Excerpt
As they met at The Shamus, a favorite local lunch spot, on a September day a year ago, Niagara County officials considered some good news. Thanks to low interest rates, they might be able to refinance a big chunk of Niagara's tobacco bonds – debts payable from the county's share of a massive 1998 legal settlement with Big Tobacco.
Eager to lower costs by replacing the bonds with less-expensive debt, they decided to move ahead. As a bonus, they figured the county could raise some new money for projects like fixing up Niagara's jail.
But when details of the transaction became public last month, the biggest winner wasn't Niagara County, which received $2 million from the deal, but investors of Oppenheimer Funds, a large mutual fund manager that held deeply distressed Niagara tobacco bonds that were last in line for repayment.
Oppenheimer investors got $6.9 million for the bonds, which had been expected to default. That's more than triple the county's take and $5.1 million more than the value Oppenheimer carried on its books, according to data from Morningstar, which tracks mutual fund holdings.
Why did the last-in-line investors get a $5.1 million windfall while the county got a mere $2 million?
The answer lies in the shifting world of tobacco bonds, where big investors are pressing governments like Niagara to bail out bets that have turned bad, owing to a drop in smoking and a parallel decline in the settlement payments that underpin the bonds.
ProPublica reported earlier how states, territories and counties have exposed themselves to $64 billion in tobacco debt by selling $3 billion in high-risk securities called capital appreciation bonds, or CABs, as part of "securitization" deals that mortgaged their annual tobacco payments for immediate cash.
The CABs are particularly toxic because no payments are required until the bonds mature, usually in 40 or 50 years. In the meantime, they pile up huge sums of interest owed – so much that Niagara and several other counties were told last year that some of their CABs would never pay off.
Niagara is the first county to engineer a bailout. In March, New Jersey pledged $406 million from future tobacco settlement income to rescue CABs. Oppenheimer has sued to block a refinancing plan in Rhode Island, and New York's Chautauqua County is pursuing a $34 million deal similar to Niagara's.
Wall Street has taken to calling these deals "investor-led refinancings," a label that invites questions about who's getting the most benefit — taxpayers or bondholders.
As Niagara's case demonstrates, money for the bailouts isn't free. It comes from new debt deals, like refinancings, or from future tobacco payments that otherwise would flow to the governments. That means taxpayers benefit less than they otherwise might, even when some upfront cash is thrown in.
"The banker who sold this deal to Niagara should be canonized," said Sylvain Raynes, co-head of credit research firm R&R Consulting, who reviewed the transaction at ProPublica's request. Raynes was one of six experts who questioned the size of the payout to Oppenheimer given the firm's own low valuation of the bonds.
Niagara's banker, Susan Schmelzer of the investment firm Raymond James, declined to comment. Oppenheimer also declined to comment or answer written questions.
Deals like Niagara's also challenge a major selling point for tobacco securitizations, which in the years following the legal settlement were pitched as a type of insurance to protect taxpayers. The idea was that governments would secure money upfront while investors took the risk of payments shrinking over time.
Bailouts flip the calculus. "There really wasn't any kind of a risk transfer," said Edward Grebeck, a Connecticut debt consultant. At the end of the day, he said, bondholders "are coming to the party to take money which you would think the taxpayers of Niagara County would be entitled to."
Governments have no legal obligation to cut investors' losses. The bonds are what's called "non-recourse" debt, meaning taxpayers aren't on the hook to repay them. Bondholders are owed money only from the settlement, which is supposed to flow in perpetuity and so far has paid out $101 billion.
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