March 4, 2002 - As the focus on state budget deliberations intensifies, I have been asked my opinion of proposals to sell off future tobacco payments in exchange for cash to help balance the budget.
I recognize the terrible budget situation the state is in today. According to Chang Mook Sohn, 80 percent of the budget problem is attributable to September 11 and its aftermath.
I think we have to be very careful to make sure we don't let the terrorist acts of 9/11 harm this state and its future. I am willing to help legislators any way I can to ensure this state is on a sound financial footing this biennium and for the future of our state.
But I think that offer to help also means I have to let legislators know when I think they are pursuing a bad idea. And the proposal to securitize tobacco payments will not help us ensure a sound financial footing now and into the future.
Under the proposal the state will get only 25 to 30-cents on the dollar, it would jeopardize the state's bond rating, and it will create a budget hole of at least $75 million in future biennia.
The devastating effects of September 11 on this state's economy won't last forever. But the consequences of this one-time budget fix will be with us for years to come. It's a bad deal for Washington taxpayers and a great deal for the underwriters.
More specifically, I have the following concerns.
1. It is not good fiscal management of public money to give away 75 cents on a dollar of income.
The cost of selling our future revenue stream for cash today is expensive. Based on the experience of other states, the Senate's revenue projections are high. Recent trends indicate we could lose anywhere from 70 to 75 cents on the dollar. Over 25 years Washington would lose more than a billion dollars in revenue. Vermont considered then rejected securitization because state officials estimated the discount rate to be from 73 percent to 93 percent. A current securitization plan in Wisconsin is expected to bring in only 25 cents on the dollar.
2. Selling our tobacco restitution dollars for a one-time budget fix creates budget problems for future biennia.
The tobacco settlement payments provide the state with approximately $300 million a biennium. Today this money is spent on public health, which has allowed General Fund monies to be used for other programs. Selling off a portion of this revenue stream would patch a budget hole today, but it would result in the state having at least $75 million less in every biennium for the next 25 years.
3. The proposal represents the largest revenue bond sale in state history and it poses significant legal, debt limit and bond rating issues.
Many experts (and the experience of other states confirms this) believe the sale could reduce the state's bond rating, which could increase state costs in the future. There are questions about the impact the sale would have on the state debt limit. Such a complex transaction can invite a legal challenge, tying it up in the courts for months.
4. Securitization means taxpayers once again will subsidize the staggering medical costs of smoking.
Smokers are paying a higher price per pack to fund the settlement. But one of the critical goals of the tobacco settlement was to finally force tobacco companies to pay for the huge societal costs caused by their unlawful conduct and to reduce tobacco related health care costs in the future. Washington's tobacco payments have allowed us to free our taxpayers from subsidizing the costs of tobacco use.
SECURITIZATION OF TOBACCO PAYMENTS
1. What is securitization?
Simply put, the state sells its right to receive substantial tobacco settlement payments in whole or in part in the future for a substantially discounted lump sum, up-front amount. The state's right to receive tobacco settlement payments is sold to investors who pay now and will expect to be repaid over time with an appropriate rate of return. The amount received by the state would be spent immediately. Repayment of investors is made from and secured by tobacco settlement payments in the future. From the point-of-view of the state, it is essentially converting an income stream into a one-time recovery.
2. What will the state of Washington get over the next 25 years without securitization?
Washington State's share of the $206 billion settlement is expected to be $4 billion in restitution over the next 25 years. In addition, Washington is to receive approximately $500 million over a 10-year period because of its leadership role in achieving the settlement. There are potential downward adjustments based on reductions in the volume of cigarettes sold and, under certain circumstances of nondiligent enforcement by the state. On the other hand, most of the payments are subject to an inflation adjustment at the greater of three percent per year or the increase in the CPI. The total $4.5 billion figure does not include these adjustments.
3. What will the state of Washington get if it securitized the payments?
Under any type of securitization, there would be a substantial discount of future payments to present cash value. An up-front payment to the state would be approximately 25 to 30 cents on the dollar for payments to be made in the future. For instance, if the state securitized $1 billion of its expected payments over the next 25 years, the likely front-end payment would be $250 million to $300 million or less now. A portion of the up-front payment will, in all likelihood, be required to be put into a reserve account to ensure repayment to bondholders, further reducing the current value.
