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

How Wall Street Tobacco Deals Left States With Billions in Toxic Debt
August 7, 2014

[Editor’s note: “Politicians wanted upfront cash from a legal victory over Big Tobacco, and bankers happily obliged. The price? A handful of states promised to repay $64 billion on just $3 billion advanced.” So reads the teaser headline on this report from the independent, non-profit ProPublica news organization. The beginning of the article follows, with a link to the full story.]

By Cezary Podkul

In November 1998, attorneys general from across the country sealed a historic deal with the tobacco industry to pay for the health care costs of 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 upfront 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 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.

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 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 the 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 paying 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.”

Click here to read the whole ProPublica report.