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The 1998 settlement between major cigarette companies and various governments was supposed to provide massive payouts in perpetuity to 46 states, five territories and the District of Columbia. Instead, nine states, three territories and D.C. owe $64 billion on bungled financial arrangements following the deal, intended to cover the costs of treating tobacco-related illnesses.

The problem is securitization, according to a report and analysis by ProPublica and public radio show “Marketplace.” The troubled governments worked through Wall Street to get large sums up-front from investors, who would in turn be paid out of the settlements ($200 billion in the first 25 years).

How Securitization Is Supposed to Work

Securitization at its essence is simple. An organization (like a government) expects to receive a lot of money over time — maybe mortgage payments arranged by subprime lenders or a settlement with tobacco companies — but wants the cash now. So it goes to Wall Street, which creates a bond that is sold to investors. The investors pay up front for the right to get payments, with interest, over time. The up-front money becomes a lump sum for the organization. Investment banks collect hefty fees. (In the tobacco case, ProPublica estimates that bankers, consultants and lawyers have pocketed more than $500 million in fees so far.)

If everything is structured properly, the original flow of cash will cover what is owed to everyone. In the meantime, the organization has its lump sum to use. A well-structured deal will anticipate some potential drop-off — maybe some mortgage payers lose their jobs. However, in the case of the tobacco settlement deals, cigarette sales have dropped 3 percent and 3.5 percent annually — twice as fast as the Wall Street wizards expected.

Now there’s not enough money coming in to pay investors. In the case of subprime mortgage securitizations, this issue led to a major financial crash and massive government bailouts, with taxpayers ultimately footing the bill. With some of the tobacco settlement securitizations, ultimately taxpayers will foot the bill.

The Fatal Twist

That wasn’t supposed to happen. Most deals were designed so that investors would take the hit if smoking dropped off and settlement payments shrunk. Capital appreciation bonds differed, and they represent $3 billion out of the $36 billion in outstanding tobacco bonds. A CAB doesn’t make regular interest payments like most bonds. Instead, investors are promised both their principle and interest at the maturation date. Now nine states, three territories, and the District of Columbia owe a total of $64 billion on an advance payment of $3 billion

According to ProPublica, these CABs promise final payments upwards of 76 times what was originally obtained. Even if the tobacco payments stayed strong, that is still a huge amount. But the payments have dropped with cigarette usage, making the gap far worse.

Many of the CAB deals were done in the 2000s. Wall Street went wooing governors and legislators, telling them that the time to make deals was fast closing.

New Jersey was supposed to pay $1.3 billion in CABs in 2041 for $92 million it received up front to help Gov. Chris Christie and the legislature close a budget deficit. To retire the debt and avoid that incredible imbalance, Jersey agreed in March to pay out $406 million of the remaining tobacco payments it expected to get. Then the rating agencies dropped the state’s credit rating as a result, meaning more expensive borrowing in the future.

Ohio brought in $319 million up front. It’s ultimate final bill: $6.6 billion. A number of Wall Street firms collectively made $23 million in fees. The state treasurer at the time was Richard Cordray, who is now head of the Consumer Financial Protection Bureau.

A Gasping Result

Wall Street wanted to convince states to seek big initial payouts because firms make big bucks from structuring such deals. Pols, bewitched by the big sums they could get, agreed, even though critics warned of the eventual financial problems. As Christine Gregoire, a former Washington state governor and attorney general said in 2002, “It’s not good fiscal management of public money to give away 75 cents on a dollar of income.”

The tobacco settlement money was supposed to go to anti-smoking campaigns and health care considerations made necessary in the first place by smoking. Instead, it’s become the property of investors so states could get chunks of money that they used for other reasons.

As for the investors, if they can wait, the payoff is weighty. Oppenheimer Funds, the biggest holder of CAB debt, would pull in $40 billion if the bonds all went to maturity. But the value of these investments is also spiraling downward. Oppenheimer recently valued its CAB investments “at only about $700 million, or about 1.8 cents on the dollar.”

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http://www.dailyfinance.com/2014/08/11/states-tobacco-settlement-money-goes-up-in-smoke/