benefit St., Providence, for the Stephens Hopkins panel discussing the 38 Studios deal is currently at the serve-yourself sandwich table. The audience is small, but disproportionately notable (media folks, an ethics panel lawyer, other not-so-far-behind-the-scenes figures).
One panelist is delayed by traffic. On hand is Josh Barrow (a national writer on finance) and Robert Flanders, former Central Falls receiver. Locally renowned wonk Gary Sasse is moderating.
Sasse: Taxpayers are finding themselves obligated for debts that they did not approve, with the emphasis on the “moral obligation bonds” behind the 38 Studios mess.
Sasse: “The problem is escalating to the point that the Government Accounting Standards Board” is preparing to issue regulations.
Flanders begins by explaining the use of moral obligation bonds in the case of 38 Studios (he seemed amused at the appropriateness of the game’s name “Reckoning”). He says there’s no legal obligation to pay the bonds; essentially, the governor is only obligated to ask the General Assembly for the money.
Flanders: The state must at least look into the consequences if the state opts not to pay the bill… higher interest rates, lost access to lending. Flanders notes that Barro has suggested that such lost access might not be a bad thing.
Barro: “My initial thought is that the state is better off defaulting.” He says the reason to use moral obligation bonds is in order to have the possibility of default (thereby necessitating the higher interest rate).
Cites NEARI’s Bob Walsh “quite appropriately” arguing that a state that has to change pension promises shouldn’t be able to pay off moral obligation bond holders.
He says, “maybe the state isn’t using moral obligation bonds to preserve the default optionk,” but rather “as an end-run around the voters.” That looks like the federal government implicitly promising to cover Frannie Mae & Freddie Mac and allowing banks to become too big to fail.
“That’s a bad practice,” and the state should stop.
Flanders wants to have the state do “a practical analysis,” assessing whether other states have defaulted on similar bonds.
He’s presenting these bonds as mainly a matter separating the executive branch from the legislative, although he acknowledges suggestions that key members of the legislature were involved in the deal. [Wonder why he’s placing the line between branches of government rather than between the government and the people.]
Barrow has been unable to find state defaults on moral obligation bonds, except a decade ago in Spokane, Washington. The consequence that he knows about was a one-notch downgrade in general obligation bonds by one rating agency, but he says he has to do more targeted research.
He says RI’s ability to borrow is surprisingly healthy given that its financial distress is more extreme than California, and probably worse than Illinois. [Perhaps because of an attitude among our leaders to protect lenders above other claimants on public dollars.]
Sasse says the state was in somewhat of a similar situation, on moral obligation bonds, in the ’70s.
Sasse: “Who would you trust to do a cost-benefit analysis?” (Chuckles from a retired bankruptcy judge sitting near me.)
Flanders answers obliquely: the legislature has the say on whether to honor the bonds, so it’s up to them to do the analysis.
Barro: It’s worth doing the research, if only so as not to telegraph to the bond markets what the likely outcome is going to be. He says he doesn’t live here, but he’s observed that the legislature works best when guided by the executive (treasurer and/or governor).
Sasse turns the question back to when it’s appropriate to use these kinds of bonds, saying that this particular deal was more of a venture capital arrangement, rather than an economic development project.
Flanders suggests getting out of the venture-capital approach and extending debt for infrastructure projects.
“Hopefully, this points the nail in the coffin of economic development through state-sponsored venture capitalism.”
Barro: The appropriate use of moral obligation bonds would be projects when revenue and general obligation bonds are appropriate. If the purpose is really important, it should be general obligation. Moral obligation bonds are for the most questionable projects, so the tool should stay, but not be used.
“38 Studios did look like a venture capital deal, but if I were a venture capitalist, I would have a hard time financing a deal with debt.”
Barro: It would have been cheaper to just give 38 Studios a check (saving tens of millions of dollars on the deal, if successful), but that would have come with political challenges.
Sasse says the deal was inappropriately structured (as a venture capital deal) and the state had questionable capacity to manage the deal, with milestones and deeper involvement.
