How Wall Street Tobacco Deals Left States With Billions in Toxic Debt
Posted on Aug 9, 2014
By Cezary Podkul, ProPublica
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.
Square, Site wide
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.”
ProPublica’s analysis is the first to measure the magnitude of the 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: 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, ProPublica estimates. They now stand to make more as the governments look to rework old deals and try to get even more tobacco cash upfront.
In part, the troubles in the 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 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, the 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 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 and earned $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 weren’t 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 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.”
“Turbo” Tobacco Cash
Whenever governments get access to a stream of money, Wall Street bankers pitch deals to turn it into a one-time payment. Bonds are sold to investors, who give the governments cash in exchange for the income stream, similar to a loan. Bankers earn fees based on a deal’s size, giving them every incentive to maximize the value.
The 1998 tobacco settlement was no ordinary revenue stream: It was the biggest financial settlement in legal history, projected to net states and other governments $206 billion just through 2025. “The money is huge,” Iowa Attorney General Tom Miller said at the time.
A cottage industry immediately sprouted up on Wall Street. The goal: Convince states to pawn the revenues.
Citigroup, JPMorgan, UBS, Goldman Sachs, Morgan Stanley and now-defunct firms like Bear Stearns, Lehman Brothers and Merrill Lynch all dedicated bankers to the cause, pitch documents show. Bear Stearns even had its own, 21-strong “Tobacco Securitization Group” devoted to monetizing the settlement.
“The ink on the document was barely dry before these folks started coming at us, suggesting the idea of securitization,” said Christine Gregoire, who as Washington’s attorney general helped lead the tobacco settlement talks and later, as governor, opposed securitization.
“I was just like, ‘Wow, I can’t believe that they have immediately thought about how to get one-time money and be indebted to the revenue stream.’ And I remember from the very beginning being offended at the idea,” she said.
Part of Gregoire’s objection is the same reason it doesn’t make sense to buy groceries on credit: You end up spending more — and getting less — by paying interest over time on goods you quickly consume.
“It’s not good fiscal management of public money to give away 75 cents on a dollar of income,” she warned in 2002, when her state debated raising $450 million to fill a budget hole by cashing out tobacco income.
Washington lawmakers pushed ahead anyway. The plan securitized 29.2 percent of the state’s expected tobacco cash, the equivalent of $40 million to $50 million a year. Investors were promised that money until the debt was fully repaid, sometime around 2025.
Kym Arnone, Bear Stearns’ senior tobacco banker, advised the state against using CABs.
“At the present time, no market has emerged for tobacco CABs since investors are unwilling to defer all of their income until the final maturity of a bond when there is significant chance of payment interruption or payment delay,” a 2002 pitch document signed by Arnone states.
The state followed that advice. By issuing traditional bonds that regularly pay interest and principal, Washington sold what turned out to be one of the less-costly deals crafted by Bear Stearns. Through last year, when the state was able to refinance on favorable terms, investors were paid $848 million from tobacco settlement money, a little under twice the $450 million the state got.
But Washington was one of the early deals. As the securitization trend continued — with Bear Stearns alone leading $23 billion of transactions from 2000 through 2007, according to Thomson Reuters data — bankers reached for ways to fatten the deals and their fees.
Chief among these was the CAB. By 2005, investment bankers had found willing buyers for this type of bond, thanks in part to a repayment structure first suggested by Goldman Sachs: the “turbo” bond.
With a turbo bond, governments agreed to make earlier payments if they had surplus cash from the tobacco settlement. The prepayments were not an ironclad promise — they could be skipped without triggering default. Turbos were already being built into regular bonds like those sold by Washington, and they appealed to CAB investors who might want some money before a final payoff decades away.
“That’s why they call them turbos — because they pay down faster,” said John Lampasona, an analyst at Standard & Poor’s who rates tobacco bonds.
Reassuring forecasts of cigarette sales also aided the market for CABs.
IHS Global Insight, a consulting firm, earned millions of dollars providing its forecast on almost every deal done in the sector. The projections persuaded investors there would be extra cash available to prepay CABs. Since then, smoking bans and hefty tax increases have nearly doubled IHS’s projected rate of decline in cigarette sales.
