It all began when states settled their lawsuits against Big Tobacco.
After a long fight, states would finally get billions to cover the health costs of smoking, in perpetuity.
But some government officials wanted the money up front, to cover all sorts of budgetary needs. They said it would be better to get cash now in case tobacco companies couldn’t pay later on or if cigarette sales plummeted.
The answer: bonds. A bond is like a loan. Investors buy the bonds, providing states with cash. States repay the bondholders using the tobacco money. The typical bond lasts 30 years or less and pays interest every year.
If tobacco payments fall short, investors have no right – ‘no recourse’ – to be repaid with taxpayer money. But they retain rights to future tobacco payments. Because of the steep payments promised to some bondholders, that could take years or decades in which taxpayers lose out on the tobacco money.
In all, states, counties, cities, and territories sold some $36 billion in tobacco bonds that are still outstanding. Most had routine repayment terms. But to get extra cash up front, some sold capital appreciation bonds, or CABs which came with steeper repayments terms.
With CABs, no payments are required until they mature, often in 40 years or more. In the meantime, the interest compounds into a huge balance owed. In all, governments sold about $3 billion of CABs – for which they promised to repay $64 billion.
The deals assumed there would be enough settlement money available to pay off the CABs early. But people are smoking less. So tobacco payments to states are down, too — and that means they can’t repay the CABs early, if at all.
States can avoid defaulting on CABs — for a price. New Jersey recently pledged more of its tobacco money to avoid defaulting on $186 million of CABs on which it owed $1.3 billion in 2041.
By pledging another $406 million to investors — all of its remaining tobacco money from 2017 through 2023 — New Jersey will be able to repay its CABs early. The alternative – pay investors out of the tobacco money until the full debt was satisfied – would have meant paying an estimated $1.6 billion
to the bondholders over many years. By putting more money into the pot now, the state also got investors to pony up an additional $92 million for this year’s budget.
Related articles: Read our coverage about why some tobacco bonds may come back to haunt states and see which states sold the debt.