Behind New Jersey’s Tobacco Bond Bailout, A Hedge Fund’s $100 Million Payday
by Cezary Podkul ProPublica, Dec. 30, 2014, 2:24 p.m.
TRENTON, N.J. 2013 When state Treasurer Andrew Sidamon-Eristoff briefed lawmakers on New Jersey’s ailing budget in April, he brought good news. His office had just raised a welcome $92 million thanks to a deal that bailed out two bond issues headed for default.
New Jersey had no legal obligation to make good on the debts, which were backed by payments from a national settlement with the nation’s leading tobacco companies. But Sidamon-Eristoff said the bailout was a “no brainer” because it protected the state’s reputation with lenders and raised badly needed cash.
An examination of this transaction by ProPublica shows that the argument for the deal was far from clear cut. As it bailed out bond investors, New Jersey traded away an estimated $400 million in future tobacco revenues that would have flowed into state coffers starting in 2017.
One undeniable winner, however, was Claren Road Asset Management, a New York hedge fund that walked off with more than $100 million in profits from its investment in the debt, according to interviews with deal participants, an analysis of the bonds’ trading data and previously undisclosed public records.
Records and interviews show that Claren Road bought up the bonds when they were heavily discounted and sold them after the bailout substantially raised their value.
A spokesman for Washington D.C.-based Carlyle Group, the majority owner of Claren Road’s management company, declined to comment on the profit estimate.
How could a hedge fund make more money from the bailed-out debt than New Jersey’s taxpayers?
It’s eminently possible in the tangled world of tobacco bonds, where dozens of states and municipalities borrowed heavily against future proceeds from the landmark 1998 tobacco settlement.
The money was intended to reimburse state governments for the past and future costs of smoking. In exchange for immediate cash, governments sold bonds that entitled investors to collect some or all of their annual settlement payments, often promising huge lump-sum payouts decades from the date of issue.
Now, nearly all of those bonds are careening toward default because of a steeper-than-expected drop in smoking. The tobacco settlement payments to governments are tied to cigarette sales, so there is not enough money to pay off the vast amounts promised on the bonds.
New Jersey’s case illustrates the difficult choices the governments now face. If they let the bonds default, investors are entitled to keep collecting the tobacco payments they were promised until the debt is satisfied. The alternative is to cut new deals with bondholders, which also comes at a cost.
In recent months, two New York counties completed bailouts that gave bondholders more money than went to the governments. Iowa and Virginia have also been pitched rescues, while Rhode Island has put a deal with Claren Road on hold after another bondholder filed a lawsuit opposing the plan.
New Jersey’s is the biggest rescue to date and remarkable for its novel structure 2013 a two-step refinancing engineered by bankers from Barclays Capital. The bankers brought the deal to the treasurer’s office and reaped $4.5 million in fees, in part for “developing the idea,” according to a pitch document.
Claren Road, which has $7.3 billion under management, began buying up New Jersey’s riskiest tobacco bonds in 2011. The bonds, called capital appreciation bonds, or CABs, could be bought at a massive discount because they called for a $1.3 billion payment in 2041, an amount that is now improbable given falling cigarette sales.
Enter the rescue plan.
First, Claren Road and a few other investors sold the New Jersey bonds they held back to the state for a premium over market prices. After the state pledged to pay bondholders an estimated $400 million in tobacco revenues, the investors bought the bonds back at a higher price.
The state received $92 million after fees, and Claren Road was then able to flip the improved bonds on the open market for additional profit.
The New Jersey Treasury said the bailout secured tobacco revenue for the future while preserving the state’s standing with investors. Had the bonds defaulted, most of the state’s tobacco money from 2041 to 2049 would have gone to make good on the debt, the Treasury said. By repaying early, New Jersey made sure that future settlement payments will flow into its general fund. The state valued the net savings, including the $92 million in immediate cash, at $137 million in today’s dollars, a Treasury spokesman said in answer to questions from ProPublica.
Public finance experts consulted by ProPublica, however, cautioned that the projected benefit to New Jersey was unlikely to materialize in the amounts expected. Cigarette sales, for one, have proven notoriously difficult to predict even over a few years, let alone decades.
“Tax policy, health care, incentives, smoking bans … Smoking demand is hard to forecast even if none of this stuff happened,” said Daniel Smith, a professor of public budgeting at New York University, who reviewed the state’s cash projections for ProPublica.
Given the uncertainty, some question whether the state really is better off trading away $400 million in near-term tobacco payments to recapture what may be a far weaker revenue stream in nearly 30 years’ time.
“It’s like trading your new BMW for a Yugo,” said Gordon MacInnes, head of the nonpartisan think tank New Jersey Policy Perspective. “The immediate beneficiaries are speculators in junk bonds. The big losers are New Jersey’s taxpayers.”
‘Distinctly Horrible’ Bonds
New Jersey, like 45 other states that signed on to the 1998 accord with cigarette manufacturers, was originally going to be a big winner. The settlement meant some $250 million flowing each year to state taxpayers to reimburse them for smoking-related health care costs.
The windfall touched off a rush of borrowing by states eager to get the cash upfront rather than collect annual payments. To do so, they sold bonds 2013 including the capital appreciation bonds, or CABs, that were at the center of New Jersey’s rescue.
These were no ordinary bonds.
Unlike regular bonds, CABs don’t make annual cash interest payments, instead letting what’s owed add up over years into a hefty tab, often due decades later.
As ProPublica has reported, states, territories and local governments pledged to repay $64 billion of future tobacco money in return for $3 billion they raised using CABs. About $186 million of that was cash New Jersey received by issuing its two series of CABs back in 2007, with a promise to pay a lump sum of $1.3 billion in 2041.
At the April hearing, Sidamon-Eristoff minced no words describing what a bad choice that was.
“CABs are 2013 for good reason 2013 known as a distinctly horrible means of public finance. They are bad policy,” said Sidamon-Eristoff, who wasn’t treasurer when the CABs were issued. “Everybody knew it then, everybody knows it now. But that’s the situation that we’ve inherited.”
Unlike other governments that issued tobacco bonds, however, New Jersey was in a better position. The 2007 CABs were part of a larger, $3.6 billion deal to refinance older tobacco bonds that required the state to pay out 100 percent of its annual settlement money. Refinancing freed the