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IPED Boston Conference The Municipal Auction Market Dislocation April 2008 Matthew Pearson (212) 762-8274.

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Presentation on theme: "IPED Boston Conference The Municipal Auction Market Dislocation April 2008 Matthew Pearson (212) 762-8274."— Presentation transcript:

1 IPED Boston Conference The Municipal Auction Market Dislocation April 2008 Matthew Pearson (212)

2 IPED Table of Contents Section 1 Recent Market Events Section 2 Historical Trends Section 3 Refinancing Alternatives Appendix A Disclaimer

3 IPED Section 1 Recent Market Events

4 IPED Municipal Market Summary of Recent Impacts 1 Recent Market Events Potential Further Results? Higher long-term rates – Refinancing of $250 – $300 billion will cause municipal yields to rise to attract investors to absorb supply Wider credit spreads – As investors have more alternatives for investments, they will extract wider spreads Flatter yield curve –Will flatten dramatically, except for money market eligible instruments, due to the inflow of puts into the market Catalyst Monoline bond insurers perceived inability to pay future claims jeopardized by subprime related exposures Results Widespread ARS failures, with broker-dealers unable to commit enough capital to support an orderly market Issuers implementing solutions, from LOC-backed VRDBs, to put bonds, to long-term fixed rate Reaction Investors exit insured municipal short-term products, particularly auction rate securities and insured variable rate demand securities Intense selling pressure in insured VRDB market sends yields high and further threatens liquidity markets The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

5 IPEDRecent Market Events The Catalyst Municipal Monoline Bond Insurers The municipal market has been severely impacted by the credit deterioration of most monoline bond insurers –Primarily due to guarantees provided on subprime-related securities As rating actions continue with respect to the monolines, the municipal market will continue to remain volatile Notes 1.Watchlist – Review for Possible Downgrade for Moodys, CreditWatch Negative for Standard & Poors and Ratings Watch Negative for Fitch means that there is at least a 50% probability that a rating change will occur within 90 days. Developing indicates a possible positive or negative outcome. Management has the opportunity to address concerns, but rectification actions usually must be executed within 90 days. 2.Outlook typically means that within the next 18 to 36 months a rating change can occur, the urgency is not as severe as the Watchlist or comparable designation, although the rating agencies reserve the right to act sooner. Source Fitch Ratings, Moodys Investors Service, Standard & Poors Watchlist/CreditWatch/Ratings Watch for possible downgrade Negative Outlook Watchlist/CreditWatch/Ratings Watch developing 2 The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

6 IPED Size of the Problem and Investor Reaction 3 Recent Market Events Auction Rate Market: Approximately $300 billion (About $200 billion in the tax-exempt and $100 billion in the taxable sectors) Most of this market is likely to be refinanced due to the following factors: –ARS are clearly not the cash equivalent money market instrument they were considered, because there is no hard put –Investors can no longer rely on the auction rate process for liquidity (trapped cash) –A new class of investors needs to emerge –A very small subset of the ARS market may survive as a long-dated floating rate instrument – Rates would likely move toward intermediate rates, not the current short-term / cash equivalent rates Variable Rate Demand Bond Market: $300 - $400 billion 23% of VRDB market is insured (approximately $81 billion) –Only 5% of the insured VRDBs are insured by FSA ($4 billion) and a significant portion of the remaining $77 billion is likely to be refinanced Liquidity documents typically specify immediate termination upon insurer insolvency and sometimes upon downgrade Significant increase in remarketing risk and puts is being caused by: –Fear of insurer deterioration in claims paying resources and further downgrades –Fear of liquidity term out provisions that force issuers to amortize loan in 5 years VRDB Market ($ Billion) ARNs Issuance Volume ($ Billion) VRDBs Issuance Volume ($ Billion) The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

7 IPEDRecent Market Events Series 2005C Auctions as Spread to SIFMA 4 Series 2005C 7-day Auctions as Spread to SIFMA The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

8 IPED Borrower Reaction 5 Recent Market Events Current high rates in the ARS market are forcing the majority of borrowers to act quickly to refinance out of that market; many borrowers in the insured VRDB market are facing similar situations Rush to the LOC market, despite higher prices and limited capacity –Programs that rely on interest rate swap hedges and asset-liability matching are most impacted by converting to fixed rate debt Due to the size of the problem, the LOC market can only absorb a fraction of the bonds that need to be refinanced; therefore a large majority of borrowers will be forced to access the fixed rate or put bond markets –Put bond market allows issuers to stabilize programs temporarily and provides optionality in the future We expect monthly supply to increase to approximately $50 billion over the next quarter Borrowers are reacting to severely higher auction rates and VRDB rates by defeasing debt, changing modes (short and long), refinancing with LOC-backed VRDBs, refinancing with put bonds and fixed rate debt The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Historical and Projected Long-Term Issuance $Billion

