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

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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.

The “Max Out” Strategy

Analysts say states agreed to the CABs’ steep repayment terms to squeeze the tobacco settlement money for all it was worth. “They were designed to milk every last dime,” said Dean Lewallen, a senior research analyst at investment manager AllianceBernstein in New York.

By layering in CABs, states got more upfront cash than they otherwise would. Once standard 30-year bonds were paid off, it would free up tobacco money to cover any CABs included in the package. They could then be prepaid before the big balloon payments came due at maturity.

The scenario assumed that settlement revenues would come in as predicted. But when many of the securitizations sold in 2007, the bankers and politicians were more concerned about another aspect of the deals: their size.

In February of that year, soon after he took office, Richard Cordray, Ohio’s newly elected treasurer, began trumpeting the idea of securitizing the state’s tobacco money, according to news reports from the time.

Ohio’s then-governor, Ted Strickland, backed the idea, and it sailed through the legislature that June. The plan was to sell all of Ohio’s tobacco money to finance new school buildings and cover tax cuts for the elderly.

By July, Cordray and then-Budget Director Pari Sabety had the sale process in full swing. In public statements promoting the deal, Cordray said it made sense because tobacco payments might shrink in the future.

“Five years from now, 10 years from now, smoking bans are kicking in, taxes may change, maybe court decisions. If the tobacco companies are not profitable, Ohio would be out its money. But if we cash in now, we will have our money and we will shed the risk,” Cordray was quoted saying in a July 2007 report by The Associated Press.

The state requested proposals from investment banks on how to generate $5.05 billion from a bond sale 2014 including “CABs, subordinate CABs, or any other proposed element.”

“Bear Stearns is pleased to present its qualifications,” opened a letter from Arnone, who by then had done 26 tobacco deals worth $25.3 billion, according to the document.

Bear Stearns warned that it was getting pricier to sell CABs. The bank said Puerto Rico halted a CAB sale that Bear was leading because of “sticker shock” at the “dramatically higher” interest rates needed to get the deal done. But Bear put CABs into its recommended Ohio deal structure anyway.

“CABs are increasingly difficult and costly to sell,” JPMorgan chimed in. Yet it, too, proposed them as part of a “max out” strategy for Ohio to raise about $5.4 billion 2014 and added that it now had a “leading tobacco bond résumé” because it had hired away executives from UBS, Goldman Sachs and Merrill Lynch to work on its team.

The major purchasers of CABs 2014 including Oppenheimer Funds 2014 had their portfolios “relatively full” of the debt, Morgan Stanley warned, but added that it could use its “unique insight” to sell the bonds anyway, a pitch document states.

Eventually, Ohio chose Bear Stearns and Citigroup to lead the sale. The firms packed $319 million of CABs into the overall $5.53 billion deal. The state received $5.05 billion after fees and setting aside reserves.

The CABs were costly. They accrue interest at even higher rates, 7.25 and 7.5 percent, than the “sticker shock” rate of 6.5 percent that had caused Puerto Rico to pull its CAB sale. At their respective maturities in 2047 and 2052, $6.6 billion will come due on them. Absent any turbo payments that might pay off the debt early, that’s a final repayment ratio of about 21 times the amount borrowed.

Interest rates on the other, less-risky, Ohio tobacco debt ranged from a low of 4 percent to 6.5 percent.

Just a few months after the deal closed, Bear Stearns went under, foreshadowing the financial crisis ahead. Shortly after, Arnone moved to Lehman, which filed for bankruptcy in September 2008 and had its North American operations bought out by Barclays Capital.

Two weeks later, Arnone was pitching another tobacco deal: “Individuals make the difference 2014 not firms, which have unfortunately proven to be transient in this environment,” she wrote to Iowa officials on Barclays’ letterhead.

By then the run had finally stalled. Oppenheimer Funds 2014 which had been the “sole source” of liquidity in the CAB market 2014 was no longer buying in the wake of the Lehman collapse. Arnone recommended the state not use CABs. Unable to hit its target amount, Iowa pulled the deal.

Citigroup, Morgan Stanley and JPMorgan declined to comment for this story. Arnone and Barclays also did not respond to requests for comment or to a list of specific questions.

Asked about the wisdom of Ohio’s transaction, the state’s Office of Management and Budget said in a statement, “The decision to move forward with the transaction was made by Ohio’s leadership in 2007. We can’t speak to their thinking at the time.”

Strickland did not respond to a request for comment, but Cordray told ProPublica the state made the right decision. The decline in tobacco payments means they were riskier than believed, he said, and CABs helped the state maximize its proceeds. If payments decline further, he said, investors should pay the price, not Ohio.

“Obviously, they are always going to want to come back, cup in hand, saying to the state, 2018Put some money in it,'” Cordray said. “But it’s not necessary; it’s not legally required and in fact was the whole purpose of this deal.”

