Nov. 21, 2008 at 8:00 AM ET
Consider this the next time you see a teenager take a drag on a cigarette: Your state government likely has a financial stake in that kid continuing to smoke. And quite possibly, so does your retirement portfolio.
That was hardly the intention 10 years ago, when a collection of state attorneys general delivered a crushing blow to Big Tobacco. On Nov. 23, 1998, the nation's four largest cigarette sellers agreed to pay $200 billion over 30 years in what seemed like a victory for David over Goliath. The money was supposed to help the states pay for health care and anti-smoking campaigns. Instead, much of it -- even payments that aren't due for 20 years -- has already been spent on politically popular tax breaks through complicated borrowing schemes initiated by Wall Street investment banks.
Because these states have essentially borrowed against future payments from the tobacco industry, they are now dependent on the continued vitality of cigarette sales. If Big Tobacco stumbles, states will be on the hook for these massive, billion-dollar loans. In other words, David and Goliath are now allies.
Where did those loans come from? Perhaps from you. When Wall Street talked 25 states into borrowing against future tobacco payments -- a process known as "securitization" -- it sold bonds to individual investors and mutual funds that buy municipal bonds. Now, they are betting on Big Tobacco, too.
Worse yet, anyone invested in tobacco bonds has been seeing their money go up in smoke. Some bond funds that are heavily invested in tobacco have lost nearly 40 percent of their value this year. The reason for the sharp drop is disputed, but some observers say it's partly attributable to anti-smoking efforts. For the first time, fewer than 20 percent of American adults are smoking, new government statistics show. In other words, good news for the state health department is bad news for the revenue department -- and for the portfolios of those who invested in tobacco bonds.
It's a stunning reversal: The lawsuit designed to cut the legs out from under the tobacco industry has instead landed much of America -- often unwittingly – in the industry's corner. One such investor is Avivah Litan, of Potomac, Md., who two years ago purchased shares in one of Oppenheimer & Co.'s "Rochester" municipal bond funds.
Like many investors, she was attracted to municipal bonds by tax free returns and the relatively low risk. Governments rarely go bankrupt. Cities issue municipal bonds to pay for such infrastructure as firetrucks and schools, and bond funds pool hundreds of such securities together. Similar to stock funds, the value of a bond fund fluctuates with changes in investors' perceptions of the ability of the issuer to repay the loan. Because of governments' solid record of paying off bonds, the funds have proven popular with investors. Americans have placed about $1.7 trillion in bond funds, according to the Investment Company Institute, compared with about $6.5 trillion in stock funds.
Litan was taken aback by the Rochester fund's recent poor performance, and began looking into its holdings. What she saw was confusing: 4 percent invested in "Tobacco Settlement," about 3 percent in "Golden St. Tob Securitization" and another 1 percent in the "Buckeye Ohio Tob Settlement."
In fact, none of the fund's top 10 holdings appeared to have anything to do with government infrastructure projects.
Here's the explanation: Bond issues aren't just for firetrucks and schools anymore. Bond funds can invest in complicated bonds issued by pseudo-government agencies that are ultimately backed by private ventures, such as housing developments. The largest segment of this pseudo-bond market is made up of tobacco bonds -- bonds issued by states that have borrowed against their future tobacco settlement payments.
"I didn't really understand that I would lose money every time a state passed an anti-smoking law," Litan said. "I didn't really understand what tobacco bonds were."
What are tobacco bonds?
Oppenheimer's Rochester family offers 18 different bond funds, some of which have as much as 20 percent of their assets invested in tobacco bonds, according to fund manager Daniel Loughran. The Rochester funds, while among the most aggressive investors in tobacco bonds, are hardly unique. A review of 660 leading bond funds covered by the investment research firm Morningstar Inc., conducted at msnbc.com's request, showed that more than 260 are invested in tobacco bonds.
