California Debt and Investment Advisory Commission Arbitrage Compliance for Bonds

1. California Debt and Investment Advisory Commission Arbitrage Compliance for Bonds February 3, 2011

2. What is Arbitrage? Page 2 • Simultaneous Transactions to Exploit Difference in Yield or Price of Securities • Make Arbitrage by • Borrowing at Tax-Exempt Rate, and • Investing at Taxable Rate

3. Figure 1 - Actual Investment Yield 7.00% Positive Arbitrage 6.50% 6.00% 5.50% Yield 5.00% 4.50% Negative Arbitrage 4.00% 3.50% 3.00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 3 Year Construction Period (Months) Bond Yield @ 5.30% Investment Yield What is Arbitrage? Page 3

4. What is Yield Restriction? • The Internal Revenue Code imposes a general requirement that proceeds of tax exempt bonds not be invested at more than the yield on the bonds. • Four Exceptions to general yield restriction Requirements (e.g. temporary period, Reasonable Required Reserve, Bona Fide Debt Service Fund and Minor Portion) • Yield Reduction Payments • Payable at Same Time as a Rebate Payment • Not Available in all Instances (e.g., Restricted Reserve Fund Allocable to Advance Refunding) Page 4

5. What is Rebate? Certain proceeds can be invested at more than the bond yield (e.g., make arbitrage during the temporary periods) but, any arbitrage must be rebated to the federal government unless an exception to rebate is available and qualified for. Page 5

6. General Arbitrage and Rebate Rules • General Arbitrage Rule: No Arbitrage is Permitted – Subject to Yield Restriction • Exceptions to General Arbitrage Rule: • Temporary Periods • Reasonably Required Reserve Fund • Minor Portion • Bona Fide Debt Service Fund • General Rebate Rule: Must Rebate if Arbitrage is Made • Exceptions to General Rebate Rule: • Spending Exceptions • Small Issuer Exception • Bona Fide Debt Service Fund Exception Page 6

7. Importance of Temporary Periods Page 7

8. Reasonably Required Reserve Fund (RRR) • Amount Invested Without Yield Restriction • 3 Prong Test: The RRR is the Least of • 10% of Principal or Issue Price • Maximum Annual Debt Service • 125% Average Annual Debt Service Page 8

9. Minor Portion Lesser of 5% of Sale Proceeds or $100,000 Page 9

10. Bona Fide Debt Service Fund • Definition: A Fund Used Primarily to Achieve Matching of Revenues with Debt Service Within Each Bond Year • Requirement: Fund is Depleted at Least Once Each Bond Year Except for Carryover Amount Not to Exceed the Greater of: • Earnings in the Fund for the Bond Issue for Immediately Preceding Bond Year, or • One-Twelfth of Debt Service on the Bond Issue for Immediately Preceding Bond Year Page 10

11. Rebate and Exceptions • General rule: All Arbitrage Must be Rebated to U.S. (100% tax) • Exceptions to Rebate: • Any of Three Spend-Down Exceptions • Small Issuer Exception • Bona Fide Debt Service Fund Exception Page 11

12. Rebate Spend-down Exceptions • 6-Month Rebate Exception (Any Expenditure) • 100% of “Adjusted Gross Proceeds” at End of 6 Months • 18-Month Rebate Exception (Capital Expenditures) • 15%, 60% and 100% of “Adjusted Gross Proceeds” at End of Each 6-Month Period • 24-Month Rebate Exception (at Least 75% “Construction Issue”) • 10%, 45%, 75% and 100% of “Available Construction Proceeds” at End of Each 6-Month Period Page 12

13. Small Issuer Exception to Rebate • Government Bonds for Issuers with Taxing Power; • $5 Million limit; • $5 Million limit Increased when Financing Public School Capital Expenditures by the lesser of $10 Million or so much of the aggregate face amount of the bonds attributable to financing the Construction • Conduit Borrowers Qualify if: • Not private activity bonds (bonds and loans) • Meets all requirement for small issuer exception Page 13

14. Bona Fide Debt Service Fund • Amounts in BFDSF are Exempt From Rebate if: • Governmental Bonds, Fixed Rate and WAM >= 5 years • Annual Earnings are <= $100K • 100K Deemed Met if Weighted Annual Debt service is <= $2.5M Page 14

15. Arbitrage Rules • Bond Year • A One Year Period Ending on a Date Selected by the Issuer but not Later Than 5th Anniversary After Issue Date • First or Last Bond Year May be Less Than a Year • Special Rules for Variable Rate Issue • May Affect Amount of Rebate Payment Particularly for Variable Rate Bonds Page 15

16. Arbitrage Rules • Determination Dates • Every 5th Bond Year or Earlier, and • Last Maturity or Redemption Date • Payment Dates • 60 Days After Every Determination Date • Payment Amounts • At Least 90% for All Determination Dates Except the Last Determination Date • 100% of Accrued Rebate Amount for Last Determination Date Page 16

