Debt Structuring Debt Essentials Accessing the Market California

Debt Structuring Debt Essentials: Accessing the Market California Debt and Investment Advisory Commission February 2, 2011 Scott Nagelson, Managing Director snagelson@jefferies. com, 415. 229. 1428

Introduction At this point, the Issuer has made several decisions: n Identified a need to borrow money n Identified a revenue stream to pay debt service n Assembled a finance team n Bond counsel/Disclosure counsel n Investment banker n Financial advisor It’s now time to STRUCTURE THE FINANCING! 1

Topics Types of Debt Obligations Sizing the Bond Issue Debt Service Structure Refunding Bonds Ratings Credit Enhancement Variable Rate Debt Managing Interest Rate Swaps 2

Types of Debt Obligations There are many types of debt that California governments issue: n General Obligation Bonds n Sales Tax Bonds n TRANs n Pension Bonds n Lease Revenue Bonds n Special Tax Bonds n Certificates of Participations n Tax Allocation Bonds n Revenue Bonds n Assessment Bonds 3

Types of Debt Obligations The type of debt being issued can directly affect the structure of the bond issue n Reserve Fund Requirement n Additional Bonds Test n Debt Service Coverage Requirements n Term n Tax Treatment n Call Features n Leased Assets 4

Sizing the Bond Issue Depending on the type of debt and the nature of the plan of finance, proceeds of the bonds may be used for a number of purposes Project or Construction Fund Refunding Escrow Capitalized Interest Fund Debt Service Reserve Fund Costs of Issuance Underwriting Discount 5

The Project Fund acquisition of the asset or construction of the project n Based on actual costs or reliable estimates n Net Funded or Gross Funded? n Gross Funded – Deposit exact amount required to pay for asset or project n Net Funded – Amount deposited plus interest earnings during the drawdown period sufficient to fund project 6

Refunding Escrow Refinance outstanding bonds n Current refunding or advance refunding n An amount of proceeds sufficient to pay principal and interest on the prior bonds is deposited into an escrow account n Escrowed funds are used to pay off the prior bonds at the call date or maturity 7

The Capitalized Interest Fund Bonds proceeds used to pay interest for a finite period of time n Interest is capitalized for a number of reasons n Until a project/asset can produce revenue n Until the issuer has beneficial use (COPs, Lease Revenue Bonds) n Until revenue is projected to be sufficient to pay debt service Project Construction Period Jan 1 Jul 1 Jan 1 2011 Bonds Issued Int Pmt Date Jul 1 2012 Int Pmt Date Jan 1 Jul 1 2013 Int Pmt Date Interest Paid From Bond Proceeds 8

The Debt Service Reserve Fund Provides additional security for investors n Found in most credits with the exception of GO Bonds and Pension Obligation Bonds n Tax Code limits the size of the Reserve Fund to the lesser of: n Maximum Annual Debt Service n 125% of Average Annual Debt Service n 10% of Par Amount n Fund is invested with earnings usually going as an offset to debt service n Debt Service Reserve Fund Surety Policy 9

Costs of Issuance Bond proceeds may be used to pay certain eligible costs n Bond Counsel and/or Disclosure Counsel Professional Services n Financial Advisor and Trustee/Paying Agent n Rating Agencies n Appraisal, Feasibility Study, Engineer’s Report n Special Tax Consultant n Title Insurance n Bond Insurance and/or Surety Bond Premium Credit Enhancement n Letter of Credit fees 10

Underwriting Discount Underwriter’s compensation and expenses n Average Takedown Components n Management Fee n Expenses Funding Method n At closing, Underwriter pays for bonds an amount less the underwriting discount $100, 000 (650, 000) $ 99, 350, 000 Par Less discount of 6. 50/$1, 000 Purchase Price n Expressed as dollars per thousand dollars of bonds (e. g. , $6. 50/$1, 000) 11

Sizing Example Net Funded Construction Fund Ammonia Springs Clean Water Authority Capitalized Interest Fund Debt Service Reserve Fund Costs of Issuance Underwriting Discount 12

Ammonia Springs Clean Water Authority Sizing Assumptions – Ammonia Springs Clean Water Authority Project Cost and Draw Schedule 4/1/2011 $ 10, 000 10/1/2011 $ 10, 000 4/1/2012 $ 10, 000 10/1/2012 $ 10, 000 $ 40, 000 Total Project Cost Bonds Dated: 1/1/2011 Final Maturity: 1/1/2041 13

