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
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Recent Market Events
Municipal Monoline Bond Insurers
“The Catalyst”
Rating Agency Actions on Municipal Bond Insurers Since Revaluation of Structured Finance Exposure(1)(2)
• 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
As of March 31, 2008
Moody’s Investors Service
Standard & Poor’s
Fitch Ratings
FGIC
Downgraded from “Aaa” to “A3” (2/14)
Downgraded from “AAA” to “AA” (1/31)
Watchlist, Review for Possible Downgrade Downgraded from “AA” to “A” (2/25)
Downgraded from “A” to “BB” (3/28)
Negative Outlook
Downgraded from “AAA” to “AA” (1/30)
Downgraded from “AA” to “BBB” (3/26)
Negative Outlook
XLCA
Downgraded from “Aaa” to “A3” (2/7)
Downgraded from “AAA” to “A-” (2/25)
Watchlist, Review for Possible Downgrade Credit Watch Negative
(3/4)
Downgraded from “AAA” to “A” (1/24)
Downgraded from “A” to “BB” (3/26)
Negative Outlook
MBIA
“Aaa” (2/26)
Negative Outlook
“AAA” (2/25)
Negative Outlook
“AAA” (2/5)
Watch Negative
Ambac
“Aaa”
Negative Outlook (3/12)
“AAA”
Negative Outlook (3/12)
Downgraded from “AAA” to “AA” (1/18)
Negative Outlook (3/12)
Radian
“Aa3”
Negative Outlook (3/28)
“AA”
Stable Outlook
Downgraded from “AA” to “A+” (9/5/07)
Watch “Evolving” (9/5/2007)
CIFG
Downgraded from “Aaa” to “A1” (3/6)
Stable Outlook
Downgraded from “AAA” to “A+” (3/12)
Negative Outlook
Downgraded from “AAA” to “AA-“ (3/7)
Downgraded from “AA-” to “A-“ (3/31)
Negative Outlook
Assured
Guaranty
“Aaa”
Stable Outlook
“AAA”
Stable Outlook
“AAA”
Stable Outlook
FSA
“Aaa”
Stable Outlook
“AAA”
Stable Outlook
“AAA”
Stable Outlook
Source Fitch Ratings, Moody’s Investors Service, Standard & Poor’s
Watchlist/CreditWatch/Ratings Watch
for possible downgrade
Watchlist/CreditWatch/Ratings Watch
“developing”
Negative Outlook
Notes
1. Watchlist – Review for Possible Downgrade for Moody’s, CreditWatch 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 W atchlist 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
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Recent Market Events
Size of the Problem and Investor Reaction
ARNs Issuance Volume
Auction Rate Market: Approximately $300 billion
(About $200 billion in the tax-exempt and $100 billion in the taxable sectors)
($ Billion)
45
40
35
30
25
20
15
10
5
0
• 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
2002 2003 2004 2005 2006 2007
– 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
Variable Rate Demand Bond Market: $300 - $400 billion
VRDBs Issuance Volume
• 23% of VRDB market is insured (approximately $81 billion)
($ 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
70
60
50
• Liquidity documents typically specify immediate termination upon insurer insolvency and
sometimes upon downgrade
40
30
20
• Significant increase in remarketing risk and puts is being caused by:
10
– Fear of insurer deterioration in claims paying resources and further downgrades
0
2002 2003 2004 2005 2006 2007
– 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
Recent Market Events
Series 2005C Auctions as Spread to SIFMA
Series 2005C 7-day Auctions as Spread to SIFMA
350
300
250
200
150
100
50
0
(50)
8
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1M
8
7
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1Ju
7
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1-
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p06
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1-
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p05
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5
1Se
1Ju
-0
ay
1-
M
ar
-0
5
5
(100)
1M
IPED
Series 2005C 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
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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
60
50
40
30
20
10
0
March
2007
April
2008 (Projected)
May
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
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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)
– Catalyst for new investors
will be price
– MMD yield curve will be
less relevant; it will be
about funding, likely at
wider MMD spreads
– 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
$Bn
450
400
350
300
250
200
150
100
50
0
350
300
250
200
150
100
50
2002
New Money
2003
2004
Refundings
2005
Combined
2006
2007
0
VRDBs
ARNs
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
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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
30Y MMD vs. 30Y UST
Since 1990
80
60
40
20
0
-20
-40
-60
-80
M
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-0
Ju 0
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pD 00
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M 00
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Ju 01
nSe 01
pD 01
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M 01
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Ju 02
nSe 02
pD 02
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M 02
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-0
Ju 3
nSe 03
pD 03
ec
M 03
ar
-0
Ju 4
nSe 04
pD 04
ec
M 04
ar
Ju 05
nSe 05
pD 05
ec
M 05
ar
Ju 06
nSe 06
pD 06
ec
M 06
ar
-0
Ju 7
nSe 07
pD 07
ec
M 07
ar
-0
8
-100
30Y MMD - 30Y UST
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
5.50%
5.25%
5.00%
+84 bps
4.50%
4.75%
-45 bps
4.00%
4.25%
3.50%
3.75%
3.00%
3.25%
2.50%
2.00%
2.75%
1.50%
2.25%
1.00%
1.75%
0.50%
1.25%
0.00%
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
MMD Today
MMD March 2007
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
UST Today
UST March 2007
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
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Historical Trends
Short-term Rates: SIFMA vs. 1M LIBOR
• SIFMA is now 81.7% of 1M
LIBOR
• From 2005- August 2007,
SIFMA averaged 70% of
LIBOR
SIFMA vs. 1M LIBOR
7.00%
6.00%
5.00%
4.00%
3.00%
2.70%
2.21%
2.00%
1.00%
M
ar
-0
Ju 0
nSe 00
pD 00
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M 00
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-0
Ju 1
nSe 01
pD 01
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M 01
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-0
Ju 2
nSe 02
pD 02
ec
M 02
ar
-0
Ju 3
nSe 03
pD 03
ec
M 03
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-0
Ju 4
nSe 04
pD 04
ec
M 04
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-0
Ju 5
nSe 05
pD 05
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M 05
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-0
Ju 6
nSe 06
pD 06
ec
M 06
ar
-0
Ju 7
nSe 07
pD 07
ec
M 07
ar
-0
8
0.00%
SIFMA
1M LIBOR
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
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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
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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
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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
Estimated Cost
As of 3/31/08
LOC-backed VRDB
SIFMA – 10 bps
Estimated Trading Level
Plus: Letter of Credit (3-Year Term)
65 bps
Plus: Remarketing
7 bps
Net Cost (Excluding Up-front Fees)
SIFMA + 62 bps
2.83% (at current SIFMA)
4.45% (at 25-year average SIFMA)
Pros
Cons
LOC Backed VRDB Refunding
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
Indicative Rates
As of 3/31/08
Indicative Rates
1-Yr
2-Yr
3-Yr
5-Yr
4.00%
4.25%
4.50%
4.75%
Pros
Cons
Conversion to Put Bonds
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
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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
Summary of Economics
As of 3/31/08
Estimated Blended Yield1
5.60%
Estimated All-in TIC1
5.68%
1. Actual yields and all-in-tic will depend on amortization schedule of the bonds converted to fixed.
Pros
Cons
Conversion to Fixed Rate
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
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Appendix A
Disclaimer
IPED
Disclaimer
Disclaimer
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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.
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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
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tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan
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realized or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document
may be aggregated data of transactions in securities or other financial instruments executed by Morgan Stanley that has been compiled so as not to identify the
underlying transactions of any particular customer.
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