Introduction to Variable Rate Financing April 2008 Table of - - PowerPoint PPT Presentation

California Debt and Investment Advisory Commission

Introduction to Variable Rate Financing

April 2008

Presentation to:

Table of Contents

I. Alternative Short-Term Products II. Municipal Variable Rate Market Update

Alternative Short-Term Products

Why Issue Variable Rate Bonds?

Cost savings and flexibility are key considerations

Achieve Interest Rate Savings

– Move “down the yield curve” where rates traditionally are lower – May be paired with swaps for “synthetic” fixed rates lower than “natural” fixed rates – “Diversified portfolio” may have long-term advantages

Achieve “No-cost” Call Options

– Flexibility to call bonds with little notice and no call premium – Take advantage of lower fixed interest rate environment in the future

Asset-Liability Management

– Natural hedge against investment risk – May hedge certain cyclical enterprise revenue characteristics

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Alternative Short-term & Variable Rate Instruments

Commercial Paper Bond Anticipation Notes Variable Rate Demand Bonds/Notes Put Bonds Index Bonds Auction Rate Securities

A variety of structures exist to meet a range of issuer needs

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Structures Differ by Terms & Re-pricing Mechanisms

Commercial Paper/BANs – Most common use is to facilitate low-cost, early financing

• f multiple-phase projects; often “taken out” with long-term bonds. CP typically requires

liquidity and/or credit support, BANs may not.

Variable Rate Demand Bonds/Notes – Can be re-marketed in daily, weekly or other

reset modes, and may be put-back to issuer on periodic basis by investor; can be left

• utstanding to maturity or called with little notice. Require outside liquidity support to

ensure timely payment to investors. Also may have bank or insurer credit enhancement.

Put Bonds – Are fixed-rate bonds with a date-certain upon which the borrower my

require the investor to “put them back” to borrower, and are priced to the yield at the put date; mechanisms for future rate reset are specified in advance for case where borrower does not redeem on put date. Investor carries remarketing risk.

Index Bonds – Periodic repricing is based on an index, so no liquidity facility or

remarketing agent involved; have no put option by investor, but are callable by issuer. When using with swaps for synthetic fixed rate, can eliminate basis risk.

Auction Rate Securities – Periodic repricing is done via auction, with no resulting need

for outside liquidity support; can be left outstanding to maturity or called on short notice – recent market dislocation is curtailing market for ARS.

Structures have trade-offs between flexibility and interest rate risk

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Profile of Variable Rate and Short-term Investors

Corporations Money Market Funds Trust Funds, Insurance Companies

Tier 4 Retail investors represent approximately 3% of the total short-term market. Commercial banks, trust funds, and insurance companies represent approximately 5% of the total short-term market. Corporations also may be significant investors in short-term notes, representing as much as 16%

• f the total market. However, they

typically are “crossover” buyers and enter the market only when yields are attractive as an alternative to taxable investments. Money Market Funds are the largest and most consistent investors in the short-term market, representing approximately 76% of the total market. Tier 3 Tier 2 Tier 1

Retail

Money market funds dominate the market for these instruments

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National Tax-Exempt Money Funds Net Assets Variable Rate as a Percentage of All New Issues

$0 $100 $200 $300 $400 $500 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 ( in B illio ns) Tax-Exempt Net Assets $0 $100 $200 $300 $400 $500 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Billions

Variable Rate Fixed Rate

Averages (1993-2007) Fixed Rate $232.8 billion VRDBs $55.5 billion VRDBs as % 18.5% $155B $179B $209B $277B $215B $191B $282B $351B $376B $353B $402B $377B $418B 8.9% 14.2% 10.8% 14.6% 24.5% 12.4% 19.2% 21.9% 23.7% 26.7% 24.1% 24.4% 24.0%

$483.25 B

Past 12-month average +27% + $102.9B

$287B $160B 14.7% 13.0%

Variable Rate Bond Issuance Has Increased Over Time

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Municipal Variable Rate Market Update

BMA/SIFMA and LIBOR Rates

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 2000 2001 2002 2003 2004 2005 2006 2007 2008 Absolute Interest Rate (%) 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 120% 1m LIBOR BM A BM A as % LIBOR