Ammonia Springs Clean Water Authority Sizing Assumptions – Ammonia Springs Clean Water Authority Costs of Issuance $200, 000 Legal, FA, Trustee Ratings, Printing, Misc. Bonds Insurance 40 bps Bond Insurance Premium (Total Debt Service x. 40%) Underwriting Discount $6. 50/bond Takedown, Management Fee, Expenses 14

Ammonia Springs Clean Water Authority Sizing Assumptions – Ammonia Springs Clean Water Authority Debt Service Reserve Fund Lesser of: ü Maximum Annual Debt Service ü 125% of Average Annual Debt Service ü 10% of Par Amount Capitalized Interest Through 2 -year Construction Period 1/1/2013 15

Ammonia Springs Clean Water Authority Sizing Assumptions – Ammonia Springs Clean Water Authority Reinvestment Assumptions Fund Capitalized Interest Fund: Rate 2. 50% Earnings Go To: Construction Fund: 2. 50% Construction Fund Debt Service Reserve Fund: 5. 0% (Bond Yield) Construction Fund 16

Ammonia Springs Clean Water Authority Sizing Example – Net Funded Project Fund Sources of Funds: Par Amount: $ 46, 390, 000 Total Sources of Funds: $ 46, 390, 000 1/1/2011 Initial Deposit: $ 38, 723, 636 Project Fund Earnings $ 968, 704 Cap Interest Fund Earnings $ 112, 609 Debt Service Reserve Fund Earnings $ 195, 051 Total Project Cost $ 40, 000 Uses of Funds: Project Fund $ 38, 723, 636 Cap Interest Fund: Debt Service $ 4, 008, 591 Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: $ 46, 390, 000 17

Ammonia Springs Clean Water Authority Sizing Example – Capitalized Interest Fund Sources of Funds: Par Amount: $ 46, 390, 000 Total Sources of Funds: $ 46, 390, 000 1/1/2011 Initial Deposit: $ 4, 008, 591 7/1/11 Interest Payment ($ 1, 005, 697) 1/1/12 Interest Payment ($ 1, 005, 697) 7/1/12 Interest Payment ($ 998, 599) 1/1/13 Interest Payment ($ 998, 599) Fund Balance on 1/1/13 $ Uses of Funds: Project Fund $ 38, 723, 636 Cap Interest Fund: $ 4, 008, 591 Debt Service Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: 0 $ 46, 390, 000 18

Ammonia Springs Clean Water Authority Sizing Example – Debt Service Reserve Fund Sources of Funds: Par Amount: $ 46, 390, 000 Total Sources of Funds: $ 46, 390, 000 Uses of Funds: Project Fund $ 38, 723, 636 Cap Interest Fund: $ 4, 008, 591 Debt Service Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: Lesser of: Maximum Annual Debt Service $ 2, 795, 850 125% of Average Annual Debt Service $ 3, 491, 698 10% of Par Amount $ 4, 639, 000 $ 46, 390, 000 19

Ammonia Springs Clean Water Authority Sizing Example – Bond Insurance Premium Sources of Funds: Par Amount: $ 46, 390, 000 Total Sources of Funds: $ 46, 390, 000 Uses of Funds: Total Principal & Interest Project Fund $ 38, 723, 636 Cap Interest Fund: $ 4, 008, 591 Debt Service Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: $89, 387, 448 x. 40% Bond Insurance Premium $ 357, 550 $ 46, 390, 000 20

Ammonia Springs Clean Water Authority Sizing Example – Costs of Issuance Sources of Funds: Par Amount: Costs of Issuance: $ 46, 390, 000 Bond Counsel: $100, 000 Total Sources of Funds: $ 46, 390, 000 Financial Advisor: $ 50, 000 Uses of Funds: Trustee: $ 5, 000 Project Fund $ 38, 723, 636 Rating Agencies: $ 30, 000 Cap Interest Fund: $ 4, 008, 591 Printing: $ 7, 500 Miscellaneous: $ 7, 500 Debt Service Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: Total COI: $200, 000 $ 46, 390, 000 21

Ammonia Springs Clean Water Authority Sizing Example – Underwriting Discount Sources of Funds: Par Amount: Underwriting Discount: $ 46, 390, 000 Total Sources of Funds: $ 46, 390, 000 Uses of Funds: Project Fund $ 38, 723, 636 Cap Interest Fund: $ 4, 008, 591 Debt Service Reserve Fund: $ 2, 795, 850 Bond Insurance: $ 357, 550 COI: $ 200, 000 Underwriter’s Discount: $ 301, 535 Rounding: $ 2, 838 Total Uses of Funds: Takedown: ($3. 50/bond): $ 162, 365 Management Fee ($1. 00/bond): $ 46, 390 Expenses: ($2. 00/bond): $ 92, 780 Underwriter’s Discount ($6. 50/bond): $301, 535 $ 46, 390, 000 22

