1. CDIAC Workshop: February 1, 2011 Current Short Term Financing Options Richard Hiscocks Orrick, Herrington & Sutcliffe (415) 773-5416 rhiscocks@orrick.com Eileen Gallagher Stone & Youngberg (415) 445-2311 egallagher@syllc.com

2. 1 Introduction: Short Term Financing Options  What is “short-term”?  less than 120 days? within a fiscal year? 3-5 years?  a period less than the economic useful life of the asset?  For what purpose is short-term debt issued?  Cash flow financing  Provide working capital to pay operating expenses  Examples: tax and revenue anticipation notes (TRANs), working capital notes  Bridge financings  Provide interim short term financing for capital projects  Examples: bond anticipation notes (BANs), commercial paper (CP)  Permanent financings  Provide long-term project funding at short-term interest rates  Examples: variable rate demand obligations (VRDOs), floating rate notes

3. 2 Short-Term Interest Rates Tend to be Lower Illustrative Rates by Maturity 6-month:0.30% 1 year:0.46% 2 year:0.79% 5 year: 1.75% 10 year:3.44% 30 year:4.90% Source: Bloomberg.

4. 3 Short vs. Long Term Interest Rates Over Time Source: Bloomberg. RBI: Long Term Tax-Exempt Bonds Maturing in 30 Years with Average Rating of A1/A+. SIFMA: All bonds in Index must be tax-exempt, non-AMT, have $10mm or more outstanding and the highest short-term rating by Moody’s or S&P, and pay interest monthly with interest rate resets occurring on Wednesdays. Financial market panic in wake of Lehman collapse, fall 2008 Spread between short and long maturities is particularly wide in current market

5. 4 Why Issue Short-Term Debt?  Access lower short term rates  Avoid locking-in long-term rates in unfavorable market conditions  Align short term or variable revenues with short term or variable liabilities  Defer full debt service payments until project is completed  Restructure debt to postpone payments, relieve near-term financial stress  Retain variable rate debt compatible with an outstanding swap

6. 5 Who Buys Short Term Debt?  Money Market Funds  Must keep investments very short to provide liquidity to investors  Investors expect “check book” access to funds  Seek high quality credits to preserve Net Asset Value (NAV)  Investors expect $1 for $1 valuation, no principal risk  Regulations limit maturity of investments to less than 397 days  Additional limits on credit quality and concentration of portfolio  Short, Intermediate and Long Term Bond Funds  Have ability to purchase longer-dated maturities for particular funds  More flexible investment parameters  Long term fund participation in limited circumstances  Unlikely in current very low short term rate environment  Some Individual “Retail” Participation  Depends on investment goals, sophistication and means of investor  Many short-term debt issues have $100,000 denominations that limit participation

7. 6 Short Term Debt Alphabet Soup  Revenue and Grant Anticipation Notes (RANs, TRANs and GANs)  Working Capital Notes  Commercial Paper (CP)  Bond Anticipation Notes (BANs)  Auction Rate Securities (ARS)  Variable Rate Demand Notes (VRDOs)  Credit Enhancement and Liquidity (LOCs, SBPAs)  Interest Rate Derivatives (Swaps, Locks, Caps)  Floating Rate Notes (FRNs, SIFMA-Index notes, LIBOR-index notes)

8. 7 RANs, TRANs and GANs  Tax Revenue or Grant Anticipation Notes (RANs or TRANs or GANs)  Purpose: used for cash flow or capital projects  Benefit: smooth out inconsistent revenue streams like property tax receipts or grants  Risks: short term and fixed repayment require careful forecasting of future cashflow  Interest rate: fixed at time of note sale  Requirements: Government Code and federal tax requirements  Example:  City relies heavily on property tax receipts due in December and April while expenses are fairly evenly spread throughout year  With diminished reserves in current economic climate, cash flow shortfall peaks after early December payroll payment  TRAN proceeds bolster cash position in July to cover peak deficits in fall; balances are restored and funds are set aside to repay TRANs throughout winter and spring, before June TRAN maturity  Credit rating is based on predictability of revenues, accuracy of projections, expected liquidity (and alternatives) at maturity and ability to withstand less favorable results

9. 8 Deficit Borrowings  Working Capital Note (“deficit borrowing”)  Purpose: used for cash flow to address a deficit  Benefit: provides near term cash relief from cash flow pressures  Challenges: requires accelerated repayment from all free cash flow beyond a modest reserve; can be difficult to market to investors  Constraints: federal tax law limitations for tax-exempt issue  Example:  City committed cash to a capital project in expectation of reimbursement from CalTrans  Delayed reimbursements created cash flow strain on city’s operations  Working capital note provides financial breathing room  Repaying notes over 10-year horizon

10. 9 Commercial Paper  Commercial Paper (CP or TECP)  Purpose: may be used for capital projects or cash flow  Benefit: offers flexibility to create template for borrowing program and then draw down project funds as needed with streamlined approvals  Maturity: less than 270 days; a true maturity  Interest rate: set at time of CP draws  Liquidity requirements: third party (bank) liquidity or (rarely) self-liquidity  Example:  Transportation authority with large capital program  May use CP draws to fund interim, initial project funding  One large, long-term financing issued to fund balance of project and pay off CP  Credit rating based on credit quality of liquidity bank, not borrower