9 IPED Municipal Market Implications Results / Potential Results 6 Recent Market Events As the markets absorb $250 to $300 billion in the coming months, the curve is likely to flatten and yields are likely to increase –Long-term fixed rate yields are likely to rise by basis points –The benefit of put bonds versus long term bonds is likely to decrease substantially as the yield curve flattens As the market moves from borrower driven to investor driven, volatility, particularly toward higher yields rapidly at times, may cause financing delays and temporary disruptions in the marketplace Retail investor demand will increase as rates increase, although a fair amount of tax exempt capital is trapped in the failed auction rate sector Currently, Total Return Buyers (TOB) investors are likely to be sellers as cash bonds under-perform hedges In the initial phase, bond funds are likely to see redemptions as their net asset values decrease with rising rates New relative value investors will emerge (retail and institutional) –Catalyst for new investors will be price –MMD yield curve will be less relevant; it will be about funding, likely at wider MMD spreads U.S. Municipal Market Issuance $Bn Potential VR Refundings $Bn The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

10 IPED Section 2 Historical Trends

11 IPEDHistorical Trends 30-Year MMD vs. 30-Year UST Municipals are significantly underperforming Treasuries with long-term tax-exempt bonds as much as 60 bps higher in yield 7 30Y MMD vs. 30Y UST Since 1990 The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

12 IPEDHistorical Trends Municipal and UST Yield Curves Have Dislocated 8 MMD Yield Curve Shifts U.S. Treasury Curve Shift +84 bps The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. -45 bps

13 IPEDHistorical Trends Short-term Rates: SIFMA vs. 1M LIBOR SIFMA is now 81.7% of 1M LIBOR From August 2007, SIFMA averaged 70% of LIBOR 9 SIFMA vs. 1M LIBOR 2.21% 2.70% The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

14 IPED Section 3 Refinancing Alternatives

15 IPEDRefinancing Alternatives Need For Public Rating 10 Credit is becoming more important and investors are looking through bond insurance at underlying ratings in making investment decisions – even for the bonds insured by the two strongest bond insurers, FSA and Assured Guaranty Any refinancing scenario of existing auction rate securities will require underlying ratings Obtaining underlying ratings also important for investor relations –Existing fixed rate bondholders are holding illiquid securities; with the market assigning no value to the bond insurance on existing fixed rate bonds, investors cannot buy and sell the Universitys bonds at a fair price since there are no underlying ratings to guide valuation The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information.

16 IPEDRefinancing Alternatives Synthetic Fixed Rate Debt 11 The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Typical situation today Since many synthetic fixed rates were set ~3.50%, current mark to market values are negative from borrowers perspective Current market swap rate is closer to 2.90% Mechanics BorrowerMorgan Stanley Auction Rate Bond Holders Fixed Rate Payments Variable Rate Receipts

17 IPEDRefinancing Alternatives Refinancing Considerations Compelling arguments can be made for all three refinancing alternatives: variable rate demand bonds, put bonds and fixed rate bonds 12 The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Case for Variable Rate Demand Bonds –Fixed rates are unusually high compared to taxable debt due to near-term heavy supply from conversions (currently at a 5-year high) –LOC-backed variable rate demand bonds are currently performing well in the market –Risks can be managed; fixed rate conversion or letter of credit substitution always an option –In 6 months, fixed rates could come down after the market absorbs the supply –Better match for existing synthetic fixed rate swaps Case for Put Bonds and/or Fixed Rate Bonds –Eliminates interest rate, credit, tax, LOC renewal and other risks –Bonds can always be refinanced with variable rate debt in the future –Can be executed faster and at a lower cost compared to variable rate demand bonds

18 IPEDRefinancing Alternatives Alternative 1: Replace ARNs with VRDBs Maintains Current Floating Rate Exposure 13 Pros LOC Backed VRDB Refunding Maintains Universitys current floating rate exposure Potentially lowest cost of funds Assuming existing swap stays in place and SIFMA/LIBOR relationships return to more historical levels additional savings can be achieved University can execute SIFMA swap to achieve a fixed rate lower than fixed rate bonds; SIFMA swap (unlike LIBOR swap) would also eliminate tax and basis risk – credit and LOC renewal risk would remain Cons LOC Backed VRDB Refunding Significant uncertainty remains in the tax- exempt variable rate market Banks may come under significant pressure as balance sheet is required to support draws on liquidity facilities – a weakening in bank credit quality could significantly impact spreads to SIFMA LOC costs and availability not locked-in to maturity – must be renewed periodically creating additional ongoing risk The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Typically, variable rate demand bonds require the borrower to obtain a letter of credit, which provides both credit enhancement and liquidity for any un- remarketed puts In order to obtain a letter of credit, the borrower must refund the auction rate notes Refunding required because banks and bond insurers have been unable to negotiate inter-creditor agreements that satisfies perceived regulatory concerns and the need of each party to have sufficient control rights in the event of a default

