Swap Market Update

The PFM Group

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Credit Spreads Widened on Lehman Bankruptcy, Bailouts

• The yield difference or spread between risk-free (Treasury bills) and risky (LIBOR deposits) assets historically widens in times of financial stress

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Long-Term Tax-Exempt Yields Decoupled from Taxable Yields

• Long-term tax-exempt yields decoupled from taxable yields in the credit crisis remaining elevated as investors dumped municipal bonds for more liquid Treasurys and LIBOR swaps

• This trend reversed in 2009 as markets healed but resurfaced in recent Greek debt crisis

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Ratio of Municipal to LIBOR Swap Rates Rose During Credit Crisis

• Tax-exempt (SIFMA)/LIBOR swap ratio fell sharply after spiking in Q4 2008 but has crept back up– Renewed credit fears have caused municipal yields to rise relative to more liquid LIBOR swap rates

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Barclays Bank PLC Aa1 AA AA

Long-Term Debt/Counterparty RatingsFinancial Institution Moody’s S&P Fitch

Bank of America Aaa AA+ AABank of New York Aaa AA- AA-

Citibank Aa1 AA AADeutsche Bank Aa1 AA AA-Dexia Bank Aa1 AA AA+Goldman Sachs Capital Markets Aa3 AA- AA-J.P. Morgan Chase Aaa AA AA-Lehman Brothers Special Financing A1 A A+Merrill Lynch Capital Services A1 A A+Morgan Stanley Capital Services Aa3 A+ AA-Royal Bank of Canada (RBC Dain Rauscher) Aaa AA- AASumitomo Bank Capital Markets Aa2 A+ A+Wachovia Bank Aa1 AA- AA-Wells Fargo Bank Aaa AAA AA+

as of 06/26/2008

Major Municipal Swap Providers

as of 07/13/2010

Long- Term Debt/Counterparty RatingsFinancial Institution Moody’s S&P Fitch

Bank of America Aa3 A+ A+Bank of New York Aaa AA AA-

Citibank A1 A+ A+Deutsche Bank Aa3 A+ AA-Dexia Bank A1 A A+Goldman Sachs Capital Markets A1 A A+

J.P. Morgan Chase Aa1 AA- AA-Lehman Brothers Special Financing A1 A A+Merrill Lynch Capital Services A2 A A+Morgan Stanley Capital Services A2 A ARoyal Bank of Canada (RBC Dain Rauscher) Aaa AA- AASumitomo Bank Capital Markets Aa2 A+ AWachovia Bank Aa2 AA AA-Wells Fargo Bank Aa2 AA AA-

Risk Management

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For the past twenty years, there has been at least one significant market “break” nearly every other year.

• 1987 – Stock market crash• 1990 – Nikkei crash; high yield tumble• 1992 – European currency crisis• 1994 – Orange County/Procter & Gamble derivatives losses• 1997 – Asian crisis• 1998 – Russian/Long-Term Capital Management crisis• 1999 – Brazil crisis• 2001 – Bursting of tech bubble• 2002 – Stock market “crash”• 2008 – Sub-prime housing bubble, Lehman Bros. bankruptcy, AIG bailout• 2010 – Greek/European sovereign debt crisis?

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Key principles of risk management

• Risks should not be taken without being properly understood and managed.

• Risks should not be taken that are too large relative to overall capital.

• Risks should not be taken without proper compensation.

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Lessons of Recent Financial Crisis for Tax-Exempt Issuers

• Credit crises tend to be strongly correlated with lower rates (flight to quality)• Issuers discovered the risks of declining interest rates including….

– Potential liquidity risk of large negative swap termination values in the form of collateral posting requirements or ratings downgrade ATE under ISDA Agreement

– Extreme basis risk between swap floating index and failed ARS or insured VRDO’s– Opportunity cost due to inability to refund non-call synthetic fixed rate debt

• Counterparties will enforce their rights under the ISDA Agreement– The costs of restructuring swap contract provisions, e.g. increasing collateral

Threshold Amounts or lowering ratings downgrade trigger, in the midst of a credit crisis can be exorbitant (“like trying to buy an umbrella in a monsoon”)

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• Diversify (credit, liquidity and interest rate) risk!• Possible alternatives to gain financial flexibility in future credit constrained,

low-rate environments are:• Increase proportion of committed, term funding (traditional fixed-rate bonds,

index notes) in the capital structure• Add debt or investments that perform well when rates decline

– Callable fixed-rate bonds or callable (at issuer’s option) swaps– Fixed-receiver swaps

• Add synthetic variable-rate debt (fixed-rate bonds + fixed-receiver swap)– Eliminates LOC “rollover” (renewal ) risk

• Expand # of swap counterparties – Increases swap “credit line”, e.g. executing 3 ISDA Agreements @ $20MM collateral Threshold

Amount creates a $60MM unsecured swap credit line (versus a $20MM line with only 1 ISDA)– Reduces credit risk of a payment default by counterparty– Smaller notional per counterparty makes it easier to novate (transfer) swaps if one defaults

• Plan an “Exit Strategy” for Swaps, e.g.– Identify termination payment source, other unhedged debt or investments to allocate swaps

Lessons of Recent Financial Crisis for Tax-Exempt Issuers (con’t)