Qualifications to Serve As Senior Managing Underwriter STATE OF CALIFORNIA Golden State Tobacco Securitization Corporation Tobacco Settlement Bond Program May 10, 2005 Bear, Stearns & Co. Inc. 383 Madison Avenue New York, New York 10179 Tel 212-272-2000 www.bearstearns.com (212) 272-2343 May 10, 2005 Mr. Juan C. Fernandez Director, Public Finance Division Office of the Treasurer PO Box 942809 Sacramento, California 94209-0001 Dear Mr. Fernandez: Bear Stearns is pleased to present its qualifications to serve as senior manager to the Golden State Tobacco Securitization Corporation (“GSTSC”) for its Tobacco Settlement Bond Program. In 13 separate tobacco refunding and restructuring presentations over the last two years, Bear Stearns has demonstrated the ability to create significant budgetary benefit, while minimizing the exposure to the State’s General Fund. While the attached proposal details our ideas and qualifications, highlights are presented below. Tobacco Securitization Expertise. Bear Stearns is the nation’s #1 ranked underwriter of tobacco securitization bonds, having senior managed 14 issues totaling $10.9 billion since 1999. Our past transactions include serving as the senior manager for GSTSC’s $3 billion Series 2003A unenhanced tobacco securitization. In addition, Bear Stearns senior managed the nation’s first appropriation enhanced tobacco securitization for the State of Oregon in April of 2003 and played a major role in crafting California’s Series 2003B appropriation mechanism. More importantly, with the $428 million Virginia securitization scheduled to price later this week, we are the ONLY firm to lead a major pure tobacco transaction since April of 2003. Significantly, with this financing, Bear Stearns will reestablish the primary market for tobacco securitization bonds. The Value of Experience. Given our work with Virginia, Bear Stearns is the ONLY firm in two years to have negotiated new rating criteria pertaining to stress tests and tobacco sector fundamentals and Bear Stearns is the ONLY firm to have successfully worked through the MSA and Model Statute enforceability opinion issues with the Rating Agencies. Our experience will be critical to the State in dissecting the various litigation and payment risks inherent in the MSA and implementing an overcollateralization strategy with coverage and reserves that insulate the General Fund from potential future appropriations. Bear Stearns has already begun to demonstrate the value of our experience by analyzing the key risks California faces and presenting strategic structural protections to address consumption risk, payment interruption risk and NPM Adjustment risk. As a result, we will be able to quickly address California’s issues and proceed to closing on an aggressive schedule. Comprehensive Structuring Analysis. Bear Stearns has evaluated myriad restructuring scenarios, including alternatives for the outstanding Series 2003A and Series 2003B Bonds. Our recommendation is to focus on the Series 2003B Bonds, which are already enhanced and thus provide the greatest budgetary benefit in exchange for the smallest incremental General Fund exposure. The recommended restructuring would create between $496 million and $742 million of budgetary benefit depending upon the credit enhancement strategy the State chooses. Either transaction would protect the General Fund from: q q q greater than expected declines in tobacco consumption; a 50% loss of MSA revenues for at least three years at any point in the transaction; and an NPM Adjustment. Tobacco Market Dominance. Since the Price verdict and the reinstatement of Freedom Holdings, we have continued to work with the major tobacco investors on a daily basis, consistently making markets on their behalf. Bear Stearns’ secondary market capabilities are second to none, and in the tobacco settlement bond sector, we have particularly distinguished ourselves. Since January 1, 2004, we have traded nearly $5.7 billion in tobacco bonds, including nearly $1.9 billion of GSTSC securities. We are very proud of the fact that the GSTSC Bonds represent the greatest percentage of our secondary market volume. In addition to our unparalleled trading activity, Bear Stearns supports the tobacco securitization sector with the dedication of senior banking specialists, high yield traders and #1 ranked research professionals. Unlike our competitors who provide research coverage of the tobacco sector via equity analysts, we are the ONLY firm to provide coverage of tobacco sector bonds. This enables us to rapidly brief the Treasurer’s Office on relevant events. Based on our demonstrated track record, the Bear Stearns team