Proposal To Serve As Senior Managing Underwriter VIRGINIA DEPARTMENT OF THE TREASURY January 29, 2007 Bear, Stearns & Co. Inc. 383 Madison Avenue New York, New York 10179 Tel 212-272-2000 www.bearstearns.com January 29, 2007 Mr. Kelley S. Denton Procurement Officer Department of the Treasury 101 North 14th Street, 3rd Floor Richmond, Virginia 23219 Dear Mr. Denton: Bear Stearns is pleased to present its qualifications to serve the Commonwealth of Virginia (the “Commonwealth”) and the Tobacco Indemnification and Community Revitalization Commission (“TICR”). The Commonwealth was a “pioneer” in May of 2005 leading the second wave of tobacco securitization issuance in the capital markets. Together with your advisor, Bear Stearns and the Commonwealth re-established the tobacco securitization market with the TICR’s successful inaugural financing. We would welcome the opportunity to once again serve the Commonwealth and the TICR as you seek to capitalize on favorable tobacco market conditions to restructure the Series 2005 Bonds and incorporate a sizable new money taxable tranche to enhance expenditure flexibility. While the attached proposal details our ideas and qualifications, highlights are presented below. Proven Leadership. The TICR’s taxable tranche will break new ground in terms of the largest taxable par amount and potentially the longest average life ever sold in the taxable tobacco sector and will require innovation and proven leadership. No other firm has more taxable experience than Bear Stearns. Bear Stearns is the undisputed industry leader having led the first, the largest, the longest and the most recent state level taxable tobacco tranches for South Carolina, Louisiana, South Dakota, Iowa and Michigan. Notably, Bear Stearns’ $1.2 billion of state level taxable tobacco experience is more than five times our closest competitor. The Most Relevant Experience. Our expertise perfectly matches the transactions the TICR is contemplating. Specifically, Bear Stearns: (i) possesses the most relevant Virginia tobacco experience; (ii) dominates state level tobacco issuance; (iii) leads the taxable tobacco sector; and (iv) has managed the most restructurings in the industry. q q q q q We have a proven track record of achieving superior results for the Commonwealth. With the 2005 financing, we: (i) maximized proceeds within the TICR’s chosen maturity limit; (ii) achieved a long bond yield of 5.78% which was 100 basis points lower than the Commonwealth’s 2003 yield; and (iii) generated $3.55 billion of orders from 62 separate institutional investors. Bear Stearns is the #1 ranked senior manager of tobacco securitization bonds according to Securities Data Company, having led $21.9 billion of tobacco volume. Our leadership is even more pronounced for unenhanced state level tobacco transactions having led $14.8 billion with a 79.7% market share. Since Virginia’s transaction in 2005, every state level issuer has chosen Bear Stearns to lead its tobacco securitization. Bear Stearns has led 87% of the taxable market and all of the taxable deals that will serve as the pricing benchmarks for Virginia’s taxable tranche. Bear Stearns’ leadership in the tobacco sector has continued with the advent of tobacco restructurings. Bear Stearns has led $10.2 billion of tobacco restructurings, which is $9.4 billion more than our nearest competitor. We would welcome the opportunity to once again serve the Commonwealth and the TICR. Sincerely, Kym S. Arnone Senior Managing Director TABLE OF CONTENTS Page Approach 1. Provide the optimal structure for securitizing 50% of the Commonwealth’s payments under the MSA allocable to the TICR as authorized under Chapter 488. The base case should be limited to the use of current interest bonds with a maximum maturity of 40 years with a refinancing/restructuring of the Series 2005 Bonds. Provide up to two alternate strategies that the Corporation should consider. Your alternate structures may incorporate any strategy your firm deems reasonable (e.g., CABs, subordinated debt, maturity extension, etc.), however your plan should (i) assume no state enhancements, (ii) avoid non -investment grade debt, and (iii) assume the non -refunding portion will be issued on a taxable basis. Comment on optimal size, amortization, net proceeds, term bond structure, reserve funds, and pros and cons of the various alternatives. 1 2. What rating agency would you recommend? How many and which agencies would you pursue? How would changes in the structure affect your recommendation? 2 3. Comment on the factors affecting the current market demand for tax -exempt and taxable tobacco securitization bonds. Describe your firm’s strategy to market the bonds, particularly in light of the use of taxable bonds. 2 4. Assuming selection of Bookrunning Senior Manager by February 1, 2007, provide a realistic time schedule to complete the proposed tobacco transaction. 5 Experience 5. Identify each issue of tobacco bonds in which the firm or key staff, has been involved. Include the principal amount, the date of issuance, the firm’s role, bond structure, ratings achieved and any defining attributes of the issue. 5 6. Identify key staff that would be involved in the transaction and highlight their experience in the issuance of tobacco bonds. 6 7. Describe your firm’s sale and distribution capabilities, highlighting your ability to distribute bonds secured by tobacco settlement revenues. Describe your firm’s secondary market support for tobacco bonds. 7 8. Describe your firm’s experience and capabilities in the distribution of taxable debt. 7 9. Identify any existing or potential conflict of interest, or any relationship that might be considered a conflict of interest, that may affect or involve transactions for the Commonwealth. 8 Pricing 10. Provide the proposed underwriters’ spread for the transaction. Detail all components of the underwriters’ spread. Identify proposed underwriter counsel. 8 Participation by Small, Women -Owned, and Minority -Owned Businesses 11. Describe current and planned utilization of Small, Women -Owned, and Minority -Owned Businesses. 8 CONFIDENTIAL TREATMENT REQUESTED Bear Stearns requests that this proposal and the information herein (the “Confidential Information”) be kept and treated as confidential and exempt from the Virginia Freedom of Information Law, Va. Code Ann. § 2.2-3700 et seq. (“FOIA”). This request for confidential treatment is made pursuant to Section 2.2-3705.1(12) of FOIA, Section 2.2-4342 of the Virginia Public Procurement Act (“VPPA”), and Section 2.2-3705.6(3) of FOIA. Specifically, this information constitutes: (i) trade secrets and proprietary information submitted by a bidder, offeror or contractor in connection with a procurement transaction; (ii) cost estimates relating to a proposed procurement transaction prepared for a public body; (iii) confidential proprietary records that will be voluntarily provided to the Tobacco Indemnification and Community Revitalization Commission (“TICR”) and used for business and trade; and (iv) records relating to the negotiation and award of a specific contract involving competition and bargaining, whose release would adversely affect the bargaining position and negotiating strategy of the Virginia Tobacco Settlement Financing Corporation (the “Corporation”). The Confidential Information is of significant independent economic value to Bear Stearns and derives much of that value from the fact that it is not generally known to or readily ascertainable by Bear Stearns’ competitors. This information was prepared solely at Bear Stearns’ expense, and is the result of the firm’s substantial investment of time, money and analytical resources in an effort to compete for potential business. Accordingly, Bear Stearns has endeavored to maintain the secrecy of the Confidential Information, not revealing it to any competitors or any other third parties. If the Confidential Information is disclosed, Bear Stearns’ competitors will freely acquire information and ideas for which Bear Stearns has expended substantial resources. Bear Stearns’ competitors will derive significant economic value from its disclosure and obtain a substantial competitive advantage from its use. Public release of the Confidential Information would also adversely affect the bargaining position and negotiating strategy of the Corporation. The Confidential Information not only contains Bear Stearns’ proprietary information, analysis and recommendations, but also contains a suggested compensation structure for the proposed bond sale. If Bear Stearns’s competitors obtain this information, they will be fully aware of their relative bargaining position vis-à-vis the Corporation, and will have less incentive to accede to any of the Corporation’s requests. Moreover, if the Confidential Information is disclosed, investment banks such as Bear Stearns will be less likely in the future to submit detailed proposals to Virginia government entities on an unpaid basis. The result will be submission of inferior proposals – or no submissions at all – to the ultimate detriment of the government and its constituents. This request is not to be construed as a waiver of any other protection from disclosure of confidential treatment accorded by law. If any person (outside the staff of the Treasury Department and the Corporation) asks for an opportunity to copy this proposal, Bear Stearns requests that the undersigned be immediately notified of such request and be