11. 10 Bond Anticipation Notes  Bond Anticipation Notes (BANs)  Purpose: capital projects  Benefit: can provide seed financing in advance of a planned long-term financing  Interest rate: fixed at time of note sale  Requirements: statutory and tax limits  Example:  Sales tax authorization approved by voters but revenue collections begin in 2 years  Transportation authority can issue BANs now to tap future debt capacity  BANs are repaid with long-term financing after collections begin  Credit ratings are based on expected terms of future take-out and assessment of future market access

12. 11 Variable Rate Debt: VRDOs  Variable Rate Demand Obligations (VRDOs or VRDBs)  Purpose: used for capital projects  Benefit: access rates on the short end of the yield curve, retain flexibility to pay off or restructure debt at any time  Maturity: principal amortization may be scheduled over the life of the bonds, typically 30 years, or structured as lump sum term maturity  Interest rates: variable rate may be reset daily, weekly, monthly or other periodic basis  Most debt issued is in 7-day mode  Assuming 7-day reset mode, interest payments are made on a monthly basis  Remarketing agent resets the interest rate based on market conditions on each rate reset date  Liquidity requirements: third party (bank) liquidity or (rarely) self-liquidity

13. 12 VRDO Liquidity Requirements  Liquidity is necessary for traditional VRDOs  VRDO’s generally have a “demand” feature  Investors can “put” the bonds back to the issuer/remarketing agent at each rate re-set period; this feature makes VRDOs appealing to money market funds  Necessitates a bond structure enhanced with liquidity, usually by a commercial bank  Provided for a specific time period, typically 1 to 5 years, subject to renewal  Annual fees can range from.25% to 2% (or more) of principal depending on term, credit, etc.  Standby purchase agreement (SBPA)  Provides liquidity to repay an investor who wants to liquidate his/her holdings (exercise the “put”) when another investor can’t immediately be found  Can be terminated in certain circumstances if issuer’s credit deteriorates  Direct-pay letter of credit (LOC)  Provides liquidity and credit enhancement to ensure repayment of debt service in certain circumstances  Irrevocable commitment through term of agreement

14. 13 Variable Rate Market Stress  Rating downgrades of banks and bond insurers began in late 2007  Credit enhancer’s rating and credit affects issuers’ interest rates at remarketing  Affected many VRDOs and insured ARS  Triggered termination events and “penalty” interest rates in some cases  Culminated in ARS market collapse and liquidity crisis in February 2008  Left ARS investors with no liquidity  Resulted in sharply higher rates for issuers in most cases  Many VRDOs and ARS were subsequently restructured  Some issuers retained variable rate exposure to keep interest rates low and/or to avoid termination of overlapping interest rate swap structures  Market collapse changed perception of risk  Strategic reassessment of business by liquidity providers  Many liquidity banks retreated from sector  Triggered new regulatory pressures

15. 14 Update on the Liquidity Landscape  The field of credit enhancers has declined from 15+ to less than 10 active participants  Major providers: BAML, Barclay’s, JP Morgan, Lloyd’s, US Bank, Wells Fargo  Second tier: Bank of the West, City National, Northern Trust, RBC, Scotia, Sumitomo  Capacity and saturation pressures mounting Short-term market for credit enhancement remains scarce Source: Thomson, as of 12/31/10

16. 15  New regulatory pressures  Money market reforms: greater liquidity, higher credit quality, shorter average maturities  Basel III reforms: higher capital requirements for banks => more competition, higher cost  Diminished supply at time of considerable demand for liquidity renewals  Facilities scheduled to expire (as of June 2010): $94 billion in 2011 and $45 billion in 2012  Pricing and terms  Much more challenging to secure credit approval for “weaker” credits  Pricing spiked post-crisis, has since moderated, but nowhere near pre-crisis levels Changing Liquidity Regulation and Pricing Source: SIFMA, as of June 30, 2010

17. 16 Emergence of Alternative Variable Structures  Floating Rate Notes  Benefit: can be used to create or retain variable rate debt without third-party bank liquidity  Interest rates: set at a fixed spread to variable weekly index (i.e. SIFMA or LIBOR)  Liquidity requirements: No liquidity required, essentially “ self-liquidity ”  Risks: Exposure to future short-term yields, market access and interest rate risk at maturity  Structuring considerations: amortization, put timing, call features, target investors  Fixed-Rate Notes  Benefit: accesses lower short term rates, may retain an outstanding swap  Interest rates: fixed rate based on maturity  Liquidity requirements: None, investors evaluate prospects for take-out at maturity  Risks: Issuer exposed to market access and interest rate risk at take-out Dearth of liquidity spurs development of new approaches