Ammonia Springs Clean Water Authority Debt Service Structure Sample Structures Current Interest vs. Deferred Interest Optional Redemption Refunding Considerations 23

Ammonia Springs Clean Water Authority Level Debt Service DSRF Implications Lesser of: Insurance Implications Bond Insurance Implications Total Principal & Interest: Maximum Annual Debt Service $ 2, 795, 850 125% of Average Annual Debt Service $ 3, 491, 698 10% of Par Amount $ 4, 630, 000 $ 89, 387, 448 x. 40% Insurance Premium $ 357, 550 24

Ammonia Springs Clean Water Authority “Wrapped” Debt Service DSRF Implications Lesser of: Insurance Implications Bond Insurance Implications Total Principal & Interest: Maximum Annual Debt Service $ 4, 469, 658 125% of Average Annual Debt Service $ 4, 144, 838 10% of Par Amount $ 4, 825, 500 $106, 107, 854 x. 40% Insurance Premium $ 424, 431 25

Ammonia Springs Clean Water Authority Short Maturity DSRFImplications DSRF Lesser of: Bond Insurance Implications Total Principal & Interest: Maximum Annual Debt Service $ 6, 041, 629 125% of Average Annual Debt Service $ 4, 144, 838 10% of Par Amount $ 4, 825, 500 $ 54, 359, 382 x. 40% Insurance Premium $ 217, 438 26

Ammonia Springs Clean Water Authority Structuring the Bonds Serial Bonds n Mature “serially” by year n Take advantage of positively sloped yield curve Term Bonds n Single coupon covering multiple years n Retired with annual Sinking Fund Payments 27

Current or Deferred Interest Bonds Current Interest Bonds n Pay interest at stated coupon n Interest typically paid every 6 months n May be sold at par, at a premium or at a discount n Investor’s yield determined by price paid for the Bond 28

Current or Deferred Interest Bonds Capital Appreciation Bonds n “Zero” coupon or deferred interest bonds n Interest accretes to maturity n Sold at a deep discount n Investor’s yield determined by price paid for the Bond 29

Other Considerations n Optional Redemption n Standard optional redemption period is 10 years n Callable bonds generally have a higher yield than non-callable bonds n Par Bonds, Original Issue Discount Bonds, and Original Issue Premium Bonds Coupon Yield Price Par Bond 5. 00% 100% Discount Bond 5. 00% 5. 10% 98% (est) Premium Bond 5. 00% 4. 90% 100. 9% (est) 30

Refunding Considerations Advance Refunding n Old Bonds are not currently subject to optional redemption n New Bond proceeds are used to fund an escrow that defeases old bonds to call date n Escrow invested in Treasury (SLGs) with maximum permitted yield equal to bond arbitrage yield n Can only advance refund one time Current Refunding n Old Bonds are currently subject to optional redemption n New Bond proceeds are used to redeem old bonds 31

Ratings and Credit Enhancement The Rating Agencies Obtaining a Rating Bond Insurance 32

Short-Term Long-Term The Rating Agencies Aaa Aa 1, Aa 2, Aa 3 A 1, A 2, A 3 Baa 1, Baa 2, Baa 3 Ba 1, Ba 2, Ba 3 AAA AA+, AAA+, A, ABBB+, BBBBB+, BB- AAA MIG-1, MIG-2, MIG-3 (Notes) SP-1+, SP-1, SP-2 (Notes) F-1+, F-1, F-2, F-3 (Notes) VMIG-1, VMIG-2, (Commercial Paper VMIG-3 (Commercial Paper and VRDBs) AA+, AAA+, A, ABBB+, BBBBB+, BB- A-1, A-2, A-3 (Commercial Paper and VRDBs) LOC and VRDBs) 33

Obtaining a Rating n A typical rating agency package might include: n 3 years of audited financial statements n Current and proposed budget n Bond Documents, including: § Trust Indentures § Lease Agreements § Installment Sale Agreements § Redevelopment Loan Agreements n Preliminary Official Statement n Special Reports n Sizing and Debt Service Schedules n Timing and Responsibility Schedule n Distribution List 34

Obtaining a Rating n It is often useful to meet with the rating analysts to: n Describe the project n Get feedback on the structure n Describe salient aspects of security n Review demographics and economics of service area n On-site or at rating agency offices 35

Bond Insurance - The Good Old Days Once upon a time, bond insurance was readily available and widely used 36

Bond Insurance - A More Limited Role n In 2008, most of the insurers lost their “AAA” ratings due to losses associated with sub-prime mortgage bond insurance n Today, only AGM is active with “AA” category ratings 37

