IPED Boston Conference The Municipal Auction Market Dislocation April 2008 Matthew Pearson matthew. pearson@morganstanley. com (212) 762 -8274
IPED Table of Contents Section 1 Recent Market Events Section 2 Historical Trends Section 3 Refinancing Alternatives Appendix A Disclaimer
IPED Section 1 Recent Market Events
IPED Recent Market Events Municipal Market Summary of Recent Impacts Catalyst • Monoline bond insurer’s perceived inability to pay future claims jeopardized by subprime related exposures 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 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 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 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. 1
IPED Recent Market Events Municipal Monoline Bond Insurers “The Catalyst” • 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 Source Fitch Ratings, Moody’s Investors Service, Standard & Poor’s Watchlist/Credit. Watch/Ratings Watch for possible downgrade Watchlist/Credit. Watch/Ratings Watch “developing” Negative Outlook Notes 1. Watchlist – Review for Possible Downgrade for Moody’s, Credit. Watch Negative for Standard & Poor’s 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. 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. 2
IPED Recent Market Events Size of the Problem and Investor Reaction ARNs Issuance Volume ($ Billion) Auction Rate Market: Approximately $300 billion (About $200 billion in the tax-exempt and $100 billion in the taxable sectors) • Most of this market is likely to be refinanced due to the following factors: – ARS are clearly not the cash equivalent money market instrument they were considered, because there is no hard put –Investors can no longer rely on the auction rate process for liquidity (“trapped cash”) – A new class of investors needs to emerge – A very small subset of the ARS market may survive as a long-dated floating rate instrument – Rates would likely move toward intermediate rates, not the current short-term / cash equivalent rates VRDBs Issuance Volume ($ Billion) 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 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. 3
IPED Recent Market Events Series 2005 C Auctions as Spread to SIFMA Series 2005 C 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. 4
IPED Recent Market Events Borrower Reaction • 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 • 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 Historical and Projected Long-Term Issuance $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. 5
IPED Recent Market Events Municipal Market Implications Results / Potential Results • Retail investor demand will increase as rates increase, although a fair amount of tax exempt capital is trapped in the failed auction rate sector • As the markets absorb $250 to $300 billion in the coming months, the curve is likely to flatten and yields are likely to increase • Currently, Total Return Buyers (TOB) investors are likely to be sellers as cash bonds under-perform hedges – The benefit of put bonds versus long term bonds is likely to decrease substantially as the yield curve flattens • 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) – Long-term fixed rate yields are likely to rise by 25 -100 basis points • 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 U. S. Municipal Market Issuance Potential VR Refundings $Bn – Catalyst for new investors will be price – MMD yield curve will be less relevant; it will be about funding, likely at wider MMD spreads 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 Section 2 Historical Trends
IPED Historical 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 30 Y MMD vs. 30 Y 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. 7
IPED Historical Trends Municipal and UST Yield Curves Have Dislocated U. S. Treasury Curve Shift MMD Yield Curve Shifts +84 bps -45 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. 8
IPED Historical Trends Short-term Rates: SIFMA vs. 1 M LIBOR • SIFMA is now 81. 7% of 1 M LIBOR SIFMA vs. 1 M LIBOR • From 2005 - August 2007, SIFMA averaged 70% of LIBOR 2. 70% 2. 21% 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. 9
IPED Section 3 Refinancing Alternatives
IPED Refinancing Alternatives Need For Public Rating • 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 University’s 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. 10
IPED Refinancing Alternatives Synthetic Fixed Rate Debt • Typical situation today Mechanics • Since many synthetic fixed rates were set ~3. 50%, current mark to market values are negative from borrowers perspective Fixed Rate Payments Borrower Morgan Stanley Variable Rate Receipts • Current market swap rate is closer to 2. 90% Auction Rate Bond Holders 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. 11
IPED Refinancing Alternatives Refinancing Considerations • Compelling arguments can be made for all three refinancing alternatives: variable rate demand bonds, put bonds and fixed rate bonds • 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 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
IPED Refinancing Alternatives Alternative 1: Replace ARNs with VRDBs Maintains Current Floating Rate Exposure • Typically, variable rate demand bonds require the borrower to obtain a letter of credit, which provides both credit enhancement and liquidity for any unremarketed 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 Pros Cons LOC Backed VRDB Refunding • Maintains University’s current floating rate exposure • Significant uncertainty remains in the taxexempt variable rate market • Potentially lowest cost of funds • 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 • 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 • 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. 13
IPED Refinancing Alternatives Alternative 2: Convert to Put Bonds Provides Fixed Rate Financing in Short-Term But Maintains Long-Term Floating Rate Exposure • 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 borrower’s underlying ratings Pros Conversion to Put Bonds • Eliminates near-term market/credit risk by fixing out debt for 1 -5 years or longer • Limited market for put bonds – costs expected to increase as market becomes saturated • Maintains long-term floating rate exposure • Can swap back to floating • Can do conversion under existing documents avoiding need to refund bonds • “Hard put” would have greater market acceptance but would require St. John’s 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. 14
IPED Refinancing Alternatives Alternative 3: Convert to Fixed To Maturity Eliminates interest rate risk and reduces floating rate exposure • 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 borrower’s underlying ratings • Decision to convert to fixed much more difficult than it was just one month ago – Rates are 45 bps higher Pros Conversion to Fixed Rate • Eliminates future risk (interest rate, credit, bond insurer, etc. ) • Historically highest cost • Can do conversion under existing documents avoiding need to refund bonds • Current rates at 5 -year highs due to heavy supply technicals rather than historical taxable / tax-exempt relationships • Can access the swap market to convert to a floating rate • Can always call the bonds and refinance in the future 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. 15
IPED Appendix A Disclaimer
IPED Disclaimer 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 author’s 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. 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