17. Rebate Amount Determination • Use Future Value Methodology • Rebate Amount is: • Future Value of All Payments (-) for and All Receipts (+) From Nonpurpose Investments • Investments Deemed Sold at PV or FMV on Determination Date • Future Value of All Computational Date Credits • $1,520 for a Bond Year in 2011 and thereafter, the Credits will Increase Each Bond Year by the CPI • Double the Credit for the Last Bond Year Page 17

18. $1,000,000 Invested @ 5% 6% Bond Yield FV @ Date Price Interest Total 6.000% 01/01/00 (1,000,000.00) (1,000,000.00) (1,343,916.38) 07/01/00 25,000.00 25,000.00 32,619.33 01/01/01 25,000.00 25,000.00 31,669.25 07/01/01 25,000.00 25,000.00 30,746.85 01/01/02 25,000.00 25,000.00 29,851.31 07/01/02 25,000.00 25,000.00 28,981.85 01/01/03 25,000.00 25,000.00 28,137.72 07/01/03 25,000.00 25,000.00 27,318.18 01/01/04 25,000.00 25,000.00 26,522.50 07/01/04 25,000.00 25,000.00 25,750.00 01/01/05 1,000,000.00 25,000.00 1,025,000.00 1,025,000.00 - 250,000.00 250,000.00 (57,319.40) Basic Examples - #1 Page 18

19. $1,000,000 Invested @ 5% 4% Bond Yield FV @ Date Price Interest Total 4.000% 01/01/00 (1,000,000.00) (1,000,000.00) (1,218,994.42) 07/01/00 25,000.00 25,000.00 29,877.31 01/01/01 25,000.00 25,000.00 29,291.48 07/01/01 25,000.00 25,000.00 28,717.14 01/01/02 25,000.00 25,000.00 28,154.06 07/01/02 25,000.00 25,000.00 27,602.02 01/01/03 25,000.00 25,000.00 27,060.80 07/01/03 25,000.00 25,000.00 26,530.20 01/01/04 25,000.00 25,000.00 26,010.00 07/01/04 25,000.00 25,000.00 25,500.00 01/01/05 1,000,000.00 25,000.00 1,025,000.00 1,025,000.00 - 250,000.00 250,000.00 54,748.60 Basic Examples - #2 Page 19

20. Basic Examples - #3 Page 20

21. Determination of Rebate Liability and Yield Restriction Liability • Fund by Fund Analysis • Rebatable funds may be netted against each other • Yield restricted funds may generally be netted against each other • Positive rebatable funds may be netted against negative yield restricted funds • Positive yield restricted funds must not be netted against negative rebatable funds Page 21

22. Required Documents Official Statement Tax Agreement IRS Form 8038s (i.e., 8038-G, 8038 and 8038-B) Verification Reports, if any L/C Reimbursement Agreement, if any Guarantee Investment Contracts, if any Swap Documents, if any Page 22

23. Procedures – Data Information Review Tax Agreement Sources and Uses of Funds Prepare Cash Flow of Investments and Expenditures (Purchases, Maturities, Sells, Interests, Transfers, and Withdrawals) for Each Fund and/or Gather Trustee Records from Issue Date of Bonds to Last Day Proceeds Have Been Expended for Each Fund Page 23

24. Procedures – Bond Yield Information • Review Tax Agreement • Determine Fixed Rate or Variable Rate • Fixed Rate – No Further Information • Variable Rate • Interest Payments on Bonds • Principal Payments on Bonds • Qualified Guarantee Fees for Bonds • Qualified Hedges, if any Page 24

25. Record Retention • Basic Records Relating to Bond Transaction • The trust indenture, loan agreements, and bond counsel opinion; • Documentation evidencing expenditure of bond proceeds; • Documentation evidencing use of bond-financed property by public and private sources (i.e., copies of management contracts and research agreements); • Documentation evidencing all sources of payment or security for the bonds; and • Documentation pertaining to any investment of bond proceeds (including the purchase and sale of securities, SLGs subscriptions, yield calculations for each class of investments, actual investment income received the investment of proceeds, guaranteed investment contracts, and rebate calculations) • Documentation of All Sources of Payments or Security for the Bonds, Including SWAP Payments and Receipts and Credit Enhancements Page 25

26. Record Retention Records Should Generally be Kept Until 3 Years After Final Redemption Date of the Bonds. Certain Material Records Relating to the Original New Money Issue and all Material Records Relating to the Refunding Issue Should be Maintained until 3 Years after the Final Redemption of Both Bond Issues. Page 26

27. What are the consequences of late payment or nonpayment of the rebate amount? The federal government may declare the interest on the bonds paid to the owners of the bonds to be subject to federal income taxation retroactive to the date of issue of the bonds Late interest (accrues at underpayment rate under Section 6621 beginning on the date the correct rebate amount is due and ending on the date 10 days before it is paid) and penalties (i.e., non-private activity bonds 50% of liability all others 100% of liability) Nonpayment or late payment, if not timely cured, may constitute a violation of the tax covenants made by the issuer with respect to the bonds. Page 27