is confident that it can successfully price and close this landmark tobacco restructuring on an aggressive time schedule. We will provide the highest quality investment banking and marketing services, delivered in a straightforward, hardworking and professional manner. We look forward to the opportunity to assist the State and the GSTSC with this important financing. Sincerely, Daniel Keating Senior Managing Director TABLE OF CONTENTS Page 1. Describe your firm's tobacco securitization bond experience over the past five years. Include the size of the issue, the date of such financing (or status and projected sale date if not yet completed), the role of your firm, the name of the issuer, and the issuer's principal representatives for the financing. 1 2. Describe your firm's involvement in the secondary market with respect to tobacco securitization bonds. 2 a. Provide the total amount of tobacco securitization bonds your firm has traded since January 1, 2004. b. Provide the amount of GSTSC bonds your firm has traded since January 1, 2004. 3. Provide your recommendations with respect to the optimal restructuring of the outstanding bonds. Such recommendations should relate to maximum efficiency, enhancement of ratings, and unique structuring characteristics. 3 4. Identify the key personnel who would be assigned to work with the State. Include their availability, responsibilities and relevant experience. For each person identified, please respond to the questions asked in Attachment A. 8 5. Describe your firm's proposed compensation structure for the proposed bond sale. Summary of proposed compensation shall include an indication of gross spread, any management or structuring fee (including any cap thereon), and a description of other costs to be charged and paid as compensation to the underwriters, including underwriter's counsel fees. Please note that underwriter fees and expenses will be paid solely from bond proceeds. 9 6. Please include the following: 9 a. Updated information detailing any new issues regarding licensing, registration, disciplinary action, and litigation matters since your firm's last quarterly update to the State for pool membership; b. In addition to the updated information provided in response to subsection a. above, please also provide the following information; Within the past 24 months, has your firm or any of its principals been involved in any litigation, arbitration, disciplinary or other official actions arising from any business of your firm other than the firm's underwriting, underwriting practices or management, or the purchase, sale or distribution of taxable or tax-exempt municipal securities? If your response to this question is yes, please provide an explanation. c. Information on any potential change in legal structure and/or ownership of the firm; d. Completed Legal Disclosure Certification (Attachment B); and e. Any relationship with tobacco manufacturers that may be a conflict of interest in fact or appearance (Attachment C). GOLDEN STATE TOBACCO SECURITIZATION CORPORATION 1. Tobacco Securitization Bond Experience At its core the proposed refinancing of the Golden State Tobacco Securitization Corporation (“GSTSC”) bonds is about structuring the most efficient transaction that simultaneously maximizes budgetary benefit and insulates the General Fund from the risk of appropriating debt service and operating expenses. As we have demonstrated to the State over the last two years, when evaluating refunding policy alternatives such as the appropriate level of coverage and reserves it is critically important to understand the nuances of the tobacco securitization market. No Firm is better versed in the tobacco securitization sector generally and California tobacco specifically. We successfully led the GSTSC’s $3 billion Series 2003A issue despite a challenging market environment and we played a major role in crafting the Series B appropriation mechanism. Bear Stearns also developed the nation’s first appropriation financing with tobacco settlement payments as a dedicated budgetary funding source for the State of Oregon. Bear Stearns is the undisputed leader in the tobacco securitization market. In Appendix A we present the Securities Data Company’s ranking of the top 10 tobacco securitization underwriters. Bear Stearns is the number one ranked underwriter of tobacco securitization bonds, having completed $10.9 billion as book running manager with an additional $0.4 billion to be priced this week. We are also the dominant lead manager of State-level tobacco securitization with 14 transactions totaling over $10.90 billion and resulting in a market share of 45%. In contrast, the