given advance notice of any intended release of documents or information, so that Bear Stearns may, if deemed necessary or appropriate, substantiate the request for confidential treatment at the appropriate time and pursue the remedies available. We are sensitive to this matter as our major competitors recently requested our proposal in other states, where our request for confidentiality has been honored. Kym Arnone Senior Managing Director Bear, Stearns & Co. Inc. VIRGINIA DEPARTMENT OF THE TREASURY 1. OPTIMAL STRUCTURE The optimal structure for securitizing the TICR’s 50% TSR allocation is driven by its desired use of proceeds. It is our understanding that all new money proceeds will be taxable in order to facilitate working capital grants for: i) accelerated indemnity payments to farmers,1; ii) scholarship funding; iii) seed capital for start up businesses and other economic development and technology related projects. Taxable Tobacco Market. Within the taxable tobacco market the largest and the longest average life transaction was Michigan’s $490.5 million securitization led by Bear Stearns in April 2006. The Michigan landmark taxable transaction included the first time sale of: q q q an 11-year average life bond (prior to Michigan the longest taxable average life was 7 years, also marketed by Bear Stearns); indexed floating rate bonds; and taxable Capital Appreciation Bonds (“CABs”). The TICR’s taxable tranche will also break new ground in terms of the largest taxable par amount and potentially the longest average life ever sold in the taxable tobacco sector and will require innovation and proven leadership. As the leading senior manager of taxable tobacco securitization bonds, with an 87% market share and over five times the state-level volume of our nearest competitor, Bear Stearns is the best firm to structure the optimal financing that meets the TICR’s objectives and is consistent with taxable sector demand. TICR’s Structuring Options. Below we have arranged the TICR’s structuring alternatives along a continuum, highlighting the key tradeoffs which will be influenced by the TICR’s desired amortization horizon, risk transfer objectives and preference for subordination within the capital structure. The TICR can maximize net proceeds and risk transfer but only by extending its final rated maturity and adding subordinate liens, which will increase its cost of funds. Maximize Net Proceeds/ Risk Transfer Base Case Alternative 1 Alternative 2 40 Year Senior Lien Structure 45 Year Senior/Subordinate Structure 55 Year Senior/Subordinate Structure $563 Mil TX at 5.90% $641 Mil TX at 6.04% $678 Mil TX at 6.06% Minimize Cost of Funds These structuring alternatives are summarized below. Please see Appendix A for a detailed product mix for each case. Base Case – 40-Year Senior Lien Only. A 40-year unenhanced securitization of the TICR’s TSRs with Current Interest Bonds (“CIBs”) and Convertible CABs (“CCABs”) generates $562.8 million of taxable new money proceeds. As shown in Appendix A, the taxable CIBs are frontloaded with an 11-year average life. As previously mentioned, 11-year taxable tobacco bonds are market tested, having been successfully sold by Bear Stearns in Michigan’s ground-breaking 2006 transaction. The longest bonds in the structure are the tax-exempt CIBs and CCABs, which are sized to fund the Series 2005 defeasance escrow, related reserves and costs of issuance. The inclusion of $48.1 million of CCABs with a 6/1/2011 conversion date improves performance as it relieves interest constraints due to coverage requirements from 2008 through 2011. Although the Base Case structure has the lowest cost of funds of any case presented, it does not take full advantage of the TICR’s leverage capacity under the current interest rate environment and rating agency criteria 2/3 vote of the Board of Trustees of the Foundation may be required to increase the annual endowment expenditure to 15 % of the corpus. 1 BEAR, STEARNS & CO. INC. JANUARY 29, 2007 because it limits the final rated maturity and does not include subordinate CABs. Credit tranched CAB liens have become a standard feature in tobacco securitizations. A multi-lien CAB structure allow issuers to fully leverage the longest TSRs and take advantage of less restrictive rating criteria for lower rated liens without creating any additional interest burden in the early revenue and coverage constrained years of the structure. To maximize the TICR’s leverage capacity, our alternative cases extend the final rated maturity for the tax-exempt component beyond 40 years and include investment grade tax-exempt CABs. Alternative Case 1 – 45-Year Senior and Subordinate Structure. The TICR can raise an additional $78.4 million of taxable new money proceeds (bringing its total to $641.1 million) by extending its senior lien tax-exempt CIBs to 45 years and adding 45-year BBB and BBB- CABs. Once again, the taxable bonds are front-loaded in the transaction, however, with the longer final maturity, the optimal taxable structure involves two CIB term bonds with 5-year and 15-year average lives. This tranched taxable structure minimizes the cost of funds and minimizes execution risk since it reduces the size of the longest taxable average life bond. Although the 15-year bond is unprecedented in the taxable tobacco sector, we note that BBB rated student loan transactions have recently been sold to this tenor. The structure increases the CCABs since the maturity extension creates additional interest payments in the revenue constrained years. As shown in the table below, Alternative 1 balances the objectives of maximizing net proceeds and risk transfer with minimizing the cost of funds. Base Case Approach Upfront Net Proceeds Taxable CIBs Tax-Exempt CIBs Tax-Exempt CCABs Tax-Exempt CABs Rated Final Maturity Expected Final Maturity Cost of Funds Alternative 1 Alternative 2 55-Year Senior 40-Year Senior 45-Year Senior & & Subordinate Lien Only Subordinate Liens Liens $562,787,557 $641,138,439 $678,118,074 611,979,791 691,583,865 730,452,296 421,853,089 302,044,088 279,105,766 48,048,213 58,964,950 NA NA 105,233,764 186,709,187 2047 2052 2062 2029 2032 2034 5.90% 6.04% 6.06% Alternative Case 2 – 55-Year Senior and Subordinate Structure. The TICR can increase its taxable net proceeds by another $37 million if it extends the BBB- CABs to 2062. This structure leverages 55 years of TSRs, allows the tax-exempt refunding bonds to be back-loaded as much as possible and maximizes taxable net proceeds potential. As in Alternative 1, this structure includes a 5-year average life taxable CIB and a 15-year average life taxable CIB. This structure assumes that the CIBs are rated by Moody’s, S&P and Fitch, while the BBB and BBB- CABs are rated by Fitch only. We note that the net proceeds from Alternative 2 can be increased by approximately $1 million by seeking an S&P only rating on the BBB CAB and a Fitch only rating on the BBB- CAB. This “cherry-picked” rating strategy would be more cost effective if taxable rates were lower or the yield spread between BBB and BBB- CABs were higher. We will monitor market conditions and apprise the TICR of any opportunity to raise a significant amount of incremental net proceeds by “cherry-picking” ratings. Product Diversification. The TICR’s 2007 transaction will consist of the largest amount of taxable bonds sold in the tobacco sector to date, with par amounts ranging from $611.9 to $730.5 million depending on the alternative selected. Bear Stearns recommends enhancing the marketability by offering product diversification. The TICR should consider issuing up to 20% of the taxable bonds as LIBOR indexed floaters. Bear Stearns sold $72.6 million of LIBOR indexed floaters for the first time in the tobacco market in our $490.5 million Michigan securitization. The addition of indexed floaters will not increase proceeds significantly because of rating agency stress tests. However, we are currently in discussions with the rating agencies to alter their criteria such that the inclusion of indexed floaters in any of the structures presented would increase proceeds by 1% to 2%. As an added 1 VIRGINIA DEPARTMENT OF THE TREASURY advantage LIBOR indexed floaters can also be structured with a two year call option. This feature would enable the TICR to refinance any portion of the taxably funded endowment that has been spent on tax-exempt eligible projects and potentially generate additional proceeds at that time. Tax Issues. In each case presented above, the taxable bonds are amortized ahead of the tax-exempt bonds in order to reduce the overall cost of borrowing and, most importantly, to accommodate taxable asset backed securities (“ABS”) market constraints. In the taxable ABS market: q q q q securities are sold exclusively off of expected average lives; most securities have short average lives with 86% of the market at five years or less; longer average life products with extension and credit risk are less common; and large block sizes are favored for liquidity. JANUARY 29, 2007 2. RATING AGENCY STRATEGY The optimal rating strategy to maximize upfront taxable proceeds depends on the: (i) mix of products (CIBs, CCABs, and CABs); (ii) degree of subordination on the CABs (BBB to Unrated); and (iii) final rated maturity of the transaction (40 to 55 years) that the TICR selects for its tobacco financing. Each agency has unique criteria that results in comparable leverage capacity for the Base Case with 40-year CIBs, but