Special District Association Lunch & Learn Market Outlook & Investment Portfolio Strategies October 9, 2013 Presented By: Glenn Scott – Senior Vice President / Portfolio Manager 1

2 Debt Crisis – U.S. Treasury Debt Statement Source: Bloomberg

3 Possible Next Acts at the Kabuki Theater 1)The Fed adjusts its Quantitative Easing (QE) to buy any security with a missed interest or principal payment. 2)The Fed sells QE Treasury assets not facing short term interest or principal payments and buys those that are not. 3)The Fed accepts any security with a missed interest or principal payment as repo collateral at 0% interest. 4)The Treasury strips off all interest payments and buys the IOs. 5)The Treasury uses receipts to prioritize debt payments. 6)The Treasury sells assets. 7)Private markets set prices for securities – the financial system is flush with liquidity and there will be lots of demand for U.S. Treasury Bills yielding north of 0.30% interest. 8)The House passes a bill raising the debt ceiling for the purpose of making interest and principal payments,

4 2a-7 Reform and LGIPs Source: Bloomberg

5 Who is Janet Yellen? Source: Bloomberg

6 5 Things to Know about Janet Yellen 1. She has pushed the Fed to use aggressive new policies to boost the economy. Ms. Yellen, who focused much of her academic research on the costs and causes of unemployment, has consistently called for the Fed to respond forcefully to high joblessness. She argues that inflation isn’t likely to emerge with the economy in such a debilitated state – a point on which so far she has been right. 2. She has a record of being concerned about excessive inflation. Her public statements and past actions show she is committed to maintaining low inflation. The Fed “is determined to ensure that we never again repeat the experience of the late 1960s and 1970s, when the Federal Reserve didn’t respond forcefully enough to rising inflation,” she said in a 2011 speech. She was a longstanding proponent of the Fed adopting a 2% inflation target, and was closely involved in the decision to do so in In 1996, while a Fed governor, Ms. Yellen debated then-Chairman Alan Greenspan over the right level of inflation, contending that too-low inflation could harm the economy just as too-high inflation could — a view that is now widely accepted at the Fed, but wasn’t then. Later that year, she urged Mr. Greenspan to raise short-term interest rates, fearing the booming economy threatened to unleash excessive inflation — advice he declined. 3. She is a good forecaster. The Fed must forecast growth, inflation and unemployment to make policy decisions. Ms. Yellen has produced the most accurate forecasts of all the current Fed officials from 2009 through 2013, a Wall Street Journal analysis found. 4. The financial crisis made her a believer in tougher financial regulations: Ms. Yellen has said that the 2008 financial crisis, which occurred when she was president of the San Francisco Fed, transformed her from a somewhat “docile” regional bank regulator to a believer that firm rules are more effective than leaving it up to regulators to react when trouble appears on the horizon. “This experience has strongly inclined me toward tougher standards and built-in rules that will kick into effect automatically when things like this happen that make tightening up a less discretionary matter,” she told the congressionally-created Financial Crisis Inquiry Commission. 5. She believes in transparency, and the markets thinks she’s a good communicator. In 2010, Mr. Bernanke asked Ms. Yellen to lead an internal communications committee that has produced several innovations in the way the central bank articulates its goals and policy plans to the public. These include so-called forward-guidance in which the Fed makes statements about the likely future course of policy, which has evolved to employ specific unemployment and inflation thresholds; the regular press conferences Mr. Bernanke holds; and a longer-run goals and strategy document released in January 2012 that laid out, for the first time, the rates of inflation and joblessness the Fed finds to be consistent with its mandate from Congress.

7 Fed’s Monetary Policy – Affects of Tapering Tapering or ratcheting – What we should expect going forward

8 S&P / Case Schiller – Year over Year Change in Home Prices Source: Bloomberg

9 Labor Force Participation Rates & Nonfarm Payroll Changes Source: Bloomberg Financial

10 S&P / Case Schiller – Year over Year Change in Home Prices Source: Bloomberg Financial

11 Thinking About Risk in a Public Portfolio Source: Bloomberg

12 Primary Risks We Face Investing Public Funds CREDIT RISK- Risk that the issuer of debt is unable or unwilling to make scheduled interest or principal payments. LIQUIDITY RISK- Risk that a security may not trade as expected. INTEREST RATE RISK- The risk associated with the change in the value of fixed-income with respect to a change in interest rates.

13 Additional Risks COUNTER-PARTY RISK- Risk that the counter-party to financial transactions fails to fulfill commitments. MARKET TO MARKET & PRICE DISCOVERY RISK- The risk of deviations between actual market prices and mathematical models which determine marked to market pricing. ADMINISTRATIVE RISK- Risk that any financial transaction may result in unexpected costs of administering the investment. SYSTEMIC & GEOPOLITICAL RISK – Risk of fundamental changes that alter our comprehension of the future. TRANSACTIONAL & PRICE EXECUTION RISK – Risk associated with achieving fair market price execution complete security Identification.

14 Additional Risks OPTIONALITY RISK – Risks created by imbedded call options in bonds which manifest as negative convexity. DERIVATIVE & STRUCTURAL RISK – Risks associated with derivatives and other exotic structures. INFLATION RISK – Risk that inflation will erode the future purchase power value of principle. POLITICAL RISK - Risk that political influences will alter the public entity’s perceived value of a security. LEGAL, FRAUD & LITIGATIVE RISK – Risk that a security’s legality may be uncertain as well as risks that any financial activity may create litigation.

15 Additional Risks CONTRACT & RULE OF LAW RISK – Risk that the understood meaning of a financial obligation may be arbitrarily changed by a court. SETTLEMENT & PERFECTION OF INTEREST RISK – Risks associated with failed trades and loss of perfected interest in a security. PASS THROUGH RISK – The risk that an asset backed pass through security will repay at a speed different from that we expected. TECHNOLOGICAL RISK – Risks associated with technological advancement, that market returns become allocated based upon technological capability

16 GSE Reform CURRENTLY - Fannie Mae & Freddie Mac, formally, the Federal National Mortgage Association & the Federal Home Loan Mortgage Corporation are operating in a conservatorship under the U.S. Treasury. PATH ACT - House Financial Services Committee chairman Jeb Hensarling, R-TX, passed a bill out of his committee that substantially ends the two institutions and privatizes most of the federal role in mortgage insurance. The bill is not supported by House majority leadership and has been sent to Siberia by the Speaker. CORKER–WARNER - A bill crafted by Sens. Bob Corker, R-TN, and Mark Warner, D-VA, has strong bipartisan support in the Senate. It winds down Fannie Mae and Freddie Mac over five years, just like the Hensarling bill. But the Senate bill takes another crucial step and provides government backing for the private secondary market that is supposed to replace the Fannie and Freddie MBS market. JOHNSON-CRAPO - Senate Banking Committee chairman Tim Johnson, D-SD, and the ranking Republican Mike Crapo, R-ID, are expected to put their stamp on the Corker-Warner bill, but keep the basic features. BUDGET SCORING IMPACT - Currently, Treasury is collecting billions of dollars of dividends from Fannie and Freddie as part of their bailout agreements. Meanwhile, the Congressional Budget Office continues to count the GSEs as a loss in terms of budget scoring. But that could change later next year if CBO starts to count the dividend payments in the budget base line. Once that happens, legislators will have to come up with an offset for those dividend payments if they try to wind down and liquidate Fannie and Freddie. That would put the onus on GSE reformers to come up with provisions to raise taxes or cut spending.