Why Rhode Island isn’t defaulting on its moral obligations

May 1, 2013
Josh Barro has a strong column today on the confusion and hypocrisy in Rhode Island; he gets equally strong support for his position from Ted Nesi.

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Josh Barro has a strong column today on the confusion and hypocrisy in Rhode Island; he gets equally strong support for his position from Ted Nesi.

The argument here is pretty simple. The state of Rhode Island has various obligations; among those obligations are pension obligations, general obligation bonds, and moral obligation bonds. The legislature and governor of the state are happy defaulting on their pension obligations, which are contractually obliged to rise in line with the cost of living: by freezing the pensions instead, some retirees will see their incomes slashed by a third.

Yet at the same time Rhode Island is determined to pay out the holders of moral obligation bonds in full.

Rhode Island’s pensioners would seem to be more deserving than the moral obligation bondholders, who sought out those bonds precisely because they carried an excess yield. The market priced in the fact that the bonds were more likely to default than general obligation bonds — and yet, when push came to shove, the state is standing behind those bonds, even as it cuts a billion dollars from promised future pension payments.

I think the argument here is a solid one, but there’s a gentle whiff of the faux-naive about it, as well. So without taking Lincoln Chafee’s side of the argument, let me try to explain what he might say, were he in a position to be honest about things.

The key here is the legislature voters. Why would any state ever issue non-legally-binding moral obligation bonds rather than legally binding general obligation bonds, given that the moral obligation bonds cost more to service? The answer is simple: general obligation bonds can’t be issued without the legislature’s voters’ approval, and getting that approval is a pain. So the executive doesn’t bother, and issues moral obligation bonds instead.

This is the first reason why the governor won’t default on the bonds: they’re obligations of the executive, and governors tend to honor each others’ obligations.

On top of that, when the governor signs into law a pension default which has the strong support of the legislature, that’s the whole government making the decision to cut pensions: it’s not a purely executive action. Blame shared is blame diluted. The governor is also in a weird way hewing to the principle underlying general obligation bonds: once the legislature electorate has managed to agree on something, then at that point it carries especial authority.

There’s also a more important reason why Rhode Island isn’t defaulting on its moral obligation bonds — and that’s the simple fact of what a moral obligation is. It’s true that moral obligations don’t carry the force of law. But they are pretty much equivalent to the US government, for instance, using its “full faith and credit” to backstop Treasury bonds. Governments don’t pay bonds because they’re legally obliged to do so; they pay bonds because they promised to do so. That’s what “credit” means.

Rhode Island’s moral obligation bonds, then, are a bit like the bonds of a sovereign nation: they’re a measure of willingness to pay. And when it comes to public-sector borrowers, willingness to pay is all important. Yes, it would be legally possible for Rhode Island to default on its moral obligation bonds while staying current on its general obligation bonds. That legal possibility is exactly why the moral obligation bonds do trade at a higher yield. But the holders of the general obligation bonds aren’t happy with their lower yield just because they know that in the event of default they can go to court: none of them ever wants to do that. They fully expect Rhode Island to pay its bonded debts in full, just because it promised to do so.

There are implications to this line of reasoning, which Nesi explains quite clearly.

If that’s the case, a moral-obligation bond is effectively a general-obligation bond in all but name, with full repayment by Rhode Island taxpayers promised no matter what. If so, shouldn’t voters have to approve moral-obligation bonds at the ballot box as they already do with general-obligation bonds – and shouldn’t Rhode Island be paying the lower interest rate investors get on a lower-risk general-obligation bond?

The answer is that yes, moral obligation bonds are effectively general obligations bonds in all but name. The state has found a way of issuing bonds without having to get the approval of the legislature electorate, but they’re still obligations of the state, and the state doesn’t distinguish the two types of obligation. And yes, Rhode Island should be paying the lower interest rate rather than the higher interest rate. But that doesn’t mean that voters should have to approve moral obligation bonds: it could equally mean that voters should stop having to approve general obligation bonds.

That is what all governors really want: to have the legislature and voters stop interfering in their borrowing strategy. And that is the real reason why Chafee is staying current on his moral obligation bonds. He wants the world to see voter approval as an anachronism, and in an ideal world he would love it if moral obligation bonds had the same legal backing — and therefore the same lower yield — as general obligation bonds. That way he’d never need to issue a general obligation bond, or get voter approval for such a thing, ever again. It’s a very attractive vision — and it’s not one he’s going to give up just because Rhode Island is suffering a fiscal nightmare these days.


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