different maximum capacity once subordinate lien products and longer rated final maturities are incorporated. Our rating recommendations maximize leverage capacity in each of the structuring alternatives evaluated. Comparison of Rating Recommendations Base Case Alternative 1 Alternative 2 (40 Years) (45 Years) (55 Years) Senior Lien CIBs Baa3 Moody’s Baa3 Moody’s Baa3 Moody’s BBB S&P BBB S&P BBB S&P BBB Fitch* 1st Sub CABs None BBB S&P BBB Fitch 2nd Sub CABs None BBB- S&P BBB- Fitch The TICR also has an independent rationale for front-loading the taxable bonds in that the taxable proceeds will be expended for working capital grants which do not have a known useful life. There is precedent within the tobacco sector for front-loading taxable tranches. Specifically, all new money combined taxable/tax-exempt tobacco transactions which were led by Bear * In order for Fitch to rate subordinate bonds they must rate a sizable portion of the senior capital structure. Stearns have front loaded the taxable component (South Carolina, Louisiana, South Dakota). Recent tobacco restructurings with a taxable q Base Case – 40-Year. As illustrated in the table above, our component also led by Bear Stearns (Iowa and Nassau County), have front recommendation for the base case would be to seek Moody’s and S&P loaded the taxable component. ratings given that: (i) taxable investors view Moody’s and S&P ratings as sacrosanct; (ii) only two ratings are required for senior lien Even after front-loading the taxable bonds, the average life of the taxbonds; (iii) no issuer has used all three agencies since the Corporation’s exempt tranches in each of our structures is approximately 21 years. This 2005 issuance; and (iv) this strategy would save the Corporation the average life analysis will be a focal point of the financing plan since the tax Fitch rating fee of approximately $400,000. If the Corporation would code requires that the average life of the bonds be no more than 120% of like to seek a Fitch rating for policy reasons, it can do so on the 40-year the useful life of the projects financed. Tax Counsel will need to analyze the senior lien CIBs with no cost other than the rating fee. average life of the back-loaded tax-exempt restructuring bonds and compare it to the life of the projects financed with the tax-exempt 2005 proceeds. It q Alternative 1 – 45-Year. If the TICR prefers a longer 45-year structure is our understanding that approximately 14% of the 2005 bond proceeds with BBB and BBB- subordinate liens, Bear Stearns continues to have been expended on grants to unrelated third parties which were used recommend Moody’s and S&P. Moody’s would rate the senior lien only for economic development and technology related projects. Many of the because Moody’s Monte Carlo stress tests are not well suited to CABs. grants have been used for long term projects such as a waste water S&P would rate all liens, including the BBB and BBB- subordinate treatment plant and the laying of fiber optic cables resulting in a cumulative tranches, where only one rating is needed and S&P offers the most economic life of approximately 27.4 years. Given the long life of the prior favorable rating criteria. projects, the TICR’s future tax-exempt projects only have to have a weighted average useful life of 16 years or more to support the 21-year q Alternative 2 – 55-Year. Neither Moody’s nor S&P will currently rate average life of the tax-exempt restructuring bonds. tobacco securitization bonds beyond 45 years. As a result, Bear Stearns recommends a Fitch strategy if the TICR decides to pursue the 55-year If counsel ultimately concludes it is problematic to amortize the taxable structure. Although Fitch has a much steeper consumption decline bonds ahead of tax-exempt bonds, then the TICR can, in a worst case stress test than S&P, by extending the BBB- lien out to 2062, the TICR scenario, amortize the tax-exempt and taxable tranches on a pro-rata basis. can leverage an additional 10 years of TSRs to achieve incremental An all tax-exempt restructuring and a taxable all CIB new money leverage capacity of $37 million compared to the 45-year structure securitization composed only of taxable CIBs with overlapping tax-exempt permitted by S&P. and taxable CIB maturities would generate $538.6 in taxable proceeds. Rating Criteria Improvements. The rating strategy outlined above is Defeasance Escrow. Bear Stearns recommends a custom agency escrow based on rating criteria improvements Bear Stearns has recently negotiated. which we pioneered for the $3.1 billion Golden State Tobacco restructuring These improvements directly increase the TICR’s leverage capacity. For in July 2005. Custom agency securities would: (i) yield approximately 20 example, until last month, S&P’s rating criteria assumed total PM market basis points above SLGS or Open Market Securities (“OMS”), resulting in share of 94.0%. However, the 2006 MSA Auditor’s report showed PM $5.1 million of savings for the Corporation and (ii) perfectly match the market share of 94.3%. Bear Stearns provided this data to S&P as a rationale Corporation’s escrow requirements, thereby maximizing efficiency without a to increase their market share assumption to 94.3%. As another key float contract. example, the final rated maturity for all investment grade bonds was 40 years Reserve Requirement. Our analysis assumes that the reserve will be up until last month. For some time, Bear Stearns was providing data and a funded at maximum annual rated debt service on senior taxable and tax- rationale to the rating agencies for a longer rated final maturity. As a result, exempt CIBs, as required by the rating agencies. The liquidity reserve will S&P and Moody’s now allow all bonds to have a final rated maturity of up to 45 years and Fitch allows a final rated maturity of 55 years for its not be available for the subordinate CAB holders. subordinate BBB- CABs. Reserve Earnings. Our analysis assumes the TICR’s reserve earns 4.83% based upon the average of bids received last week for New Jersey’s tobacco 3. FACTORS AFFECTING MARKET DEMAND reserve fund agreement. CURRENT MARKET CONDITIONS Costs of Issuance and Operating Cap. We have assumed all-in costs of issuance of 1% of par and an operating cap for 2007 that matches the Series Taxable Market Demand. One of the driving forces behind current taxable ABS demand is portfolio diversification. Given the recent 2005 Bonds’ inflated level of $231,750. BEAR, STEARNS & CO. INC. 2 VIRGINIA DEPARTMENT OF THE TREASURY difficulties in the consumer home equity sector and deterioration in certain mortgage-related ABS products, investors are seeking better performing collateral alternatives such as TSRs. Beyond diversification, major factors affecting demand for taxable tobacco include predictability/stability of cash flows, legal and expected maturity, liquidity, current rating level and rating trends. ABS Supply. Supply in the asset-backed market in 2006 reached all-time highs ($1.3 trillion). Almost $430 billion of the issuance was in the mortgagerelated ABS sector, predominantly in floating rate form. We expect ABS supply to diminish this year, by about 10%, with a reduction in issuance in the mortgage-related ABS sectors. Overall, the ABS market continues to be receptive to new offerings with strong liquidity and risk appetite among the investor base. Housing continues to be a concern among investors, particularly in the subordinate tranches of mortgage securitizations. As a result, the potential for diversifying away from housing related credit risk should appeal to most investors. Shape of the Yield Curve. The Treasury yield curve is currently inverted, with the differential between 2-year and 10-year yields at -10 basis points. The swap curve is relatively flat with the differential between 2-year and 10-year swaps at +6 basis points. Although the yield curve is inverted, the increase in the level of rates should continue to drive fixed rate demand. As an inverted Treasury curve and historically flat swap curve also lead to increased demand for floating rate bonds from investors looking to shed duration risk, we have recommended including Indexed Floaters to appeal to a broader base on of investors in the current environment. Corporate Spreads. The corporate trading levels are a reference point for taxable tobacco investors. The corporate bonds of the tobacco manufacturers are trading at the tightest spreads in recent history. By way of example, Philip Morris’ 2013 bond is currently trading at 65 basis points to the 10-year treasury. In contrast, in December of 2006 this same bond traded as wide as 85 over the 10-year benchmark. The improved trading levels of the underlying tobacco manufacturers are due in large part to the improved litigation environment over the last 18 months, with successes in Price, Engle, DOJ and various individual suits. Tax-Exempt Market Demand. Current investor sentiment for taxexempt tobacco bonds is the most bullish since the sector’s inception for several reasons: (i) continued investor demand for high yield bonds; (ii) a relative lack of high yield supply; and (iii) generally positive litigation news. One of the only negative factors impacting tax-exempt demand is supply. The current forward calendar consists of several large proposed state level transactions including restructurings for California and Louisiana. Total supply for the first half of 2007 could reach $14.5 billion, consisting primarily of