Tobacco bonds were supposed to be a win-win.
Cities, states, and counties would receive a massive cash infusion to help them balance budgets and build roads and schools, while investors would get their money back via recurring annual payments, under a massive, nationwide settlement between tobacco companies and the states’ attorneys general.
But thanks in part to New York City’s crusade to curb smoking, some of the investors who bought more than $1 billion of the bonds from the Big Apple might end up getting burned.
Plummeting tobacco consumption has sent the city’s bonds down a path toward default. An agreement in December in an ongoing dispute between tobacco companies and states over $7 billion in settlement payments, which analysts viewed as a victory for the industry, appear to have generated little hope of a recovery — a setback to investors who hope the bonds can still be salvaged.
About one-quarter of the city’s bonds are likely to default, one analyst predicts, unless New York is successful in its continuing legal battle with the tobacco companies to claim its payments.
“If this dispute is resolved in the state’s favor, all of these numbers will look a lot better,” said Richard Larkin, director of credit analysis at finance firm Herbert J. Sims. “I don’t believe that’s going to happen.”
The December deal is the latest turn for a peculiar corner of the financial industry — one inspired in part by a scheme to sell David Bowie’s intellectual property rights.
New York was the first city in the nation to convert its share of the tobacco settlement into bonds, helping to popularize a type of deal now widely viewed as a dud. While the maneuver successfully raised a boatload of cash for dozens of city and state budgets, it left investors exposed to a lot of risk.
After a restructuring in 2006, the city’s bonds were downgraded to junk territory by Standard and Poor’s last January, and were trading as low as 77 cents on the dollar in December.
A spokesman for the mayor’s Office of Management and Budget, which oversees the bonds, did not respond to requests for comment.
The tobacco settlement, reached in late 1998, provided New York City with roughly one-quarter of the state’s $25 billion share. But there was a catch: the payments would come every year, and the Giuliani administration, hamstrung by a constitutional debt limit, wanted the money sooner, to pay for long-term projects like school and road construction.
The resulting concept was a fairly straightforward one: find investors willing to gamble on bonds backed by the city’s annual payments under the settlement, thereby turning New York’s anticipated cash flow into a massive, one-time infusion. It was as if the city decided to take the lump sum option after winning the lottery, instead of 20 years of smaller payments.
“This was a quick and easy way to come up with hundreds of millions, billions of dollars,” Larkin said. “You basically got money instead of having to wait to get paid out.”
There was one catch: the fiscal gambit had never been tested. Among the few analogous financial instruments examined by city officials was a bond issued in 1997, backed by revenues from David Bowie’s future album sales.
“That was one of the examples I remember we looked at,” said Steve Newman, a former deputy comptroller under Alan Hevesi who worked with the Giuliani administration on the deal. “Because it was one of the early securitizations of a funding stream.”
The city found no shortage of Wall Street firms to help set up the deal, which was led by Salomon Smith Barney — after all, there were millions of dollars in fees at stake. The ratings firms approved, too, giving the bonds investment-grade marks.
Still, some skeptics voiced their concern from the outset. They saw potential for falling smoking rates to devalue the settlement: If more smokers gave up the habit than the city anticipated, then the bonds could come up short, since the annual settlement payments were tied to cigarette purchases.
In early 1999, Prudential Securities issued a report questioning whether the settlement payments would really be a “long-term, stable source of security for bonds.” The city subsequently locked the firm out of a lucrative spot on its underwriting team because of its lack of enthusiasm.
The Times, meanwhile, chiding Giuliani for his “clever fiscal acrobatics,” suggested in an editorial that it might be a better idea to use the tobacco income as it came in each year, and instead shift funds from a $1.6 billion budget surplus to pay for school construction.
Even the comptroller’s office got cold feet, reasoning that the spending should have hewed closer to the intent of the settlement, which the state attorneys general had argued should cover the costs of caring for ailing smokers.
“At some point in the comptroller’s office we said, ‘You know, this really should be health care-related in some manner,'” Newman said. “But we’d already given our word.”
