About a month ago, I wrote here about whether the 38 Studios bondholders should be repaid. At the time, I didn’t think so. In part because I believed the insurance would cover it, but later found out the policy is held by the bond buyers, not the state. Also because it was a moral obligation bond with an approximate three times higher interest rate than a general obligation bond. The bond buyers knew the risk as they were getting such a higher interest rate. They also identified the risk by purchasing the insurance, though there were also other reasons for the insurance, including the overall cost of the deal.

However, we’re now learning that the whole thing may stink even worse than first thought. I’d love to know if the originators of this deal knew all the facts as they’re coming out now.

Guess what, to a ratings agency like Moody’s or S&P, it doesn’t really matter what type of bond we default on. I know some may not believe this, but here are two pieces of evidence.

From a June 2013 Office of Management and Budget Report, Director Peter Marino stated:

Rating agencies and the market do not make distinctions in the type of debt when it comes to a default.

and in today’s S&P negative watch, posted by WPRI’s Ted Nesi:

S&P “would likely take negative rating action, lowering [general obligation], appropriation, and moral obligation debt by multiple notches” if Rhode Island lawmakers refuse to put roughly $12.5 million into the next state budget to make the next two payments to the 38 Studios bondholders.

So there’s that. What’s the next course of action?

General obligation bonds and moral obligations bonds are actually different. At recent House Oversight Committee hearings, Representative Chippendale pointed out explicit language in RI law that the state might not pay these bonds back, differing from general obligation bonds. And again, that risk was outlined by the interest rate difference on these bonds. But now if RI chooses to default on future payments, the state could suffer a credit hit to its general obligation bond ratings. They could even be lowered to the point where future borrowing extra costs could exceed that of the $125 million that the state is on the hook for already.

If that is the case, that over the long-term it will cost the state more money to default on the bonds than to pay them back, what is the prudent choice? We shouldn’t muddle the issues that the state never should have engaged in this deal in the first place. That’s done and if the House Oversight Committee wants to hold hearings to get to the bottom of who screwed up what, I’m all for that. However, I feel that information is irrelevant toward whether we should pay these bonds back. If the ratings agencies are saying that we must pay the 38 Studios bondholders or they’ll lower our general obligation bond rating, then wouldn’t it make more fiscal sense to simply pay it back and keep the better credit rating going forward?