vast majority of the transactions implemented by our competitors were for counties, facing dramatically different issues in terms of legal structure, bankruptcy and MSA/Model Statute enforceability. Bear Stearns’ tobacco experience over the last five years is listed in the table below. BEAR STEARNS’ TOBACCO SECURITIZATION EXPERIENCE ($ MILLIONS) ISSUER SENIOR MANAGED: Virginia1 New York Oregon New Jersey California Washington South Dakota New York City Wisconsin Louisiana Alaska South Carolina Puerto Rico Alaska Erie County, NY CO-MANAGED: Total: 1 2 PAR AMOUNT $428.520 40.000 431.560 1,659.170 3,000.000 517.905 278.045 500.000 1,591.095 1,202.770 126.790 934.530 198.503 116.050 246.325 $11,271.263 SALE DATE 05/05 11/03 04/03 02/03 01/03 10/02 08/02 07/02 05/02 10/01 08/01 03/01 11/00 10/00 09/00 CONTACT Jody Wagner, Treasurer Louis Raffaele Laura Lockwood John McCormac, Treasurer Juan Fernandez Kim Herman Don Templeton Alan Anders Frank Hoadley, Director John Kennedy, Treasurer Joe Dubler, CFO Grady Patterson, Treasurer Gabriel Rivera, GDB Joe Dubler, CFO Nancy Naples, Comptroller $12,016.283 $23,287.545 Virginia is expected to price the week of May 9. Subject to change. Puerto Rico’s aggregate par amount is $397 million. SDC gives 50% credit to Bear Stearns and 50% to the other Senior Manager. We are also currently leading the State of Virginia’s $428.52 million tobacco securitization which is expected to price this Thursday. Significantly, with this financing Bear Stearns will reestablish the primary market for tobacco securitization BEAR, STEARNS & CO. INC. bonds. There has not been a major pure tobacco financing since Bear Stearns led the State of New Jersey’s tobacco securitization in February of 2003. As such, we are the ONLY firm in two years to have negotiated new rating criteria (stress tests, OPM, SPM and NPM market share, 2004 shipment base, individual OPM market shares for bankruptcy purposes, and reinvestment assumptions). Additionally, we are the ONLY firm to have successfully worked through the MSA and Model Statute enforceability opinion issues with the Rating Agencies. These opinions were pivotal on the Virginia transaction given that this is the first securitization in the wake of Freedom Holdings which challenges the MSA, New York’s Model Statute and Contraband Statute. In addition to our nearly $11 billion of Senior Managed Tobacco Securitizations, we have also been mandated on a $300 million tobacco refunding Why is Bear Stearns’ experience relevant? Only the most knowledgeable firm in the tobacco securitization sector will be able to dissect the various litigation and payment risks inherent in the MSA and implement an overcollateralization strategy (structure, coverage and reserves) that insulates the General Fund. As a lead manager, Bear Stearns’ expertise will enable us to: ‰ ‰ ‰ ‰ Protect the General Fund from the potential for future appropriations to support the debt service and operating expenses; Utilize structural features and external credit enhancement in the refinancing to maximize the budgetary benefit and minimize the risks to the State; Pro-actively shape the rating agency dialogue within the evolving tobacco securitization market to insulate the State’s General Fund credit; and Implement a marketing strategy and investor outreach program to generate the broadest distribution of the bonds and lowest financing cost to the State. Although the proposed restructuring will ultimately be rated and marketed based on the strength of the State’s appropriation credit, the double-barreled credit is largely structured as though it were a pure tobacco securitization, to minimize the potential “hit” to the General Fund. That is where Bear Stearns’ experience in the sector is invaluable. Specifically, we offer the State the following: Research Analysis. Bear Stearns’ #1 ranked research analysts allow us to keep the State apprised of relevant market developments in real time. Bear Stearns’ resources include: ‰ ‰ #1 Ranked ABS credit expert Gyan Sinha, who has regularly featured issues in the tobacco bond sector in Bear Stearns’ ABS publications; and Don Lipkin, named the “All-Star” Municipal Analyst in the tobacco securitization bond category two years in a row. Bear Stearns’ ABS and tobacco analysts regularly publish relevant articles, including in-depth coverage of MSA related litigation. We consistently brief the Treasurer’s office on rapidly unfolding events. By way of example, we were the first firm to notify the State regarding the Sanders Case and its subsequent dismissal and the fact that certain SPMs placed payments into a Disputed Payments Account alleging an NPM