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Securitization of Tobacco Settlement Revenue

April 18, 2003

Why states securitize?

Securitization, a new term for the health policy field, is the process by which a state sells the revenue stream of its tobacco settlement payments, for a set number of years, in return for a single up-front payment. While the up-front payment is less then the sum of the annual payments, a state receives one large payment and has the flexibility of establishing an endowment or applying the sum to a major program. It has been compared to a lottery winner accepting an up-front payment in lieu of a 20-year annuity.

Initially states were attracted to securitization because of the perceived financial risk in the Master Settlement Agreement (MSA). There was concern that the MSA payments would bankrupt the major tobacco companies and prevent them from making the annual payments. By securitizing, states would be able to transfer the risk of those payments to bondholders, and in turn, the state receives a large up-front payment. For other states the attraction is the opportunity to obtain a critical mass of funds that would allow them to initiate a major project or program.

The economic downturn over the past two years has dramatically affected state revenue collections and budgets. States are experiencing multi-billion dollar deficits. The current attraction to securitization of tobacco settlement revenue (TSR) is a state's ability to obtain a large sum of money to address the shortfall in revenue and stave off additional cuts to education, health and human service programs.

The TSR bonds are sold like any other state capital improvement bond offering through an already existing or newly established quasi-state agency. This provides a firewall between the bondholders and the state's general fund. If the tobacco companies were to go bankrupt and default on the MSA payments, the state's general fund could not be used to pay off the tobacco bondholders.

How is the "cents on the dollar" calculated?

The issue of how much money a state realizes from the sale of its TSR bonds has been the subject of speculation and various estimates. The so-called "cents on the dollar" is dependent upon whether a state is issuing taxable or tax-exempt bonds, the term of the bonds (e.g., 10 years, 20 years or 30 years) and whether the state is paying back the bonds at an accelerated rate (turbo).

The following tables display Wisconsin's proposal to issue bonds. It is does not reflect the final numbers at the time of the sale of the bonds, but it does allow an analysis of this issue. The following analysis demonstrates how different conclusions can be drawn.

Wisconsin's Proposal to Securitize

Scenario One: 20-Year Period

1. By securitizing and issuing 30-year bonds, Wisconsin will receive an up-front payment of $1,244.0 million ($1,257 million, less $13 million for administrative costs).
2. Wisconsin plans to pay back the bonds in 20 years, rather than 30 years.
3. During this 20-year period, Wisconsin would have received $2,559.6 in annual payments.
4. Therefore, if one looks at just this 20-year period, Wisconsin is said to be receiving 48.6 cents on the dollar ($1,244.0 divided by $2,559.6).

Scenario Two: 30-Year Period

1. Over the 30-year period of 2002 to 2032 Wisconsin would receive $5,281.6 million in annual payments.
2. By securitizing and issuing 30-year bonds, Wisconsin will receive an up-front payment of $1,244.0 million.
3. Wisconsin plans to pay back the bonds in 20 years, rather than 30 years.
4. Wisconsin will again receive annual MSA payments in 2022 through 2032 and will receive $2,722.0 million during that 11 years.
5. The total amount Wisconsin will receive between 2002 and 2032 is $3,966.0 million out of the $5,281.6 million it was to receive.
6. Therefore, if one looks at this 30-year period, Wisconsin is said to be receiving 75 cents on the dollar ($3,966.0 divided by $5,281.6)

How Much of the Proceeds are Available

Selling the rights to 30 years of tobacco settlement payments could secure a total of $1.257 billion in tobacco revenue bond proceeds. The revenue would be used in the following manner.

Yields, Saturation and Considerations Regarding Tobacco ABS

Tobacco asset backed securities (ABS) are considered a single credit based on the domestic consumption of tobacco even though multiple states, counties and cities issue the bonds. Mutual funds hold approximately $265 billion of long term bonds in a total market of $1.7 trillion outstanding. If a strict 5 percent exposure rule for a single credit were applied, this approach would allow for exposure of $13.25 in aggregate of tobacco bonds. Currently, the Tobacco ABS market is at $14.3 billion. Wall Street analysts have stated that the Tobacco ABS sector does not share any real characteristics with the traditional tax-exempt bond and that the market is not yet mature. Still, there are issues and events states must consider when deciding to securitize their tobacco settlement revenue.

