Putting the “Moral” Back into “Moral Obligation Bonds”

Market Outlook

The sheer anticipation of Friday’s payrolls number has turned the US stock market into a nervous wreck, even though bond yields have stabilized over the past few days. When it comes to economic data, equities are truly caught in a “good news is bad news and bad news is bad news” situation. On the one hand, if the employment number comes out above the 169,000 consensus, “Fed tapering” fears may return. On the other, a payrolls number that is much weaker than expected may confirm that the effects of the sequester are finally showing up in the data. Neither option will provide much comfort to equity investors, here and overseas.

Presumably, only a “blowout” number would give investors confidence that the economy can now stand on its own without Fed assistance. For what it’s worth, Wednesday’s ADP employment report did come in on the lighter side of expectations (135,000 versus a 170,000 consensus) and the ISM manufacturing report was surprisingly weak.

“Moral Obligation”, Rhode Island Style

Since the onset of the Great Recession of 2008, state and local governments around the country have been pulling out all the stops to foster job creation. Some of those efforts, however, have turned out to be sadly misguided. Call it “Economic Development Gone Wild”. We’ve all heard about the Mamtek sucralose factory disaster in Moberly, MO. The State of Rhode Island has its own version of a Mamtek-style disaster, and it’s called 38 Studios.

It all started from such a great premise: after all, who would be more qualified than a future baseball Hall of Famer with limited previous business experience to start and manage a new videogame technology company? We’re being facetious, of course, but what else could have driven the State of Rhode Island, through its Economic Development Corporation (EDC), to commit close to $100 million in 2010 to lure Curt Schilling (of Red Sox and bloody sock fame) to move his company from Maynard, MA to Providence? Even the prospect of creating 350 new jobs didn’t quite make sense: the economic incentives offered to Schilling and Company come out to about $286,000 per potential job. The average salary offered by 38 Studios was reportedly $86,000. It might have been cheaper for the State just to go out and give the money directly to the unemployed.

A big part of the economic incentive package consisted of $75 million in taxable revenue bonds issued by the EDC and secured by loan payments from the company. The bonds also benefited from a so-called “moral obligation” pledge of the state and were insured by Assured Guaranty. The three term maturities were priced quite attractively: 6.00% due 11/1/15 ($24 MM), 6 ¾% due 11/1/16 ($8.86 MM) and 7 ¾% due 11/1/20 ($42.455 MM).

As you may have guessed, this story was destined to end badly and it did. Barely two years later, in May 2012, 38 Studios filed for bankruptcy and defaulted on its bonds. By now, the political back story that led to this debacle has been well-documented and we see no reason to re-hash it here (for a good summary, check out this recent New York Times article.)

Of greater relevance to us, 38 Studios’ default has put the spotlight on the state’s “moral obligation” pledge. Whether or not the state should walk away from its “moral” commitment has become a hot political issue and, understandably, a matter of great concern to muni investors.

So what exactly is a moral obligation pledge? For a standard definition, we go to Feldtein & Fabozzi’s seminal textbook, “The Handbook of Municipal Bonds”:

“Many states have issued moral obligation municipal bonds. These bonds, structured as revenue bonds with one-year debt service reserves, carry a potential state liability for making up deficiencies, should any occur, in their debt reserves. Under most state laws, if a drawdown of the reserve occurs, the bond trustee must report to the governor and state budget director the amount used. The state legislature in turn may appropriate the requested amount, though there is no legally enforceable obligation to do so (…)” (Our emphasis).

So far, Gov. John Chafee and State Treasurer Gina Raimondo have weighed in on the side of bondholders, fearing a market backlash if they walk away from the debt. In his 2013-14 budget proposal, Gov. Chafee has, to his credit, included $2.5 million to start repaying the 38 Studios bonds. The Governor has said to the press he isn’t interested in exploiting any legal distinction. “I take ’moral obligation’ to the fullest extent of those words (…) We made a moral obligation and I’m going to live up to it.”

Moody’s has also expressed confidence that the state will honor its commitment (a veiled threat if we ever heard one).