Adjustment. Structuring Expertise. Bear Stearns’ structuring track record surpasses any other firm leading tobacco securitization bonds. This is demonstrated by the fact that the actual turbo performance of the transactions that we have structured is far 1 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION superior to that of the transactions structured by our competitors. As illustrated in the table below, only transactions led by Bear Stearns have performed as projected whereas Puerto Rico, New Jersey I and Rhode Island are among the worst performing transactions in the sector and have fallen short of base case projected turbo redemption payments by 11.69%, 27.64% and 49.85%, respectively. As a result, the State will have a greater comfort level that a Bear Stearns’ structured transaction will perform as expected. Secondary Trading Volume ($ millions) California 1,864 New Jersey 1,487 Wisconsin 581 Oregon 321 South Carolina 290 Louisiana 229 Rhode Island 219 Washington 197 Iowa 117 Alaska 116 South Dakota 103 New York Turbo Payments To Date - Projected vs. Actual Coupon Maturity Base Case Projected Turbo Payment 1 Actual Turbo Payment Surplus / Shortfall % Variance Structured By 1 Golden State (CA) 1/03 5.000% 6/1/2021 $35,680 $44,375 $8,695 24.37% BEAR 2 Northern Tob (AK) 10/00 6.200% 6/1/2022 $9,050 $11,070 $2,020 22.32% BEAR 3 Washington State 11/02 6.500% 6/1/2026 $7,150 $8,745 $1,595 22.31% BEAR 4 Badger (WI) 5/02 6.125% 6/1/2027 $43,910 $45,975 $2,065 4.70% BEAR 5 South Carolina 3/01 7.666% 5/15/2016 $85,745 $88,900 $3,155 3.68% BEAR 6 Louisiana 11/01 6.360% 5/15/2025 $90,600 $93,574 $2,974 3.28% BEAR 7 South Dakota 9/02 6.720% 6/1/2025 $13,255 $13,488 $233 1.76% BEAR 8 Northern Tob (AK) 8/01 4.750% 6/1/2015 $10,430 $10,340 -$90 -0.86% BEAR 9 Children’s Trust (PR) 10/02 5.375% 5/15/2033 $31,510 $27,825 -$3,685 -11.69% 10 New Jersey I 8/02 5.750% 6/1/2032 $25,740 $18,625 -$7,115 -27.64% CITI 11 Rhode Island 6/02 5.920% 6/1/2012 $7,452 $3,710 -$3,715 -49.85% UBS 1 CITI As projected by bond issue in original offering circular Rating Agency Expertise. To the extent that California’s transaction can be structured to comply with many of the pure tobacco securitization requirements (i.e., structural protections, legal framework, MSA and Model Statute enforceability opinions), it may have a more favorable rating agency impact in terms of the State’s net tax supported debt ratio. Bear Stearns has the most in depth knowledge of the rating criteria and committee process for stand alone tobacco securitizations. We also have the most credibility with the structured financed rating analysts. Hiring the firm with the most solid rating agency track record will enable the State to complete the transaction on time and with the most favorable rating outcome possible from the perspective of the State’s contingent debt position. 2. 76 Puerto Rico Secondary Market Trading Activity Bear Stearns’ secondary market capabilities are second to none, and in the tobacco sector we have particularly distinguished ourselves. The numbers are telling, as illustrated in the following graph. Since January 1, 2004, we have traded nearly $5.7 billion in tobacco bonds in a market that has been relatively thinly traded for considerable stretches of time. Perhaps of greater significance is the fact that the GSTSC Bonds represent the greatest percentage of this secondary volume. We have traded nearly $1.9 billion of GSTSC Bonds during this same period. We are the largest market maker in “flow business” for the bell weather names (CA,WI, NJ). 31 Alabama 19 TSASC 12 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 When the State compares 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 our buy side customers and pricing integrity for our issuer clients. 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 as an investor 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 issuing clients, such as the State. That is why at Bear Stearns we approach secondary market support from a “purist” perspective with a sole focus on liquidity, price transparency and on-point research in order to facilitate a robust primary market. Bear Stearns supports the tobacco securitization sector on multiple levels with the dedication of senior banking specialists, high yield traders and number #1 ranked research professionals. We maintain our role as the top ranked underwriter of tobacco securitization bonds by being a leading player in the institutional and retail secondary market. Just as our retail performance with new issue tobacco bonds dwarfed our nearest wirehouse competitors on California’s Series 2003A securitization (Bear Stearns generated $155 million in retail orders versus $15.0 million and $18.2 million for Citigroup and UBS, respectively), we have dominated the retail secondary market. In particular, we trade California tobacco bonds to retail on a daily basis. Bear Stearns stands alone among the major broker/dealers in providing investors with independent tax-exempt and taxable tobacco bond research. Unlike our competitors who provide research coverage of the tobacco sector via equity analysts, we are the only firm to provide coverage of tobacco sector bonds. Institutional investors confirm that Bear Stearns is the only firm to support the secondary market in this way. As a result, investors look to Bear Stearns as the definitive word on relevant litigation matters such as Freedom Holdings and Sanders. Don Lipkin, named “All-Star” Municipal Analyst in the tobacco securitization bond category two years in a row, has become known for his thoughtful and comprehensive reports on the sector. We have also helped provide transparency and liquidity in the secondary market by distributing, to institutional investors, a daily report of all tobacco bond trades in blocks of $500,000 or more, as reported by the MSRB. This has demonstrated liquidity for investors as well as narrowed the bid/ask spread, as price transparency is bound to do over time. BEAR, STEARNS & CO. INC. 2 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION Bear Stearns’ comprehensive approach to secondary market trading in the tobacco bond sector is unrivaled. Our pivotal role at the center of the market provides us with unique insights into demand pattern and structural preferences of the key buyers. Bear Stearns’ commitment to support the sector translates into lower borrowing costs for our securitization clients since investors are more willing to purchase primary market offerings at aggressive levels when they are confident that an active secondary market will exist for their securities. 3. Optimal Restructuring Recommendations OVERVIEW OF RESTRUCTURING OPPORTUNITIES Over the last two years, Bear Stearns has presented 13 separate tobacco refunding and restructuring analyses for the Golden State Tobacco Securitization Corporation’s Series 2003A Bonds and Series 2003B Bonds. The focal point of these analyses has been the creation of significant budgetary benefit with an enhanced restructuring1 of the outstanding bonds that involves: ‰ a full defeasance of one or both existing Indentures; ‰ a pledge of the State’s General Fund appropriation credit; ‰ a new transaction with lower coverage levels than the existing securitizations, which were originally structured for 1.51x and 1.60x average coverage; and ‰ an extension of the final rated maturity to 2045. With this strategy, the State can generate up to $1.83 billion of budgetary benefit on the Series 2003A Bonds or up to $1.37 billion on the appropriation enhanced Series 2003B Bonds, assuming a traditional fixed rate restructuring. Budgetary benefit is comprised of all net proceeds after funding the defeasance escrow, reserves and costs of issuance. Budgetary benefit can be increased by incorporating one or more of the product alternatives described below. THE OPTIMAL RESTRUCTURING The optimal restructuring will maximize efficiency by providing the greatest budgetary benefit in exchange for the smallest incremental General Fund exposure. Bear Stearns’ recommendations are designed to achieve maximum efficiency by focusing on three key structuring elements. ‰ ‰ ‰ Credit Enhancement Strategy. Restructure the Series 2003B Bonds, which are already enhanced and therefore will minimize incremental General Fund exposure. MSA Risks and Overcollateralization Strategy. In order to minimize General Fund exposure to MSA payment risks, the restructuring transaction can be designed with sufficient coverage to withstand greater than expected declines in tobacco consumption and significant OPM payment interruption. In addition, the State may wish to fund an incremental reserve against NPM Adjustments or increase coverage to address the potential for NPM Adjustment Risk or other unforeseen risks. Product Mix/Liquidity Reserve. The State can consider increasing budgetary benefit by as much as: (i) $304 million with Synthetic Fixed Rate Bonds, CPI Bonds, Stepped Coupon Bonds, and Insured Floating Rate Bonds; and (ii) 1 An un-enhanced tobacco refunding does not generate budgetary benefit due to negative arbitrage in the refunding escrow and the inability, under current rating criteria, to achieve a higher degree of leverage than the original transaction. BEAR, STEARNS & CO. INC. $120 million by funding the reserve on the restructuring at