Nothing like a good racket, eh?

A handful of bonds backed by yearly payments from tobacco companies under a landmark settlement with 46 states are in the earliest stages of default, and more distress is expected.       

Dozens of states, counties and cities issued the bonds to receive billions of dollars upfront from the 1998 settlement. But now they are seeing smaller payments than expected from the companies as tobacco sales decline in America. There is also a renewed legal battle between the states and the tobacco companies, with the companies holding back nearly $8 billion in settlement payments, pending resolution.

Nice.

What happened here is that the states "sold forward" the cash flow from the tobacco settlement predicated on smoking continuing to increase in prevalence while at the same time raising taxes and taking other actions to deter smoking. 

The states and other agencies use "projections" from an "independent consulting firm" to look at expected payments over 40 years, then set the bond terms on that projection.  But...

“Those were all bogus,” Mr. Larkin said. “Yet the consultants used that report year after year.”

I seem to recall that ridiculously-rosy (and ultimately proved bogus) "projections" of a similar nature that house prices would go up 10% a year forever were part and parcel of the offering of securities backed by subprime and Option ARM mortgages, both of which were effectively balloon notes as nobody could make the payments once the "teaser" features expired.

There's an element of "buyer beware" in any sort of long-maturity security as people buying railroad bonds just prior to 1873 discovered.  This is especially true when some so-called "independent" entity is using some sort of model to project what's going to happen 40 years from now.

But it gets even more interesting when the party issuing the bond and thus taking the cash flow from the results up front also has the power to take actions that deter the predicate act on which the cash flows, in this case smoking cigarettes (e.g. by raising taxes on them and passing laws making it more difficult to find a legal place to smoke them.)  And it doesn't help that not all companies signed the settlement, and those that did not were subsequently attacked by the states with various discriminatory taxes and since they are almost all performing acts of interstate commerce, they have sued claiming that's unconstitutional (I presume the claim rests on the tax being an effective state-imposed tariff, which is in fact unconstitutional.)

I was amused at the time the tobacco "bond" scam was being run back in the 1990s and early 2000s, in that it looked to be a classic case of inside dealing where you were virtually guaranteed to get screwed.

It appears that I was right.

H/t: The forum