Split on 38 Studios repayment

When are Republicans the party of Wall Street outrage and Democrats the voice of deference for high finance?
When 38 Studios is involved, of course.
Rhode Island’s five major candidates for governor are split along party lines over whether the state should pay back the roughly $87 million still owed the holders of 38 Studios bonds.
Although quick to rue Rhode Island’s involvement in Curt Schilling’s ill-fated video game company, the three major Democratic contenders have all promised to repay the state’s 38 Studios debt in order to protect its reputation and avoid potentially larger, future costs.
The two Republicans battling for the nomination, on the other hand, say a compelling case for repaying the bonds has not been made, and they would default rather than commit any additional tax dollars to a state investment they consider fraudulent.
Ken Block, the most aggressive 38 Studios hawk of the group, has suggested default could be a positive, even if it ultimately costs more than $87 million, because it will help prevent the future use of moral-obligation bonds, the instrument used to finance 38 Studios.
“38 Studios was a bad deal and a bad investment from the very beginning, and now Rhode Island taxpayers are being asked to take the hit for bondholders who should have known better. As long as there are serious legal questions still to be decided, we need to stop the repayment process,” Block said in a May 12 statement.
“Wall Street insiders use moral-obligation bonds to line their pockets at the expense of taxpayers across the country. They charge higher interest on these bonds than on taxpayer-approved bonds, and then blackmail governments into treating them exactly the same,” he added two days later.
Cranston Mayor Allan Fung, Block’s opponent for the Republican nomination, doesn’t go as far as suggesting Rhode Island should default on principle alone, even if it costs taxpayers more to do so.
But he argues that based on the limited information about the potential choices gathered to date, default appears to be a better option than allocating $12.4 million from the state budget for each of the next seven years, as is now planned.
“Mayor Fung’s position has been that we need more information than just speculation of what ratings agencies might do in response to nonpayment of bonds,” said Fung spokesman Robert Coupe. “Specifically, we’d be looking for someone to speak with the investors who buy general-obligation bonds issued by Rhode Island and try to get a sense of whether they would continue to make those investments based on the state’s obvious continued willingness to pay its obligations on those debts, as opposed to moral-obligation bonds, which are not secured by the full faith and credit of the state.” On the Democratic side of the ballot, the three major contenders for their party’s 2014 nomination have been more cautious and measured in their response to 38 Studios.
From the earliest discussions about how to react to 38 Studios, General Treasurer Gina M. Raimondo has warned against any action that could jeopardize Rhode Island’s credit rating.
Raimondo acknowledged that even as treasurer, the official responsible for managing state debt, she could not provide an estimate of how much default would cost the state relative to repayment.
As the campaign has taken shape, Raimondo has argued that default should not even be considered or seriously analyzed, even if its measurable cost was less than repayment.
“You can’t think of it as a dollar amount,” Raimondo said in an interview about her economic plan. “You have to think of the reputation of the state. Do you want to be on the front page of every paper as being the only state in 50 years to default on a bond?”
Among the gubernatorial candidates, Providence Mayor Angel Taveras has been relatively quiet on the issue of 38 Studios repayment, but like his fellow Democrats, agrees that default is a poor option.
“While I share the frustration of many Rhode Islanders, I believe that not paying back 38 Studios bondholders would have a detrimental impact on the state’s bond rating that would far outweigh any short-term benefit we might gain,” Taveras said in an email response. “As governor, I would work with our legislature and other state officials to ensure a deal like 38 Studios never happens again.”
The tortured history of 38 Studios and criticisms of Wall Street aside, the partisan split on repaying the bonds is at least in part a reflection of differing views on state spending. The economic platforms of all three Democrats feature substantial borrowing to stimulate the economy and build infrastructure, while the two Republicans don’t mention bond proposals and call for limiting spending.
If the state defaults on the 38 Studios bonds, it will almost certainly result in some increase in future borrowing costs, even if those costs end up being less than $87 million, making borrowing marginally less attractive.
Democrat Clay Pell, who held back on promising support of repayment early in the year, now says it is essential to move the state forward.
“The way to rebuild the future begins by being fiscally responsible and being responsible for the fiscal stability of the state,” Pell said in a recent interview. “That’s why I think we have to pursue every effort to recoup any allotment we can, but [it] is also why Rhode Island should not default on any debt. I want to get started on the right foot so we can invest in the areas we need to invest.”
More than two years after 38 Studios collapsed, the state still has only a limited grasp on what the true cost of defaulting would be.
Just last month the state received a report on those costs from consultant SJ Advisors LLC ordered by the General Assembly during last summer’s contentious 38 Studios bond debate.
SJ Advisors held a dim view of defaulting on the debt, predicting rating agencies would respond by downgrading Rhode Island’s general-obligation credit rating to below investment grade. They estimated a 12-notch downgrade from Standard & Poor’s Financial Services and an eight-notch downgrade from Moody’s Investors Service.
As a result of the downgrade, SJ Advisors estimated a default would cost at least $36 million more than the outstanding 38 Studios bond balance, but was more likely to cost $125.6 million more and could be even higher. That middle-scenario projection included $188.3 million in additional financing charges for future bond issues, $15 million in higher interest rates for the existing I-195 Redevelopment Commission bonds and $8.6 million in lost refinancing opportunities.
The SJ Advisors analysis has been questioned by several finance-industry observers, who see a downgrade to “junk” status for an entire state unlikely based on the unwillingness to pay a single moral-obligation bond. Another issue related to the 38 Studios collapse that has made it into the campaign is the state rehiring financial adviser First Southwest, one of the firms it is suing for fraud in connection with the failed loan.
Raimondo and Gov. Lincoln D. Chafee in March approved a new two-year contract for First Southwest, who submitted one of two bids in response to a request for proposals.
Block has called rehiring First Southwest “impossible to understand” and Fung spokesman Coupe said it was “absolutely inappropriate.”
The issue is complicated by First Southwest’s extensive connections in Rhode Island, including work for both Cranston and Providence.
Coupe said First Southwest’s work for Cranston ended before the 38 Studios saga began, although he could not provide a specific date.
First Southwest is currently “working on refinancing of a [general obligation] bond” for Providence, which has had a relationship with the firm that “long predates the Taveras administration,” said campaign spokeswoman Dawn Bergantino.
Still Taveras questioned Raimondo’s decision to rehire the company during the lawsuit.
“The city of Providence has worked with First Southwest and to date has not had an issue with their performance,” Taveras said in an email. “There is still more to be known about the role of First Southwest in relation to 38 Studios. However, in my administration when the city has sued a firm, we have fired that firm.”
The Raimondo campaign referred questions on First Southwest to the state treasury, which did not immediately respond to requests for comment.
Treasury spokeswoman Ashley Gingerella O’Shea declined comment on First Southwest, outside of comments made in the RFP evaluations of the competing firms.
The evaluation explained that “this is a transition year with a new governor and treasurer next year – consistency is important. FSW has delivered excellent service for many years.”
It also notes that the other bidder, PFM Group, was led by two former First Southwest employees. PFM Group’s fees were “slightly lower” than First Southwest, it said. •

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