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38 Studios loan default could reduce RI bond rating to junk status, study says

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If Rhode Island chose to default and stop paying on the outstanding balance of its failed loan guarantee to developer 38 Studios, it could reduce the state's bond rating to junk status, according to a report by SJ Advisors (PDF link) released today by The Rhode Island Department of Administration. 

"Report on Rhode Island’s Moral Obligation on the 38 Studios Bondsanalyzes the potential impact of defaulting on the debt and the "reputational impacts" of nonpayment. It also considered the impacts of continuing to make payments and a "test the waters" scenario in which the government stopped payments to observe the impact of that decision. The independent consulting firm concluded that the Standard & Poor's Rating Services, which issues credit benchmarks for companies and governments worldwide, would give the state the lowest bond rating in the U.S. 

"We expect that the rating agency reaction will be swift and severe," the report's executive summary reads, "— that the state’s bonds will be reduced to non-investment grade (so-called 'junk bonds') — and that there will be a material and adverse effect on both the interest rates that the state pays when it issues debt and the market value of outstanding Rhode Island bonds."

According to analysts, stopping payment would create "a series of cascading events" that would have an adverse effect on the state's credit rating, "business environment" and could even decrease the value of Rhode Island bonds. 

"A series of cascading events"

Moral obligations like the 38 Studios bonds are backed by a revenue stream but also assumed to be backed by "a non-binding covenant" that would appropriate funds if the revenue stream does not provide adequate funds. Governor Lincoln Chafee addressed the state's obligation in a prepared statement, saying that he included funds to pay the debt in his budget. 

“We must protect the state’s credit rating, its positive reputation and our access to the capital markets," Chafee said. "That’s why I included $12.5 million in my FY 2015 budget to meet its obligation. While this cost to taxpayers is distasteful, we are doing everything we can to reduce the size of the burden on our citizens through litigation.  Repayment of these bonds is in the best interest to the state’s financial status and its reputation in the marketplace.”

Early this month, the state made a $2.4 million payment to investors who backed the loan guarantee. That marked the first time that the state disbursed funds not originally set aside for repayment, but instead pulled from state funds earmarked in the Chafee Administration's budget.  

Rhode Island and The Rhode Island Economic Development Corporation (now known as the Rhode Island Commerce Corporation) backed the loan guarantee in 2010. Its intent was to bring the developer of Kingdoms of Amalur: Reckoning and the unreleased massively multiplayer online role-playing game Project Copernicus and 450 jobs to the state. Former Red Sox pitcher Curt Schilling's development studio declared bankruptcy in June 2012. The state filed suit later that year maintaining that it those involved in approving the loan guarantee did not disclose all associated risks.

The bankruptcy and failure of the loan guarantee did not absolve the state from honoring its debt obligations. Since its failure, state lawmakers have discussed defaulting. The newly appointed charwoman of the Rhode Island House Committee on Oversight, Rep. Karen MacBeth, proposed legislation in 2013 and in 2014 that would prevent the state from continuing to make payments.

You can follow along with the continuing story of 38 Studios' loan guarantee in Polygon's StoryStream