19 IPEDRefinancing Alternatives Alternative 2: Convert to Put Bonds Provides Fixed Rate Financing in Short-Term But Maintains Long-Term Floating Rate Exposure 14 Pros Conversion to Put Bonds Eliminates near-term market/credit risk by fixing out debt for 1-5 years or longer Maintains long-term floating rate exposure Can swap back to floating Can do conversion under existing documents avoiding need to refund bonds Cons Conversion to Put Bonds Limited market for put bonds – costs expected to increase as market becomes saturated Hard put would have greater market acceptance but would require St. Johns to obtain liquidity near the put date Soft put would not require liquidity but would result in investors receiving the maximum rate (e.g. 15%) in the event of a failed remarketing on the tender date; a failed remarketing would constitute an event of default The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Put bonds could be executed as a conversion, which would keep the existing bond insurance policy in place – and enable quicker execution and less costs compared to refunding Although bond insurance would remain in place, bond pricing would be based on borrowers underlying ratings

20 IPEDRefinancing Alternatives Alternative 3: Convert to Fixed To Maturity Eliminates interest rate risk and reduces floating rate exposure 15 Pros Conversion to Fixed Rate Eliminates future risk (interest rate, credit, bond insurer, etc.) Can do conversion under existing documents avoiding need to refund bonds Can access the swap market to convert to a floating rate Can always call the bonds and refinance in the future Cons Conversion to Fixed Rate Historically highest cost Current rates at 5-year highs due to heavy supply technicals rather than historical taxable / tax-exempt relationships The information herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer of securities, instruments or transactions will conform to the terms hereof. Please refer to the important information, qualifications and general risk factors in the final Appendix when reviewing this information. Similar to put bonds, fixed rate bonds could be executed as a conversion, which would keep the existing bond insurance policy in place Bond pricing would be based on borrowers underlying ratings Decision to convert to fixed much more difficult than it was just one month ago –Rates are 45 bps higher

21 IPED Appendix A Disclaimer

22 IPEDDisclaimer 16 This material was prepared by sales, trading or other non-research personnel of one of the following: Morgan Stanley & Co. Incorporated, Morgan Stanley & Co. International Limited, Morgan Stanley Japan Limited and/or Morgan Stanley Dean Witter Asia Limited (together with their affiliates, hereinafter Morgan Stanley). This material was not produced by a Morgan Stanley research analyst, although it may refer to a Morgan Stanley research analyst or research report. Unless otherwise indicated, these views (if any) are the authors and may differ from those of the Morgan Stanley fixed income or equity research department or others in the firm. This material was prepared by or in conjunction with Morgan Stanley trading desks that may deal as principal in or own or act as market maker or liquidity provider for the securities/instruments (or related derivatives) mentioned herein. The trading desk may have accumulated a position in the subject securities/instruments based on the information contained herein. Trading desk materials are not independent of the proprietary interests of Morgan Stanley, which may conflict with your interests. Morgan Stanley may also perform or seek to perform investment banking services for the issuers of the securities and instruments mentioned herein. This material has been prepared for information purposes only and is not a solicitation of any offer to buy or sell any security/instrument or to participate in any trading strategy. Any such offer would be made only after a prospective participant had completed its own independent investigation of the securities, instruments or transactions and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley has no obligation to continue to publish on the securities/instruments mentioned herein. Any securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction. The securities/instruments discussed in this material may not be suitable for all investors. This material has been prepared and issued by Morgan Stanley for distribution to market professionals and institutional investor clients only. Other recipients should seek independent financial advice prior to making any investment decision based on this material. This material does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. Prior to entering into any proposed transaction, recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks and merits, as well as the legal, tax, regulatory and accounting characteristics and consequences, of the transaction. You should consider this material as only a single factor in making an investment decision. Options are not for everyone. 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Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of transactions in securities or other financial instruments executed by Morgan Stanley that has been compiled so as not to identify the underlying transactions of any particular customer. Disclaimer

23 IPEDDisclaimer 17 Notwithstanding anything herein to the contrary, Morgan Stanley and each recipient hereof agree that they (and their employees, representatives, and other agents) may disclose to any and all persons, without limitation of any kind from the commencement of discussions, the U.S. federal and state income tax treatment and tax structure of the transaction and all materials of any kind (including opinions or other tax analyses) that are provided to it relating to the tax treatment and tax structure. For this purpose, "tax structure" is limited to facts relevant to the U.S. federal and state income tax treatment of the transaction and does not include information relating to the identity of the parties, their affiliates, agents or advisors In the UK, this communication is directed in the UK to those persons who are market counterparties or intermediate customers (as defined in the UK Financial Services Authoritys rules). For additional information, research reports and important disclosures see https://secure.ms.com/servlet/cls. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. This material may not be sold or redistributed without the prior written consent of Morgan Stanley. Disclaimer


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