18. 17 Variable Rate Issuance Volume Source: Thomson Reuters. SIFMA Source for CA Issuance Data: Thomson Reuters and Ipreo. As of 12/27/2010.  California 2010 variable rate issuance down 30% from 2009  2010: 45 issues totaling $2.6 billion  2009: 57 issues totaling $3.7 billion Municipal Variable Rate Issuance 2001-2010 Outstanding Municipal Variable Rate Demand Obligations by Par 2009 Q2 through 2010 Q2 Diminished volume of issuance and outstanding variable rate debt

19. 18 Fixed Rate Note Issuance Volume Source for Charts: Thomson Reuters. Source for CA Issuance Data: Thomson Reuters and Ipreo. As of 12/27/2010. California Issuance Volume Up  11% increase in 2010 over 2009  2010: 107 issues totaling $19 billion  2009: 96 issues totaling $17.3 billion TRAN issuance  Increased in 2010 due to financial pressures  Season peaks in summer National Municipal Fixed Rate Note Issuance 2001-2010

20. 19 Strategies for Issuers of Short-Term Products  Continue to monitor cash positions and revenue trends  Developing a strategy early on for TRAN issuance helps better position issuers  Evaluate Self-Liquidity Structures  Market has proven that capacity exists for issuer-balance sheet secured obligations  Significant cost advantage for strong credits  Requires indenture flexibility for principal coming due (and put bonds)  Proven market access required for structures that are remarketed  Continue to solicit new entrants to the credit market  Fees have declined from peak, but remaining active participants face challenges  Large market participants face credit capacity with large issuers and market saturation with investors  Smaller players can only take on $50-$75mm of any given credit A B C

21. Appendices

22. 21 Short-Term Interest Rates and Fed Policy 2-Year Treasury & Fed Funds Target Rate 1 (1) Source: Federal Reserve & Bloomberg. As of 1/3/2011. Fed’s easy monetary policy keeps short-term rates near historic lows

23. 22 1-Month LIBOR : 20-Year History 1-Month LIBOR 1 (1) Source: Bloomberg. LIBOR is short for “London Inter-Bank Offered Rate”. As of 1/3/2011. Bank-to-bank borrowing rates fell to new lows in 2010

24. 23 SIFMA Index: 20-Year History Securities Industry & Financial Markets Association (SIFMA) Index 1 (1) Source: SIFMA. All bonds in Index must be tax-exempt, non-AMT, have $10mm or more outstanding and the highest short-term rating by Moody’s or S&P, and pay interest monthly with interest rate resets occurring on Wednesdays. As of 1/3/2011. Municipal variable rates remain near all-time lows

25. 24 Variable Rate Investor Demand  Exceptionally low rates  Money market returns barely cover administrative costs, if at all  Diminished investable assets  Investor panic abates  Investors withdraw funds to seek more attractive returns  Drop in money market assets  Portfolio investor preferences  Sensitive to credit quality of banks  Seek diversity of issuer and liquidity bank names, can be “full” on some names  Concerns about interest rate trends drives interest in index rate bonds  Regulatory reforms  SEC Rule 2(a)7 money market reforms  Basel III Tax-Exempt Money Market Funds Assets and Fund Flows as of 1/3/2011 Source: Bond Buyer & Investment Company Institute. As of 1/12/2011.

26. 25 Variable Rate Debt: ARS  Auction Rate Securities (ARS)  Purpose: used for capital projects  Interest rates: variable, reset through an auction based on bids of potential investors  Liquidity: did not require liquidity the way VRDOs typically do  Auction market collapsed in early 2008  No new ARS issuance since February 2008 market failure  Many ARS issues have been restructured to avoid penalty interest rates  Approximately $66.8 billion remained outstanding as of July 2010

27. 26  Interest Rate Swaps  Purpose: often used in combination with variable rate debt to limit interest rate risk, create a “synthetic” fixed interest rate  Common structure: issuer issues variable rate debt, pays fixed-rate swap rate to counterparty, receives variable rate from counterparty Interest Rate Derivatives Issuer receives variable rate Issuer pays fixed rate Issuer pays variable rate Counterparty Investors Issuer  Risks: Counterparty failure to perform, mismatch in basis of offsetting variable rate legs, liquidity renewal, termination events, etc.  Termination: Typically requires payment to terminate swap  Termination payments can benefit either issuer or counterparty depending on value  Mark-to-market values and termination costs depend on swap terms and market conditions  Interest Rate Caps, Locks, Floors  Purpose: varying tools to mitigate interest rate risk with variable rate debt

28. 27 Example: SIFMA Indexed Bonds Summary StatisticsPricing Summary  Dated Date: 5/20/2009  $104,180,000 Series A-2  Amortization: Matched to refunded ’03 bonds  Put maturity: 12 months  Call Lockout period: 6 months  Initial placement (5/2009): SIFMA +5 bps  First Remarketing (1/2010): SIFMA +0 bps  Second Remarketing (10/2010): SIFMA +0 bps  Next step: Expected to remarket 2Q 2011 Issue Date 180 Days: 11/16/09 End Tender Period Call Protection Period: Tender Period Halfway Date 7-25 days: Spread Determined 45 days: Notice of Remarketing Structure: Metropolitan Water District of Southern California Series 2009 A-2 Index Tender Bonds Six month call option provides the flexibility to determine the best time to go into the market