Legislative Analyst's Office Analysis of the 2002-03 Budget Bill

Tobacco Settlement Fund

Background

In 1998, the attorneys general of most states and the major United States tobacco companies agreed to settle more than 40 pending lawsuits brought by states against the tobacco industry. These lawsuits sought reimbursement for the expenses states had incurred for smoking-related health costs. As part of the agreement, the tobacco companies are required to make annual payments to the states in perpetuity. California's share of these receipts over 25 years is expected to total about $21 billion, with about one-half of that amount ($10.5 billion) going to the state government and the remainder going to local governments.

From 1998-99 through 2000-01, the revenues the state received from the settlement were deposited into the General Fund. Last year, however, the Legislature adopted budget bill language (Chapter 171, Statutes of 2001 [AB 430, Aroner]), that established a new special fund--the Tobacco Settlement Fund (TSF)--to support a variety of health care programs administered by the Department of Health Services and the Managed Risk Medical Insurance Board with revenues from the settlement of the case.

Chapter 171 specifies that appropriations from the TSF shall be used for health programs, including:

• Health care expansions in the Medi-Cal, Healthy Families, and other state programs.
• Health care education and outreach, including efforts to help reduce the use of tobacco products.
• Smoking cessation services.
• Enforcement of tobacco-related statutes.
• Expansions of primary care and other state-funded clinics that serve low-income, uninsured, or underinsured Californians.

Summary of Governor's Budget Proposals. The Governor proposes to spend about $476 million in 2002-03 from the TSF for health programs. He further proposes to change state law so that an additional $62 million in revenues anticipated from the legal settlement--money that would otherwise also be dedicated to health programs--could instead be used in 2002-03 to pay the debt service resulting from a plan to address the state's fiscal problems by selling future TSF proceeds for $2.4 billion in cash.

The Governor's budget also reflects a significant decrease in anticipated spending from the TSF in the current fiscal year. The 2001-02 budget allocated about $73 million from the legal settlement to the General Fund and the remaining $402 million to the TSF for various health programs. The Governor's revised budget plan assumes that the expenditures made from the TSF for health programs during the current fiscal year will actually be about $338 million, or $64 million below the level specified in the 2001-02 Budget Act.

This projected decrease in current-year spending is due primarily to the administration's plan to initially postpone implementation of an expansion of the Healthy Families Program to parents until 2003-04 because of federal delays in approving this expansion and the state's current fiscal problems. (Following the recent federal approval of the waiver, however, the Governor has indicated his intention to revise his budget plan to enable the program expansion to proceed.) Consistent with the legislation creating the special fund, this $64 million in unspent TSF funds would be carried over to the budget year and, thus, be available for expenditure in 2002-03 for the support of health programs.

The Governor's budget also proposes to significantly change the line-up of health programs that would be supported from the TSF. Some programs would be shifted to General Fund support while others previously supported from the General Fund would be shifted to the TSF.

We discuss the Governor's major proposals relating to the TSF in more detail below.

Securitization of Tobacco Settlement Revenues

The administration's proposal to sell, through securitization, its rights to a portion of the state's tobacco settlement revenues for $2.4 billion is, in general, a feasible and reasonable step for the Legislature to consider as part of a comprehensive solution to the state's budget problems. In considering this specific proposal, the Legislature will have to weigh the potentially adverse implications of securitization for future funding of health programs against its contribution in the short term to addressing the state's budget problem. We recommend that the Legislature consider such a transaction only if the administration presents a more detailed proposal and an analysis demonstrating that the net financial outcome would be beneficial to the state.