tax-exempt tobacco bonds. As the sector leader, we are acutely aware of the cascading effect that a “cheaply” priced transaction can have in establishing higher yielding benchmarks for future transactions. Bear Stearns demonstrated leadership last week on New Jersey’s $3.6 billion restructuring, the largest unenhanced tax-exempt tobacco transaction ever marketed. We aggressively priced the transaction at yields ranging from 3.95% to 5.80% and supported our pricing convictions by underwriting a sizable portion of the bonds in an environment characterized by: (i) unstable market conditions with U.S. Treasury yields increasing 13 basis points on the day of pricing; (ii) threatened litigation against the financing; and (iii) certain co-senior managers’ deliberate lack of support. As illustrated in the chart below, we achieved among the tightest spreads to MMD of any recent transaction, notwithstanding the fact that New Jersey was 35x as large as the most recent transaction priced by a competitor. Furthermore, we believe we work for our issuer clients and, the fact is, we “stepped-up” for the State of New Jersey. We would encourage you to call Nancy Feldman, Director of Public Finance, in the New Jersey Treasurer’s Office as reference for our performance. We believe the only appropriate reference is a fellow issuer and it is noteworthy that our competitors often proffer investor references – begging the question of “where does a given firm’s priorities lie”. BEAR, STEARNS & CO. INC. JANUARY 29, 2007 Recent Tax-Exempt Tobacco Subordinate CAB Pricing 240 Basis Points Spread to MMD $102 Million 220 $584 Million 200 180 223 $412 Million 202 200 187 178 175 $3.62 Billion 168 160 153 140 San Diego County Alaska Santa Clara* New Jersey Bear Stearns Bear Stearns Citigroup Bear Stearns 1st Subordinate CAB 2nd Subordinate CAB * 1st Sub. CAB has a rating of BBB- and 2nd Sub. CAB had a rating of BB. The reality is that as supply increases, yields increase to entice investors as they approach saturation levels on a single MSA credit. With $14.5 billion of supply during the first six months of 2007, yields are likely to increase from New Jersey’s pricing. By establishing the most aggressive benchmarks for New Jersey we have set the stage for lower absolute yields for California and Louisiana. BEAR STEARNS’ MARKETING STRATEGY Bear Stearns’ marketing plan has been finely honed as a result of our experience as the # 1 ranked tobacco securitization underwriter. We customize our marketing plans based on each issuer’s financing objectives, relying on our unique insight into investor preferences for average life, innovative products and stress test performance. Identify Taxable Anchor Orders. Using our sector knowledge, Bear Stearns will identify the Corporation’s institutional “anchor” orders. Key taxable targets will include tax-exempt portfolio managers who have previously bought taxable tobacco (i.e., “crossover accounts”), top original purchasers from the taxable Michigan and Iowa transactions, and other major taxable tobacco buyers. The table below highlights the potential demand each of these groups could generate. Taxable Targets Crossover Accounts Top Michigan & Iowa Buyers Other Major Taxable Buyers TOTAL Potential Capacity ($ Billions) $1.0 1.0 1.5 $3.5 Crossover Accounts. Bear Stearns is the undisputed industry leader in the taxable tobacco sector having led $1.2 billion or 87% of state level taxable tobacco bonds compared to $151 million for the second ranked firm. Bear Stearns was elevated to Joint Book Running Manager on the Iowa transaction in recognition of our dominance in the taxable arena. As taxable tobacco issuance has expanded, Bear Stearns has been singularly instrumental in generating sizable taxable orders from tax-exempt portfolio managers such as PIMCO, Allstate and Standish. These investors are well versed in the tobacco credit and would be targeted for the TICR’s 2007 taxable tranches. Top Michigan and Iowa Buyers. The top purchasers of the Michigan and Iowa taxable transactions are additional investor candidates. Bear Stearns’ municipal and ABS sales force worked seamlessly together to generate 100% of the orders on the Michigan transaction from Standish, ING, Loomis, Riversource, Allstate and Putnam. Sizable orders were also placed by dealer arbs and hedge funds such as Susquehanna and Cedar Ridge. Many of the original Michigan purchasers currently represent the top holders of all taxable tobacco bonds. Other Major Taxable Tobacco Participants. Taxable ABS institutional targets for the fixed rate tranche also include those investors who were buyers of Louisiana, South Carolina and South Dakota including Cap Re, WAMCO, Nationwide, Deerfield and Vanderbilt. Further demand could originate from other top taxable tobacco holders such as 40/86, AIG, American 3 VIRGINIA DEPARTMENT OF THE TREASURY JANUARY 29, 2007 Financial, Baird and Wells Capital. Bear Stearns will be able to maximize taxable tobacco participation given: (i) the continually improving MSA credit profile; (ii) the relative spread advantage when compared to BBB corporate bonds and generic asset-backed securities; and (iii) the credit diversification offered by tobacco which is not correlated to the real estate risks in the ABS market. Targeted Taxable Fixed Rate Buyers ($ Millions) PIMCO Allstate Oppenheimer Cap Re Nationwide 40/86 Advisors Standish AIG AMERICAN Baird AAA Mid-Atlantic Ins Evergreen SCOR United Fidelity Wells Capital Equitrust United Fire&Casualty Federated Catholic Knights TX Mutual Beneficial Life Ins Orion Century Phoenix Agincourt Top 25 Holders of Taxable Tobacco Bonds 0 30 60 90 120 Identify Tax-Exempt Anchor Orders. The tax-exempt lead orders will come from: (i) the current 2005 holders; (ii) additional major tax-exempt tobacco buyers with little or no current Virginia tobacco exposure; and (iii) tax-exempt hedge funds and arbitrage accounts. Tax-Exempt Targets Current 2005 Holders Other Major Buy & Hold Accounts Hedge Funds & Arbitrage Accounts TOTAL Potential Capacity ($ Billions) $1.0 2.0 2.5 $5.5 Current Holders of the 2005 Bonds. Several of the largest original purchasers of Virginia’s Series 2005 issue such as PIMCO, Rochester, Van Kampen and Guardian continue to have significant holdings of the Series 2005 Bonds. Other significant 2005 purchasers like Nuveen, Dreyfus, Cap Re, Riversource and Federated have substantially increased their holdings in the Series 2005 Bonds through secondary market purchases. This group is significant as it represents the largest core of traditional investors in the taxexempt tobacco sector today. These investors will directly benefit when their current holdings are pre-refunded and re-rated “AAA” which they will transfer to a high grade portfolio. In addition to replacing their existing Virginia tobacco bonds, many investors will add incremental exposure, including subordinate lien CABs, reflecting pent up demand for yield paper and the strong investor sentiment currently favoring tobacco bonds. This is particularly true for Rochester, the single largest tobacco holder of both CIBs and CABs. On the New Jersey restructuring led last week by Bear Stearns, the CABs were 3 times oversubscribed with investor interest from Rochester, Eaton Vance, VK, Cap Re, Lord Abbett, GSAM, Morgan Stanley, Mass Financial, Dreyfus, Columbia and Wells Fargo. Other Dominant Tax-Exempt Buy-and-Hold Accounts. Other major institutional sector participants such as Putnam, GSAM, Fidelity, Radian, WAMCO, Lord Abbett, US Trust, Vanguard, USAA, Loews, T. Rowe Price, Boston Company and Pioneer are active purchasers in the tobacco sector with no current holdings of the Corporation’s bonds and have ample capacity to purchase the 2007 tax-exempt tranches. Tax-Exempt Hedge Fund and Arbitrage Accounts. Over the last few years, hedge funds and arbitrage accounts have brought substantial liquidity to the tobacco sector. These purchasers are trading accounts that buy and sell tobacco based on relative value compared to alternative investments and employ leverage in their purchases (i.e., up to ten times the amount of cash holdings). These groups were not as active in May of 2005, however within BEAR, STEARNS & CO. INC. the last year over 20 new tax-exempt hedge funds were created and could provide sizable capacity for the Corporation’s 2007 transaction. Hedge funds such as Susquehanna, Saybrook, Tahoma, Stark, Duration, 1861, Cedar Ridge and Jane Street, as well as “dealer arbs” will be attracted to the Corporation’s transaction because: (i) it will become a liquid name in the sector; and (ii) they have cash to put to work and tobacco represents one of the only remaining yield opportunities in the Municipal market. Using CDS to Expand the Investor Base. One of the tools that could theoretically expand the tobacco investor base is Credit Default Swaps (“CDS”). In a CDS, the buyer pays a periodic premium to the seller in return for default protection on a specific Reference Security. We are aware of competitors proffering to take down bonds in the primary market, provide CDS and reoffer the bonds to investors with appetite for credit protection. However, the Corporation should be aware that this is a hollow promise in that it the trade the MSA CDS being offered: (i) it has a 5-year termination date yet the rated final maturity of the referenced bond is much longer; (ii) it covers limited credit events such as failure to pay (which would be interest and rated payments of