Instead of nixing the move, Newman said he and his colleagues made clear to the mayor’s office that the initial bond offering was the only one they’d support. Ultimately, the city ended up issuing slightly more than $1 billion in tobacco bonds, instead of the more than $2 billion over four years that the Giuliani administration had been shooting for.
In 2006, the city restructured its bonds, after the struggles of one tobacco company forced officials to set aside tens of millions of dollars in a rainy-day fund for investors.
The move freed up more settlement money to go to the city budget. But over the next few years, the bonds started to break down. Just as Prudential had warned, more people were giving up smoking than the bonds’ projections had anticipated.
“The bankers crunched numbers and structured it,” said Alan Schankel, head of fixed-income research at Janney Capital Markets. “They had a worst-case scenario of 4 percent a year. If consumption declines were 4 percent, they would pay off right on time. Above 4 percent, they could potentially run into trouble.”
In 2009, cigarette sales declined by 9 percent nationwide. A 6.5 percent drop followed in 2010. Thanks to big hikes in federal excise taxes, and new bans on smoking in public places like those promoted by Mayor Michael Bloomberg, sales were plunging.
Making matters even worse, the tobacco companies started withholding a big chunk of their payments because, they said, the states had reneged on a part of the settlement that required them to regulate competitors that hadn’t signed the agreement.
With that as a backdrop, Larkin issued a report in 2011 predicting that unless trends reversed, New York City would have to start siphoning money from a special reserve fund to pay its investors beginning in 2026. Ultimately, some 25 percent of the bonds would default, he predicted, unless the states were successful in a legal battle over the withheld payments.
New York State issued its own set of bonds in 2003, but with one key difference from the city’s: if the settlement payments fall short, investors get bailed out by money from the state budget. The state expects to budget $254 million this year, just in case, as a guarantee to bondholders.
Because the state’s bonds mature on a shorter schedule, a bailout won’t be necessary, Larkin said, unless New York is trounced in its legal proceedings with the tobacco companies.
A spokesman for the state budget office said that it would cover any shortfall, but that it does not anticipate having to do so.
In December, 17 states, Puerto Rico and Washington, D.C., announced a settlement with the tobacco companies, with terms that left the bonds no better off, according to Larkin.
New York didn’t join the settlement, and could be holding out for a better deal. But Larkin, who has watched the battles between states and tobacco companies for years, doesn’t like the chances of Attorney General Eric Schneiderman, whose office declined to comment.
Larkin compared the attorneys for the tobacco companies to the Yankees, while equating the lawyers working for the states to the much-maligned Mets.
“If this was the World Series, Yankees versus Mets, I’d bet the Yankees,” Larkin said. “These guys are like sharks.”
For the investors who bought the bonds — many were big, institutional bond funds — the outlook isn’t all bad, because even in the event of a default, they’ll still get the money they’re owed. They’ll just have to wait for it, until the states have received enough cash under the terms of the settlement to pay for the bonds.
“You do get paid off at some point,” said Bart Mosley, co-president at Trident Municipal Research.
In fact, because of the poor interest rates currently offered by the rest of the bond market, there’s still an active market for tobacco settlement paper, which offers outsize returns reflecting the risk of an eventual default. Last year, the tobacco bonds earned a hefty 32 percent tax-free return, outperforming the rest of the municipal bond market.
“It’s hard to find high returns in a market where U.S. Treasuries yield 3 percent,” Mosley said. “So people are willing to take a little more risk to earn 6 percent.”
Since a default would leave investors, not the city, on the hook, the tobacco deal may turn out to be a smart fiscal move: New York got a hefty chunk of its tobacco money up front, and shifted the risk of diminishing settlement payments to its bondholders. A default would have no impact on the city’s credit rating, either, since the bonds were issued by a special corporation set up for that purpose.
But Newman, the former deputy comptroller, doesn’t see it that way. While emphasizing that a potential default was still a long way off, he said that the city needs to keep in mind what investors will think the next time it goes to the market with a bond offering.
“You don’t want to create bad deals, even if they work,” Newman said. “You want the people who buy the bonds to actually get their money at the end of the day, because you’re going to be back to them.”