The Governor's Budget Proposal

Future Revenues Would Be Sold for Cash. As part of his plan to deal with California's budget shortfall, the Governor proposes to "securitize" future tobacco settlement revenues (TSRs) to obtain $2.4 billion that would be used to help balance the 2002-03 budget and to meet the state's short-term cash flow needs. The term "securitization" simply means that the state would sell part of its long-term TSR stream for cash that would be obtained in the short termin this case, the current fiscal year. The conversion of the future TSRs into cash would be accomplished through the issuance of a $2.4 billion revenue bond issue secured by the state's future TSRs. (This $2.4 billion is equivalent to roughly 45 percent of the present value of the TSR stream expected over the bonds' lifetime.)

The administration's rationale for this proposal is that, absent the receipt of the $2.4 billion in bond proceeds, it would be forced to make further reductions in health or other state-supported programs to keep the state budget in balance. The administration has also indicated that these funds could be needed to ensure there is sufficient cash available to enable the state to pay its bills.

As noted earlier, the securitization debt service payment would amount to $62 million in 2002-03, leaving $476 million available in the budget year for various health programs. The administration's estimate of annual debt service costs for the bonds assumes a 23-year bond maturity, a level-payment structure of $190 million annually in 2003-04 and thereafter (where initial principal payments are relatively small, like with a typical home mortgage), and an interest rate of about 5 percent (similar to that for investment-grade general obligation debt).

We are advised that the administration's plan for issuing the bonds would give bondholders "first call" on the state's receipts from the legal settlement until the bonds are retired. Put another way, the administration's securitization plan assumes that, should future TSRs be less than expected, bondholders would be promised that their payments would "come first" and any TSR shortfall would be passed along to the health programs supported from the TSF.

State legislation would be necessary to implement the Governor's plan. That is because authorization is needed to incur long-term debt. Legislation is also being sought because the statute creating the TSF specifies that, in 2002-03 and thereafter, the total amount of the state's share of monies received pursuant to the tobacco settlement agreement is to be deposited in the TSF. Under the Governor's proposal, the share of settlement funds needed for debt service would not be deposited in the TSF.

The question of whether securitization makes sense involves two separate issues: (1) does securitization make sense from a strictly financial perspective, and (2) is it desirable from a policy perspective, both in terms of its implications for the state's health-related programs and its overall effect on budgeting for the state's future needs?

Does Securitization Make Financial Sense?

From a strictly financial perspective, a determination of whether securitization is a good or a bad idea for the state depends upon the specific provisions included in the securitization arrangement involved and several other key factors. These additional factors are:

• The risk premium that investors demand as reflected in the interest rate on the bonds or other provisions, given the uncertainty about future TSRs.
• Whether the bonds will be tax-exempt versus taxable.
• What percent of future dollars the state feels is reasonable to give up in order to get dollars today.
• Whether bond-related reserve funds have to be maintained and, if so, how they can be invested and who gets the proceeds.
• The extent to which TSRs in excess of debt-service costs in any given year must be used to accelerate retirement of the bonds, versus being available to the state.

From a financial perspective, securitization should only proceed when all of the above factors have been taken into account and it can be shown that its net financial outcome is beneficial to the state. However, neither a detailed securitization proposal nor a comprehensive financial analysis has thus far been presented to the Legislature that explains how the administration's plan takes these key factors into account.

Is Securitization a Sound Health and Budget Policy?

Several Factors to Consider. Two important factors should be weighed in any determination as to whether securitization is an appropriate policy from a health and budgeting perspective. These include the potential impact of shifting a portion of the resources now dedicated by statute to health programs to debt repayment, including the further effect on these programs if future TSRs fall short of projections or if the cost of borrowing the $2.4 billion is higher than anticipated. The Legislature should also consider the longer-term impact on overall state finances of borrowing against these future revenues.

Proposal Would Revise Recent Funding Commitments. Adoption of the Governor's securitization plan would represent a revision of the policy adopted last year to commit all TSRs received during 2002-03 and thereafter to certain health programs.

