Thursday, July 21, 2011

Lining up at the pawn shop

Amy, Kurt, Junior the Deputy, and Matt are all standing there in line. They each have a stack of papers that have Tobacco Bond printed on the top. What they are proposing to do is trade these bonds for a loan of $700 million dollars.

These tobacco bonds represent a promise to repay that loan: IOU's printed up really nice. The thing that's uncertain is what the pawn broker is going to want in interest. The higher the interest, of course, the less net money is raised by the bonds.

So, Amy, Kurt, Junior the Deputy, and Matt are understandably nervous. Because, you see, these bonds aren't exactly AAA. Well, nothing in Minnesota is AAA these days, but the tobacco bonds border on flim-flam artistry: they aren't exactly investment grade.

The tobacco bonds aren't the general obligations of the State of Minnesota; they are backed only by a revenue stream to the state made payable under the tobacco settlement that was made way back when Skip Humphrey was the Attorney General. It was supposed to be kind of an annuity to help defray the health care costs to the state associated with smoking by its citizens and for anti-smoking education efforts.

These payments are not in a guaranteed amount, and they are only the promise of the tobacco companies. Companies never borrow money nearly as cheaply as governments do, and when you factor in the fact that the amounts payable are uncertain, you can be sure that the pawnbroker is going to demand a pretty high interest rate.

Experience elsewhere teaches us that the risks of tobacco bonds are subject to a lot more vagaries than general obligation bonds, and the prices they fetch reflect that. Here are a few grafs from the linked 2003 article:
In addition to New York City, there are a number of counties across New York State that will begin losing access to millions of dollars in annual revenues starting next spring because of the structure of their tobacco bond deals.

The counties include Nassau, Westchester, Monroe, Erie, Niagara, Ulster, Rockland, and Rensselaer. In addition, a number of other counties participated in two pooled New York county tobacco deals.

As a result of the unexpected budget hit, which was triggered by the hard and fast fall in tobacco company credit quality, some of those counties could follow New York City’s lead and begin reviewing a restructuring of their tobacco debt.

The impact on the underlying credit of the issuers “depends on the structure” of their tobacco bond deals, said Robyn Kapiloff, an analyst at Moody’s Investors Service. “It varies [from issuer to issuer] whether it will be a short-term event or a long-term event.”

In all, New York City, the New York counties, Iowa, and the District of Columbia, have sold nearly $4 billion in tobacco bonds that are structured with so-called trapping mechanisms. The mechanisms were built into early tobacco bond deals to provide additional security to bondholders, requiring the issuer to fund additional reserves if tobacco company credit quality fell below investment grade.
One of two things is likely to happen in the pawn broker's office.

If Amy, Kurt, Junior the Deputy, and Matt offer a straight tobacco payment stream deal, they won't get beans for the bonds. (The interest rate will be very high.)

If they offer bonds with a "trapping mechanism" as described above, there is a risk - a substantial one - that funds will have to come out of future state budgets to keep the tobacco bond holders happy.

And never mind, as Rep. Ryan Winkler points out, we're just borrowing money to fund general fund matters; we're not getting a bridge or a building or even just a shiny new car.

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