Barro: “It’s kind of sad to have the governor on TV debating Curt Schilling about how successful a videogame was.” He says analyzing that sort of business should not be in the job description of a governor.
Barro: RI has a fiscal disadvantage funding services, based on its size, so RI tries to make up for it with deals like 38 Studios. The problem is that competing states could use those strategies, too, and appear to do them better.
Flanders acknowledges RI’s disadvantages and asks how we could turn our size into an advantage. “What does it take to get jobs created.” “We’ve got to figure out how to make ourselves more attractive to make people want to come here and start up a business.”
Sasse: Are there alternative financing options that would help us to meet the moral obligation but not hurt the bottom line so heavily.
Flanders refers to the state’s ownership of the assets that 38 Studios did have (including intellectual property), so the state should seek advice on making the most of that. “That’s one way to potentially mitigate the loss, here: Get somebody who knows what they’re doing in this business.”
He says we should also negotiate with the bond holders to lessen the damage. He draws on his experience as a city receiver to say that negotiation can help to work things out. “Given that it’s a moral obligation bond, that does give the state some leverage in negotiating with the bond holders.”
Barro cautions that negotiating smaller bond payments would still be “a partial default.” Potentially, if you’re already annoying the bond markets with a partial default, it might be worth going all the way.
“There was a trade of these bonds in late May, after 38 Studios had started to fall apart, and there was only the slightest upward tick in the yield of the bonds.” That indicates that bond markets really believe that the obligation will be covered in full.
Barro says RI has the foundation for a knowledge industry, but it needs a good fiscal structure above that.
Audience question: Do we know who holds the bonds?
Barro: That information isn’t really available. Bonds tend to be within the state, but this wasn’t tax free, so some might have gone out of state.
In the audience, Gio Ciccione notes that EDC, which issued the debt, has assets of its own.
Flanders says he isn’t sure whether bond holders could go after EDC’s assets. Quonset, for one, is effectively a separate entity.
Bob Cusack says that EDC may be a pass-through entity, not a guarantor. (Now listing his credentials in finance and in the bond market.) “To me, a moral obligation means something, but in light of our circumstances in Rhode Island… there ought to be a dialogue” with representatives and constituents about paying the debt.
(Pictured here after the panel, center, speaking with Sasse & a Providence Journal reporter.)
He also says that the bond insurers have to be considered in all talk about negotiation with bond holders.
Cusack giving a brief history of bonds, insurance, default, politics. (Sounds like testimony. Sadly, the three people on the panel are not the decision makers, in this case.)
Barro says people worry too much about bond ratings. At the level of local fire district, lenders don’t know with whom they’re dealing, so ratings are important. At the level of a state, lenders have a higher comfort level with its knowledge of the entity. “The real question is the reaction of the bond market, not the ratings agency.”
Cusack follows up that RI borrows cheaply because its assets are scarce, and bond holders want diversification.
Audience question: “Should taxpayer funds be utilized to subsidize ideas,” as the major product of a “knowledge market.”
He says he knows a lot about the 38 Studios deal and couldn’t find anybody in favor of it, beforehand.
“Where was the business community when this thing first hit the news?” Says, except for Ed Mazze, Angus Davis, and himself, nobody objected. “That deal was going to happen come hell or high water.”
Brian Bishop says that one of the reasons they rushed to have this panel is that there are rumors that the Senate might come back into session to appoint new people to the EDC board, and he hopes the hearings could expand to cover notions of oversight.
Bishop says the bond markets appeared to approve of, essentially, a partial default on pensions.
He closes by asking whether paying off the moral obligation debt will have an effect on pension litigation.
Flanders notes that one of the reasons the bond market liked pension reform was that, in the process, the state put bond holders first in line.
Flanders: “Contra” some statements from Judge Taft-Carter, pension benefits aren’t really a contract. He says one legislature shouldn’t be binding future legislatures in that way.
Flanders: “There’s not going to be any miracle of the loaves and fishes, here. There are limited resources to go around, and the question is how we’re going to spread them around equitably.”
Sasse: In closing, “we should learn from our experience” and rethink our approach to economic development.