A Word About Fair Isaac and Our Response to the Kitchen Sink Being Thrown
at Tobacco Bond Issuers

Categories: Commentary, Uncategorized |

August 11, 2014

This week we offer a change to our Commentary approach. An article published last week by Propublica regarding Tobacco Bond Issuers got Mike’s goat and he decided to provide his critique of a main-stream media’s “story” about the muni market. Before going there, one quick point regarding relaxed lending standards.

In last Friday’s WSJ, there was an article about FICO relaxing its standards to promote lending. I recall seeing this act before and it lead to an unfortunate end. Recall that debt forgiveness was part of the Main Street bailout (we only hear about the Wall Street/corporate bailout – the majority of which was paid back – other than the auto makers). The US government had the HARP program for folks who took out mortgages they couldn’t afford and they had the cash for clunkers program not exactly debt forgiveness but a program to ‘promote’ car sales which, it was reported last week actually hurt the automakers.

I wish I was smart enough to have coined the next line (I’m not sure who did) — debt forgiveness for people acquiring debt they might not otherwise qualify for and the Government bailing them out creates moral hazard. People go on asking for more (because they can) — especially when standards are relaxed – they then blame the banks for lending to them! They take larger loans and become not willing to pay them back, expecting instead the Government to repay their debt.

Sure hope the good folks at FICO know what they are doing. Maybe Congress will add a provision to Dodd Frank to remove mortgage providers’ reliance on FICO (similar to what they did with credit ratings).

Propublica Throws the Kitchen Sink at Tobacco Bond Issuers

Issuance of municipal MSA tobacco bonds by states was the subject of a highly critical article published by Propublica last week. The article attempts to make a case that states erred in deciding to issue tobacco bonds. The article was widely circulated across social media. As we frequently observe, the national media focus on the muni market is appreciated, but the facts got muddied in the pursuit of a good story.

In order to makes its case, the article conflates several different issues. We think it is helpful to unpack these issues and examine the underlying thesis and conclusions of the Propublica article one by one.

“Decision to issue was unwise”

We could list numerous examples of states making unwise decisions to issue bonds based on questionable motives or dubious rationales: pension bonds; bonds to pay back Federal loans; convention center bonds; stadium bonds. We don’t believe tobacco bonds fit the bill.

The motivations of tobacco bond issuers varied widely. Some states were motivated by a legitimate desire to shed the risk of MSA payment variability. This turns out to have been a wise decision. Other states motivations were not so laudable, but by transferring away the MSA risks, these states may have done the right thing for the wrong reasons.

A 2002 report by the Federal Reserve Bank of Boston discussed the risk transfer:

“Securitization also transfers risks from the state to the capital markets; such risks include the possibility that the tobacco companies will go bankrupt or move overseas, that consumption patterns will change, or that the settlement will be successfully challenged in court by nonparticipating tobacco firms.”

With the benefit of hindsight, achieving this risk transfer was a prudent, correct policy goal. A glance at the price history of one of the tobacco bonds sold by Ohio illustrates the point. These bonds, which were sold at $100 in 2007, are now worth approximately $75.

It seems hard to criticize a public official for selling an asset before it declines in value by 25%. If only more of our elected representatives made that kind of mistake.


Source: MSRB

“Use of proceeds violated spirit of MSA”

The article points out that many states violated the spirit of MSA settlement by using the proceeds of tobacco bond issuance for purposes other than smoking prevention and health care. This is certainly true and is perhaps the strongest point made in the article. But this fault is not inherent in tobacco bond issuance. A state could have issued tobacco bonds, transferred MSA risk, and still used the proceeds for the intended purposes. The simplest way would have been to deposit proceeds into a trust fund with strict restrictions on purpose and pace of disbursements.

While few states spent the proceeds on tobacco prevention and many unwisely used the money for short-term budget fixes, not all the spending decisions were poor. The article notes that Ohio used the proceeds of its tobacco deal to fund school construction. While not consistent with the spirit of the MSA, school construction is a legitimate use of proceeds and a legitimate public policy decision.

It is also important to note that the “misspending” of MSA proceeds is not limited to the tobacco bond issuing states. The Campaign for Tobacco Free Kids recently published a report which concluded that states overall will spend only 1.9% of Fiscal 2014 MSA receipts on smoking prevention.

The report also details state-by-state smoking prevention spending. It is interesting to note that Alaska (a tobacco bond issuer) is one of six states that are spending more than 50% of CDC’s recommended amount for tobacco prevention programs.

