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Rating Action:

MOODY'S ASSIGNS RATINGS OF A3 TO TOBACCO SETTLEMENT FINANCING CORPORATION, TOBACCO SETTLEMENT ASSET BACKED BONDS, SERIES 2001

20 Nov 2001
MOODY'S ASSIGNS RATINGS OF A3 TO TOBACCO SETTLEMENT FINANCING CORPORATION, TOBACCO SETTLEMENT ASSET BACKED BONDS, SERIES 2001

Approximately $23.7 Million of Debt Securities Affected.

New York, November 20, 2001 -- Moody's Investors Service assigned ratings of A3 to the $23,685,000 Tobacco Settlement Financing Corporation, Tobacco Settlement Asset-Backed Bonds, Series 2001. Nicolas Weill, vice president in the Structured Finance Group, said that the ratings are expected to be based on Moody's (a) projections of domestic tobacco consumption over the life of the transaction, (b) analysis of the material risks and (c) evaluation of the structural and legal protections.

SOURCE OF PAYMENT

The Tobacco Settlement Financing Corporation transaction involves the pledging of payments owed to the United States Virgin Islands pursuant to the Master Settlement Agreement (or the MSA). Under the MSA, which settled litigation between states and territories and the major US domestic tobacco manufacturers, the states agreed to suspend their litigation against the "Big Four" domestic tobacco companies -- Philip Morris, BAT, RJR and Loews -- in exchange for current and future payments to be made to the states based primarily upon the amount of tobacco sold in the US domestic market.

The negotiations originally involved the Big Four US tobacco companies. Additional tobacco manufacturers can join in the settlement and thereby limit their litigation exposure to the states. To date, manufacturers with over 98% of the domestic market have signed onto the MSA. Under the MSA, the manufacturers have agreed to make payments to the states based on their market share. In each case, the annual payment obligations are the individual obligations of the manufacturers and therefore no manufacturer is liable for the payment obligations of another manufacturer.

VOLUME PROJECTIONS

The most significant variable in the analysis of this transaction is the projected domestic tobacco consumption over the 30-year term of the transaction. Each annual payment due under the MSA is based on the volume of tobacco sold in the domestic market. Moody's analyzed the potential declines in consumption including those that could result from litigation, tax increases and regulatory changes. Moody's simulated several different scenarios that resulted in cumulative declines averaging approximately 75% over the life of the transaction. Based on this modeling and the structure of the transaction, Moody's believes that the bonds have a low risk of default consistent with the assigned ratings.

NONPARTICIPATING MANUFACTURERS

Moody's also considered the extent to which the structure of the tobacco industry and the MSA limit the likelihood that manufacturers who do not participate in the MSA would be able to capture a significant share of tobacco sales volume, reducing the payments to the states under the MSA. There are two primary ways in which manufacturers might not participate in the MSA: (a) the bankruptcy of a participating manufacturer and (b) the entry into the market of new manufacturers that do not join in the MSA. Each of these risks is addressed below.

Bankruptcy Risk of a Participating Manufacturer

Moody's long term unsecured ratings on the big four tobacco companies (Philip Morris Companies, Inc.: A2; R.J. Reynolds Tobacco Holdings, Inc.: Baa2, backed by a guarantee from R.J. Reynolds Tobacco Company; British American Tobacco plc: A2; and Loews Corporation: A1) reflect the bankruptcy risk facing each company for the next three to five years. These ratings reflect concerns about potential litigation risk and the likelihood that credit issues could result in the bankruptcy of one or more of these companies. Because the big four tobacco companies are the largest obligors under the MSA (manufacturing over 90% of the tobacco consumed domestically) changes in the ratings of these companies may have an impact on the ratings of bonds backed by payments under the MSA.

The biggest potential threat to the tobacco companies is the Engle class-action lawsuit initiated by a group of Florida smokers seeking damages from the tobacco manufacturers for smoking- related health problems. On July 17, 2000, Moody's confirmed the ratings of the four major tobacco companies despite a jury verdict of a $145 billion punitive damage award to the entire class of possible plaintiffs. On May 10, 2001, Moody's also confirmed the ratings and stable outlooks of the companies, following the announcement by Philip Morris and Lorillard, US tobacco subsidiary of Loews, of a court-ratified agreement between them and plaintiffs' attorney regarding bonding in the case. For these two companies only, plaintiffs' attorney has agreed not to challenge the constitutionality of a law passed by the Florida legislature capping bonds at $100 million. The confirmations and stable rating outlooks reflect the facts that (i) based on the trial structure defined by the trial court judge, the companies would not have to pay these damages before the end of a possibly decades-long process of individual trials, (ii) the companies that have not entered into an agreement with plaintiffs' attorney on bonding should be protected by caps on bonds in North Carolina and Kentucky - where substantially all of their assets are -- if the Florida bond cap was successfully challenged, and (iii) the probability of class-action decertification on appeal of Engle is high in view of federal and state jurisprudence. However, the unusual structure of Engle remains a source of significant uncertainty in future proceedings of this case. Moody's will continue to closely monitor developments in Engle. Moody's will also monitor whether the well-publicized Engle decision induces a shift in court sentiments in other cases that would be adverse to the companies.

The bankruptcy of one or more of the participating manufacturers (PMs) could result in the disruption of cash flows for a transaction backed by MSA payments because of a bankruptcy stay pursuant to either a Chapter 7 or Chapter 11 bankruptcy filing. In the event of a bankruptcy filing by one or more PMs, the bankruptcy court could stay (temporarily suspend), all payment obligations of the bankrupt. Thus, the ability of the bankrupt to make any payments pursuant to the MSA for the duration of the stay could be limited. In order to protect against this risk, this transaction contains sufficient liquidity that will build-up to meet one-year of maximum annual debt service for the bonds.

