The deal to close Minnesota’s $5 billion budget deficit included $640 million in borrowing through state bond sales. The source of that money has typically been referred to as “tobacco bonds,” but that’s not necessarily an accurate description of how the state will generate the short-term infusion of cash.
The tax bill authorizing the bond sales actually lays out two possible scenarios. The preferred option is to issue “appropriation bonds,” which are secured by the state’s future general fund revenues. The other option is tobacco bonds, which essentially means borrowing against future proceeds from the state’s 1998 settlement with tobacco companies for nefarious business practices.
The difference between the two methods is significant in terms of the ultimate cost to the state. According to figures circulated by the Minnesota Management & Budget (MMB) office, it’s estimated that appropriation bonds can be sold with an interest rate of 4.75 percent and would ultimately cost the state $980 million. By contrast the estimated interest rate for tobacco bonds is 6.65 percent, with a total cost of $1.13 billion. In other words, the method ultimately chosen could mean a $150 million difference in the state’s future liabilities.
So why doesn’t the state simply go with the cheaper option? In short because there are questions about whether appropriation bonds would amount to deficit spending in violation of the state’s constitution. In 2009 Attorney General Lori Swanson issued a letter questioning whether the financing scheme passes constitutional muster. “A court may be concerned that, if it allowed funding for this purpose here, there would be very little to stand in the way of future legislatures from borrowing to fund general operation expenses, thereby rending meaningless the balanced budget requirement in the Minnesota Constitution,” Swanson wrote. Therefore the Minnesota Supreme Court must explicitly validate their legality before any appropriation bonds can be issued.
That’s a problem because time is of the essence. In order to meet its financial obligations, the state must begin receiving proceeds from the bonds by Dec. 1. It’s doubtful that there will be sufficient time to receive the court’s blessing ahead of that initial sale. That means that the first round of bond sales will almost certainly be backed by future tobacco settlement proceeds. But there is expected to be a second issuance of bonds in December 2012 in order to reach the $640 million in required revenue. If appropriation bonds are an option at that point, the state may try to reach back and refinance the 2011 tobacco debt at the more favorable appropriation bond rate.
On Monday, MMB issued a request for proposals to issue the bonds. The solicitation leaves it up to bidders to determine the appropriate mix of tobacco and appropriation bonds. “Firms may submit proposals to serve as senior manager for Tobacco Settlement Asset-Backed Bonds, senior manager for Appropriation Bonds, co-manager or any combination thereof,” reads the request for proposals. Bids are due Aug. 24.
Tobacco bonds have become a popular financial crutch for states struggling with budget shortfalls. At least 20 other states have raised revenue by borrowing against future tobacco settlement proceeds. More than half of those states have issued tobacco bonds on at least two occasions. Some states — including New York and California — have exhausted nearly their entire windfall.
In 1998, 46 states reached an agreement with the four major tobacco companies on the terms of a financial settlement to be paid out over 25 years. Minnesota was among four states that negotiated a separate deal. So far the tobacco companies have paid out in excess of $75 billion.
But in recent years the market for tobacco bonds has significantly dried up. The primary reason is that consumption of tobacco products has steadily declined by about 4 percent annually. That in turn leads to smaller payments to the states from tobacco companies. In Minnesota’s case, proceeds have dropped from a high of $184 million in 2008 to $169 million this year. By 2015 that figure is expected to drop by an additional $20 million. Nationwide the proceeds decreased from $7.6 billion to $6.4 billion from 2009 to 2010 — a 16 percent drop. Those decreasing returns have made tobacco bonds a less reliable investment.
“Five years ago, states like Minnesota could have sold tobacco bonds for a 5 percent interest cost,” said Dick Larkin, senior vice president and director of credit analysis at Herbert J. Sims & Co. “That was really the height of the tobacco bond market where there was a lot of demand. That’s completely changed.”
Illinois is the most recent state to sell tobacco bonds, issuing $1.5 billion in bonds last December. But those bonds were sold with an interest rate of 6.1 percent — significantly higher than in past years. In addition, they were conservatively structured so that bondholders would still be paid even if tobacco sales dropped by up to 10 percent annually.
“They were successful, but only because they structured those tobacco bonds in such a way that they made sure to provide a lot of excess revenue bond coverage,” said Larkin, who previously worked as the chief municipal rating officer for Standard & Poor’s. “There’s room for error.”
Whichever type of bonds Minnesota ultimately issues, the process will be further complicated by turbulence in the financial markets. Last month Fitch Ratings downgraded Minnesota’s debt rating, citing the state’s overreliance on short-term budgetary fixes like tobacco bonds as a primary concern. Then last week, Standard & Poor’s downgraded the credit rating of the United States for the first time in the country’s history. That move is expected to have a ripple effect on borrowing across the country at all levels of government.
“It’s a lousy time to be selling any kind of municipal bonds, because people are worried,” Larkin said. “People are waiting for the dust to settle to see what it’s going to look like when it’s all over.”