4. What is the value of tobacco payments currently, and how are they being used?
Under the Master Settlement Agreement (MSA) with the tobacco industry, the state receives settlement payments each year in perpetuity. Prior to this biennium, Washington had received over $300 million under the tobacco settlement agreement. This biennium, the state expects to receive from $300 million to $310 million. The state's budget is built on this revenue for funding local government health programs, health care for poor children, tobacco prevention and control, and the basic health plan.
5. Why is securitization a bad deal for the state?
- The state ends up with only a fraction of the amount of money it would receive over the long term, due to the steep discount (i.e., $.25 - $.30 on the dollar).
- Securitization entails costs, requiring the state to pay fees to investment bankers, brokers, accountants and lawyers. It is an expensive transaction to complete.
- Selling off this revenue stream will result in a budget hole in future biennia.
- The state's bond rating may suffer. Rating agencies consider the need to securitize to meet current operational budget needs as an element of the state's overall financial health. Further, it is considered a short-term fix to a continuing problem.
- The money from the settlement is not used for the purposes for which it was intended.
- If the state guarantees the repayment, there may be a constitutional question with the state's debt limit under article VIII, section 1 of the Washington Constitution.
MECHANICS OF SECURITIZATION
6. How does a securitization transaction work?
Typically, the state creates a separate governmental corporation or entity and transfers to that entity the right to receive all or a portion of the revenue stream from the MSA payments. In the second step, the entity issues bonds secured by the expected revenue stream from the MSA payments. The state receives the revenues from the sale of the bonds less the amount that must be retained as a reserve and less the costs of the transaction.
7. What is the Liquidity Reserve?
In order to decrease the possibility of default, the securitization instruments require the issuer to retain a portion of the proceeds in a Liquidity Reserve Account, usually about ten percent. This amount of the proceeds is therefore unavailable to the state from the proceeds of the sale.
8. What other costs are there?
There are substantial fees involved that are payable to investment bankers, accountants, lawyers, and others involved in the transaction. These fees can amount to about one percent of the proceeds. These fees are taken out of the proceeds of the sale of the bonds and are never available to the state or the government corporation.
9. How does the government corporation amortize its obligation to the bondholders?
From the proceeds of the revenue stream, the government corporation has to earn enough to make all the interest payments to the bondholders as well as make contributions to a sinking fund for the eventual retirement of the bonds. In addition, it has to pay its operating expenses.
10. What are the implications of a "partial" securitization?
If, for example, the state securitized half its payments, one might expect that for future payments from the tobacco industry, the state would receive one half and the investor the other half. That's not the way it works. Repayments to investors are secured by the totality of tobacco payments, and repayments to investors must be made first before the state would realize its share of the annual payments. Accordingly, if there were any reduction or delay in tobacco payments for future years, it would come first from the state's share, before there would be any reduction in payments to bondholders.
11. What is the likelihood of bankruptcy by the tobacco industry (Participating Manufacturers)?
Nothing in the market indicates a perception that there is a substantial risk of a bankruptcy by an Original Participating Manufacturer (OPM). Although cigarette sales have declined since the MSA was entered into, volume of sales is not likely to be significantly reduced in the future. OPM profits have increased. Philip Morris, for example, is expected to give $9 billion in dividends this year. Liability in class action lawsuits represents the only credible threat of bankruptcy and most observers believe there are formidable obstacles to recovery in such lawsuits. The MSA was also structured to minimize the impact on payments if a company sells a portion of its business or goes into bankruptcy.
12. Does securitization eliminate a conflict of interest for states in the receipt of payments under the tobacco settlement agreement?
Some people feel that the state has a vested interest in tobacco industry profits and the growth of tobacco consumption because this influences the amount of payments to states. This simply is not accurate. The state does not promote smoking as a way to increase tobacco payments. A significant goal of the MSA was to reduce tobacco consumption particularly among youth smokers. It was understood that state payments in the future may indeed be reduced by reductions in smoking. This was with the recognition, however, that there would be societal benefits to reduced smoking, including reduced costs to public health funds. There simply is no conflict of interest in receipt of payments.
With securitization, however, investors would have a heightened interest in tobacco profitability simply to ensure that repayments can be made on time.
13. Could the state securitize now and redeem the securities later?
The state could and likely would structure a securitization agreement to provide for optional redemption in the future. Redemption would require a considerable lump sum current payment to buy back the right to receive payments. It is highly unlikely that the state, having once securitized a portion of the settlement, would ever be in a position to devote current funding in an amount in the future to redeem the securities.