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Source: Campaign for Tobacco-Free Kids

“A state puts its credit quality at risk by issuing tobacco bonds”

The contention by Propublica that states put their credit quality at risk by issuing tobacco bonds flies in the face of the risk transfer benefits we discussed earlier. By reducing future revenue volatility; by transferring risk to the capital markets; and by potentially avoiding the need for “on balance sheet borrowing; a prudent tobacco bond issuance could actually be a positive contributor to a state’s credit profile.

The owners of most tobacco bonds have no recourse to the issuing states if MSA payments fall below the level needed to service their bonds. The issuing states went to great lengths to make this clear. The risk language in the offering documents was very explicit. The article seems to acknowledge this, but also raises the specter of a negative perception of a state’s willingness to pay if it doesn’t step in to bail out or restructure troubled tobacco bonds.

Sophisticated investors know and understand that there should be no expectation of state assistance for these bonds. To drive home the point, most states issued the bonds through legally separate entities with names seemingly designed to create distance from the state’s own issuance: Buckeye Tobacco Settlement; Golden State Tobacco Securitization; Badger Tobacco Asset Securitization, Northern Tobacco Securitization.

While we believe investors know and understand the risks, we are also realistic enough to acknowledge that some bondholders may attempt to pressure states into bailing out poor investments. States should resist any of these efforts.

Some commenters have drawn parallels between the tobacco bonds and the 38 Studios bonds in issued in Rhode Island. This comparison is not valid. The 38 Studios bonds included explicit language requiring the Governor to make a budget request for appropriation to replenish (if necessary) a reserve fund. No such pledge exists in most tobacco bonds.

Two states (not mentioned in article) did choose to issue tobacco bonds with “recourse” to the state. New York and California issued some of their tobacco bonds with a back-up appropriation pledge if MSA payments fell short. The decision to use this security package was poor, but poor debt management practices by New York and California are not unique to the tobacco sector. While the credit ratings of both states were recently upgraded, they stand out as examples of states that incur higher borrowing costs in order to avoid legislative and statutory limits on borrowing. Both are frequent borrowers via appropriation debt and New York makes extensive use of its public authority structure to avoid debt limits.

The article cites the recent downgrade of New Jersey after a tobacco bond sale as evidence of the negative credit consequences resulting from a tobacco bond issuance. The downgrade of New Jersey was due to the state’s weakening fiscal position and continuing reliance on one-shots rather than long term solutions. The most recent tobacco bond issuance was an egregious example of these one shots, but the issuance itself was not a primary driver of the downgrades.

“Use of Capital Appreciation bonds was unwise”

CAB’s are not inherently bad. CABs are a tool, which like hammer, can be useful if used correctly and destructive if used incorrectly. The CAB hammer has been misused in the municipal market (most notably by various school districts in California). In other cases, the use of CABs made sense: for instance, by acting as pseudo-equity in start-up toll roll financings to make the capital structure more resilient. In the case of tobacco bonds, CAB’s were a useful tool to help maximize risk transfer.

The article cited the state of Washington’s ease of refinancing of its 2002 deal (no CABs) as evidence that CABs complicate refinancing transactions. Washington was a relatively early transaction. By being early, the Washington deal made turbo payments for several years prior to the tobacco companies’ decision to start annually withholding a portion of their MSA payments due to NPM adjustments The “extra” turbo payments gave the Washington deal some cushion relative to later deals. This cushion was a bigger contributor to the relative ease of refinancing the Washington deal than the absence of CABs.

“Consumption projections were too optimistic”

Propublica faults the states for using overly optimistic forecasts of the rate of cigarette consumption in their offering documents. Propublica states that demand consultant made millions (“$2mm or $99MM”?) providing the forecasts.

Propublica states:

“Just as mortgage lenders bet that home prices would keep rising, the tobacco deals relied on optimistic projections of how much Americans would smoke… now the yearly drop –about 3 to 5.5 percent—is nearly double what was cooked into the deals….the outdated estimates mean an ever-widening gap between what states expected to collect under the settlement and the payments they promised investors.”

If we ignore the imprecise use of the word “promised,” this sounds like a ringing endorsement of MSA payment risk transfer.

Bondholders have seen numerous faulty (usually to the optimistic side) demand studies by issuer paid consultants in multiple sectors. If they relied solely on the IHS forecasts they were ignoring the lessons of history.

“Underwriting of tobacco bonds was lucrative for Wall Street”

Yes. Tobacco bond deals were novel, complex and large. These three factors are clearly correlated to profitable deals for Wall Street. The article does not provide any comparisons to fees from other comparable deals. If the fees were indeed too high, this would have been a legitimate line of inquiry for the article.

Have a great week,


Gregg L. Bienstock Esq. & Michael Craft, CFA


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