principal– highly unlikely during the term of protection), bankruptcy of the SPV issuer (not the manufacturers) and restructuring of the debt; and (iii) does not cover MSA enforceability. Any sophisticated buyer would view the CDS that has been offered to date as an inefficient product. In fact, the only activity in this market has been sellers of protection as opposed to buyers because CDS spread levels, to date, have exceeded market levels for MSA Bonds themselves. Maximize Retail Sale Component. Bear Stearns’ retail performance in the primary tobacco market has surpassed all competitors, including “wire houses”, which translates into greater pricing leverage with institutional investors. Conversely, our wire house competitors concentrate their retail efforts in the secondary market which is characterized by dramatically higher broker compensation. Current retail participation in the tobacco sector is primarily comprised of sophisticated high net worth investors, which is precisely Bear Stearns’ retail client base. Their participation can be maximized through a one-day retail order period or, as we did on the successful 2005 Virginia, 2006 Alaska and 2007 New Jersey transactions, priority could be given to retail on the day of sale. Coordinate Taxable/Tax-Exempt Pricing Process. The taxable pricing process has a number of important differences from the tax-exempt sector which must be considered in coordinating the marketing of a transaction containing taxable and tax-exempt securities. q q q q q q q q Unlike the tax-exempt market where bonds are priced and quoted off their rated final maturities with increasing consideration given to the expected average life, taxable tobacco bonds are priced and quoted exclusively off of their expected average lives. Taxable investors require slightly more lead time and prefer to have access to the roadshow and POC at least two weeks prior to pricing. While taxable investors will participate in group investor calls, they prefer to ask questions via one-on-one follow up calls. Taxable investors often request customized stress scenarios. Initial price talk for taxable bonds is released very shortly after the POC distribution. “Price talk” continues to be refined and the “circling” of orders begins at least one week earlier than on the tax-exempt tranche. The formal taxable “launch” and the tax-exempt pricing occur on the same day. Once spreads for taxable bonds are agreed upon, a formal time will be set to determine the yield on the benchmark Treasury and the coupon will be set. As the only firm to maintain a tobacco securitization joint venture between municipals and the ABS department, we have perfected the seamless coordination of taxable and tax-exempt tobacco pricing. KEY MARKETING ISSUES Given our dominance in the sector and our daily dialogue with key investors, we are best positioned to proactively address any credit 4 VIRGINIA DEPARTMENT OF THE TREASURY issue that may arise during the Corporation’s transaction and to maximize investor participation. The key credit issues that drive investor participation are summarized below. MSA Related Litigation. Major tobacco investors view the Freedom Holdings and Grand River challenges to the MSA and related state legislation as the most potent litigation threat. Freedom Holdings involves claims that the MSA creates an output cartel in violation of the Sherman Antitrust Act. The Plaintiffs seek to enjoin the enforcement of New York’s Qualifying Statute and Complementary Legislation. Thus far an injunction against New York’s repeal of Allocable Share Release (“ASR”) legislation has been granted. The case is likely to go to trial in the first quarter of 2007. The Grand River case challenges the MSA, Qualifying Statute and Complementary Legislation of 31 Settling States, excluding Virginia, on the grounds that they violate the Commerce Clause and antitrust laws. In September 2005, the Second Circuit found that the dormant Commerce Clause claim in Grand River should be decided by the New York District Court along with the antitrust claim in Freedom Holdings. In October 2006 the U.S. Supreme Court declined to hear an appeal of the Second Circuit’s jurisdiction ruling. Grand River sought a preliminary injunction against enforcement of the ASR Repeal Amendment. The District Court denied the preliminary injunction and Grand River has appealed to the 2nd Circuit. A hearing on this matter is scheduled for February 12, 2007. A preliminary injunction would be negative for MSA bonds since NPM market share would be expected to increase from current levels of approximately 5% back to the 9% NPM market share range that was in effect prior to the enactment of ASR Amendments. Copycat cases by NPMs challenging the MSA, or in some cases the Model Statutes and the repeal of ASR legislation have been filed in other states, including CA, LA, OK, KS, KY, TN and AR, with varying results. To date, these challenges have not been ultimately successful. In addition to Grand River and Freedom Holdings, the only other case to survive initial appellate review of motion to dismiss is Xcaliber filed in the Louisiana federal district court. These three cases plus A.B. Coker in Louisiana have proceeded to a stage of litigation where the ultimate outcome may be determined by, among other things, findings of fact. Tobacco Manufacturer Litigation. Tobacco manufacturer lawsuits are much less of an obstacle to investor participation as this litigation environment has improved since the TICR’s 2005 securitization with victories in the Price, Engle and DOJ lawsuits, removing the threat of $435 billion in aggregate damages. Investors are less concerned about the certification of the Schwab national class action which seeks damages of $120-200 billion, since the case has been stayed and the Second Circuit has previously reversed Judge Weinstein on smoking class certification. NPM Adjustment. The NPM Adjustment received heightened scrutiny following the Brattle Group’s March 2006 Significant Factor Determination for calendar year 2003. The 2004 NPM Adjustment estimated at $1.14 billion remains in the spotlight. On January 15, 2007 the Brattle Group preliminarily determined that the MSA was a significant factor contributing to the PM’s 2004 market share loss. A final determination is due by February 12, 2007. While 37 states have sought declaratory orders that they are diligently enforcing their model statutes, of the 26 courts, including the Commonwealth’s, that have ruled, all but one have determined that arbitration is the appropriate forum for diligent enforcement disputes. While investors have been patient to date on the issue of NPM Adjustment, heightened anxiety is likely if Philip Morris, with 50% of the MSA market share, places a portion of the April 2007 payment into the Disputed Payments Account or withholds a portion of its payment, as it has alleged. We recommend entering the market before the April 15th MSA payment. JANUARY 29, 2007 liquidity reserve. To offset the state-specific risk that an NPM Adjustment introduces, we would highlight for investors that Virginia has diligently enforced its Qualifying Statute and adopted Complementary and ASR Legislation. In addition, since January 2003 the Commonwealth has filed at least 33 enforcement actions against NPMs. Consumption Declines. While most major investors acknowledge that Global Insight’s forecast has accurately tracked consumption, certain investors have expressed concern regarding greater potential consumption declines given the magnitude of excise tax increases slated for 2007, the proliferation of smoking bans and the potential expansion of the smokeless tobacco market. At least 8 states are considering sizable excise increases ranging from $0.25 to $1.90 per pack. The weighted average state excise tax increased to $1.038 per pack in 2007. While Global Insight’s forecast clearly captures increasing excise taxes, one potential vulnerability is whether the trend decline variable in the consumption model adequately captures the impact of smoking ban proliferation. To compensate for this uncertainty, investors increasingly focus on the performance of individual turbo term bonds under Global Insight’s more stressful consumption declines (i.e., 3.5% and 4% year over year declines). 4. TIME SCHEDULE Bear Stearns’ ability to deliver superior results in a compressed timeframe is best illustrated by our performance in 2005 and 2006 on the Virginia, California, TSASC and Alaska transactions. In several of these transactions, we priced and closed within six weeks from selection, and for TSASC we closed the transaction within three weeks of selection. For the Corporation’s 2005 tobacco securitization, we priced on a Thursday and closed on a Monday. No other firm has executed a tobacco closing in such a short time frame. Bear Stearns is the best firm to position the Corporation to price rapidly and avoid competing supply or potential saturation concerns. Bear Stearns closed New Jersey’s transaction in 4 business days. Bear Stearns commits to the Corporation that we will work around the clock to accomplish its important tobacco transactions as quickly and effectively as possible. Based on our experience and leadership, the restructuring transaction and new money securitization can comfortably be completed in six weeks, as illustrated in the milestones chart in Appendix B. As we described in Question 3, California’s $4.5 billion restructuring is expected to price in late February and although California does not have a taxable component we recommend separating the California and Virginia pricings by several weeks to avoid unnecessary supply penalties. 