'Foreclosure Bonds' Coming?

While the recently unveiled foreclosure settlement is widely touted as a $26 billion agreement, the deal comes out to closer to $40 billion, according to SNL Research, of which states stand to collect $4.25 billion.

However, the settlement is so flexible that states like Missouri and Wisconsin are using their settlement bucks to paper over big holes in their state budgets, and not help homeowners, reports CNN.

That's exactly what happened in the historic tobacco settlement between four tobacco companies and 46 states in 1998. But there’s another danger, too — that to raise much-needed money, cash-strapped states could issue what some bank officials euphemistically dub “foreclosure” bonds built on this newfound cash, just as states quickly issued a type of municipal bond called tobacco bonds built on the historic $206 billion tobacco settlement in 1998—and then spent the money on other things, bank officials who asked to remain anonymous tell FOX Business.

The tobacco deal was so lax that 41 out of the 46 states spent their money on all sorts of budget items, and failed to meet the Centers for Disease Control and Prevention's standard that up to 25% of their tobacco settlement ought to be spent to fight tobacco use, says the Campaign for Tobacco-Free Kids.

As we told you last October, the states can get their money and then distribute the settlement funds to help borrowers with foreclosure relief or spend it on other housing programs, like credit counseling or legal aid.

The key here is, will the banks pony up all of this money, and when?

Under the new foreclosure settlement, the banks get to take as long as nine months to figure out who is eligible for relief and, another three years to distribute the aid, says a bank researcher.

According to details of the settlement, it’s unclear if the banks could delay those payments even further, says another bank official who asked to remain anonymous. Moreover, one of the five companies in the settlement, Ally Financial, the old GMAC, still owes U.S. taxpayers $17.2 billion in bailout money, and has been struggling to go public again after it nearly collapsed.

Market history shows states should be wary of issuing “foreclosure” bonds.

States were supposed to use $206 billion in tobacco settlement money coming in their doors over 25 years to treat sick smokers. A number of states, however -- like California, New York, Alabama, South Carolina, and Ohio -- issued tobacco bonds to plug budget deficits.

What they did was yank forward, in one lump sum, the present value of their future tobacco settlement payments. They did so by selling bonds, some with yields as high as 8%. In so doing, they front-loaded their tobacco money into their budgets. Within a decade, it became clear these tobacco bonds should have come with their own health warnings.

The tobacco bonds typically were backed only by these settlement payments and not by any state guarantee. Moreover, the tobacco bonds were floated on the backs of smokers, whose smoking habits fueled profits at tobacco companies.

But smoking plunged more rapidly than the 2% annual declines the states had anticipated when they sold these tobacco bonds. Smoking dropped, ironically, because of government restrictions on smoking, as well as higher federal and state cigarette taxes.

Smoking actually declined 9% in 2009, and 6% in 2010, to an estimated 304 billion cigarettes sold, well off the 441 billion sold in 1999, industry estimates show.

In the fall of 2010, weighing heavily on the muni bond markets were the year-end expiration of the federal stimulus program called the “Build America Bonds” program, plus imperiled budgets in California and Illinois.

Then, suddenly, S&P’s dramatic downgrade of state tobacco bonds sent the muni bond markets into a tailspin.

The markets were closed Veteran’s Day 2010, but on that day S&P downgraded huge slugs of state "tobacco bonds" to junk status.  When the market reopened that Nov. 12, 2010, the states woke up to the bayonets of the bond markets.

A huge dump of these “tobacco” bonds occurred, triggering a nasty whipsaw cycle of selling and redemptions by mutual-funds (whose offering documents generally don’t allow junk bond holdings), as well as hedge funds, and other investors.

So, here we have federal and state officials touting a $26 billion foreclosure settlement with five of the nation’s biggest banks to settle charges of improper foreclosures stemming from alleged robosigning, among other things. (That sum rises to $40 billion due to other relief measures like loan modifications, says SNL Research.)

Banks must spend about $17 billion on a variety of programs to help beleaguered borrowers. In addition, the deal includes $3 billion dedicated to refinancing loans and $5 billion to be paid to federal and state governments, says SNL.

California will receive up to $18 billion, “a large proportion of the overall settlement.

“Trouble is, will they actually get the money, and when given how shaky the banks still are?” asks a bank official.