Tobacco Bonds Flame Out

When Big Tobacco began paying states billions of dollars a year, making good on a landmark legal settlement, many governments took their share straight to the bond market.
by | June 2004

When Big Tobacco began paying states billions of dollars a year, making good on a landmark legal settlement, many governments took their share straight to the bond market. Not only could states get a lump-sum payment upfront to use in a variety of ways, but most of the securitization deals also unloaded risk: Why fret about the chances of the tobacco titans going bankrupt when bondholders will pay to do the worrying for you?

Since New York City sold the first tobacco bonds in 1999, some 17 states, along with Washington, D.C., Puerto Rico and multiple counties in New York and California, have sold around $18 billion worth of the bonds. But the bandwagon seems to be stalled, at least for now. The securitization market, tumultuous from the start because of all of the court cases swirling around Big Tobacco, has lately been hit with more bad news that is scaring state and local issuers away.

In April, Moody's Investors Service slashed the ratings of nearly all tobacco bonds and dropped those of New York counties to junk status. The move followed the decision of a federal appeals court in Manhattan to send a crucial case to trial, perhaps as soon as this summer. The case, Freedom Holdings v. Spitzer, attacks key elements of the states' settlement with Big Tobacco. In particular, the suit accuses New York of treating small tobacco companies that aren't part of the settlement unfairly. If New York loses, not only would the payments securing county tobacco bonds decline but other states would likely be sued as well.

States that were seriously considering securitization are now backing off. Legislatures in Colorado, Indiana and West Virginia this session killed bills aimed at authorizing bond sales. A spokesman for Colorado Treasurer Mike Coffman calls the Moody's downgrades "not a death blow but a major blow" for tobacco bonds. "With a security rated this low, it's hard to find enough appetite among investors," says Brian Anderson, a treasurer's office spokesman. "We'd have to pay a high interest rate, as high as 9 or 10 percent."

Can tobacco bonds come back? They have before. Last spring, the market choked when an Illinois judge nailed Philip Morris with a huge fine in a class-action consumer fraud case. But the cigarette-maker made its payments to states, soothing their fears, and the market rebounded. "The view was that the market wouldn't come back," says Mark Moore, director of public finance for the Indiana Development Finance Authority. "Anytime last fall into January we could've sold our share of the revenue."

Others aren't so sure another comeback is in the cards. Eric Lindblom, a lawyer who monitors bond issues for the Campaign for Tobacco-Free Kids in Washington, D.C., thinks the market is already glutted. Like many critics of tobacco bonds, Lindblom argues that bonding out the settlement was generally a bad deal for states because many of them will get back only pennies on the dollar. Further, his group wasn't happy that some states used their bond proceeds to plug budget gaps rather than for the anti-smoking and public health programs for which the settlement was intended. "The fundamental flaw with securitization is that states think they'll outsmart Wall Street," Lindblom says. "That's nuts."