5. EXPERIENCE Bear Stearns is the #1 ranked senior manager of tobacco securitization bonds according to Securities Data Company, having led $21.9 billion of tobacco volume. Bear Stearns has always dominated the tobacco sector and never has this been more true than over the last two years. Lead Managers for Tobacco Securitizations 1999-2007 2005-2007 Lead Par Amount Lead Par Amount Underwriter ($mil) Underwriter ($mil) Bear Stearns $21,909.7 Bear Stearns $11,067.0 Citigroup 12,662.8 Citigroup 1,912.6 JP Morgan 2,171.7 Merrill Lynch 506.5 UBS 1,881.7 First Albany 321.7 Merrill Lynch 1,077.1 UBS Securities 295.6 First Albany 827.1 M R Beal 67.9 M R Beal 288.4 Lehman Brothers 59.4 Bear as a % of Total: 53.5% Bear as % of Total: 77.8% Source: Securities Data Company As we did in 2005, Bear Stearns would structure Virginia’s coverage to withstand an NPM Adjustment without requiring a draw on the BEAR, STEARNS & CO. INC. 5 VIRGINIA DEPARTMENT OF THE TREASURY JANUARY 29, 2007 Our expertise perfectly matches the transactions the TICR is contemplating. Specifically, Bear Stearns: q q q q possesses the most relevant Virginia tobacco experience; dominates state level tobacco issuance; leads the taxable tobacco sector; and has managed the most restructurings in the industry. has selected Bear Stearns to lead manage a $4.5 billion restructuring expected to price in late February. A complete list of all of Bear Stearns’ tobacco experience is presented in Appendix C. 6. PERSONNEL MOST RELEVANT VIRGINIA TOBACCO EXPERTISE In May of 2005, Bear Stearns re-established the tobacco primary market with the Commonwealth’s $448 million transaction. Bear Stearns made certain that the market’s first tobacco securitization in over two years was flawlessly executed. We have a proven track record of achieving superior results. With the 2005 financing, we: (i) maximized proceeds within the Commonwealth’s 2037 final maturity requirements achieving nearly $390 million for the TICR’s endowment; (ii) achieved a long bond yield of 5.78% which was 100 basis points lower than the Commonwealth’s 2003 yield; and (iii) generated $3.55 billion of orders from 62 separate institutional investors. No other firm is as well versed in the Corporation’s existing documents, original purchasers and current holders or has more taxable tobacco expertise. As a result, we are best suited to maximize the value of the TICR’s TSRs. Bear Stearns offers the Corporation the most experienced team in the tobacco securitization industry and the same professionals that achieved exceptional results in 2005. The #1 ranked Bear Stearns team has created, by far, the most innovations leading to exceptional structuring and pricing accomplishments. Bear Stearns maintains its position as the dominant underwriter of tobacco bonds by dedicating a consistent team of municipal finance and ABS specialists to this important sector. The Bear Stearns tobacco team has worked on every one of the 24 tobacco securitizations that the Firm has led, including the Corporation’s successful 2005 tobacco securitization. Tobacco Banking DOMINANT STATE LEVEL TOBACCO UNDERWRITER While Bear Stearns is the #1 ranked senior manager of tobacco securitizations according to Securities Data Company, as illustrated in the graph below, our leadership is even more pronounced for unenhanced state level tobacco securitizations. Bear Stearns has led $14.8 billion of transactions with a 79.7% market share. Since Virginia’s transaction in 2005, every state level issuer has chosen Bear Stearns to lead its tobacco securitization. Tobacco Structuring Member Title Kym Arnone SMD Public Finance Department Lead Banker Ira Wagner David Rush SMD SMD Asset Backed Securities Public Finance Lead Banker Banking Expertise John Schopfer Amy Kessler MD MD Public Finance Public Finance Documentation Expert Structuring & Stress Testing Reshma Patel Mike Karlosky MD AD Public Finance Public Finance Structuring & Stress Testing Structuring Specialist John Suh Larry Cohen VP SMD Public Finance Asset Backed Securities Structuring Specialist FAST Monte Carlo Specialist Frances Barone MD Asset Backed Securities Department Head & FAST Monte Carlo Specialist Dan Keating SMD Municipal Bond Department Head & Underwriter Jeff Verschleiser SMD Asset Backed Securities Unenhanced Tobacco Underwriting Volume 18 $ Billions % State Level Market Share 90 15 TE State-Level TE County Level Taxable State- Level Market Share 75 12 60 9 45 6 30 3 15 0 0 Bear Citigroup Stearns UBS First Albany Merrill M R Beal Morgan Lehman Merchant Lynch Stanley Brothers Capital Source: Securities Data Company TAXABLE EXPERIENCE No other firm has more taxable experience than Bear Stearns. Bear Stearns is the undisputed industry leader having led the first, the largest, the longest and the most recent state level taxable tobacco tranches for South Carolina, Louisiana, South Dakota, Iowa and Michigan. Bear Stearns has led 87% of the taxable market and all of the taxable deals that will serve as the pricing benchmarks for Virginia’s taxable tranche. Notably, Bear Stearns’ $1.2 billion of state level taxable tobacco experience is more than five times our closest competitor. We have introduced numerous products and structures to the taxable sector including indexed floating rate tranches and taxable capital appreciation bonds. Furthermore, the Bear Stearns team was the first to market a 100% taxable securitization. UNPARALLELED RESTRUCTURING EXPERIENCE Bear Stearns’ leadership in the tobacco sector has continued with the advent of tobacco restructurings. Bear Stearns has led $10.2 billion of tobacco restructurings, which is $9.4 billion more than our nearest competitor. Only Bear Stearns has senior managed restructurings in excess of $1 billion, for California in 2005, TSASC in 2006, and the largest restructuring in the sector for New Jersey in 2007. In addition, California BEAR, STEARNS & CO. INC. Sales, Underwriting & Trading Role John Young SMD Municipal Bond Department Head & Trader Underwriter Dan Hoffman Carol Fuller SMD SMD Asset Backed Securities Asset Backed Securities Sales & Marketing Manager Underwriter Aaron Fink MD Asset Backed Securities Trader Lead Bankers. Bear Stearns’ lead bankers will be Kym Arnone and Ira Wagner. David Rush will provide banking expertise and John Schopfer will provide documentation expertise. Quantitative Expertise. Our quantitative team is led by Amy Kessler, Reshma Patel and John Suh. Larry Cohen and Frances Barone in the Financial Analytics and Structured Transactions (“F.A.S.T.”) group are responsible for Monte Carlo analysis. Mike Karlosky, Anika Kreider and Rachel Betton will provide quantitative and banking support. Underwriting and Marketing. Tax-exempt and taxable marketing will be jointly coordinated from our municipal bond desk by Dan Keating who will be assisted by John Young, Jeff Verschleiser, Aaron Fink, Carol Fuller and Dan Hoffman. The directly relevant experience of Bear Stearns’ key team members, described below, will result in an efficient and streamlined financing process. Kym Arnone is a Senior Managing Director who co-runs the Firm’s tobacco securitization group. In 2005, Ms. Arnone senior managed the Corporation’s $448 million tobacco securitization. She has led all 24 tobacco securitizations senior managed by Bear Stearns, including taxable tranches for South Carolina, Louisiana, South Dakota, Iowa, Michigan and Nassau County. Ira Wagner is a Senior Managing Director who co-runs the Firm’s tobacco securitization group and will provide ABS expertise to the Corporation as he did in 2005. Mr. Wagner has worked on every taxable tobacco transaction senior managed by Bear Stearns. These transactions will be the structuring and pricing benchmark for the Corporation. 6 VIRGINIA DEPARTMENT OF THE TREASURY David Rush is a Senior Managing Director whose tobacco securitization experience includes transactions for the States of Michigan, Louisiana and Iowa as well as Alameda County, CA. John Schopfer is a Managing Director who started his career as a municipal bond attorney at Hawkins, Delafield & Wood. Mr. Schopfer has worked on tobacco transactions for the States of New Jersey, Alaska, Michigan, and Iowa, and the Counties of San Diego, Los Angeles, Sacramento and Nassau. Mr. Schopfer specializes in document review and disclosure. Larry Cohen is a Senior Managing Director who runs Bear Stearns’ ABS Group for F.A.S.T. He designed and built Bear Stearns’ proprietary, multilien, stochastic models used in the simulation of tobacco settlement revenues. He is responsible for all Monte Carlo simulations and stress testing for Bear Stearns’ tobacco securitizations. Amy Kessler is a Managing Director and has designed and built Bear Stearns’ proprietary linear optimization models used to structure tobacco securitizations. During her career, Ms. Kessler has structured nearly $22 billion of tobacco securitizations including the Corporation’s 2005 issuance. Reshma Patel is a Managing Director who has worked with the nation’s largest tobacco securitization issuers. Most recently, she assisted in structuring the New Jersey and San Diego tobacco refinancings. Ms. Patel also served as part of the analytical team for the restructurings for TSASC, Nassau County, Sacramento County and the State of California. John