Swap Market Update The PFM Group

2 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

3 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

4 Ratio of Municipal to LIBOR Swap Rates Rose During Credit Crisis Tax-exempt (SIFMA)/LIBOR swap ratio fell sharply after spiking in Q but has crept back up – Renewed credit fears have caused municipal yields to rise relative to more liquid LIBOR swap rates

5 Barclays Bank PLCAa1AA as of 06/26/2008 Major Municipal Swap Providers as of 07/13/2010 Long-Term Debt/Counterparty Ratings Financial InstitutionMoodysS&PFitch Bankof AmericaAa3A+ Bankof New YorkAaaAA - CitibankA1A+ Deutsche BankAa3A+AA- DexiaBankA1AA+ Goldman Sachs Capital MarketsA1AA+ J.P. Morgan ChaseAa1AA- - Lehman Brothers Special FinancingA1AA+ Merrill Lynch Capital ServicesA2AA+ Morgan Stanley CapitalServicesA2AA Royal Bankof Canada(RBC Dain Rauscher)AaaAA- Sumitomo Bank Capital MarketsAa2A+A Wachovia BankAa2AAAA- Wells Fargo BankAa2AAAA- Barclays Bank PLCAa3AA-

Risk Management

7 For the past twenty years, there has been at least one significant market break nearly every other year – 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?

8 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.

9 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 VRDOs – 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)

10 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 issuers 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 $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 (cont)