I saw a discussion on Twitter between Ian Donnis and Andrew Morse about an article where the author wrote that Rhode Island may choose to default on the 38 Studios bonds. Andrew and Ian questioned whether the author truly understands the difference between general obligation bonds and moral obligation bonds. I know to some, there is no difference with regard to whether they should be repaid. I disagree and here’s why I think that.

First, general obligation bonds are and should be solid investments. Those are the type where a state puts their full faith and credit behind them. The only chance they don’t get repaid is if the entire state virtually falls off the map. They are as close to a lock for repayment as you can get. When you have such a guaranteed repayment rate, you don’t make very much in interest on them. There’s very low risk, and there’s very low reward. Additionally, with a general obligation bond, the voters need to approve the sale of the bond and to its repayment.

On the other hand, a moral obligation bond does not require approval of the voters and there is a greater risk of non-payment. With increased risk, comes increased reward. We’ve all seen this in the stock market as well. If you invest in a solid company, like a US Steel, an IBM or others like that, you have a very high likelihood of that kind of company being around for a long time, and there’s little to be made off those. Or, you can invest in a startup, some small unknown company. These have a higher likelihood of going bankrupt and out of business, but if they do succeed, the rewards can be great.

The people who purchased the 38 Studios bonds were well aware of this. They knew the bonds they were buying were moral obligation bonds, so they required a higher rate of return in exchange for the risk. Well sometimes, that risk comes up on the wrong end and the investors lose. That’s what happened here. The state sold the bonds at a much higher than normal rate because there was the risk of default. The default happened, so it’s not unreasonable to not pay back the bonds.

One last part that was also included in the article was this line:

The 38 Studios bonds are protected by insurance from Assured Guaranty Municipal Corp., which would be on the hook to repay bondholders if the state decides to default.

I’ve yet to hear an explanation of why we are not simply telling Assured Guaranty Municipal Corp, “Sorry, you lose. Pay up.” If you’re a homeowner, you buy insurance on your house. If your house burns down, you’ll cash in the insurance policy, right? That’s why you paid the premiums. The state The bondholders paid the premiums on these bonds in the event of 38 Studios going bankrupt. Well the house burned down so now it’s time to cash in the policy. Why aren’t we?

It is for these two reasons, that the bond buyers knew there was a chance of default and took the higher interest rates in exchange for the risk, and the fact that the state bondholders purchased insurance against the default of 38 Studios, that I also feel that the taxpayers should not repay the bondholders. We should simply walk away from this debacle.

ADDENDUM: Ted Nesi tweeted that is is actually the bondholders and not the state who paid the premiums to the insurance company. To me, that doesn’t make a difference, as if the state doesn’t pay the bondholders, they will still be made whole. But thanks to Ted for the information.