Variable Rate Bonds Historical Interest Rates Structuring Options Pros and Cons of Alternative Structures Managing Interest Rate Swaps 38

Variable Rate vs. Fixed Rate Securities Industry and Financial Markets Association (SIFMA) Index (formerly BMA) vs. Bond Buyer Revenue Bond Index (RBI) A Ten Year History RBI 10 Year Avg = 5. 13% SIFMA 10 Year Avg = 1. 89% 39

Pros vs. Cons of Variable Rate Structures Variable Rate Fixed Rate PROS CONS n No interest rate risk n Less flexibility to refinance n Easier to budget n Historically higher cost n Less time to manage n Poor hedge for floating rate assets n Historically lower cost n Interest rates may rise n Easier to restructure/refinance n Takes more time to manage n Hedge for floating rate assets n Bank renewal and trading risk n More challenging to budget 40

Variable Rate Issuance over Time 41

Introduction to Variable Rate Structures Historically, there have been a number of ways for issuers to achieve variable rate exposure in the municipal market n Commercial Paper n Variable Rate Demand Bonds n Auction Rate Securities n Indexed Floaters n Fixed Receiver Swaps 42

Variable Rate Structuring Options Commercial Paper n Can be drawn down and paid back as needed n Outstanding CP is remarketed for a maximum of 270 days n Bank credit facility required for liquidity n Money Market Funds are the primary investor n Often used to fund construction draws and then taken out with long-term bonds n Interest rate determined by CP 43

Variable Rate Structuring Options Variable Rate Demand Bonds n Long-term bond with rate that resets periodically (daily, weekly, monthly, etc. ) n Investor can “put” bonds on short notice (allows bond to trade at par) n Bank credit facility required to support put n Interest rate determined by Remarketing Agent 44

Credit Facilities n Bank Credit capacity has been constrained since 2008 n Fewer banks with less capital has driven LOC pricing to high levels n Approximately $80 billion of bank credit facilities supporting variable rate bonds will be up for renewal in 2011 45

Variable Rate Structuring Options Indexed Floating Rate Bonds n Interest rate resets based on an index (i. e. SIFMA or LIBOR) n Rate typically based on a spread over the index (i. e. SIFMA + 50 bps) n No need for a Remarketing Agent n Investor does not have a put, so no need for a bank credit facility n Index period is typically less than 5 years. At the end of the index period, the issuer remarkets the bond for another index period or switches to a different variable rate mode 46

Variable Rate Structuring Options Auction Rate Securities n Long-term bond with rate that resets periodically (weekly, monthly, etc. ) n No “put” feature and thus, no bank facility n Rate reset via Dutch Auction process The ARS market died in 2008 with the demise of large scale bond insurance 47

Variable Rate Alternatives At-A-Glance Summary of Variable Rate Alternatives Traditional VRDBs Remarketing Agent Commercial Paper Index Floater CP Dealer Index + Fixed Spread Credit Support Yes No Rmkt Fee Yes No Rmkt Agent Risk Yes No Bank Facility Renewal Risk Yes No Roll-Over Risk No No Maybe Term Out Yes Maybe Callability High Moderate/High Moderate Attribute Reset Method 48

Managing Existing Interest Rate Swaps Many issuers have converted floating rate bonds to synthetic fixed rate by entering into interest rate swaps Fixed rate Payment Issuer Counterparty Variable Rate Payment Variable Rate Bonds 49

Interest Rate Swaps Have a Number of Risks Basis Risk Swap variable rate received and the actual bond variable rate does not match perfectly • LOC bank is downgraded, causing bonds to trade at higher spread to SIFMA • Market rates compress Tax Event Risk Changes in income tax rates alter the value of tax-exempt interest rates relative to taxable interest rates • If tax rates go down, variable bond yield will go up Counterparty Risk Swap counterparty will not perform pursuant to the contract’s terms. For example if the swap provider defaults or its credit rating declines • Lehman, DEPFA, AMBAC, UBS Termination Risk A material decline in credit worthiness could lead to a termination of the swap and require a payment to be made to or from the issuer depending on prevailing market conditions at the time of termination • Negotiate favorable credit triggers and terms for collateral posting • Monitor the mark to market value of the swap 50

If You Have an Interest Rate Swap… n Monitor the bank providing liquidity for the variable rate bonds n Rating n Expiration Date of credit facility n Trading characteristics n Monitor the performance of your Remarketing Agent n Monitor the credit rating of your swap counterparty n Monitor long-term interest rates n As rates go up, termination values should fall n May create an opportunity to terminate the swap 51

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