How Wall Street To­bacco Deals Left States With Bil­lions in Toxic Debt

Politi­cians wanted up­front cash from a le­gal vic­tory over Big To­bacco, and bankers were happy to oblige. The price? A hand­ful of states promised to re­pay $64 bil­lion on just $3 bil­lion ad­vanced.

The Suit - - Contents -

Politi­cians wanted up­front cash from a le­gal vic­tory over Big To­bacco, and bankers were happy to oblige. The price? A hand­ful of states promised to re­pay $64 bil­lion on just $3 bil­lion ad­vanced.


Novem­ber 1998, at­tor­neys gen­eral from across the coun­try sealed a his­toric deal with the to­bacco in­dus­try to pay for the health care costs that re­sulted from smoking. Go­ing for­ward, nearly ev­ery cig­a­rette sold would pro­vide money to the states, ter­ri­to­ries and other gov­ern­ments in­volved – more than $200 bil­lion in just the first 25 years of a le­gal set­tle­ment that re­quired pay­ments to be made in per­pe­tu­ity.

Then, Wall Street came knock­ing with an of­fer many state and lo­cal politi­cians found ir­re­sistible: Cash up front for those gov­ern­ments will­ing to trade in­vestors the right to some or all of their to­bacco pay­ments. State after state struck deals that crit­ics de­rided as “pay­day loans” but which pro­po­nents deemed only pru­dent. As de­signed, pri­vate in­vestors – not the tax­pay­ers – would take the hit if peo­ple smoked less and the to­bacco money fell short.

But things haven’t ex­actly worked out as planned.

A ProPublica anal­y­sis of more than 100 to­bacco deals since the set­tle­ment found that they are cre­at­ing new fis­cal headaches for states, driv­ing some into bailouts or threat­en­ing to in­crease the cost of bor­row­ing in the fu­ture.

One source of the pain is a lit­tle-known fea­ture found in many of the deals: high-risk debt that squeezed out a few ex­tra dol­lars for the gov­ern­ments in­volved, but promised mas­sive bal­loon pay­ments – some in the bil­lions – down the road.

Th­ese se­cu­ri­ties, called cap­i­tal ap­pre­ci­a­tion bonds, or CABs, have since turned toxic. They amount to only a $3 bil­lion sliver of the ap­prox­i­mately $36 bil­lion in to­bacco bonds out­stand­ing, ac­cord­ing to a re­view of bond doc­u­ments and Thom­son Reuters data. But the nine states, three ter­ri­to­ries, Dis­trict of Columbia and sev­eral coun­ties that is­sued them have promised a whop­ping $64 bil­lion to pay them off.

Un­der thees deals, the debts must be re­paid with set­tle­ment money and not tax dol­lars. Still, tax­pay­ers lose out when to­bacco in­come that could be spent on other gov­ern­ment ser­vices is di­verted to pay off CABs. And states can’t sim­ply walk away from the debt – bond­hold­ers have a right to fur­ther to­bacco pay­ments, even after a de­fault.

“It’s go­ing to cost tax­pay­ers, ei­ther di­rectly or in­di­rectly,” said Craig John­son, an as­so­ciate pro­fes­sor of pub­lic fi­nance at In­di­ana Univer­sity in Bloom­ing­ton, who has stud­ied to­bacco bonds and CABs. “I don’t doubt that at all.”

ProPublica’s anal­y­sis is the first to mea­sure the mag­ni­tude of high-risk debt in­volved in the to­bacco deals and to cal­cu­late how much Wall Street’s deal­mak­ers earned. It also shows how much of the to­bacco money has been se­cu­ri­tized – that is, turned into pay­ments that go to in­vestors. As of this year, at least one out of ev­ery three dol­lars com­ing in un­der the set­tle­ment is pledged to in­vestors, ac­cord­ing to bond dis­clo­sures

and pay­ment data from the Na­tional

As­so­ci­a­tion of At­tor­neys Gen­eral, which tracks the flow of funds.

The sure win­ners so far are in­vest­ment bankers from Cit­i­group, the now de­funct Bear Stearns and oth­ers who, along with con­sul­tants and lawyers, have pock­eted more than $500 mil­lion in fees for their fi­nan­cial en­gi­neer­ing, ac­cord­ing to ProPublica es­ti­mates. They now stand to make even more as the gov­ern­ments look to re­work old deals and try to get even more to­bacco cash up front.

In part, trou­bles with to­bacco bonds arise from the same kind of mis­cal­cu­la­tion that led to the hous­ing bub­ble.

Just as mort­gage lenders bet that home prices would keep ris­ing, the to­bacco deals re­lied on op­ti­mistic pre­dic­tions of how much Americans would still smoke. Fore­cast­ers rightly saw that cig­a­rette sales would con­tinue to de­cline, but now the yearly drop – about 3 to 3.5 per­cent – is nearly dou­ble what was cooked into the deals.

Be­cause the bonds sold to in­vestors can stretch 40 years or more, th­ese out­dated es­ti­mates mean an ever-widen­ing gap be­tween what states ex­pected to col­lect un­der the set­tle­ment and the pay­ments they promised in­vestors.