The impact of securitization in the budget year would be to divert from the TSF an estimated $62 million for securitization debt-service payments that would otherwise be used for the support of health programs. However, as it considers the impact of securitization, the Legislature should also take into account the additional reductions that would have to be made in health programs (as well as other types of state programs) if the plan to borrow against future TSRs does not go forward. The administration has indicated that it would make much deeper cuts in health programs in the budget year if the $2.4 billion gained from securitization were not available to help close the overall state budget gap between projected revenues and expenditures.

Impact on Fund Greater After 2002-03. Securitization would only divert about 12 percent of the TSF revenues that the Department of Finance estimates would otherwise be available for expenditure during 2002-03. The ongoing impact of securitization upon the state's health programs would become more significant in 2003-04 and the fiscal years that follow, however. This is because, in 2003-04, the share of the TSF that would be diverted to debt service would grow as the state's remaining share of TSRs declined. Specifically, the administration estimates that the debt service for the securitization bonds would increase in 2003-04 from $62 million to about $190 million and would remain at that level until the bonds were retired in 2024.

The administration has stated its intention to backfill the future loss of TSF for health programs with General Fund resources. However, the administration has also acknowledged that, in the event of future budget shortfalls, these programs would henceforth have to compete with other state programs for support from the General Fund. This is because the TSRs would no longer be dedicated to their support.

Settlement Revenues Subject to Uncertainties. The full budgetary impact of securitization on health programs could be greater than discussed above because of the continued uncertainty about how much the state will actually receive in TSFs. This funding stream is subject to a variety of risks.

For example, potential disputes between the tobacco companies and the states that are a party to the settlement agreement over the calculation of their regular settlement payments could result in reduced TSR payments. In addition, a decline in cigarette consumption that is sharper than the decline that was projected when the settlement was structured could result in a shortfall in future receipts. Finally, the inability of U.S. tobacco companies to make their full payments due to financial problems could reduce payments to the states.

All of these risks add uncertainty to the accuracy of the long-term projections of the TSRs the state is expected to receive. We would note that the state Department of Justice (DOJ) estimates of TSRs are lower than the administration's during the 2004 through 2007 calendar years by about $29 million annually.

Given the long-term nature of these estimates, we believe the administration's assumptions on TSRs are reasonable. But these differences in the administration's and DOJ's estimates over the long term do demonstrate that there is some risk that the monies available for health programs could be less than the administration has assumed in its securitization plan.

Of course, these risks to the flow of TSRs exist independent of whether any securitization proposal goes forward. Supporters of securitization have pointed out that one potential benefit of such a transaction is that it would permit the state to receive funding that it might never receive at all in the event that payments from tobacco companies were halted at some point in the future due to financial problems.

Debt Service Costs Could Be Even Higher. If the state proceeds with securitization, the ongoing funding available for health programs could also be affected by the terms that the state could get from the financial marketplace on its bonds. Given investor uncertainties about the amount of future TSRs, the cost of debt-service payments could turn out to be significantly higher than the administration has estimated, especially during the next several years. This situation could result if investors demanded a higher interest rate or other costly provisions in the transaction intended to make the bonds more secure, such as an accelerated repayment structure, when funds are available.

As an illustration of the potential impact of added costs, selling the bonds at an interest rate of 6 percent instead of 5 percent would increase debt-service costs by $8 million in 2002-03 and by $16 million annually thereafter. These added costs would leave less funding available for the TSF and put at greater risk the programs that are to be supported from that funding source.

Securitization and Budget Policy. In our December 2001 report to the Legislature, Addressing the State's Fiscal Problem, we urged the Legislature to consider a wide range of budget solutions, including options to augment revenues, reduce state programs, and "monetize" physical and financial assets that are not needed now. We also noted that the state could appropriately consider a mix of both one-time solutions as well as those that are repeatable or ongoing in nature. Securitization of TSRs was identified as an example of such an option. Our analysis suggests that securitization is, in and of itself, a feasible and reasonable strategy that could be considered as part of a comprehensive budget solution. The question is: should we actually do it?