• There has been concern that there may be too much supply. This is said to be driving up the yields on the bonds compared to past sales. In order to attract new buyers bond firms are have to sell the bonds at higher yields, which lowers the amount of dollars a state realizes from such a sale. The sale of Tobacco ABS in Washington (November 2002) and California (January 2003) with yields of 6.62 percent and 7.0 percent, respectively, are cited as examples. The rate as of late-April is quoted to be 7.55 percent.
• The difference in the interest rates between Tobacco ABS and municipal bonds was 2.55 percentages points as of late-April 2003. This is one of the reasons lawmakers in Missouri chose to issue general obligation bonds rather than securitize tobacco settlement revenue to cover $150 million of the state's shortfall.
• The sheer size of the transactions places considerable pressure on the market to absorb the bonds in a primary offering. At the time, New Jersey's sale of $1.8 billion in Tobacco ABS represented 15 percent of the market. This is why California divided its offering into two sales-$2.5 billion in January and $2.0 billion in May 2003.
• New institutional investors are entering the field, including property and casualty companies. Given the performance of the equity market Wall Street analysts expect this movement to continue. These new institutions initially shunned Tobacco ABS because of their complexity or on ethical grounds. However, they have seen the yields hold steady or increase in comparison with other non-taxable bond holdings.
• A secondary market or retail market, individual investors, for Tobacco ABS is growing. This phenomenon provides a new outlet for institutional investors to sell Tobacco ABS and creates new capacity and opportunities for them. The individual tobacco bond investors have unique characteristics. They are high income, risk tolerant investors looking for tax breaks. A 7.5 percent tax-free yield provides a taxable equivalent return of 12.22 percent for someone in the top 35 percent income tax bracket.
• The yield on Tobacco ABS may be affected by the tax structure in the state offering the bond. Tobacco bonds are said to trade better in states with higher tax rates or contemplating raising taxes. The fact that Washington does not have a state income tax was said to be one of the reasons the yield on their bonds was higher. In states like California, New Jersey and New York the tax exempt status of these bonds is said to be very attractive.
• Master Settlement Agreement payments to the states and the bondholders in certain states, counties and cities are based the annual production of cigarettes for consumption in the U.S. DRI-WEFA has forecast the long-term decline in production to be 1.69 percent a year. The tobacco industry has at times been very creative in creating demand with promotions and special pricing. However, 19 states increased their tobacco excise tax in 2002 and several more are expected to do so in 2003. In addition, the "roll-your-own" market of cigarettes has increased from 1 percent to almost 5 percent in the past two years as tobacco users seek cheaper alternatives to the name brands. The stock of Philip Morris and R.J. Reynolds (representing over 72 percent of the market) has suffered as a result.

All of the above was correct until the ruling of Judge Nicholas Byron in the Price vs. Philip Morris lawsuit in Madison county, Illinois. And it may continue to be true in the future. But, its clear the case sent shock waves through the bond market and state governments.

Price vs. Philip Morris, USA

The recent ruling against Philip Morris and the amount of the original appeal bond increased states' and investors' concern about Tobacco ABS, yields and risk. Philip Morris is appealing the judgement, but initially was required to post a $12 billion bond. This amount exceeded the company's cash reserves and there was speculation the company would have to file for bankruptcy. The concern for state legislatures was that a $5.2 billion annual payment under the Master Settlement Agreement was due to the states on April 15. Philip Morris' part of that payment, based on their market share, is $2.6 billion. The company notified Washington State Attorney General Christine Gregoire that it might not be able to make the payment. This sent a shudder through the states, which in February had a collective FY 2003 deficit of $27 billion. State governments had already calculated the April MSA annual payment into their FY 2003 budgets. If Philip Morris was unable to make the $2.6 billion payment, state governments would experience a corresponding $2.6 billion shortfall in revenue, with less than 3 months before the end of the fiscal year.

Philip Morris' inability to pay its half of the annual MSA payment sent a second tremor through the tobacco bond market; directly affecting plans and initiatives in California, Colorado, Illinois, Indiana, Kansas, New York, South Carolina and Virginia. Investors were questioning whether the tobacco companies would be able to fulfill their future payments. The situation increased the risk of tobacco bonds in the minds of investors and interest rates spiked to 8.55 percent. This in turn has increased the interest rate on the bonds and lowered the amount of revenue a state would derive from the sale. California was slated to sell $2.3 billion of tobacco settlement bonds in early May; part of its $4.5 billion sale of bonds to help rescue the budget.

Several states now are considering whether to back Tobacco ABS with additional credit, such as state general revenue. The practice is known as double barrel bonds.

Recent State Actions

As of late-April, thirteen states are considering whether to securitize their tobacco settlement revenue-Colorado, Florida, Illinois, Indiana, Kansas, Louisiana, Michigan, Minnesota, Nevada, New York, Oregon, South Carolina, and Texas. The level of interest in these states ranges from determining how much to securitize to debating whether it is good fiscal policy. Earlier this year, Missouri lawmakers rejected Gov. Bob Holden's proposal to securitize $300 million to address the state's revenue shortfall. Instead, the legislature opted to issue $150 million in general obligation bonds. In January, Indiana Gov. Frank O'Bannon proposed securitizing 40 percent of the state's tobacco settlement revenue and use the funds for job development and venture capital to jump-start Indiana's faltering economy. Indiana is one of eight states that dedicated all its tobacco settlement revenue for health care services. Key state lawmakers did not want to lose those critical funds and reduced to 20 percent the amount of tobacco settlement revenue that would be securitized for "Energize Indiana."

