Tobacco settlement ABS bonds are not likely to experience increased liquidity risk in the short term, at least not because two tobacco companies diverted a portion of April's payments due to five states, according to Moody's Investors Service.
Last April, R.J. Reynolds Tobacco and Lorillard Tobacco made $2.6 billion in payments under the 1998 master settlement agreement (MSA) to California, New Hampshire, Massachu-setts, New Jersey and Ohio. The April payments, however, fell short by more than $750 million, which the companies placed in disputed payment accounts. Pending resolution of the dispute, the escrowed funds are not available to fund securitizations.
The tobacco companies are in a protracted disagreement with the states over how much money is owed under the MSA. One condition of the settlement allows the tobacco companies to reduce their payments to the states, if they can show that they lost market share to tobacco companies that were not part of the original agreement.
The tobacco companies saw their chance to reduce the amount of their scheduled payments in March. The Brattle Group, the economic consulting firm nominated by the participating manufacturers and the states, determined that the MSA was a significant factor in their loss of market share to other tobacco companies that were not part of the 1998 agreement.
Because of the withheld payments, June 2006 turbo payments were 48% less than anticipated when the bonds were issued, wrote Bear Stearns' municipal bond analyst Jerry Solomon in a report. Still, "it appears that no tobacco settlement bond issues will need to tap their Liquidity Reserve Account to meet 2006 debt service requirements," according to Solomon.
The bank identified 30 tobacco bond issues that projected turbo payments for May and June 2006, totaling $332.7 million. Twenty-eight of the 30 bonds were able to make turbo payments totaling $173.7 million. Two deals, the 2005 California Counties issues for Merced and Sonoma counties, did not make the June 2006 turbo payments, although they did not have to dip into their liquidity reserve accounts to make interest payments, Solomon added.
The states, however, are pushing back against the tobacco companies' claims that their payments should be reduced. At press time, 35 of the original 52 states and territories involved in the settlement have filed suit in their respective state courts, asking for a declaratory order stating that they have diligently enforced the laws they enacted as part of the MSA. Such a declaration would undermine tobacco companies' claims to an adjustment to their obligations, according to Bear Stearns.
On that score, the tobacco companies believe that the diligent enforcement question should be decided by arbitration. Earlier this month, courts in Kentucky and New Hampshire issued rulings that agreed with the tobacco companies. Courts in Massachusetts are expected to decide on the matter shortly.
As for how the recent escrowing of funds might pose risks to future securitizations, Moody's says participating companies could escrow future payments that would otherwise be used to service securitization debt. Secondly, if any state is found not to be enforcing its model statute diligently, "the burden of the entire national adjustment would fall on the one or few non-enforcer states." Furthermore, Moody's said the payment shortfall could offset the states' expected revenues by up to 100%. If that happens, it could cause a tobacco settlement securitization to default.
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