“I take all the credit and take all the blame,” James Diffley, IHS’s lead forecaster for cigarette sales told ProPublica. “It’s a forecasting exercise. The world will not turn out exactly like anybody imagined.”
A 2005 deal involving Puerto Rico was the first CAB sale, according to the bank that arranged it. That year, Merrill Lynch convinced the Puerto Rico Children’s Trust to issue $108 million of CABs that wouldn’t come due until 2045 and 2050 — when many of the officials deciding to sell the debt might well be dead and a $2.5 billion payment would be owed.
Merrill Lynch estimated that Puerto Rico could pay off the debt early, however, by shelling out some $372 million in turbo repayments from 2024 to 2028. That prediction, tucked inside the 2005 bond offering, was based on industry payments coming in line with IHS’s basic expectation of cigarette sales.
Mutual fund managers Oppenheimer Funds, BlackRock, Eaton Vance, Dreyfus, Nuveen and Goldman Sachs Asset Management all bought Puerto Rico’s turbo CABs, according to a Merrill Lynch pitch document. A spokesman for Merrill Lynch, now part of Bank of America, declined comment for this article.
After that deal, bankers started layering CABs into many tobacco issues. In all, ProPublica identified 92 CABs that incorporated turbo repayments, raising nearly $3 billion between 2005 and 2008.
The $64 billion payoff for these bonds is about 21 times the amount borrowed. Even in the unlikely scenario that all of them get repaid early, the payoff would be about five times, ProPublica estimates. By comparison, traditional bonds like those Washington sold typically repay about three times what’s borrowed, said Estes, the finance professor.
Steep repayment terms have made CABs controversial in other arenas. In the mid-1990s, for instance, Michigan limited the ability of school districts to sell CABs precisely because they can create giant debt burdens far into the future.
Nevertheless, in 2006, Michigan sold a $55 million CAB that Bear Stearns tucked into a larger, $490 million tobacco issue. The CAB promised to repay $1.5 billion, or 27 times the amount borrowed, in 40 years.
Asked about the transaction, Michigan treasury spokesman Terry Stanton said, “CABs can be a useful structuring tool when the risks and costs are properly understood and analyzed.” The state sold the bonds, he said, because there were investors interested in buying them.
As Wall Street manufactured more turbo CABs, a dominant buyer emerged: Oppenheimer Funds, the Rochester, New York, mutual fund manager. The firm gobbled up hundreds of millions of dollars in CABs, sometimes buying entire issues in one gulp and sprinkling the debt throughout at least 17 of its municipal bond funds, according to data from Lipper, which tracks mutual fund holdings.
Oppenheimer Funds declined to comment for this story. But in May, Michael Camarella, senior portfolio manager for the firm’s municipal team, told Bloomberg News the tobacco sector presented a buying opportunity for investors willing to hold on to the debt. “We’ve been willing to take those risks,” he said. “Tobacco and Puerto Rico are the two cheapest sectors right now.”
Oppenheimer Funds declined to make Camarella available for an interview.
As of May, the firm was the largest owner of turbo CABs, according to Lipper data. The holdings were large enough that, were they all to pay off in full at maturity, Oppenheimer Funds would collect some $40 billion. With the 1998 settlement proceeds declining, however, that appears highly unlikely. In May, the firm valued these CABs at only about $700 million, or about 1.8 cents on the dollar, according to Lipper.
“I have yet to see a capital appreciation bond that I think is going to get paid,” said Dick Larkin, credit analyst at brokerage firm Herbert J. Sims & Co. in Florida, who has been warning for a decade that tobacco bonds are headed for trouble.
Some of the early investors have come to the same conclusion.
“We don’t want to have any bonds in this sector overall,” said Tom Metzold, senior portfolio adviser for Eaton Vance, one of the mutual funds to buy into the Puerto Rico CABs sold by Merrill Lynch. A $6.6 million chunk of that 2005 deal was the last CAB standing in one of the firm’s funds as of May, according to Lipper.
But as investors like Metzold cut their losses, hedge funds are stepping in. By scooping up the debt at distressed prices, they may still be able to make money. Tobacco bonds of all stripes have been a favorite playground for speculators this year, returning 10.83 percent and making it one of the top performing sectors of the municipal bond market, according to S&P Dow Jones Indices.
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