October 23, 2013

1. October 23, 2013 Public finance 2013 state controller’s conference With county auditors Robert Larkins Managing Director 1 Embarcadero Center, Suite 650 San Francisco, CA 94111 Office: 415-616-8025 robert.larkins@raymondjames.com

2. In its efforts to avoid global meltdown (2008-09) and to stimulate the u.s. economy (2009-13), the fed has driven interest rates to half-century lows Source: Federal Reserve

3. Volatility is the “new normal” in the muni market • Key drivers are: the Fed, mutual fund outflows and Detroit • While the pace of outflows has declined, municipal bond funds have experienced 18 successive weeks of outflows • Detroit’s pending bankruptcy and the City’s assertion that GO bonds are “unsecured” has investors asking “what IS a GO pledge?” • In California, the outcome of court decisions as to PERS’ assertion of “super seniority” in the Stockton and San Bernardino bankruptcies could have a profound impact on how investors view unsecured credits like Lease Revenue Bonds, especially for PERS agencies • Fiscal Cliff 2.0

4. the yield curve has steepened considerably • From a demand perspective, Prop 30 has increased the value of tax-exemption for high income investors, as has the increase in Federal income tax rates • Retail investors have returned to the primary market in a big way, enticed by new higher yields • Many market participants expect short term rates to remain ultra low through 2015, increasing the appeal of issuing variable rate debt

5. INTEREST RATES REMAIN ATTRACTIVE IN HISTORICAL CONTEXT • The chart shows the frequency of the AAA-Rated Municipal Market Data (“MMD”) rates at each 1 to 30 year point on the MMD yield curve since 1993. The more intense the color, the more often interest rates are at the given level, moving in intensity from light red to dark red. Interest Rate Intensity Map (MMD Yields - 1993 to Current) Interest Rate 10/8/2013 MMD Curve 84.9% of the time 30-yr bonds have been above the rate of 4.11% since 1993. Term (years)

6. As borrowers, these low rates have been a boon to counties

7. California Refunding Volume HISTORICALLY LOW RATES Unleashed A TSUNAMI OF REFUNDINGS Source: CDIAC *January 1, 2013 to August 31, 2013

8. Investment income remains anemic Negative arbitrage adversely impacts advance refundings Increased PERS contribution rates Retirees’ savings income has shrunk (though roaring stock market has been a plus) However, prevailing ultra low rates have some material negative consequences for counties

9. Most county investment pools are yielding 300 basis points lower than just Five years ago, creating yet another revenue hole in budgets Current Rate: 0.24% Source: California State Treasurer

10. As of October 1, 2013, 1-year “Index TRANs” would clear the market at SIFMA flat, or 6 basis points!! Ultra steep yield curve may well increase issuance of floating rate debt

11. Typically, municipal bonds have a 10 year call feature that allows issuers to call/refinance bonds prior to maturity and generate budget savings In an advance refunding, a county issues refunding bond, placing proceeds in an escrow of Treasury/Agency securities which pays the debt service on the refunded bonds until the call date The Fed’s near zero target for short term rates has reduced available defeasance yields well below longer-term tax exempt borrowing rates, producing “negative arbitrage” in refunding escrows Typically, issuers measure the efficiency of potential refundings by evaluating net present value savings compared to the par value of refunded • 5% PV savings is often the benchmark for “advance refundings” (where call date is >90 days from closing), while 3% PV savings is the common rule for “current refundings” • Some issuers have adopted a 2:1 rule  PV savings must be at least 2x negative arbitrage But since net PV savings factors in all transaction costs, including negative arbitrage, one could argue that many issuers have missed the boat on refunding savings by focusing on negative arbitrage Low Short-term Treasury yields adversely impacts advance refundings

12. Effective July 1, 2012, PERS lowered its 7.75% assumed investment earnings rate to 7.5% Additionally, PERS has adopted shorter smoothing and amortization periods that will lead to higher employer rates beginning in FY 15-16 for counties • Median Miscellaneous Plan employer contributions to rise from ~18% in FY 15-16 to ~23% in FY 20-21 (that’s not 5%...it’s a 27% increase!) • Median Safety Plan employer contributions to rise from ~30% in FY 15-16 to ~39% in FY 20-21 (12% increase) Reflecting lower global fixed income returns, pers Reduced ITS ACTUARIAL EARNINGS ASSUMPTION – WITH ATTENDANT BUDGET HIT TO COUNTIES

13. Hypothetical examples of anticipated increased Employer Contribution rates

14. Over the next twenty years, nearly 10 million people, or 25% of the State’s population, will be entering retirement age The precipitous drop in bond and CD yields has decimated senior citizens’ investment income The fed’s near zero target for Fed funds has hammered retirees Source: Census Bureau, Federal Reserve

15. Volatility is the new normal as the Fed remains the dominant driver of global financial markets The Fed-orchestrated decline in rates has been beneficial to counties as borrowers, but has eviscerated local government investment pools’ interest earnings PERS’ return to more conservative actuarial assumptions is intended to improve pension plan funded ratios, but counties should be prepared for many years of substantially higher employer contribution rates When the Fed ultimately tapers its $85 billion monthly open market purchases, long-term interest rates are likely to rise, with many market participants calling for 5% Treasury rates However, until unemployment drops to near 6%, short-term rates are expected to remain low • County treasury pool investment returns likely to remain depressed • Counties may find it beneficial to go back to the future by issuing variable rate debt summary

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