Consider this the next time you see a teenager take a drag on a cigarette: Your state government likely has a financial stake in that kid continuing to smoke. And quite possibly, so does your retirement portfolio.
That was hardly the intention 10 years ago, when a collection of state attorneys general delivered a crushing blow to Big Tobacco. On Nov. 23, 1998, the nation's four largest cigarette sellers agreed to pay $200 billion over 30 years in what seemed like a victory for David over Goliath. The money was supposed to help the states pay for health care and anti-smoking campaigns. Instead, much of it -- even payments that aren't due for 20 years -- has already been spent on politically popular tax breaks through complicated borrowing schemes initiated by Wall Street investment banks.
Because these states have essentially borrowed against future payments from the tobacco industry, they are now dependent on the continued vitality of cigarette sales. If Big Tobacco stumbles, states will be on the hook for these massive, billion-dollar loans.
Where did those loans come from? Perhaps from you. When Wall Street talked 25 states into borrowing against future tobacco payments -- a process known as securitization -- it sold bonds to individual investors and mutual funds that buy municipal bonds. Now, they are betting on Big Tobacco, too.
Worse yet, anyone invested in tobacco bonds has been seeing their money go up in smoke. Some bond funds that are heavily invested in tobacco have lost nearly 40 percent of their value this year. The reason for the sharp drop is disputed, but some observers say it's partly attributable to anti-smoking efforts. In other words, good news for the state health department is bad news for the revenue department
Bond issues aren't just for firetrucks and schools anymore. Bond funds can invest in complicated bonds issued by pseudo-government agencies that are ultimately backed by private ventures, such as housing developments. The largest segment of this pseudo-bond market is made up of tobacco bonds -- bonds issued by states that have borrowed against their future tobacco settlement payments.
What are tobacco bonds?
Oppenheimers Rochester family offers 18 different bond funds, some of which have as much as 20 percent of their assets invested in tobacco bonds, according to fund manager Daniel Loughran. The Rochester funds, while among the most aggressive investors in tobacco bonds, are hardly unique. A review of 660 leading bond funds covered by the investment research firm Morningstar Inc., conducted at msnbc.com's request, showed that more than 260 are invested in tobacco bonds.
The rush to tap the revenue stream began soon after the tobacco settlement was signed 10 years ago. The cigarette companies agreed to make annual payments that would total $200 billion by 2025. The money was to be divided among the 46 participating states, with New York and California each getting about $700 million a year, Ohio about $300 million, Wisconsin just over $100 million and so on.
It didn't take long for Wall Street to invent a way to take a cut. The creative minds at the now-defunct Bear Stearns investment bank traveled the country making this pitch to statehouses: Why wait for the money? Why not take a lump sum payment up front? Bear Stearns and other Wall Street firms eventually persuaded legislators in most states to securitize the payouts by issuing bonds and paying the bondholders back with the annual tobacco payments.
30 cents on the dollar
Taking the early lump-sum payment has its price, however. Many states receive only 30 or 40 cents on the dollar. In a typical example, Wisconsin would have been entitled to about $5 billion in payments through 2025. Instead, it settled on one payment of $1.6 billion in 2001.
When you securitize on the municipal market, you lose a lot of money, said Kevin Olson, who runs the independent Web site MunicipalBonds.com. Its not very efficient.
Through the years, state officials have offered numerous rationales for the benefits of securitization. Five years ago, Don Benton, a Republican state senator in Washington, told USA Today that spending on smoking cessation programs was a complete waste of money. You'd be hard-pressed to find any citizen who does not know smoking is hazardous to your health." He wanted the money to go instead to infrastructure projects like new roads. "Sitting in traffic for two hours would make you want to smoke," he told the newspaper.
States also say that they prefer the certainty of immediate payments to the uncertainty surrounding the tobacco industrys long-term future.
Investment banks, in particular, love tobacco bonds. Because they are more complex than standard debt offerings, they offer steeper commissions. In 2007, when Ohio traded its future payments for an immediate payout of about $5 billion, it paid brokers $30 million. The outcome for many states including California, New York, Ohio and Wisconsin -- is that the tobacco money destined for state coffers in 2010, 2015 and 2025 has already been spent.
'An incentive not to put tobacco out of business'
The irony is that the states and some smaller governmental bodies need tobacco firms to make their payments every year because, to varying degrees, they are on the hook to pay off bondholders if the cigarette companies default. Some, including New York and California, have directly guaranteed their tobacco bond debt with general revenue in order to secure more favorable rates. Others have an implied obligation not to let their bonds default, lest their credit ratings be tarnished.
They have created mass structural deficits, said Hans Baden, a lawyer at the Competitive Enterprise Institute, a think tank that has filed a lawsuit claiming that the Master Settlement Agreement is unconstitutional. They have sold the money they are getting in the future in exchange for money now, based on a gradually dwindling revenue stream. They have retained the risk while selling the money
and now they have an incentive not to put tobacco out of business.
An interruption in tobacco industry payments would be catastrophic both to state budgets and individual investors.
Critics of the arrangement contend that states that have issued tobacco bonds have no incentive to pass anti-smoking laws or launch advertising campaigns. Doing so could lead to fiscal ruin. So could any additional class-action lawsuit success against the tobacco industry.
Fears that new tobacco litigation could undermine the settlement run so high that 36 states filed briefs in 2003 in support of the tobacco industry after it was hit with a $10 billion judgment from a lawsuit for alleged false advertising.
In the briefs, state officials fretted that the judgment would impair the industrys ability to make its annual payments and directly impact important state programs.
'A real tragedy for our country'
Those state programs often have nothing to do with tobacco.
From the start, the tobacco settlement money was intended to help states pay for health care costs related to smoking illnesses and to fund smoking-cessation programs, though the agreement not bind the states to use it for those purposes.
But to date, only about 3 percent of the tobacco settlement money has gone to cessation efforts, such as "quit smoking" marketing campaigns. Meanwhile, 10 times that amount has been used by state legislatures to plug budget gaps, or by governors to offer tax relief.
Though smoking continues to decline in the U.S., it remains a major health problem. Every year, according to the federal Centers for Disease Control, smoking-related illnesses are responsible for $96 billion in health-care expenses. But states have invested only about $3 billion from the settlement fund in the past 10 years on anti-smoking campaigns.
None of the states covered by the settlement spends the amount recommended by the Centers for Disease Control on tobacco-cessation programs. Only nine states pay even half that amount. Meanwhile, 13 states spend less than 10 percent of what the agency recommends. Ohio, for example, will spend $7.1 million on anti-smoking efforts in 2009, compared to the $266 million prescribed by the CDC.
The future of tobacco bond issues
"The main risk some people (worry about) is litigation, he said. We've identified it as a risk but a very slight risk. In fact the industry has a long winning streak
against class-action lawsuits -- a 57-case run dating to 1998.
Having state attorneys general filing amicus briefs on your behalf doesnt hurt, he noted, adding, They are in our corner.
That, he suggested, indicates the smoking industry isnt going anywhere for a long time.
