Bloomberg News

Schilling Debt Payment Tests Rhode Island’s Commitment to Bonds

June 24, 2013

Rhode Island stands on the brink of becoming the first state since Reconstruction to renege on its debts, if it doesn’t cover $75 million in bonds that backed ex-Boston Red Sox pitcher Curt Schilling’s failed 38 Studios LLC.

Lawmakers must pass a $2.5 million appropriation to make payments next year on the debt, incurred by a state development agency to get Schilling to move his video-game developer to Providence in 2010. The money is part of a $3.4 billion fiscal 2014 general-fund budget set for a vote today in the state House of Representatives. Some legislators have balked at its passage.

Debate on the issue already led Moody’s Investors Service to put the state’s Aa2 credit rating under review for a cut, saying that an unwillingness to cover payments on bonds backed by the state’s “moral obligation pledge” would undermine the credit quality of Rhode Island’s more than $2 billion in debt.

“There’s a cloud over whether or not they’re going to fully meet this obligation for the remaining eight years,” said Robert Kurtter, a managing director at Moody’s in New York. “If this appropriation is included in the budget but it’s approved so that a couple of votes one way or another could alter the course of this, it might create concern for the rating for future years.”

If the payment is rejected, Rhode Island would join cities in Pennsylvania, California and Washington in showing a political unwillingness to put bondholders ahead of essential services for residents with budgets still showing the lingering effects of the longest recession since the 1930s. The cities chose to skip debt payments even though they may have had the resources to make them, according to Moody’s.

Mismanagement Complaints

Schilling’s 38 Studios entered Chapter 7 bankruptcy in June 2012 amid allegations of mismanagement and unmet obligations. In addition to what Rhode Island must appropriate to service the debt next year, the cost will rise to about $12.5 million annually through 2021, Kurtter said. He said the ballooning expense may lead to wavering on meeting future commitments.

Rhode Island would be the first state since the aftermath of the Civil War to willingly halt debt payments, said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors, who spoke to Ocean State officials this month about the possible investor backlash from defaulting.

Former Confederate states were among those to repudiate debt payments in the 1870s, Fabian said. Arkansas, which defaulted on its bonds during the Depression of the 1930s, eventually repaid investors, he said by telephone.

‘Precedent-Setting’

Just debating a state-level default on a moral-obligation bond is “precedent-setting,” Fabian said. “The reasonable investor can’t assume the state is more willing to pay now.”

Legislative leaders aren’t saying whether they have the votes needed to pass a spending plan that includes the payment. They need at least 50 out of 75 members, only six of whom are Republicans.

“We’ll wait and see,” Larry Berman, a spokesman for House Speaker Gordon D. Fox, a Providence Democrat, said June 21 when asked about the level of support in his chamber.

The House Finance Committee last week voted 12-0 to approve the budget with the payment, with two Republicans abstaining.

Not all the panel’s members plan to support the measure for final passage.

“This stinks,” Representative Ray Hull, a Providence Democrat, said by telephone. “Something about it just doesn’t sit well with me. Don’t lie to the general public and say we need to pay this back.”

Insured Bonds

The 38 Studios bonds, Hull and other opponents point out, are insured. That means investors would get paid even if the legislature decides not to provide the cash.

“Assured Guaranty’s insured bondholders will be paid their scheduled principal and interest on time and in full,” even if the state reneges on its obligation, Robert Tucker, a company spokesman, said yesterday in a statement.

USAA Life Insurance Co., based in San Antonio, owned about $36 million of the 38 Studios debt as of March 31, data compiled by Bloomberg show. USAA anticipates the amount owed on the bonds, which were sold by the Rhode Island Economic Development Corp. on behalf of 38 Studios, will be covered by the state or Assured Guaranty Ltd. (AGO:US), which backs the debt.

“We believe that Rhode Island will remain committed to their economic development bondholders,” Matt Walters, a USAA spokesman, said by e-mail.

Serious discussion of default began when Representative Karen MacBeth, a Cumberland Democrat, introduced a bill to erase the payment from the 2014 budget.

“I know we made promises but we don’t have the money,” MacBeth said by telephone. “We don’t have the ability to pay.”

Workers’ Pensions

The lawmaker, also a high school principal, pointed to the 2011 pension law, which cut benefits to state workers, and a provision in the proposed spending plan that would freeze inflation-based increases in nursing home payments as items that should be covered by the state before the 38 Studios debt.

“We are doing it on the back of the taxpayers,” she said.

MacBeth also objected in 2010 when the legislature voted to let the state development agency borrow the $75 million to back 38 Studios and cover its move to Providence from Massachusetts.

Then-Governor Donald Carcieri, a Republican, had offered the financing to Schilling as an incentive to bring hundreds of jobs to Rhode Island, where post-recession unemployment peaked at almost 12 percent in January 2010. About 400 jobs were lost when the company collapsed, while the jobless rate remained at almost 11 percent, compared with 8.2 percent nationally.

‘Scary’ Debate

Rhode Island’s deliberations are “the sort of thing that you can’t have happen” in the $3.7 trillion municipal-bond market, said Adam Stern, director of municipal research at Breckinridge Capital Advisors in Boston. “Because it’s so affordable for the state, and because of how that deal was issued, it’s a little scary that somebody wouldn’t pay that.”

House approval would send the budget to the state Senate, where there has been less debate on the 38 Studios debt.

Governor Lincoln Chafee, 60, supports covering the obligation, said Christine Hunsinger, a spokeswoman. She stopped short of saying he’d veto a budget that excludes the payment.

“I suspect it is something he’d have to think long and hard about,” Hunsinger said of Chafee, who switched to Democrat from independent last month.

State Treasurer Gina Raimondo, 42, who is expected to challenge Chafee for the Democratic nomination for governor next year, also supports repaying the bonds.

Moody’s cut its rating on the 38 Studios securities two levels to Baa1 from A2 on June 18 because of the debate over appropriating funds for debt service.

Investors are demanding less additional yield to own the state’s debt rather than top-rated municipal bonds. Rhode Island general-obligation bonds maturing in August 2022 were valued yesterday at a yield of about 0.5 percentage point higher than a benchmark index, down from 0.7 percentage point at the start of the year, data compiled by Bloomberg show.

To contact the reporters on this story: Annie Linskey in Boston at alinskey@bloomberg.net; Brian Chappatta in New York at bchappatta1@bloomberg.net; Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net


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