Analyst's Recommendation. In making its decision regarding the Governor's securitization proposal, the Legislature will need to assess several trade-offs. The Legislature will have to weigh the long-term, potentially adverse implications of securitization for health program funding against its contribution in the short term to addressing the state's budget problem. The Legislature will also have to take into account the alternatives to securitization--the various other spending and revenue actions that would probably have to occur in the absence of receiving the $2.4 billion from such a transaction. Finally, the Legislature must ensure that any securitization arrangement that is considered makes financial sense.

Accordingly, we recommend that, prior to budget hearings and any securitization of future tobacco settlement revenues, the administration present its specific securitization plan to the Legislature and an analysis of its estimated net financial outcome to the state. Absent this specific information, the Legislature cannot determine from a strictly financial perspective whether this proposed transaction is a good or a bad "deal" for the state.

If the Legislature confirms on the basis of that information that securitization makes financial sense and is an appropriate budget solution, there are additional issues it may wish to consider.

For example, if the Legislature deems the health programs now supported from the TSF to be an important priority, it should consider what specific steps could be taken this year to ensure that support for these programs is not disrupted when the share of tobacco settlement money diverted to debt service escalates beginning in 2003-04.

This could involve identifying alternative revenue sources or savings in state programs that, taken as a whole, would eventually be sufficient to offset the future loss of funding to the state that would result from securitization. Some revenue or expenditure reduction options considered by the Legislature might take until 2003-04 or later to realize their full impact. While such options might not be helpful in addressing the 2002-03 budget shortfall, acting on some of them now may help offset the impact of securitization on health program funding in subsequent years.

The Legislature may also wish to consider whether maintaining a separate special fund of proceeds from the tobacco settlement for the support of health programs would continue to make sense once almost half of this revenue stream is diverted to debt service for securitization bonds. One alternative approach would be to rescind the legislation creating the TSF, once again allow all future TSRs to be deposited in the General Fund, and provide future funding for those particular health programs now funded from the TSF that the Legislature deems to be its highest priority.

Settlement Fund Could Have Shortfall

The amount of tobacco settlement revenues available for support of state health programs could be significantly less than the $476 million assumed in the Governor's budget, due in part to a pending dispute over payment amounts with one tobacco company. We recommend that the state Department of Justice, which monitors implementation of the tobacco settlement, report at budget hearings on whether the state is likely to face a shortfall in the funding available for health programs.

Funding Could Come Up Short. As noted earlier, the Governor's budget proposes to spend about $476 million in 2002-03 from the TSF for health programs. This total includes about $64 million in TSF funds that the budget plan assumes would go unspent in the current fiscal year and be carried over to the budget year for the support of health programs.

However, an ongoing dispute with one tobacco company over the amount of payment it owes under the settlement could result in significantly less funds being available to the state for the support of health programs. As a result of this dispute, we are advised that a $124 million payment received by the state on December 31, 2001, was about $12 million less than anticipated. Unless this dispute is resolved, an estimated $337 million payment due in April 2002 could also be below projections and the additional TSRs anticipated in the budget year could also be overstated, according to DOJ.

Analyst's Recommendation. The situation discussed above is unlikely to have any immediate effect on state health programs because $64 million was expected to be left unspent in the current fiscal year. However, if such shortfalls were to persist, they could complicate decision-making on the budget by potentially reducing the funding available in the budget year for the support of health programs by as much as several tens of millions of dollars. Accordingly, we recommend that DOJ report at the time of budget hearings on TSRs and the related dispute over such payments, so that the Legislature can better assess the amount of funds that will be available for support of health programs in the budget year.

List of TSF-Supported Programs Would Change

The budget makes significant changes in the line-up of health programs that would receive support from the Tobacco Settlement Fund (TSF). The Legislature should consider whether the programs selected to receive dedicated funding from the TSF are in-line with its own health program priorities and how the line-up of programs it chooses to support from TSF would fit with the funding available from this revenue source in future years.