The rush to tap the revenue stream began soon after the tobacco settlement was signed 10 years ago. The cigarette companies agreed to make annual payments that would total $200 billion by 2025. The money was to be divided among the 46 participating states, with New York and California each getting about $700 million a year, Ohio about $300 million, Wisconsin just over $100 million and so on.
It didn't take long for Wall Street to invent a way to take a cut. The creative minds at the now-defunct Bear Stearns investment bank traveled the country making this pitch to statehouses: Why wait for the money? Why not take a lump sum payment up front? Bear Stearns and other Wall Street firms eventually persuaded legislators in most states to "securitize" the payouts by issuing bonds and paying the bondholders back with the annual tobacco payments. The first tobacco bond issue hit in 1999. Soon, states around the country fell in line.
"Every time there are economic problems in a state, it happens," said Eric Lindblom, director of Policy Research at Campaign for Tobacco-Free Kids. "The governor says, 'We're in trouble, we need money. But we are not going to get it by raising taxes, we're going to do this securitization gobbledygook.' People think, 'Well, either our taxes are going up or they will do this thing we don't understand. So let's do that.' "
For years, tobacco bonds have been an easy sell. Because they are perceived as more risky than standard state-issued bonds, they offer slightly higher interest rates, making them popular with municipal bond fund managers seeking strong returns. The first tobacco bond and the 94 others that followed have raised a total of $55 billion, said Loughran, the Oppenheimer fund manager.
30 cents on the dollar
Taking the early lump-sum payment has its price, however. Many states receive only 30 or 40 cents on the dollar. In a typical example, Wisconsin would have been entitled to about $5 billion in payments through 2025. Instead, it settled on one payment of $1.6 billion in 2001.
"When you securitize on the municipal market, you lose a lot of money," said Kevin Olson, who runs the independent Web site MunicipalBonds.com. "It's not very efficient."
Through the years, state officials have offered numerous rationales for the benefits of securitization. Five years ago, Don Benton, a Republican state senator in Washington, told USA Today that spending on smoking cessation programs was "a complete waste of money. You'd be hard-pressed to find any citizen who does not know smoking is hazardous to your health." He wanted the money to go instead to infrastructure projects like new roads. "Sitting in traffic for two hours would make you want to smoke," he told the newspaper.
States also say that they prefer the certainty of immediate payments to the uncertainty surrounding the tobacco industry's long-term future.
But Lindblom, the Campaign for Tobacco-Free Kids official, said that line of thinking is foolish.
"The states have this horribly naive view that they will outsmart Wall Street," he said. "Wall Street always gets the better deal."
Investment banks, in particular, love tobacco bonds. Because they are more complex than standard debt offerings, they offer steeper commissions. In 2007, when Ohio traded its future payments for an immediate payout of about $5 billion, it paid brokers $30 million. During the dot-com bust, when initial public offerings all but vanished from Wall Street, tobacco bond offerings filled the void for companies like Bear Stearns, nearly doubling from around $7 billion in 2002 to nearly $13 billion in 2003.
From the beginning, Bear Stearns was at the forefront of tobacco bond sales, and ultimately brokered about half of them before it was sold off to JPMorgan Chase.
The outcome for many states – including California, New York, Ohio and Wisconsin -- is that the tobacco money destined for state coffers in 2010, 2015 and 2025 has already been spent.
'An incentive not to put tobacco out of business'
The irony is that the states and some smaller governmental bodies need tobacco firms to make their payments every year because, to varying degrees, they are on the hook to pay off bondholders if the cigarette companies default. Some, including New York and California, have directly guaranteed their tobacco bond debt with general revenue in order to secure more favorable rates. Others have an implied obligation not to let their bonds default, lest their credit ratings be tarnished.
"They have created mass structural deficits," said Hans Baden, a lawyer at the Competitive Enterprise Institute, a think tank that has filed a lawsuit claiming that the Master Settlement Agreement is unconstitutional. "They have sold the money they are getting in the future in exchange for money now, based on a gradually dwindling revenue stream. They have retained the risk while selling the money … and now they have an incentive not to put tobacco out of business."