The CABs prom­ise gi­gan­tic pay­outs – as high as 76 times what’s bor­rowed – be­cause noth­ing is due on them for decades. Mean­time, in­ter­est com­pounds on both the prin­ci­pal and ac­cu­mu­lat­ing bal­ance.

De­faults by state and lo­cal gov­ern­ments are rare, but rat­ing agen­cies have been warn­ing that to­bacco bonds in gen­eral could go un­der en masse. Moody’s said in May that up to 80 per­cent of the to­bacco is­sues it tracks are likely to de­fault.

For CABs, de­faults ap­pear cer­tain.

“They’re doomed,” said Jim Estes, a fi­nance pro­fes­sor at the Cal­i­for­nia State Univer­sity, San Bernardino, who helped ProPublica an­a­lyze the bond doc­u­ments. “It’s not a ques­tion of whether or not, it’s a ques­tion of when.”

Wall Street firms are al­ready pitch­ing their ser­vices to help un­wind the deals they helped cre­ate.

The first state to act was fi­nan­cially strapped New Jersey. In March, it res­cued two CABs that were part of a larger 2007 deal. The CABs promised to re­pay $1.3 bil­lion in 2041. To pay off that gi­ant tab be­fore it comes due, the state agreed to hand over $406 mil­lion of its re­main­ing to­bacco pro­ceeds be­gin­ning in 2017, money that oth­er­wise would have gone into state cof­fers.

Bar­clays han­dled the trans­ac­tion for New Jersey, earn­ing $4.5 mil­lion. The state also got $92 mil­lion in up­front cash out of the deal to help Gov. Chris Christie and law­mak­ers plug a bud­get deficit. Still, rat­ing agen­cies were not im­pressed: They down­graded the state any­way, mak­ing it costlier for New Jersey to bor­row.

In late July, Rhode Is­land an­nounced a plan to buy out some hold­ers of $197 mil­lion of the CABs it sold in 2007. The deal would shave $700 mil­lion off a $2.8 bil­lion tab due on the bonds in 2052 and let the state re­fi­nance some of its older to­bacco bonds at more at­trac­tive in­ter­est rates. Now, some bond­hold­ers are su­ing to block the deal.

Most of the deals in­volv­ing CABs sold right be­fore the 2008 fi­nan­cial cri­sis, ProPublica found. As the hori­zon dark­ened, the mar­ket for them be­gan fall­ing apart, with one lone buyer keep­ing Wall Street’s CAB ma­chine go­ing. Pitch doc­u­ments show that bankers pressed the states to act fast be­fore the win­dow shut.

“We are con­fi­dent that we can stim­u­late de­mand,” Bear Stearns bankers told Ohio prior to a $5.5 bil­lion to­bacco bond pack­age cham­pi­oned in 2007 by then State Trea­surer Richard Cor­dray, who th­ese days heads the U.S. Con­sumer Fi­nan­cial Pro­tec­tion Bureau.

Ohio’s to­bacco deal was the largest ever. It in­cluded CABs that brought in $319 mil­lion in re­turn for an even­tual $6.6 bil­lion bal­loon pay­ment – a nickel on the dol­lar. Bear Stearns, Cit­i­group and other Wall Street firms made about $23 mil­lion in fees on the trans­ac­tion, ac­cord­ing to the bond of­fer­ing doc­u­ment.

Then there is Puerto Rico, a gov­ern­ment with a long his­tory of fi­nan­cial woes.

In April 2008, as Bear Stearns was col­laps­ing, it closed a $196 mil­lion to­bacco bond sale that sad­dled the Puerto Rico Chil­dren’s Trust, a fund set up to ben­e­fit is­land fam­i­lies, with an even­tual $8.6 bil­lion bal­loon pay­out. Bear Stearns and Cit­i­group made $1.4 mil­lion in fees.

This year, Puerto Rico’s to­bacco set­tle­ment re­ceipts fell 13 per­cent be­low what was fore­cast when the deal was done. The com­mon­wealth is also strug­gling to pre­vent de­fault on a moun­tain of other debt. Of­fi­cials there did not re­spond to writ­ten ques­tions, phone calls or in­ter­view re­quests.

Crit­ics have re­peat­edly lam­basted the states and other ju­ris­dic­tions for violating the in­tent of the to­bacco set­tle­ment by spend­ing the money on uses other than anti-smoking pro­grams and health care.

“The se­cu­ri­ti­za­tion scheme not only ac­cel­er­ated the ex­pi­ra­tion of the use­ful­ness of that money, but ba­si­cally guar­an­teed that it would never be used for its con­ceived pur­pose,” said Dave Dob­bins, an ex­ec­u­tive with the Amer­i­can Legacy Foun­da­tion, a non­profit cre­ated un­der the set­tle­ment to fund smoking-preven­tion pro­grams.

“Now the money’s gone, the se­cu­ri­ti­za­tion scheme is sort of com­ing home to roost for some peo­ple … and the to­bacco prob­lem is still there: 480,000 peo­ple [are] ex­pected to die this year due to to­bacco-re­lated dis­ease,” Dob­bins said.

“It’s a grim story.”

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