The Washington Post had an excellent piece on states and how they handled their tobacco settlement dollars (available here). It is a longer article but well worth the read given that it is one of the first analyses of what states are doing with the money from this settlement. The answer for many: squandering it. I am not going to rehash all the details of the article but there are bigger issues to tackle.

It never ceases to amaze me how states and local governments can make so many wrong moves with their finances. The big picture: many states attempted to bring forward the stream of payments they expected to receive over the next decades. This is not a bad idea really. I remember when Frank Thomas did this for his charitable foundation. He issued bonds that represented a claim to the stream of payments promised in his contract. States issuing bonds today that represent a claim on future payments from tobacco might be a good idea, except that most fundamentally misunderstood who they were dealing with and what they were doing.

You want to create a new bond based on a stream of revenues from a legal settlement, where do you go? Well, nowhere really. Wall Street got the jets warmed up and pitched these ideas to many of the states. It is a tempting idea too. Wall Street told the states they could get them more money than they were to receive now by selling bonds.

Whether it is Orange County and derivatives, Detroit and pensions, or any of the other (far too many) examples of government fiscal mismanagement one thing seems to be consistent: governments get involved with deals and transactions they just do not understand. The first issue for government is they fail to understand the banks are not necessarily on their side here. They are chasing fees. In fact, it is really easy to understand the incentives facing the banks. What is going to generate the most revenue for the firm?

The second problem is governments do not hire their own people to do the math and rely on the banks. They also fail to realize the bank’s incentives and the government’s incentives do not necessarily align. So where did the math go wrong? The assumptions about how fast people quit smoking were too low. That is, people stopped smoking at a rate faster than anticipated. It would be interesting to see the rationale behind these original assumptions. Predictions of this sort are certainly difficult, but were the assumptions employed in clear opposition to reality?

Notice that this means a public health plus becomes a public finance debacle. That sounds about par for the course for what we experienced so far this century. Think about this, fewer people smoking meant less revenue coming to the states. This should not be a problem since the money was really meant to help with the public health issues raised by smoking. Lower costs and lower revenues could still match. However, once securitized the public finance aspects become an issue.

The revenues were now promised as a payment to the bondholders. With less money than anticipated the payment amounts are less than promised and states face the likelihood of default. Even with default it is not the case that states suddenly reclaim the future revenue streams. Essentially states watched those structured settlement commercials and wanted their cash now.

Now there were other bells and whistles, such as capital appreciation features, added to make bonds more marketable. Essentially these are balloon payment features where states fooled themselves into thinking that they would not need to make payments for a long time and that revenues would be readily available. I do not normally call out individuals in my blog, well except for Tim Geithner, but let’s talk about Richard Cordray. He got Ohio into these bonds, and they are a disaster. So it seems natural that he currently runs the U.S. Consumer Financial Protection Bureau. Fills me with nothing but confidence. More feckless financial leadership for the United States. Just what we need.

I could rant on about this, and I probably will later, but the big point here is that governments at all levels need to do better with fiscal management. Rather than listen to highly leveraged financial institutions like investment banks, maybe they need to talk to insurance companies and others that match maturities and follow a different model. At least realize that the one selling you on the idea might have motives of their own.

This work by Flynnglis is licensed under a Creative Commons Attribution-NonCommercial 4.0 International