Index Averages

2001 2002 2003 2004 2005 2006 2007 3/12/08

1 month LIBOR 3.84% 1.76% 1.21% 1.50% 3.36% 5.08% 5.25% 2.86% BMA/SIFMA* 2.61% 1.38% 1.01% 1.22% 2.46% 3.44% 3.63% 2.75% BMA/SIFMA as % of LIBOR 68.14% 78.55% 83.51% 81.23% 73.18% 67.66% 69.06% 96.12%

*Note: The BMA Index has been renamed the SIFMA Municipal Swap Index

Key Indices Show Variable Rate Market Performance

• The Securities Industry and Financial Markets Association Municipal Swap Index is a 7-day high-grade short-term

market index comprised of tax-exempt VRDOs.

• The Index is comprised of actual issues as participating dealers report rates. The number of issues in the Index will

vary in time as issues are called, converted, mature or are newly issued. In addition, if changes occur which violate the criteria or calculation methods, an issue will be dropped. The Index typically has 650 issues in any given week.

• The Index serves as a benchmark floating rate in swap transactions, explaining the significance of the above ratios.

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Monolines and the Making of a Credit Crunch

Insurer financial conditions have deteriorated as a result of sub-prime exposure – full extent of solutions remains unknown

Recent turmoil from mounting foreclosures and write-downs on structures tied to mortgage loans has

put pressure on the monoline insurers that have guaranteed such securities – This has resulted in notable widening of credit spreads – Even as some monolines have been actively raising capital, total need remains unknown

Approximately half of the municipal market is insured by one of the AAA monoline insurance

companies, with the future bringing significant activity to restructure insured variable rate securities – Trends may result in relatively high exposure to FSA-insured paper on part of investors (FSA insured 53% of issues in the most recent quarter)

200 400 600 800 1,000 M-07 J-07 J-07 A-07 S-07 O-07 N-07 D-07 J-08 (bps) AMBAC FSA FGIC MBIA XLCA

5-Year Credit Default Swap Spreads (Protection Cost)

Increased costs of credit default swaps for insurers reflect investor concerns regarding the insurers’ ability to meet obligations

30% 40% 50% 60% 70% 80% 90% 100% 110%

J-06 A-06 J-06 O-06 J-07 A-07 J-07 O-07 J-08

This increased spread suggests both a lack of liquidity in the municipal market as well as a flight to quality in times of uncertainty

BMA / SIFMA as a Percentage of 1-Month LIBOR 7

Market Dislocation is Focused Primarily in ARS Market

Current dislocation in the ARS market may continue in the near- and medium-term, if not longer

Short-Term Product Indices

0% 1% 2% 3% 4% 5% 6% 7/07 8/07 9/07 10/07 11/07 12/07 1/08 2/08

SIFMA (VRDO Index) Bond Buyer 1-Year Note Index 7-Day Specialty State Auction Rate Index 30-Day Commercial Paper Index

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Possible Solutions

Long-auction or “Put Bond” mode (1-3 years) Incremental amendments to liquidity facility to bypass insurer

ratings in favor of issuer ratings

Restructure to direct pay letter of credit (bond insurance provides

• bstacles)

Use Commercial Paper to “take out” insured variable rate bonds Private Placement Special “Trust” or other structured solutions Fixed Rate Refunding (may include termination of variable-to-

fixed swaps)

Issuers have pursued multiple strategies to mitigate recent problems

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Lessons Learned

Impact of bond insurer downgrades can be severe

– Lack of highest short-term ratings = no longer money market eligible

Lack of investors may lead to failed remarketing

– Investor tenders increased, as did draws on bank facilities

Consequences of “Bank Bonds”

– Rate reset at “Bank Rate” (Differing Bank Rate definitions can lead to vastly different economic results) – “Term-out” requirements can trigger significant amortization changes

Bank facility “Termination Events”

– Can be triggered by insurer downgrades – Cure periods may be important feature

Structural differences led to different impacts from the insurer crisis

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Wrap Up and Q & A

David Persselin Debt Administrator City of San Jose (408) 535-7012 David.Persselin@sanjoseca.gov

For More Information

Barbara A. Lloyd Senior Vice President Lehman Brothers (310) 481-4963 barbara.lloyd@lehman.com

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