14. The state retains the obligation to enforce the MSA.
The state cannot walk away from its obligations to enforce the MSA. The state will retain its obligation to enforce the MSA and related legislation even if it gives up its right to the stream of payments. Any indenture will likely impose a specific enforcement obligation on the state. If tobacco payments in the future are insufficient to meet repayment obligations, investors may sue the state to recover the difference. With securitization, the state will be placed in a position of continuing to have to expand the same resources to protect recoveries from which the states will not benefit.
15. Which states have securitized their MSA payments, and for what return?
Alabama, Alaska, Arkansas, Iowa, Louisiana, and South Carolina chose to sell off their proceeds. Others like Ohio, Pennsylvania, Vermont, and Michigan have considered it but rejected the idea.
In the case of Wisconsin, the original plan was to put $450 million into an endowment. As the budget hole grew deeper, they sold it all, placed the monies in the general fund, and pledged to cut local government funding by $1 billion in the next biennium to avoid downgrading the state's bond rating.
Lastly, in the case of Vermont, they refused to securitize because current estimates vary from a 73 percent to a 93 percent discount.
Campaign For Tobacco Free Kids
Immediate Release: Contact: Tony Iallonardo
March 5, 2002 202-296-5469
Statement of Matthew L. Myers
President, Campaign for Tobacco-Free Kids
Washington State Proposal to Securitize Tobacco Settlement Funds
Is a Raw Deal for Taxpayers and Kids
WASHINGTON, DC (March 5, 2002) - The Washington State legislative proposal to securitize a portion of the state's tobacco settlement income is a raw deal for kids and taxpayers. This proposal would leave Washington with just a fraction of its tobacco settlement money, and it would make it virtually impossible for the state to adequately fund a comprehensive tobacco prevention program in the future, which Washington voters have said is their priority. It is a nearsighted approach to the state's budget crunch that will cost taxpayers more in the end.
Selling enormous amounts of future tobacco settlement income to investors for a much smaller one-time lump-sum payment is not only unfair to future generations but a bad deal for current taxpayers. Washington taxpayers should be skeptical of claims that selling just a quarter of the state's settlement proceeds could raise $525 million now - a return of as much as 50 cents on the dollar. Based on the experience of other states that have recently securitized their settlement payments, Washington would receive as little as 25 cents on the dollar. Like Enron shareholders, Washington taxpayers would get only pennies on the dollar. This proposal's only winners would be Wall Street bond brokers.
Securitization also makes it far less likely that any of the tobacco settlement money will be used as intended - to fund tobacco prevention programs that reduce youth smoking and save money for taxpayers by reducing smoking-caused health care costs. When they overwhelmingly approved Initiative 773 in November, Washington voters sent a loud and clear message that they want their state's leaders to fund a comprehensive tobacco prevention program based on the recommendations of the U.S. Centers for Disease Control and Prevention. By endangering future funding for tobacco prevention, this securitization proposal breaks faith with the voters.
Instead, Washington lawmakers want to use the money to alleviate this year's budget crunch. That quick fix is a near-sighted solution that only delays the hard decisions until the next budget debate. Because it's a one time payment, the securitization money will not be there next year, meaning the state will be forced to raise taxes or cut programs more drastically in the future.
If Washington lawmakers truly want to reduce state expenses, they would invest a portion of their tobacco settlement money in tobacco prevention programs proven to reduce health care costs. Recent studies have found that states are saving about $3 dollars in health costs for every dollar invested in effective tobacco prevention programs.
Unfortunately, Wall Street brokers have been pressuring states to sell their settlement funds by raising worries about tobacco company bankruptcy and declining cigarette consumption. But these same bond brokers are getting A or even A+ ratings on tobacco-settlement bonds, which are among the very highest ratings. That means Wall Street firmly believes in the long-term profitability of the tobacco industry.
The issue of declining cigarette consumption is another red herring. While the state's settlement payments will be reduced as national cigarette sales decline, no one expects that will amount to more than a one or two percent reduction per year. In addition, the state's tobacco settlement payments are automatically adjusted upward each year for inflation, which will more than offset any future reductions caused by U.S. smoking declines.
The Washington State proposal is little more than a budgetary gimmick that will end up hurting taxpayers and kids vulnerable to the lure of tobacco addiction. We urge the Legislature and Governor Gary Locke to reject this proposal.