The Arbitrage Advantage in Tax-Exempt Financing

1. The Arbitrage Advantage in Tax-Exempt Financing HFMA Region 11 Healthcare Symposium Anne Pelej, Vice President Randal Webb, Principal Consultant

2. What is Arbitrage?

3. Taxable Securities Investment Opportunity Tax-Exempt Bonds Arbitrage

4. Two Sets of Rules Arbitrage Rebate Yield Restriction • Compares Yield on Investments • to • Interest Paid • to Bondholders • Limits • Investment Yield • to • Bond Yield

5. Multiple Leverage Points Arbitrage Rebate Yield Restriction • Small issuer • Spending Exceptions • 6 months • 18 months • 24 months • Bona fide debt service • Temporary Periods • 13 months • 3 years • Reserve Funds • Escrows Funds

6. Bond Yield Investment Yield 5.00% Positive 4.50% Arbitrage Bond Yield 4.00% 3.50% 3.00% Negative 2.50% Arbitrage 2.00% Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Graphic Illustration of Arbitrage

7. Understand the Financing

8. Bond Structure • Is this a tax-exempt bond? • Are the bonds fixed or variable rate? • Is the bond hedged and/or insured? • What is the purpose of the issue? • Is the issue an advance or current refunding issue? • Is there a Construction Fund? Reserve Fund?

9. Transaction Activity • Have the bonds been refunded? • Were bond proceeds remaining at the time of the refunding? • Are monies remaining in a construction fund after 3 years? • Are any funds commingled? • Is there a parity reserve? • Are you trying to meet a spending exception?

10. Compliance Status • Have you passed a required payment date? • Have you had a prior computation? • Were there any special elections made? • Is the bond hedged or insured? • Do you have all required bond and transactional documentation?

11. Managing Arbitrage Rebate Compliance

12. “It’s funny how two intelligent people can have such opposite interpretations of the tax code!”

13. Substance vs. Form • Economic consequences overrule verbal characterization • Rules focus on - Timing - Purpose - Security

14. Plan for the Future • Promote due diligence • Educate elected officials • Prepare for staff turnover • Document….document…..document… • Remember the good news

15. Customize the Flow of Information • Monitor spending • Track escrowed investments • Be aware of special elections • Review investment strategies • Strategically place “gatekeepers”

16. Achieve Optimum Payback • Leverage investments • Meet exceptions • Earn arbitrage • Retire bonds early • Be prepared for an audit

17. Rebate Payment Fully Leveraged Investments Under Leveraged Investments Gaining an Edge Lost Opportunity Bond Yield

18. Consequences of Noncompliance • Stiff financial penalties • Loss of tax-exempt status • Open season for IRS audits

19. Arbitrage Rebate Reporting & Payment

20. Required Documents • Official Statement • Tax Certificate • 8038G • Trust Indenture • Escrow Verification Report (Refundings Only) • Cash flow transactions/ Asset Statements • SWAP Agreement

21. Fund Analysis Tracking proceed investment by fund provides easy audit. Cash flow analysis helps to meet expenditure tests.

22. Calculation Summary Snapshot analysis puts critical detail at your finger tips.

23. Compliance Monitoring Agency Arbitrage Rebate Compliance Summary as of 1/31/04

24. Computation Schedules • Annual calculation on all variable rate issues and fixed rate bonds that have accrued liabilities. • 1st year, 3rd year, 5th year schedule for fixed rate bonds with no accruing liability. • Minimum computation schedule, every 5 years.

25. Payment Requirements • Installment Dates • Every 5 years from issue date or bond year • Bond year election – first year can be shorter than a year • 90% payments due within 60 days • Final Maturity • Date bonds matured or redeemed early • 100% payment due within 60 days

26. Filing for a Refund • Use Form 8038R for filing. • Overpayment of less than $5,000 may not be recovered before the final computation date. • Overpayment is limited to actual dollars paid.

27. Leveraging the Arbitrage Regulations

28. Rules of the Game • The computation uses a “future value” method for computing arbitrage rebate. • All transactions must be at market rate. • Issuers may not manipulate the rate in order to decrease the amount of receipts, or increase the purchase price to avoid rebate.

29. Maximizing Cash at Issue • Parity Reserve • runs risk if all bonds default at once • Surety Bond • can be costly for disclosure reporting

30. Creating the Best Bond Yield • Fixed Rate Bond Cost of credit enhancements increases arbitrage yield • Variable Rate Bond Manipulation of annual periods prior to the 5th bond year can reduce liability

31. Allocation & Accounting Rules • Common sense principals • Consistently applied • Methodology • first in first out (FIFO) • specific tracing • ratable allocation • gross proceeds spent first (GPSF)

32. Maximizing Cash Flow • Goal is to meet a spending exception, expenditures should be recorded on the on earliest date possible. • Goal is to calculate the lowest possible rebate liability on a construction fund, expenditures should be recorded on the last possible date.

33. Applying Exceptions to Rebate

34. Common Exceptions • Small Issuer Exception • Spending Exceptions • Bona Fide Debt Service Funds

35. Small Issuer Exception • General taxing powers • Not “Private Activity” Bonds • 95% or more proceeds used toward local government activities • Aggregate tax-exempt debt must not exceed $5 million within a calendar year

36. Spending Exceptions • Six Month Spending Exception • Eighteen Month Spending Exception • Twenty-Four Month Spending Exception

37. Six Month Exception Applies to any type of tax-exempt issue 501(c)(3) have additional 6 months to spend 5% of proceeds Private activity bonds are not afforded the additional 6 months

38. Eighteen Month Exception Applies to any type of tax-exempt issuance for a capital project including industrial bonds or qualified mortgage bonds

39. Twenty-Four Month Exception • Governmental bonds, 501(c)(3), or private activity construction bonds. • 75% of proceeds to be used for construction • Expenditures must be on property owned by a governmental unit or • 501( c)(3).

40. Bona Fide Debt Service Funds • Used primarily to match revenue and debt service in a bond year. • Must deplete annually minus a reasonable carryover.

41. Enhancing Earnings

42. Control Yield Restriction • Leverage Temporary Periods • Maximize Reserve Fund Earnings • Carefully match liquidity to need

43. Temporary Periods • Three Year Temporary Period • Five Year Temporary Period • Working Capital Expenditures/Operating Expenses • Pooled Financings

44. Reasonable Required Reserve • Should not exceed the lesser of • 10% of principal amount • Maximum annual debt service • 125% of the average annual debt service • Excess Reserve Portion must be yield restricted

45. Match Liquidity to Need • Ladder long-term investments • Monitor construction schedules • Review overall all performance

46. Common Errors

47. Failure To: • Comply with both the arbitrage rebate and yield restriction regulations • Pay on time • Take into account all “Gross Proceeds” • Verify the bond yield

48. Failure To: • Understand the Exceptions • Remember a bond year election • Consider the impact of a refunding • Spend construction proceeds