Although the amount of money allocated from the TSF for health programs under the Governor's budget for 2002-03 is about the same as the level of funding initially authorized in the 2001-02 Budget Act, the Governor's budget plan would significantly change the way TSF resources would be allocated in the budget year. These proposed changes in TSF allocations are summarized in Figure 1.

This revised TSF spending plan primarily reflects the Governor's initial proposal to delay expansion of the Healthy Families Program to parents. (As discussed further in our analysis of the "Healthy Families Program" later in this chapter, the Governor has since indicated his intention to revise his budget plan to enable the program expansion to proceed in the budget year with a yet-unspecified source of state funding.) This expansion in program eligibility had been funded entirely with TSF resources in the 2001-02 Budget Act, but would not be funded from any sources in 2002-03 under the Governor's January proposal. The spending plan would shift the ongoing Healthy Families Program for children from the General Fund entirely to the TSF, except for state operations costs.

Other health programs are also affected by the Governor's proposal. For example, support for the expansion of Medi-Cal Program coverage for aged, blind, and disabled with incomes below 133 percent of the federal poverty level would shift from the TSF to the General Fund, although this change in funding source would have no direct programmatic effect on this expansion in coverage.

The Governor's budget also proposes to strike all TSF resources in the budget year from the Child Health and Disability Prevention program (CHDP), in keeping with the Governor's 2002-03 budget proposal to eliminate the program and shift its caseload to Medi-Cal, Healthy Families, and the Expanded Access to Primary Care (EAPC) community clinic program. The Governor proposes to fund a $17.5 million augmentation to EAPC to handle this increased caseload from the TSF. 

The administration's spending plan would augment base funding for youth antitobacco programs by $20 million in the budget year, increase the budget-year allocation of TSF to the Breast and Cervical Cancer program by about $13 million in accordance with the caseload growth projected for that program, and replace $1.7 million in General Fund support for the Access for Infants and Mothers Program with TSF.

Fitting Programs to Funds a Future Problem. As it considers which programs to finance with TSRs in 2002-03, it should also consider how this program line-up would fit with the funding that would be available from this revenue source in future years. Our analysis indicates that the TSF program line-up proposed by the Governor would significantly exceed the TSRs available in 2003-04 and subsequent years. That is due to three factors:

• The increase from $62 million in 2002-03 to $190 million in 2003-04 (and thereafter) in the annual debt-service payments resulting from securitization.
• The fact that the 2003-04 TSF spending plan would not include the carryover of any unspent funds from the prior year. The 2002-03 budget plan proposes to spend all of the $64 million projected to be carried over from 2001-02 and sets no funding aside in reserve for future needs.
• Significant caseload and cost increases expected in the Healthy Families Program for children, which the Governor proposed to shift to support from TSF in the budget year. We estimate that the cost of this caseload would grow by as much as $90 million in 2003-04, and continue to have cost increases in the range of tens of millions of dollars annually in subsequent years.

Taking into account the combination of these three factors, we estimate a gap of about $340 million in 2003-04 between the projected cost of these TSF-supported programs and the TSRs actually available to pay for them. We estimate that this gap would grow to about $450 million annually by 2006-07.

Analyst's Recommendation. We discuss the Governor's proposals relating to youth antitobacco programs, CHDP, and EAPC in the "Public Health" section of this chapter of the Analysis. Our review of issues related to the Healthy Families Program can be found in the section of our analysis of "Major Risk Medical Insurance Board" programs, which can also be found in this chapter.

The TSF spending plan proposed by the Governor reflects the administration's priorities for future health funding. Once the Legislature has determined which health programs it wishes to fund, and the level of support for these programs that it deems to be appropriate, it should carefully consider which health programs it wishes to fund from the TSF. The Legislature should also consider how the line-up of programs it chooses to support from the TSF would fit with the funding that would actually be available from this revenue source in future years.