On the other side of the issue, several state politicians and concerned citizen groups oppose repaying the bonds: to them, the bond documents clearly state that the pledge is not legally enforceable and that’s just that. Two bills are even pending in the Rhode Island legislature prohibiting the state from paying 38 Studios debt. Lately, the debate has even taken on a “Wall Street versus Main Street” overtone, complete with Occupy Providence demonstrations.

While it is true that the moral obligation pledge is, in theory, not legally enforceable, it is imbedded in muni market protocol, similar to an “annual appropriation pledge”. Issuers have used it extensively in the past to enhance revenue credits, particularly housing finance agencies, although the relative strength of such a pledge does vary from state to state. The rating agencies do take it seriously and usually assign a higher rating to bonds with such a pledge.

While there have been several reported instances of local entities reneging on their moral obligation, very few issuers at the state level has ever backed out of such a pledge, at least to our knowledge. In the past, both the rating agencies and bond investors have reacted quite negatively to such a move. As we recall, back in the 1980s, the States of Minnesota and Utah briefly toyed with the idea of walking away from moral obligation bonds, only to back off under pressure from the market.

Can Rhode Island afford to lose this potentially useful tool for future, hopefully better conceived, economic development projects? The current benign interest rate environment won’t last forever, and when rates start to rise significantly, the Ocean State will need every tool in its financial toolbox to keep its interest costs down for the benefit of its citizens.

Couldn’t the state just affect an early redemption of the bonds? Not really. The bonds do benefit from an optional redemption clause commonly found in taxable bonds, usually referred to as a “make-whole” provision. The official statement for the 2010 Bonds states that the bonds are subject to early mandatory redemption by the issuer at a price equal to the greater of (1) par or (2) the price equivalent of the yield on a Treasury bond of similar maturity plus 35 basis points. Given the massive drop in Treasury rates over the past few years, the state would have to pay an exorbitant premium over par for the bonds in order to exercise this early redemption. For example, the seven year Treasury yield currently stands at 1.52%, so the State would have to pay bondholders around 133 by our calculation, the price equivalent of a 1.87% yield to maturity (1.52% + .35%). Thus, for all practical purposes, the bonds should be viewed as non-callable in the current market environment.

That said, we would suggest the following compromise solution: instead of contemplating an outright default on the bonds, perhaps the state would be better off trying to renegotiate the early call provision with the bondholders? If we were in the bondholders’ shoes, even the potential loss (or preferably, a reduction) of a market premium might be preferable to a default situation. Besides, the bond insurance policy only guarantees recovery at par (i.e. 100 cents on the dollar) in the event of default.

If the state can get the bondholders to agree to a less onerous call provision, then perhaps a new refunding bond could be issued to defease the previous debt, also with Asset Guaranty insurance. Under current market conditions, this should result in very significant debt service savings to the state and its taxpayers.

Our friend Matt Fabian at Municipal Market Advisors will be testifying today before the R.I. House Finance Committee regarding the potential market ramifications of not honoring the moral obligation pledge. We hope he’ll remind state legislators they may have used the moral obligation pledge to entice Asset Guaranty to insure the bonds, thereby lowering their interest costs. Without the indirect state backing, we can’t imagine Asset Guaranty would have agreed to guarantee the debt of a startup technology company. Without Asset Guaranty’s involvement, we doubt the deal could have been done at all, particularly back in 2010 when the market was still reeling from the effect of the financial crisis. It would be extremely disingenuous on the state’s part to now pretend that its moral pledge was never meant to enhance the bonds’ perceived creditworthiness.

Incidentally, a few months ago, we at Axios also got a call from a R.I. “concerned citizen”, who did not identify himself. He took us to task for telling Bloomberg News we believe the state is on the hook for the bonds, if not legally, then based on long-standing market protocol. He kept pointing out to us that the state has no liability for the credit, as clearly stated in the offering statement. We could only beg to disagree, of course, and the caller hung up in a huff.

Those of us who have been around for a while know that, unlike any other fixed-income sectors, the municipal market remains a bastion of traditions, customs and protocol. The simple fact that the EDC bonds are still trading at a hefty dollar price of 121 shows that the market expects the state to “do the right thing”. To violate established market protocol is a step that should never be taken lightly, particularly by a sovereign entity. In our view, working out a compromise solution with bondholders is almost always the preferred approach, one which would preserve Rhode Island’s strong reputation in the muni market.

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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