An interruption in tobacco industry payments would be catastrophic both to state budgets and individual investors. For example, when the tobacco industry threatened to exercise a loophole in the settlement in 2006 and withhold about $1.5 billion in payments, the value of tobacco bonds sank. It happened again in 2007. The price recovered even though the payments remain in dispute, but notice was served of the perilous relationship between governments and the smoking industry.
Critics of the arrangement contend that states that have issued tobacco bonds have no incentive to pass anti-smoking laws or launch advertising campaigns. Doing so could lead to fiscal ruin. So could any additional class-action lawsuit success against the tobacco industry.
Fears that new tobacco litigation could undermine the settlement run so high that 36 states filed briefs in 2003 in support of the tobacco industry after it was hit with a $10 billion judgment from a lawsuit for alleged false advertising.
David, in other words, was sticking up for Goliath.
In the briefs, state officials fretted that the judgment would impair the industry's ability to make its annual payments and "directly impact important state programs."
'A real tragedy for our country'
Those state programs often have nothing to do with tobacco.
From the start, the tobacco settlement money was intended to help states pay for health care costs related to smoking illnesses and to fund smoking-cessation programs, though the agreement not bind the states to use it for those purposes.
But to date, only about 3 percent of the tobacco settlement money has gone to cessation efforts, such as "quit smoking" marketing campaigns. Meanwhile, 10 times that amount has been used by state legislatures to plug budget gaps, or by governors to offer tax relief.
"There is a horrible failure of the states to invest even a minuscule amount of the funds for tobacco control," said Lindblom of the Campaign for Tobacco-Free Kids. "It's a real tragedy for our country."
Though smoking continues to decline in the U.S., it remains a major health problem. Every year, according to the federal Centers for Disease Control, smoking-related illnesses are responsible for $96 billion in health-care expenses. But states have invested only about $3 billion from the settlement fund in the past 10 years on anti-smoking campaigns.
Washington Gov. Christine Gregoire, who was the state's attorney general at the time of the tobacco settlement and one its chief negotiators, said five years ago that tobacco securitization was her "wildest nightmare." Over her objections, Washington state securitized part of its tobacco settlement in 2002, before she became governor.
"My hope was to see as much of the settlement money as possible go to improving health," she told msnbc.com recently. "We've certainly done that in Washington state and the results have been tremendous — youth smoking is down by half and adult smoking is down 25 percent. I'm disappointed that other states haven't done the same thing. Far too many have used the money for purposes other than it was intended."
None of the states covered by the settlement spends the amount recommended by the Centers for Disease Control on tobacco-cessation programs. Only nine states pay even half that amount. Meanwhile, 13 states spend less than 10 percent of what the agency recommends. Ohio, for example, will spend $7.1 million on anti-smoking efforts in 2009, compared to the $266 million prescribed by the CDC.
Anti-smoking education can have a tremendous impact, the agency says. If every smoker on Medicare quit smoking today, Ohio would save more than $500 million annually.
The end of Ohio's tobacco-fighting foundation
Ohio had planned to spend much more on anti-smoking campaigns. Soon after the signing of the tobacco settlement , the state Legislature created the Ohio Tobacco Prevention Foundation and vowed to put $1 billion of the $10 billion it expected to receive over 25 years in a trust fund to generate $60 million a year for the foundation's operating expenses.
Ohio's smoking rate in 2001 was 28 percent, well above the national average. But thanks in part to foundation-funded projects like the state's toll-free Ohio Tobacco Quit Line, it had fallen to 22 percent by 2006.
But by that time, Ohio's economy was reeling and the tobacco money was too tempting for new Gov. Ted Strickland. In 2007, Ohio traded in its future payments for a one-time sum of $5 billion – the largest tobacco bond issue to date. The money paid for a massive property tax relief program for senior citizens and helped build schools.