In the event of a Chapter 11 bankruptcy proceeding, Moody's believes that the MSA will likely be considered an executory contract (which is defined as a contract in which both parties have unfulfilled obligations). As an executory contract, a bankrupt PM must either accept the MSA and pay amounts due or reject it and lose the benefits provided by the MSA. If the MSA is rejected by a PM, payments to bondholders could be reduced because the market share of the bankrupt entity would no longer be included in the measure of tobacco sales used to compute the payment obligations under the MSA and would reduce the required payments by the remaining PMs.

The impact of the reduction in payments caused by a rejection of the MSA by a bankrupt PM may be limited by the reduction in market share that a PM would likely experience as it approaches bankruptcy. As a PM approaches and seeks to avoid bankruptcy, it may attempt to raise capital though the sale of one or more significant brands. It is also likely that due to liquidity constraints, a stressed PM will reduce advertising and promotional activities in support of its brands. These actions are likely to result in a reduction in the market share of the affected PM. Because the payment obligations of a PM under the MSA are based upon each PM's market share, to the extent that a manufacturer's market share declines as it approaches and enters bankruptcy, any impact on the issued bonds will be decreased.

In connection with the MSA, the United States Virgin Islands has passed a Model Statute that reduces the economic incentive for a tobacco manufacturer to sell products without acceptance of the MSA. The Model Statute requires nonparticipating manufacturers to make payments into an escrow account roughly equal to the required payments under the MSA. These funds are held by the Virgin Islands and will be used to make payments to potential plaintiffs in connection with future suits against such nonparticipating manufacturers. Virgin Islands has only passed its Model Statute in June 2001 and was among the last signatories to the MSA to pass a Model Statute. Should there be an NPM adjustment for the reference year 1999 or 2000 (basis of the 2000 and 2001 payments respectively) when Virgin Islands was one of the few entities that had no Model Statute in place, the payments made to Virgin Islands in 2001 may have to be entirely reimbursed to the tobacco companies. A special reserve fund has been set aside to cover the risk of a reimbursement of the full amount of the 2001 payments and a partial reimbursement of the 2000 payment (together with interest) to the tobacco manufacturers. To the extent the rating are then confirmed, its unused portion will be returned to the Virgin Islands after four years, which is the maximum period of time within which the tobacco manufacturers may claim a NPM adjustment.

Although there are questions as to the constitutionality of the Model Statute, at present it acts as an economic equalizer that reduces the incentive for a nonparticipating manufacturer to reject the MSA in bankruptcy. In addition, it is likely that in the context of a Chapter 11 bankruptcy proceeding, the states will use all means at their disposal to convince the bankrupt to accept the MSA. Every court, which has rendered a decision concerning challenges to the Model Statute, has found it to be constitutional and enforceable. Moody's analysis concluded that in order for the bankruptcy of a participating manufacturer to affect this transaction a series of joint events must occur: bankruptcy, retention of market share by the bankrupt, Model Statute failure, and failure of the state to take action to cause the bankrupt to affirm the MSA. In Moody's opinion, the probability of these events happening is extremely low.

New Entrants

In addition to the bankruptcy of a manufacturer, volume can escape from the MSA if a new manufacturer gains market share and chooses not to become a participating manufacturer under the MSA. Moody's believes that the MSA is a positive settlement for the tobacco industry which removed the single largest litigation risk facing the industry at a reasonable cost which was passed on to the consumer. In fact, well over 98% of the tobacco sold in the domestic market is produced by PMs. It is likely that given the benefits of the MSA and its low cost, most new market entrants will choose to become PMs. In addition, the Model Statutes remove the economic advantage for a potential non-participating manufacturer. Furthermore, even if the Model Statute is no longer in place, new entrants will have significant incentive to join the MSA and avoid potential state action against them.

STRUCTURE

The structure includes convertible capital appreciation serial bonds with fixed rated maturities of May 2008 to May 2014 and term bonds with rated maturities of May 2021, and 2031.

Convertible capital appreciation serial bonds will accrete interest up to 2007, thereafter they will pay current interest. The term bonds will receive interest and principal payments starting from 2002.

This transaction benefits from a turbo structure that uses all available cash to retire bond principal in order of maturity. The application of these funds, if available, will accelerate the repayment of outstanding principal and decrease the risk of default on the bonds. In an event of default, payment on the bonds switches from sequential pay to pro-rata pay based on outstanding bond principal amounts.

Since there is no cash being paid to the residual holder, this transaction does not require the structural feature provided by trigger events (which result in the trapping of payments otherwise released to the holder of the residual certificate upon the occurrence of certain events).

Moody's does not currently rate the obligations of the United States Virgin Islands. Moody's assessed the risks of the Government of Virgin Islands using its police powers to disrupt the transaction for the benefit of its citizens in a case of great public calamity and found it commensurate with the assigned rating of the notes.

Based on the statistical modeling, the structural integrity of the transaction, and the credit analysis of the tobacco manufacturers and the US tobacco industry, Moody's believes that the Series 2001 bonds have expected losses consistent with the assigned ratings of A3.

The complete rating action is described below:

Issuer: Tobacco Settlement Financing Corporation

$8,105,000 Convertible Capital Appreciation Serial Bonds; Rated Maturities of 2008 to 2014: A3

$7,430,000 Term Bonds; Rated Maturities of May 15, 2021: A3

$8,045,000 Term Bonds; Rated Maturities of May 15, 2031: A3

New York
Michael Kanef
Managing Director
Structured Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Nicolas S. Weill
VP - Senior Credit Officer
Structured Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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