“We Basically Burned It All”

By using the tobacco bond money to build schools, Ohio didn’t have to sell general obligation bonds, which are repaid with taxes, to cover construction costs. But not all states used tobacco debt for such long-term investments.

New Jersey stands as the prime example. The state first issued tobacco bonds in 2002 and 2003, spackling holes in the state budget with the $3.5 billion they raised. “We basically burned it all in two years,” said David Rousseau, a deputy treasurer at the time who became state treasurer from 2008 to 2010. “It was not one of New Jersey’s better financial moves.”

In 2007, the state raised another $3.6 billion to repay those bonds. The deal, brokered by Arnone’s Bear Stearns team, had one silver lining: It let New Jersey keep about 24 percent of its tobacco payments, as opposed to the 100 percent it had given up in the earlier deal. That left up $50 million to $60 million a year in payments for the state instead of investors.

But not for long.

Staring at another $800 million budget gap this year, state officials again turned to Arnone. The two CABs issued in 2007 and their $1.3 billion payoff were now a concern, too. The solution was to sign over the untapped tobacco money expected from 2017 to 2023 2014 an estimated $406 million2014 to repay the debt early and get some new cash from investors in exchange.

The state said it came out ahead in the deal, largely because it also brought in $92 million for the budget. Still, Standard & Poor’s downgraded New Jersey’s taxpayer-backed debt a notch, citing the state’s “reliance on one-time measures that are contributing to additional pressure on future budgets.” The Moody’s and Fitch rating agencies followed suit, citing the same concern.

The downgrade shows how CABs can do damage despite legalities designed to shield the state and taxpayers.

Like most states that sold tobacco bonds, New Jersey did so through a shell entity. The New Jersey Tobacco Settlement Financing Corp. exists “in, but not of” the state’s treasury, its authorizing legislation states. The corporation’s only assets are the tobacco revenues the state signed over to pay back its debts.

“It’s only those monies, and no other monies, that the bondholders have a claim on,” said David Narefsky, a municipal bond lawyer at law firm Mayer Brown in Chicago.

But if the CABs aren’t paid back in time, they don’t go away. Barclays told the state that in a default, the bondholders would still be in line ahead of taxpayers for subsequent tobacco income. The bonds would continue to earn interest and would have to be paid back at an even higher cost 2014 $1.6 billion from 2041 through 2049.

In a statement explaining the March deal, New Jersey made clear the CAB bondholders couldn’t be ignored.

The statement said that while New Jersey is “not legally compelled” to prevent a default, it did not want the corporation’s financial troubles to flow onto its books 2014 or upset its creditors: “The State sees an advantage in maintaining good relations with the tobacco bond investors, as they are likely to invest in other bonds of the State.”

Rhode Island also decided it couldn’t simply ignore its CABs. The state wants to refinance its 2002 tobacco settlement bonds to take advantage of lower interest rates. But the deal, which involves selling $594 million in new tobacco bonds to pay off the old ones, can’t go forward without the approval from the owners of its 2007 CABs.

As a result, Rhode Island proposes to spend more than $60 million to buy them out and get their permission. “All of the CAB bondholders are getting something,” according to a person familiar with the transaction.

Rhode Island had hoped to collect at least $20 million out of the transaction for its budget. But the deal is on hold after Oppenheimer Funds, which holds some of the tobacco debt, filed a lawsuit this week alleging that it would “siphon off” money from bondholders to the state.

Money 2018Out Of Heaven’

As CAB debt piles up on state balance sheets, hopes of repayment 2014 turbo or otherwise 2014 are fading.

Of the four jurisdictions with scheduled CAB turbo prepayments so far, only one has made them, ProPublica found: Placer County, California, which has a relatively small, $14.3 million issue promising a $68 million payoff. The other three, pooled tobacco CABs sold by New York counties, have not.

Even on traditional bonds, making those turbo prepayments has proven difficult. Ohio has fallen about $70 million behind on prepayments toward its regular tobacco bonds, which must be paid off before any money goes to the CABs. Kurt Kauffman, the state’s debt manager, said it’s too early to tell how Ohio’s CABs might be repaid.

“We just don’t know,” he said. “That’s going to be up to kind of the future leaders.”

Others are watching to see how their peers deal with the problem.

In California, which has promised to repay nearly $3.7 billion on $350.5 million of CABs sold by its Golden State Tobacco Securitization Corp. in 2007, the entity’s debts are a concern. The corporation is behind schedule on early turbo repayments for its 2007 bonds.

“Hopefully it doesn’t come to the point of default because this office would be concerned about a negative fallout in the market,” said Tom Dresslar, spokesman for Treasurer Bill Lockyer.

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