California, Colorado, Illinois, Kansas, Louisiana, New York, Oregon, South Carolina and Virginia are, to varying degrees, contemplating the sale of tobacco bonds. A majority of these states are doing so to address significant budget shortfalls.

• California Treasure Phil Angelides recently stated that California will have to re-evaluate its sale, but it is not giving up on selling $2.3 billion worth of bonds as an integral part of the state's plan to address its deficit. The determining factor will be whether the yield on the bonds is too high and state would be unable to realize the proceeds it needs.
• Colorado is planning to securitize 47.1 percent of the state's $1.2 billion in tobacco settlement revenue. It expects to receive an up front payment of $313 million.
• Illinois Senate Majority Leader Emil Smith is advocating for the sale of half of the state's tobacco settlement revenue stream. He believes the sale will net the state 57 cents on the dollar for a total of $2.2 billion. The funds would stave off budget cuts and capture federal funds through Medicaid.
• Kansas Governor Kathleen Sebelius has proposed securitizing $261 million of tobacco settlement revenue to garner $175 million. Republican legislators are skeptical of the plan, but an alternative revenue plan to raise the needed revenue has yet to be proposed.
• Louisiana previously securitized 60 percent of its tobacco settlement revenue and dedicated the proceeds to its Millennium Fund (endowment).
• New York House Speaker Bruno and Senate Majority Leader Sheldon Silver have modified Governor Pataki's original plan to issue tobacco settlement bonds. They are proposing that initially $700 million of bonds be sold. The remaining $3.5 billion would not be sold until the FY 2004 budget is enacted. Unlike previous securitizations of tobacco settlement revenue, Silver and Bruno are proposing that the tobacco bonds be backed by state income tax revenue. The move would give the bonds a lower interest rate from which the state would realize more revenue. In addition, their plan calls for the use of general fund income tax revenue to replenish the dollars the Health Care Reform Act programs would lose because of securitization.
• Oregon previously securitized $200 million for deficit reduction and is planning on securitizing an additional $150 million for the FY 2003 budget.
• The South Carolina Senate's plan to finance Medicaid through the refinancing of its current tobacco settlement bonds has been affected. The planned refinancing would net the state and its Medicaid budget an additional $43 million and nearly three times that amount in federal matching dollars.
• Virginia cancelled its sale of tobacco bonds in early April as a result of the controversy that ensued following the judgement in Illinois against Philip Morris. However, the state's sale of bonds was to create an endowment for its Tobacco Grower Indemnification Fund.

As of late-April, consideration of securitizing tobacco settlement revenue has not gone passed the stage of discussion in Florida, Massachusetts, Michigan, Minnesota and Texas.

The aggregate market in Tobacco ABS is approximately $20 billion. Given the fiscal conditions of states, i.e. the budget shortfalls and the electorate's desire not to have their income taxes increased, some Wall Street analysts believe the market could go to $30 billion and as high as $45 billion. State governors, treasures and lawmakers, along with investors, will continue to weigh their options and opportunities. It's anticipated that after a 30- to 60-day period, states will actively re-enter the market of Tobacco ABS. If that is the case, the sale of bonds in California, Colorado, New York and Virginia will quickly take the total market to $30 billion.

States That Have Securitized Tobacco Settlement Revenue - 2003
State & Year	Amount	Purpose
Alabama (2000)	$153 million	Industrial bonds to attract new industry and new jobs
Alaska (2000 and 2001)	$242 million	Remodel and build new schools, rehabilitation buildings at University of Alaska and upgrade several port facilities
Arkansas (2001)	$60 million	Biomedical research facilities
California (2002)	$4.5 billion	Deficit
Illinois (2002)	($750 million)	Legislation enacted. Securitization not implemented. Deficit, 50% Rainy Day Fund
Iowa (2001)	644 million	Retire capital debt, freeing up General Revenue that is dedicated to Health Care Services
Louisiana (2001)	$1.2 billion	Millennium Fund (endowment) to be used for health care, education and scholarships
New Jersey (2002)	$1.8 billion	Deficit
North Dakota (2000)	$32 million	Debt service on water resource and flood control projects
Oregon (2002)	$200 million	Deficit
Rhode Island (2002)	$685 million	Deficit
South Carolina (2000)	$934 million	72% Health Care Endowment, balance for rural infrastructure, tobacco farmers
South Dakota (2002)	$278 million	Education Endowment
Washington (2002)	$518 million	Deficit
Wisconsin (2001)	$1.6 billion	Deficit
Puerto Rico (2002)	$1.1 billion	Children's Trust Fund
California Counties and San Diego	$1.566 billion	Variety of purposes, including health care
New York Counties and New York City	$2.645 billion	Variety of purposes

Sources: Health Policy Tracking Service, National Conference of State Legislatures, April 2003. For more information, contact 202-624-3567 or info@hpts.org.

Reviewed December 2003.
Email statebudget-info@ncsl.org for more information.
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