38 Studios, Curt Schilling’s video game company, was lured to Rhode Island last year with a $75-million loan guarantee. Then this month it went bust. Now the state's taxpayers are on the hook to cover 38 Studios’ debts.
Or are they?
38 Studios’ bonds were backed by a “moral obligation” from the state of Rhode Island. The state ordinarily honors such an obligation, but unlike a general obligation, it is under no legal requirement to do so. At a panel today put together by the Stephen Hopkins Center for Civil Rights in Providence, we'll discuss the option that the state simply default on the guarantee. That has been a taboo subject in Rhode Island, and both the governor and the treasurer have been adamant that the state will honor its debts.
Why does default seem to be off the table? To understand, we need to think about the two possible reasons why governments might issue moral obligation bonds instead of general obligation bonds.
The first -- the stated reason for moral obligation bonds -- is to preserve the option of default in bad economic times. Moral obligation bonds bear higher interest rates than general obligation bonds because of this added risk of default, and governments should only pay that premium if they actually feel the option to default is valuable.
You would expect to use the option to default on a moral obligation when two things happen: The primary obligor of the bond (in this instance, 38 Studios) has defaulted, and the guarantor (Rhode Island) cannot afford to pay.
Now, perhaps Rhode Island has not yet reached the level of distress where it should default on this bond. But last year, as part of its major pension reform, the state discharged over $2 billion of pension liabilities by canceling cost of living adjustments that workers and retirees had been promised. If Rhode Island can’t afford to keep its promises to pensioners, isn’t it time for the state to default on its moral obligations to bondholders? If not now, when would Rhode Island exercise its default option?
Perhaps the answer is “never.” That brings us to the other reason to issue a moral obligation bond: Legally, doing so is much easier than issuing a general obligation bond. In Rhode Island, general bond issuances have to be approved by the legislature and then by voters; moral obligation bonds need approval only from the legislature.
Legislators might be drawn to moral obligations by their ease of issuance, not by the option to default. Indeed, they might choose to issue moral-obligation bonds even if they think the default option is effectively unusable, for example because defaulting would have unacceptably negative impacts on the state’s ability to issue general-obligation bonds. In this case, the “moral obligation” is simply a gimmick used to create a general obligation without voter approval.
Performing on the 38 Studios guarantee will cost nearly $100 million, a nontrivial amount in a state with just more than a million residents. Rhode Island lawmakers owe taxpayers an explanation of why the state issues moral-obligation bonds. If the answer is in order to preserve the option of default, they should provide guidance as to what kind of circumstances would lead the state to consider defaulting -- and how that guidance relates to 38 Studios.
If the answer is that the state uses moral obligations to create general obligations, lawmakers should admit that’s an invalid reason, and stop issuing moral-obligation bonds. One way to do that would be with a default on the 38 Studios bonds themselves, as that would end any enthusiasm for buying Rhode Island’s moral-obligation bonds. If that would lead to unacceptable contagion, then the state should perform on the 38 Studios guarantee -- but then it becomes even more important not to issue more moral-obligation bonds.
(Josh Barro is lead writer for the Ticker. Follow him on Twitter.)
-0- Jun/27/2012 12:14 GMT