What are tobacco bonds?

Gov. Mark Dayton's proposal to end the state shutdown and reach a new two-year budget deal includes $700 million in revenue from the sale of "tobacco bonds."

(The plan was initially proposed by GOP legislative leaders on June 30.)

That's left many people wondering what the bonds are and how the proposal would work.

What is tobacco money?

The money in question comes from a massive settlement with tobacco companies. In the 1990s, the attorneys general from nearly every state sued tobacco companies, arguing that the companies misled the public about the health risks of smoking. States argued they were left footing the bill for the high costs of treating patients who developed lung cancer and other health problems due to smoking.

Minnesota and big tobacco companies reached a settlement in 1998. Tobacco companies agreed to provide one-time payments for anti-smoking efforts and provide ongoing funding for a nonprofit group, now called ClearWay Minnesota. The group oversees funding for tobacco-related public health programs.

The tobacco companies also agreed to make annual payments in perpetuity - in other words, forever. That money goes directly into the state's general fund. There aren't any restrictions on how the money can be spent. This is the money that would be used for the tobacco bonds.

Over the next two years, Minnesota will receive about $320 million in annual payments, according to former state finance commissioner Tom Hanson, who served in Republican Gov. Tim Pawlenty's administration. The exact amounts vary based on inflation, tobacco product sales, and tobacco industry profits.

What's being proposed?

The plan would raise $700 million right now by issuing state bonds against future payments from tobacco companies.

It would work like this: Investors would buy the bonds and make money from the interest on their investment. The state would use the lump sum it receives from selling the bonds right now. The money would help close the state's projected $5 billion budget deficit.

But as the state receives the annual payments from tobacco companies, it has to pay the investors who bought the bonds. It could get expensive. The state will also have to pay interest and fees.

How much does it cost?

A fiscal analyst at the Minnesota House of Representatives crunched the numbers this week. The answer?

The deal could cost the state $500 million. That includes interest payments and other costs. So, the state gets $700 million now. But the state will have to pay $1.2 billion down the road.

Another way to look at it: The state takes $700 million in tobacco settlement money, and because of interest and fees, receives only $200 million.

The report cautions that the number could easily change. "These preliminary estimates are highly dependent on the market at the time of the sale, the state's bond rating, and the structure of the bonds," it notes.

One potential problem: If cigarette sales continue to decline, Minnesota could receive less money each year from the tobacco settlement. Inflation and industry profits could also make the number go up or down. That's one reason it's difficult to estimate what the proposal could cost the state down the road.

What does this mean for the state's bond rating?

The fiscal report points out that the state's bond rating was already downgraded this month, by Fitch Ratings, from AAA to AA+. That makes it more expensive for the state to borrow money.

A state's bond rating is based on many factors, but the recent downgrade was partly due to the state's reliance on one-time budget fixes. The letter from Fitch Ratings says:

"The downgrade reflects the state's reliance on non-recurring gap-closing measures over the course of the recession, the difficulties in reaching consensus on a plan to address the resulting large budget gap for the biennium that began on July 1, the likelihood that the final budget agreement will again include non-recurring solutions, and an increasingly contentious budgeting environment in the state in recent years."

Fitch Ratings appears to have guessed correctly about the state's budget plan.