Tobacco Bonds to Rescue Minnesota, for Now

 
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The budget deal that ended a government shutdown in Minnesota this week leans heavily on a strategy that critics deride as a gimmick but supporters view as a lifeline: tapping into money the state expected to get from a legal settlement with tobacco companies.
 
Underneath the debate about Minnesota's decision to sell $640 million worth of so-called "tobacco bonds" is the question of whether now is a good time to sell them — and what the decision means for Minnesota's long-term finances.
 
Like other states, Minnesota gets money each year from a 1998 settlement with several large tobacco companies. The exact amount depends on several factors, including how many cigarettes are sold and the tobacco companies' profitability. Minnesota expected to get some $320 million this year and next from the tobacco settlement. Instead of waiting for those payments, the state will get the money upfront by issuing bonds backed by those future tobacco payments.
 
Minnesota now joins 19 other states that have "securitized" future tobacco payments since 2000 (see sidebar). So it's hardly a new idea, even for Minnesota. Former Governor and current Republican presidential candidate Tim Pawlenty floated the idea in his 2009 budget . The state legislature, then controlled by Democrats, rejected it.
 
Some states have already tapped all or nearly all of their future tobacco payments, says Arturo Pérez, fiscal affairs program director at the National Conference of State Legislatures . That includes California, New York and Ohio. Just last year, Illinois sold $1.5 billion of tobacco bonds.
 
But it's an approach that many in Minnesota had hoped the state wouldn't take. "It's a short-term fix when we need a more permanent and transparent solution," says Nan Madden, director of the Minnesota Budget Project in St. Paul. Madden backed Democratic Governor Mark Dayton's idea to increase income taxes on Minnesota's top earners. Republicans, in control of both chambers of the legislature for the first time in nearly 40 years, wanted to close the deficit with spending cuts. The resulting package responsible for breaking Minnesota's budget impasse relies on cuts, and delays payments to K-12 schools, in addition to the tobacco bonds.
 
How does it work?
Tobacco bonding has pros and cons. Securitization allows cash-strapped states to use the tobacco dollars right away, rather than wait for smaller payments spread over a number of years. The flip side is that the interest a state must pay investors who buy the bonds can really add up. In the end, a state may end up with a fraction of the money it otherwise would have received over the long term.
States that have borrowed from tobacco funds
Source: National Conference of State Legislatures, Citi
 
In Minnesota, an analyst from the state House of Representatives did the math on selling $700 million worth of tobacco bonds — more than the $640 million that ended up in the final budget deal. The analysis found that it would cost the state $315 million in debt service over the next two years to access that $700 million upfront, bringing the total cost over the 20-year life of the bonds to total some $1.2 billion. The analysis cautions, however, "These preliminary estimates are highly dependent on the market at the time of the sale, the state's bond rating, and the structure of the bonds; they are subject to change."
 
The market for tobacco bonds also could be problematic for the state. Dick Larkin, senior vice president and director of credit analysis at Herbert J. Sims & Co., says that the heyday for new tobacco bond issuances was 2005-07 when the demand from investors was high and the yield on a 40-year bond was 5 percent. But early this year interest on 40-year bonds ranged between 8 and 10 percent. That means states would have to pay more to issue tobacco bonds, because investors see them as more of a risk.
 
The reason why they've been viewed as more of a risk is because of an ongoing dispute between states and the tobacco companies they settled with. The tobacco companies have been arguing that they shouldn't have to pay as much as they agreed to in 1998 because they have lost market share to other manufacturers that are not part of the settlement.
 
According to Larkin, there are rumors on Wall Street that the tobacco companies and states are close to resolving the $7 billion dispute, which would bring some stability to the market. And investors like stability. "The market is still crummy," Larkin says, "but it's improving."
 
However, Larkin adds that the tobacco bond market still faces major challenges. Americans are smoking less, which is eating into the profit of tobacco companies and resulting in reduced revenue for states to repay those bonds, he says. Decreasing tobacco use was one of the reasons that Standard & Poor's last November downgraded 51 tobacco bonds in 16 states to " junk" status .
 
On the other hand, if tobacco companies were to some day go bankrupt, the states that have issued bonds would look brilliant because they would have already received their payments.
 
Mixed results
Rhode Island has borrowed from its future tobacco payments twice, with mixed results, says Gary Sasse, who served in several key tax and revenue Cabinet positions for former Rhode Island Governor Donald L. Carcieri and now directs the Bryant Institute for Public Leadership in Smithfield, Rhode Island.

The first time, Rhode Island used future tobacco proceeds to pay down its debt. Sasse sees that as a smart move. But the second time, the state used the future payments to help balance the budget, which Sasse says did nothing to help Rhode Island with its long-term problem of not having enough revenue to pay for all the services the state provides. It's the latter scenario that Sasse sees states turning to tobacco bonds for, using them as a bridge to get by until revenues bounce back. "Hope burns eternal," he says, but with the uncertain economy and market "that's a hard bet to make."

In Minnesota, the budget deal will buy some time. But Wall Street doesn't seem impressed. Already, one credit rating agency, Fitch Ratings, has downgraded the rating on approximately $5.7 billion in Minnesota general obligation bonds to 'AA ' from 'AAA,' citing the state's reliance on one-time fixes. Other agencies may follow suit. That would mean the state could have to pay more to borrow.

For anti-smoking activists, Minnesota's decision to use tobacco money to balance the budget is troubling for another reason. "The state should be spending that money from the settlement for which it was intended: to help people stop smoking or to make sure they don't start," says Dan Cronin of the Campaign for Tobacco-Free Kids in Washington, D.C., which monitors the settlement.
 
The campaign's latest report shows that states have cut funding for tobacco prevention and cessation programs to the lowest level since 1999. In the fiscal year that just ended, the group estimates that states collected $25 billion in revenue from the tobacco settlement and tobacco taxes, but only spent 2 percent of those funds ($518 million) on programs to prevent kids from smoking and help smokers quit. "We're not a fan" of tobacco bonding, Cronin says.
 
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