Suh is a Vice President and tobacco structuring specialist. He recently structured the State of New Jersey’s refinancing, the State of Alaska’s refinancing, assisted in the State of California’s $3.1 billion tobacco restructuring and the Commonwealth’s 2005 securitization. Dan Keating is a Senior Managing Director and head of Municipal Markets. As the Firm’s senior underwriter for tax-exempt securities, Mr. Keating has priced each of Bear Stearns’ 24 tobacco securitizations, totaling over $21.9 billion. John Young is a Senior Managing Director and the marketing manager for the Municipal Bond Department. He has particular expertise with respect to tobacco securitization bonds having played an integral role in the marketing of Bear Stearns’ 24 tobacco securitizations. Jeff Verschleiser is a Senior Managing Director who heads the non-agency Mortgage Trading Desk and ABS Desk and is a member of the Firm’s Board of Directors. His 14 years of experience includes taxable tobacco bonds, ABS trading, CMOs, subordinates, derivatives and CMBS. Dan Hoffman is a Senior Managing Director who heads Fixed Income institutional sales for all mortgage and rate products including taxable tobacco bonds. He has over 20 years of experience at Bear Stearns and has been a key member of the team that marketed Bear Stearns’ $1.2 billion of senior managed taxable tobacco volume. Carol Fuller is a Senior Managing Director who heads the Mortgage Syndicate Desk. She coordinates the new issue marketing and pricing for taxable tobacco securitization bonds and other ABS, ARMS, ALT-A and CDO products. 7. DISTRIBUTION AND SECONDARY MARKET Bear Stearns dominates the tobacco sector in retail and institutional distribution as well as secondary market activity. Retail Distribution. The Firm’s retail sales force of 505 retail account executives, which is among the largest retail sales force of any institutionally oriented securities firm, serves over 230,000 retail customer accounts with more than $94 billion of assets. Bear Stearns' retail sales force has been rated as the most productive in the industry. These sales professionals target high net worth individual investors, the most active retail buyers in the municipal market. Although Bear Stearns is not a wirehouse, our retail performance in the tobacco sector has surpassed that of our primary wirehouse competitors. BEAR, STEARNS & CO. INC. JANUARY 29, 2007 While certain firms claim that they facilitate retail sales by buying bonds in the secondary market for resale to retail, this activity does not improve tobacco issuers’ primary market pricing and reveals an inclination to encourage retail sales only when bonds can be dramatically marked up with higher takedowns. Deal California ‘03 New Jersey ‘03 Virginia ‘05 California ‘05 San Diego ‘06 New Jersey ‘07 Total Retail Performance Bear Stearns Merrill Lynch ($mil) ($mil) $ 155.20 $ 12.65 64.96 25.51 3.00 367.44 16.78 46.58 9.20 17.90 0.03 $ 655.08 $ 64.17 Citigroup ($mil) $ 15.04 10.52 1.08 31.31 0.45 6.50 $ 64.90 UBS ($mil) $ 18.16 17.48 0.69 10.92 0.30 $ 47.55 Institutional Distribution. The Firm employs 283 institutional sales people including 54 municipal specialists, and over 60 ABS traders, underwriters, and salespeople. Bear Stearns’ institutional sales force has distributed $21.9 billion of tobacco bonds – no other firm in the industry has a distribution track record in the same league. Our institutional sales force has been pivotal in the expansion of the taxexempt tobacco investor base, having brought in more first time purchasers than any other firm. Just last week, we brought in first time buyer Delaware Asset Management on the New Jersey refinancing. Furthermore, Vanguard, Capital Research, Bank of America, Sanford Bernstein, J.P. Morgan, American Express, Van Kampen, Allstate, USAA and CNA/Loews first participated in the sector on Bear Stearns led tobacco transactions. Secondary Market Presence. Bear Stearns’ secondary market capabilities are second to none, particularly in the tobacco sector. Since January 1, 2001, we have traded $49 billion in tobacco bonds including nearly $1.18 billion of the Corporation’s bonds. Bear Stearns has been a dominant secondary market player in all tobacco products and under all market environments. For example, from March through December 2003, in the wake of the initial Price verdict and the associated market dislocation, Bear Stearns traded $3.9 billion of tobacco securitization bonds. We note that even after underwriting a sizable portion of New Jersey’s restructuring we continue to buy New Jersey bonds in the secondary market. Our secondary market involvement will provide a direct benefit to the Corporation by maximizing demand, minimizing yield, and optimizing structure on the upcoming transaction. When comparing secondary market trading performance among firms it is important to ensure an “apples to apples” comparison. Bear Stearns’ trading volume consists of “flow” business designed to facilitate liquidity for buy side customers and pricing integrity for issuers. Certain of our competitors often inflate secondary market volume to reflect bonds held in proprietary portfolios (i.e., TOBs or arb accounts) unrelated to their “flow book”. When an underwriter holds bonds in a proprietary account they are motivated by what is best for their overall portfolio objectives. This creates the potential for conflicts of interest and selling or unwinding related trades in front of primary issue supply. These actions may not always be in the best interest of tobacco issuers, such as the Corporation. That is why Bear Stearns approaches secondary market support from a “purist” perspective with a sole focus on liquidity and price transparency. 8. TAXABLE TOBACCO DISTRIBUTION CAPABILITES As the dominant taxable tobacco underwriter, Bear Stearns has a commanding knowledge of the taxable investor base and is best suited to distribute the Corporation’s ground breaking taxable tranche. Bear Stearns’ taxable distribution is seamlessly coordinated from our ABS and municipal bond syndicate desks. Together we offer over 114 sophisticated sales professionals that have brought in every major purchaser in the taxable tobacco sector from WAMCO, Putnam and Nationwide as traditional ABS 7 VIRGINIA DEPARTMENT OF THE TREASURY JANUARY 29, 2007 buyers to cross-over municipal buyers such as PIMCO, Allstate and Standish. Bear Stearns’ combined taxable sales force has distributed $1.2 billion of taxable tobacco bonds compared to $151 million for the second ranked firm. Our taxable tobacco distribution network is both proven and unsurpassed in the industry. than the entire takedown. As noted above, we do think that current market conditions merit an aggressive takedown, but being too aggressive has a high probability of failing to meet the TICR’s overall objectives of maximum proceeds. In addition, investors are well aware of our secondary market support for the taxable tobacco sector and as a result are confident entering large orders on deals senior managed by Bear Stearns. The most actively traded taxable names have been the Bear Stearns led Michigan and Iowa transactions and these bonds provide an obvious benchmark for Virginia’s new tranches. Since the issuance of the Michigan transaction, Bear Stearns has traded approximately $70 million of the 11-year average life fixed rate bonds in 10 different trades at spreads as tight as +200 to Treasuries. The following tables provide a detailed breakdown of our proposed fees and an estimate of underwriting expenses assuming a transaction par of approximately $1.086 billion. 9. CONFLICTS OF INTEREST Bear Stearns is not aware of any existing or potential conflict of interest, or any relationships that might be considered a conflict of interest, that may affect or involve transactions for the Corporation. 10. FEE PROPOSAL Since the inception of the market there have been seven state level tobacco transactions that have included taxable tranches, five of which had takedowns of $6.25/$1,000, one had a takedown of $6.00/$1,000 and the most recent transaction led by Bear Stearns, Michigan’s $490.5 million 100% taxable tranche (the largest ever marketed) had a takedown of $5.50/$1,000. We note that the Corporation’s taxable tranche will be the largest ever marketed. Our takedown proposal for the Corporation’s taxable tranche is $5.25/$1,000 Bond. As illustrated in the table below, the major tobacco securitizations mandated during the last nine months have had gross spreads ranging from a low of $4.93 to a high of $49.17, with takedowns ranging from $4.77 to $6.25. With the improvement in the tobacco market, Bear Stearns believes a reduction in the takedown to $5.25 for the taxable tranche and $4.77 for the tax-exempt tranche will provide lower fees without negatively impacting pricing. Sale Date 4/06 4/06 4/06 5/06 5/06 5/06 6/06 8/06 8/06 1/07 1/07 Recent Tobacco Securitization Gross Spreads Lead Gross Deal Par Manager Spread Virgin Islands 7 CITI $49.17 Fresno 39 UBS 6.36 Cal Statewide 62 CITI 13.06 Michigan 490 BS 6.70 Placer 59 LEH 7.00 San Diego 584 BS 5.98 San Diego City 105 CITI 8.42 Alaska 412 BS 5.85 DC 248 CITI 8.40 Santa Clara 102 CITI 5.66 New Jersey 3,622 BS 4.93 Take down While we believe that our proposed fee structure is reasonable, we would rather negotiate our fees than lose the opportunity to serve the Corporation on this important financing. Proposed Underwriter’s Spread $/$1,000 Average Takedown $5.089 Total Expenses (exclusive of 0.133 Underwriter’s Spread) Total Gross Spread $5.222 Underwriting Expense Breakdown $/$1,000 $0.009 Out of Pocket 0.061 Dalcomp/ Dalnet 0.005 Net Roadshow 0.028 Day Loan (1%) 0.001 Other (Cusip, DTC) 0.030 BMA Sub-Total Expenses $0.134 $ Amount $5,527,911.26 144,326.51 $5,672,237.77 $ Amount $10,000.00 65,962.55 5,000.00 29,894.69 883.00 32,586.27 $144,326.51 Bear Stearns would recommend Sidley Austin and Troutman Sanders as Co-Underwriter’s Counsel and we estimate a fee of $300,000. 