Bond Deal Gives State an Unhealthy Interest in Big Tobacco

Of the state Legislature’s move this summer to backstop the tobacco industry’s lousy credit rating with California’s lousy credit rating we can say this much: It is a terrible idea, but its timing is impeccable.

The deal involves placing a state guarantee behind a $2.3-billion bond issue to be floated next week and paid off from California’s share of the $206- billion settlement Big Tobacco reached with 46 states in 1998. In effect, this means that if a major tobacco company goes bankrupt or otherwise defaults on its legal commitment to California in the next few years, the state’s taxpayers are on the hook for what could be billions of dollars owed to the bondholders.

And because cigarette sales are sliding while the threat of litigation is rising, we’re standing up for the tobacco industry just at the moment when its financial condition looks the most perilous.

As my colleagues Myron Levin and James F. Peltz reported this week, Gov. Gray Davis and legislative leaders slipped the backstopping deal across the Legislature -- along with another, even more egregious bill capping the size of the appeal bonds that tobacco companies have to post in California courts when they lose big judgments at trial -- in the dead of night, at the end of a 29-hour marathon budget-closing session last month.

According to the deal, $2 billion used to balance the budget will come from the $2.3 billion in bonds maturing up to 40 years from now, backed by the flow of tobacco settlement money.

But because the industry’s ills have lately led the bond market to look askance at such securities, the state would have had to pay an exorbitant interest rate to make them palatable to buyers. The state’s agreement to cover any shortfall in debt service will allow the rate to come down. Experts say the state would gain as much as $500 million more from the guaranteed bonds than it would have if it did not pledge its own credit.

It’s bad enough that the deal exploits long-term tobacco settlement money to close the short-term budget gap, because the funds have been intended for health-care expenditures and anti-smoking campaigns.

But for years, California’s public policy has been -- let’s face it -- to put tobacco out of business.

The number of venues where it is legal to smoke has steadily shrunk, unrelenting anti-smoking ads on TV are turning the habit into the essence of uncool, and the excise tax on tobacco has been raised to the point where two bucks will buy you a full gallon of gas at your service station but not even half a pack of cigarettes.

Yet this deal gives the state an interest in the continuing health of Big Tobacco: If a major company goes under, the bondholders will come knocking on Sacramento’s door.

“That’s a really bad policy,” says Ben Alamar, a tobacco economist at the Center for Tobacco Control, Research and Education at UC San Francisco. “It makes a bankruptcy something the state doesn’t want to happen.”

This won’t be the first example of how the 1998 tobacco settlement has linked the industry and the public interest in a sort of unholy matrimony.

This year, concerns for the health of the biggest domestic company, Philip Morris USA, forced a gaggle of state attorneys general to petition an Illinois court to reduce an appeals bond levied on the company after it lost a huge class-action lawsuit; the company had threatened to file for bankruptcy if the $12-billion bond were upheld. (This week the bond was finally cut to about $6 billion.)

With these discomfiting relationships in mind, many people in the anti-smoking lobby have argued for years that the states should have packaged their anticipated settlement payments into bonds and sold them off from the very first. The idea was that in return for ceding a future income stream that might or might not materialize, they would get sizable lump sums up front.

The money would be a bird in the hand, and guaranteed. If there were any risk that a big company would go out of business, that would be the bondholders’ problem.

This so-called securitization also would insulate them from the risk that the continuing decline in domestic cigarette sales, which are factored into the formula, would slash the payout in the future.

The opportunity to securitize was certainly there at the outset. In 1998 and 1999, the tobacco industry looked a lot more robust than it does today, now that a string of huge liability judgments seems to have jeopardized the future of some of the country’s biggest cigarette manufacturers. Sacramento was teeming with investment bankers eager to handle the bonds.

“These guys were crawling all over the place to lend money on this stuff,” recalls Steve Peace, the current director of the state Finance Department, who was a state senator at the time. “We could have unloaded 100% of risk to bondholders, and we would have been assured we’d get all our money.”

The counterargument was that so much money, delivered all at once, would burn a hole in the state government’s pocket and get spent right away, instead of being committed to long-term health programs.

Peace says there were plenty of ways to protect the windfall from irresponsible spending, such as segregating it in a special fund. He says his proposals fell on deaf ears. “That was the beginning of the reality of a term-limited Legislature and the running of the state by teenagers,” he grouses.

Some jurisdictions did securitize all or part of their settlement shares, including Nevada, New Jersey and Connecticut. California floated a $3-billion securitization in January, when the market was still strong, but that was a tiny fraction of the more than $20 billion the state might receive over time.

And 11 mostly rural California counties presciently pooled their shares into a $196-million bond issue in August 2002. “They thought there was a strong risk that the funds might go down because of reduced consumption and bankruptcies,” says Norma Lammers, deputy executive director for the California State Assn. of Counties, which managed the pool.

As it turns out, of course, forgoing a large-scale bonding of the settlement hasn’t kept the state from dipping into the money before it’s in hand. Peace says the backup credit arrangement entered the budget negotiations this spring when it became clear that the Davis administration’s initial revenue proposal, to raise $3.6 billion over two years by increasing the cigarette tax and raising the top income tax rate to 10.3%, wouldn’t fly in the Legislature. Once it was evident that the market wouldn’t buy the tobacco bonds at a reasonable price, the state backing was thrown in.

Peace tries to dress up the arrangement by arguing that under the technical terms of the bond issue the state’s exposure to liability is minimal, especially if there’s no tobacco bankruptcy in the first year after the sale.

But it’s far from clear that the risk is all that slim, given the deteriorating condition of the tobacco industry. And it doesn’t change the fact that by placing its credit behind the tobacco industry’s obligations, California has now compromised its public stance against smoking.

Just a year or two ago, State Treasurer Phil Angelides was instrumental in persuading CalPERS and the state teachers pension fund, two of the most powerful institutional investors in the country, to divest their tobacco stock holdings; now he’s stuck with the legal obligation to market a security that links the state’s financial health to those same companies. His office gives the strong impression that he’ll be holding his nose as he brings these bonds to market.

Shouldn’t we all?

Golden State appears every Monday and Thursday. Michael Hiltzik can be reached at golden.state@latimes.com.