Even when taxpayers aren’t explicitly on the hook, tobacco bonds can cost states and local governments money. Here’s how.

We recently wrote about the hidden cost of tobacco bonds—debts issued by states and other governments in the years following a historic 1998 legal settlement with Big Tobacco. That settlement required tobacco companies to pay billions in perpetuity to reimburse states for the health care costs of smoking.

Rather than wait and collect over time, many states used tobacco bonds to get their money in a lump sum, kind of like cashing in lottery winnings for a one-time payment. But in doing so, some issued what are called capital appreciation bonds, or CABs. These special securities are costlier and obligate governments to huge balloon payments years down the road.

As our story reported, the CABs are now likely to default. And that could force governments to pony up even more of their future tobacco windfall to investors—money that could otherwise benefit taxpayers.

How did it all happen? Here are answers to some basic questions:

Cigarette sales are plummeting nearly twice as fast as predicted when the CABs were sold. That leaves less money to repay—let alone prepay—the debt piling up on CABs.

What is the tobacco settlement?

It is a hard-fought agreement to get cigarette manufacturers to pay their share of the medical costs for treating smokers. Thus far, 46 states, five territories, and the District of Columbia have received about $101 billion under the settlement. This year, the total payout was nearly $6 billion.

When does the cash run out?

Never. As long as people smoke, tobacco companies must keep wiring money to states. Payments are tied to cigarette sales. If more people smoke, more money rolls in. Fewer smokers means smaller payments—a big reason tobacco bonds are in trouble right now.

Why not just sit back and collect billions forever?

Everyone expected smoking to decline—and thus the payments. So some government officials said it would make sense to get their money right away. By trading future tobacco income for immediate cash, they wouldn't have to worry about the risk of payments dropping later. Many state and local governments needed the money to balance budgets, too, making it convenient to cash in sooner.

Is this where the bonds come in?

Exactly. Bonds are like a loan. Investors buy them from states, providing up-front cash. States then promise to repay bondholders with their tobacco money, which is used to pay interest each year, usually for 30 years or less, and pay down the up-front principal. Once the debt is repaid, the tobacco money flows back to the states, or other local governments that did similar deals.

OK. So why are CABs different?

They are a special kind of bond that does not pay out interest every year. Instead, the interest builds up on the amount borrowed and gets added to the total owed—a process called compounding—until the whole tab comes due, often in 40 years or more. Plus, to compensate investors for the extra risk of investing for so long, the CABs typically pay higher interest. This is how several million borrowed can snowball into billions of dollars owed.

Why would anyone do that?

CABs allowed the governments to get a little more cash up-front—three cents on the dollar here, five cents on the dollar there—without having to pay interest until many years in the future. By then, their regular interest-paying tobacco bonds presumably would be paid off, freeing up settlement money to cover the CABs.

What did state and local governments get for the CABs?

Relatively little. ProPublica identified about $3 billion raised from investors who bought CABs backed by the 1998 tobacco settlement. That's less than 10 percent of the estimated $36 billion in all tobacco bonds that are still outstanding. All of the CAB debt was sold before the financial crisis, from 2005 to 2008.

What did they promise to repay?

Collectively, $64 billion. That's about 21 times the amount borrowed. But if extra money rolls in under the settlement, bond documents say the states will try to make "turbo" payments to pay down the debt faster. Were all the CABs repaid using turbos, ProPublica estimates the cost at about five times the amount borrowed. That's less than 21 times but still a lot more than the more typical three times repayment for a regular interest-paying bond.

Are taxpayers liable?

Not in most cases. California and New York sold some tobacco bonds that included pledges to use taxpayer dollars if needed to pay bondholders in case of a shortfall. But the vast majority of tobacco bonds sold—including all the CABs identified by ProPublica—are not backed by such pledges. Instead, the money is supposed to come from the tobacco settlement only and bondholders have no rights—called "no recourse" in the trade—to taxes or other revenues. But they keep rights to future tobacco income and can put pressure on government officials to put more money into the deals.

So what's the problem with CABs?

Cigarette sales are plummeting nearly twice as fast as predicted when the CABs were sold. That leaves less money to repay—let alone prepay—the debt piling up on CABs. Thus, while analysts have been warning that tobacco bonds in general face increasing risks of default, the CABs in particular are almost certain to default, and in very large volume.

What happens in a default?

The CABs don't go away. Instead, they keep earning interest, and sometimes, penalty interest rates kick in. If a state or local government's other tobacco bonds are paid off and settlement money becomes available, CAB investors can collect until they are made whole. That can take years, decades, or longer.

How does default affect taxpayers?

Many states turned only a portion of their tobacco payments into bonds, with the remainder flowing directly into their treasuries. Using some of that money to shore up the CABs means states could have to cut programs or find more revenue to make up the difference. Taxpayers also miss out on the benefits of tobacco money that's diverted to pay off CABs in default. It can add up to big bucks: Last year, bankers warned New Jersey that the state has a "very real economic interest" in avoiding default on its CABs because taxpayers would lose out on $1.6 billion in future tobacco money. To avoid that, New Jersey grabbed seven years' worth of unobligated future tobacco money—$406 million—and promised to use it to pay off the CABs early. In exchange, the state got another $92 million in up-front cash from the CABs' investors. Rhode Island planned a similar deal to buy out some CAB owners and shave $700 million off a $2.8 billion tab due in 2052. A bondholder lawsuit put that deal on hold.

This post originally appeared on ProPublica as “Q&A: The Hidden Costs of Tobacco Debt” and is republished here under a Creative Commons license.