It did not, however, shore up the state's economy. This year Strickland pushed through a $1.4 billion economic stimulus package funded in part by money from the Ohio Tobacco Prevention Foundation trust fund. The bill authorized seizure of most of the $300 million in the foundation's accounts, leaving it with $40 million – less than one year's operating expenses. The foundation rebelled and tried to shift the money to an anti-smoking nonprofit agency. In retaliation, the Legislature voted to close the foundation. Dozens of anti-smoking programs around the state were shut down.
After a 2003 lawsuit scare, the market for tobacco bonds went silent. This year's credit crunch has similarly discouraged new tobacco bond issues.
Keith Daily, a spokesman for Strickland, said the money, which remains frozen pending resolution of a lawsuit over the state seizure, is critical to the effort to create more than 50,000 jobs by investing in infrastructure and boosting industries.
"We recognize the great importance of reducing tobacco use and making other healthy decisions," he said. "The governor's top priority is creating jobs here in Ohio -- ... $230 million from the former Ohio Tobacco Prevention Foundation's endowment will be used to pay for the biomedical and bio-products portions of the jobs plan."
Lindblom, the anti-smoking activist, said the decision of the Ohio legislature to close effective tobacco-fighting programs has been repeated around the country.
'It's in the prospectus'
"There was the full expectation that the money was going to be used to prevent and reduce tobacco use and to treat smoking-caused illnesses," he said. "That's gone out the window. There's been a complete breaking of the promise of the settlement."
Loughran, the Oppenheimer manager, said that the settlement money is "fungible" and states can use it for anything they choose.
While it's "certainly possible" some people invest unknowingly in tobacco, Loughran said it should be obvious to anyone who researches Rochester funds that they are heavily tilted toward tobacco bonds. "It's in the prospectus," he said.
"Some people, when they look at this sector, they think, 'this is tobacco, so it's evil.' But remember, the settlement penalizes the industry," Loughran said. Buying one of his funds is more like investing in the penalty, he suggested. And plenty of consumers clearly have no moral issues with tobacco bonds, he said, noting that many individual investors buy them directly.
The future of tobacco bond issues
While a substantial amount of the tobacco settlement money has already been spent, some states have held out. But each year, Lindblom said, more dominoes fall.
Earlier this year, Nevada Lt. Gov. Brian Krolicki tried to persuade state legislators to trade in the state's $50 million annual payment for a one-time $600 million windfall. While legislators argued, the bond market collapsed, effectively eliminating any opportunity for issuing tobacco bonds.
But with the bond market expected to recover before the overall economy does, pressure is certain to mount for states like Nevada to seek quick fiscal rescues courtesy of the tobacco industry.
"I expect more of this as our economic situation continues. From our perspective and a fiscal perspective it will be hard to beat it back," Lindblom said.
As for individual investors who are backing tobacco, Loughran – whose fund bought the very first tobacco bond in 1999 -- makes a compelling case that the bonds will recover. Their yields are still higher than other state-issued bonds, he said, and in 10 years there hasn't been any hint of a default.
"Every one has made their scheduled interest and principal payments on time, and many of them have made principal payments ahead of maturity," he said. While the smoking rate has been sinking about 2 percent every year, inflation adjustments built into the settlement make up for the loss, he said. He wouldn't predict when tobacco bonds might turn around, but he asserted that their fundamental value remains strong.
"The main risk some people (worry about) is litigation," he said. "We've identified it as a risk but a very slight risk. In fact the industry has a long winning streak … against class-action lawsuits" -- a 57-case run dating to 1998.
Having state attorneys general filing amicus briefs on your behalf doesn't hurt, he noted, adding, "They are in our corner."
That, he suggested, indicates the smoking industry isn't going anywhere for a long time.
But Baden, of the Competitive Enterprise Institute, isn't so sure. He said the constitutional challenge filed by his organization or other legal challenges could undo the settlement. Or the declining smoking rate could at some point overtake the tobacco companies' ability to pay, he said.
"It just seems weird the idea that the tobacco (settlement) is going to go on forever," Baden said. "In the long run my suspicion is something will take out the settlement. The thing won't last forever."