11. SMALL, WOMEN & MINORITY OWNED BUSINESS AFFILIATIONS To reward sales performance by small firms as well as M&WBE firms, various designation or retention policies could be employed. The market has evolved to the point that designation policies that encourage small firm and M&WBE participation are readily accepted. If appropriate, we would set a policy that requires a minimum percentage of the designation be granted to a small firm and /or a M&WBE firm. 5.50 5.50 5.02 6.25 4.77 We are aware that some of our competitors, especially those who do not have significant state level tobacco securitization experience, have been bidding below market takedowns in an attempt to buy business and compensate for lesser credentials. We also note that these firms have never marketed tobacco bonds at these “low ball” levels. Bear Stearns can only conclude that buying market share without regard for an issuer’s pricing result is more important than establishing a realistic compensation level that will motivate the sales force to aggressively price bonds and, if necessary, “step up” and underwrite unsold balances as Bear Stearns did for New Jersey last week. Based on our experience as the leading state level underwriter of tobacco securitization bonds, it is our view that a “low ball” takedown will result in higher yields, especially with the $14.5 billion forward calendar. We note that a 2 basis point increase in yield due to either a poor marketing effort or product competition will cost the Corporation more BEAR, STEARNS & CO. INC. 8 APPENDIX A RESULTS APPENDIX A STRUCTURING RESULTS Base Case 40-Year Senior Lien Only Maturity Type TX Turbo CIB TE Turbo Term CIB TE Turbo Term CCAB TOTAL CIB Proceeds $611,979,791 421,853,089 48,048,213 $1,081,881,093 Rated Maturity 2041 2047 2030 Last Expected 2024 2029 2016 Expected Avg. Life 11.3 20.2 8.1 Alternative 1 45-Year Senior & Subordinate Lien Maturity Type TX Turbo CIB TX Turbo CIB TE Turbo Term CIB TE Turbo Term CCAB TOTAL CIB Proceeds $224,047,653 467,536,211 302,044,088 58,964,950 $1,052,592,902 Maturity Type BBB CAB BBB- CAB TOTAL CAB Production 75,601,564 29,632,200 $105,233,764 Rated Maturity 2031 2047 2052 2034 Last Expected 2016 2026 2028 2018 Expected Avg. Life 4.9 15.6 20.5 10.5 Rated Maturity 2052 2052 Last Expected 2031 2032 Expected Avg. Life 22.9 24.8 Alternative 2 55-Year Senior & Subordinate Lien Maturity Type TX Turbo CIB TX Turbo CIB TE Turbo Term CIB TOTAL CIB Proceeds 289,782,552 440,669,743 279,105,766 $1,081,881,093 Maturity Type BBB CAB BBB- CAB TOTAL CAB Production 82,057,007 104,652,180 $1,081,881,093 Rated Maturity 2031 2043 2047 Last Expected 2018 2025 2027 Expected Avg. Life 6.0 14.7 19.4 Rated Maturity 2047 2062 Last Expected 2030 2034 Expected Avg. Life 21.5 25.0 Approach: Pledge of TSRs First TSRs Pledged Proceeds Senior Lien Turbo Term CIB (TX) Senior Lien Turbo Term CIB (TE) BBB Rated CCAB BBB Rated CAB BBB- Rated CAB Subtotal Net Proceeds Base Case 40 Year Senior Lien Structure 50% 2007 Alternative 1 45 Year Senior and Subordinate Structure 50% 2007 Alternative 2 55 Year Senior and Subordinate Structure 50% 2007 $611,979,791 421,853,089 48,048,213 0 0 $1,081,881,093 $691,583,865 302,044,088 58,964,950 75,601,564 29,632,200 $1,157,826,667 $730,452,296 279,105,766 0 82,057,007 104,652,180 $1,196,267,249 $0 $1,331,800,000 $3,297,140,000 Net Proceeds Existing Reserves Total Sources of Funds $ 1,081,881,093 32,682,406 $1,114,563,499 $1,157,826,667 32,682,406 $1,190,509,073 $1,196,267,249 32,682,406 $1,228,949,655 Escrow Deposit Net Proceeds Liquidity Reserve Deposit Capitalized Op. Expenses Costs of Issuance Total Uses of Funds $464,762,391 562,787,557 76,151,461 0 10,862,090 $1,114,563,499 $464,762,391 641,138,439 72,998,240 0 11,610,003 $1,190,509,073 $464,762,391 678,118,074 74,078,292 0 11,990,898 $1,228,949,655 5.90% 1.38x 6.04% 1.49x 6.06% 1.46x $442,195,000 2037 2023 $442,195,000 2037 2023 $442,195,000 2037 2023 2047 NA 2029 2052 2052 2032 2047 2062 2034 Total CAB Future Value Cost of Funds Senior Average Coverage Amount Refunded Rated Final of Refunded Expected Final of Refunded Rated Final Senior Maturity Rated Final Subordinate Maturity Expected Final Maturity APPENDIX TIME SCHEDULE APPENDIX B- TIME SCHEDULE Week Feb 5 Feb 12 Feb 19 Feb 26 • • • • • • • • • • • • • • • • • Mar 12 • • Mar 19 • • Milestones Structuring Discussions Engage Consumption Consultant & Verification Agent Select structure Documents Drafted Documents & Opinions Circulated Calls on Documents Draft Consumption Forecast Circulated Cash Flows to Rating Agencies Revised Documents Distributed/ Call on Documents Rating Agency Feedback Draft Investor Presentation Circulation Preliminary Ratings Received Final Consumption Report Distributed POC Structure and Investor Presentation Finalized POC Available Investor Calls/Meetings & Electronic Roadshow Begin Release taxable “price talk” and begin circling taxable orders one week in advance of tax-exempt bonds Release tax-exempt “price-talk” on the day before formal pricing Price Bonds, Bid Escrow Investments, Liquidity Reserve Agreements, if necessary, and Verify Cash Flows Allot Bonds, Sign BPA and Mail FOC Finalize Closing Documents and Close APPENDIX BEAR TOBACCO SECURITIZATION EXPERIENCE BEAR STEARNS’ TOBACCO SECURITIZATION SENIOR-MANAGED EXPERIENCE Ratings Ratings Moody’s/S&P/ Fitch S&P/Fitch Bond Type Firm Role Par CIB CCAB CAB 1st 2nd 3rd & 4th Dated Date (Manager) ($ m) ($m) ($m) ($m) SR Lien SUB CAB SUB CAB SUB CAB 1/29/2007 Lead 3,622.2 8/11/2006 Lead 411.9 399.6 12.3 Baa3/NR/BBB NR/BBB NR/BBBNA 5/31/2006 Lead 583.6 536.9 46.7 Baa3/BBB/NR BBB/NR BBB-/NR BB/NR 5/17/2006 Lead 490.5 436.6 53.9 Baa3/BBB/NR NA NA NA Lead 344.9 265.5 4/5/2006 27.7 51.7 NR/BBB/BBB NR/BBB NR/BBBNR/BB & NR/NR 2/8/2006 Lead 1,353.5 1,353.5 NR/BBB/BBB NA NA NA 11/30/2005 Lead 255.5 219.7 12.8 22.9 Baa3/BBB/NR BBB/NR BBB-/NR NA 12/06/2005 Lead 415.9 324.4 79.0 12.5 Baa3/BBB/NR BBB-/NR BB/NR NA 8/4/2005 Lead 3,140.6 2,889.3 125.6 125.6 A3/A-/A-* NA NA NA 5/16/2005 Lead 448.3 448.2 Baa3/BBB/BBB NA NA NA 12/2/2003 Lead 40.0 40.0 NR/AA-/A+* NA NA NA 4/16/2003 Lead 431.6 431.6 A1/AA-/A* NA NA NA 3/7/2003 Lead 1,659.2 1,659.1 A1/A/A+ NA NA NA 1/29/2003 Lead 3,000.0 3,000.0 A1/A/A+ NA NA NA 11/5/2002 Lead 517.9 517.9 A1/A/NR NA NA NA 9/24/2002 Lead 278.0 278.0 A1/A/NR NA NA NA 8/15/2002 Lead 500.0 500.0 Aa1/A/A+ NA NA NA 5/23/2002 Lead 1,591.1 1,591.1 A1/A/A+ NA NA NA 11/7/2001 Lead 1,202.8 1,202.8 Aa3/A/A+ NA NA NA 8/15/2001 Lead 126.8 126.8 Aa3/A/A+ NA NA NA 3/22/2001 Lead 934.5 934.5 A1/A/A+ NA NA NA 11/15/2000 Lead 198.5 198.5 Aa3/A/A+ NA NA NA 10/26/2000 Lead 116.1 116.1 Aa3/A/A+ NA NA NA Erie County, NY 10/5/2000 Lead 246.3 246.3 A1/A/A+ NA NA NA Lead Managed Subtotal: $21,909.7 * Enhanced, Underlying Ratings Shown + Puerto Rico’s aggregate par amount is $397 million and Iowa’s aggregate par amount is $832 million. SDC gives 50% credit to Bear Stearns and 50% to the other senior manager. Nassau’s aggregate par was $431 million, SDC gave 80% credit to Bear Stearns. Tobacco Restructurings State Level Deals Issuer New Jersey Alaska San Diego Cty, CA Michigan Nassau Cty, NY+ NYC (TSASC) Sacramento Iowa+ California* Virginia New York State* Oregon* New Jersey California Washington State South Dakota NYC (TSASC) Wisconsin Louisiana Alaska South Carolina Puerto Rico+ Alaska BEAR STEARNS’ TOBACCO SECURITIZATION CO-SENIOR & CO-MANAGED EXPERIENCE Ratings Ratings Moody’s/S&P/ Fitch S&P/Fitch Bond Type Firm Role Par CIB CCAB CAB 1st 2nd 3rd & 4th Dated Date (Manager) ($ m) ($m) ($m) ($m) SR Lien SUB CAB SUB CAB SUB CAB 8/30/2006 Co 248.3 248.3 NA NR/BBB NR/BBBNR/BB & NR/NR 2/8/2005 Co-Senior 319.8 294.2 25.6 NR/BBB/BBB NR/BBBNR/BB 12/06/2005 Co-Senior 415.9 324.4 79.0 12.5 Baa3/BBB/NR BBB-/NR BB/NR NA 12/2/2003 Co 2,015.4 2,015.4 NR/AA-/A+* NA NA NA 9/30/2003 Co-Senior 2,572.3 2,572.2 Baa1/BBB-/A- * NA NA NA 6/19/2003 Co 1,796.9 1,796.9 NR/AA-/A+* NA NA NA 6/19/2003 Co 296.3 296.2 NR/AA-/A+* NA NA NA 10/30/2002 Co 220.5 220.5 A1/NR/A+ NA NA NA Co 1,171.2 1,171.2 A1/A/A+ 10/10/2002 NA NA NA 1,801.5 1,801.5 A1/A/A+ 8/28/2002 Co-Senior NA NA NA Co 93.0 93.0 A1/A/NR 7/25/2002 NA NA NA Co 685.4 685.4 A1/A/A+ 6/27/2002 NA NA NA 644.2 644.2 A1/A/NR 10/25/2001 Co-Senior NA NA NA Co 521.1 521.1 A1/A/A+ 3/13/2001 NA NA NA 198.5 198.5 Aa3/A/A+ 11/15/2000 Co-Senior NA NA NA 294.5 294.5 Aa3/A-/A+ 11/23/1999 Co-Senior NA NA NA 709.3 709.3 Aa3/A/A+ 11/18/1999 Co-Senior NA NA NA Co-Senior & Co-Managed Subtotal: $14,004.1 Total: $36,003.4 * Enhanced, Underlying Ratings Shown + Puerto Rico’s aggregate par amount is $397 million and Iowa’s aggregate par amount is $832 million. SDC gives 50% credit to Bear Stearns and 50% to the other senior manager Tobacco Restructurings State Level Deals Issuer Washington D.C. LA Cty, CA Iowa+ New York State* California* New York State* New York State* Alameda County, CA Puerto Rico New Jersey Fresno County, CA Rhode Island Iowa District of Columbia Puerto Rico Nassau County, NY NYC (TSASC)