one-half of maximum annual debt service, although we do not recommend this strategy since it would materially reduce the structural protection available to insulate the General Fund. CREDIT ENHANCEMENT STRATEGY To maximize efficiency, Bear Stearns recommends an enhanced restructuring of Series 2003B, which already carries the State’s General Fund appropriation pledge. As shown in the following table, this transaction generates up to $1.37 billion of budgetary benefit in exchange for a $1.61 billion increase in General Fund exposure. This is a very efficient approach with a Benefit to Exposure Ratio (“Efficiency Ratio”) of up to 85%. In contrast, an enhanced refunding of the “pure tobacco” Series 2003A Bonds is considerably less efficient. This transaction would generate up to $1.83 billion of budgetary benefit, but would require a $5.22 billion increase in General Fund exposure (an Efficiency Ratio of 35%) since the Series 2003A Bonds are not presently enhanced. Given this significant “efficiency gap”, the remainder of our discussion will focus on restructuring the Series 2003B Bonds. Should the State be interested in restructuring Series 2003A, we have provided a detailed summary of results in Appendix B Series 2003A Existing Security: Restructuring Benefit: Incremental Exposure: Benefit / Exposure (“Efficiency”): Unenhanced $0.79 to $1.83 billion $4.05 to $5.22 billion 19% to 35% Series 2003B Existing Security: Restructuring Benefit: Incremental Exposure: Benefit / Exposure (“Efficiency”): Appropriation Enhanced $0.50 to $1.37 billion $0.63 to $1.61 billion 79% to 85% Maximizing Efficiency- Enhancement of Ratings. Series 2003B. As shown in the table below, the State’s restructuring will not result in a higher underlying rating than the outstanding Series 2003B Bonds since these securities are already rated Baa1/ A-/ BBB+ on the basis of the State’s appropriation pledge. Nonetheless, given the State’s upgrade in the Spring and Summer of 2004 and improved financial position, the ratings on the Series 2003B restructuring can be enhanced with approximately $1.2 billion of insurance. Moody’s S&P Fitch Series 2003B Current Ratings Baa1 ABBB+ Restructuring Ratings Baa1 ABBB+ Series 2003A. In contrast, a Series 2003A restructuring would enhance ratings from Baa3/BBB/BBB to Baa1/A-/BBB+. However, we do not recommend this structure. Maximizing Efficiency-Early Call Structure. We have also maximized the efficiency of the Series 2003B restructuring with a cost effective early call structure, where a few specific maturities bear the cost of early call options that allow all of the annual coverage to be used to retire debt. MSA RISKS In developing the optimal refunding structure, we believe that it is critically important to build in reasonable structural protection (i.e., coverage and reserves) against the various tobacco risks so that it is not necessary to draw upon General Fund appropriations for payment of debt service or operating deficiencies. As the lead manager for the first State level tobacco securitization to be marketed in over two years, we 3 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION are the only Firm to have negotiated new rating criteria and to have completed the Rating Committee process with Moody’s, S&P and Fitch since 2003. We have the most up to date perspective on the risks inherent in a tobacco securitization, including one of the latest focal points – the risk of an NPM Adjustment as described below. billions in monetary damages. The manufacturers are also subject to other class actions, individual suits, and health care recovery suits seeking damages in the billions of dollars. However, we note that the litigation environment is actually improving on several fronts including the: ¾ Dismissal of the DOJ $280 billion disgorgement claim; ¾ Enactment of the Class Action Fairness Act of 2005 transferring all state level class actions seeking damages in excess of $5 million to the federal venue; and ¾ Dismissal of the Simon II national class action suit. As we have described to the State over the last two years, there are two major categories of risks to insulate against: ‰ ‰ reduction in MSA Payments beyond forecasted levels (i.e., declines in cigarette consumption and other potential payment decreases); and catastrophic risk (i.e., payment interruption). The specific risks within these two major categories are described below. Reductions in MSA Payments. Declines in MSA payments beyond forecasted levels may be due to the following. ‰ ‰ ‰ ‰ Pharmaceutical Solution to Nicotine Addiction. The next generation of smoking cessation products may be potentially more effective than gum and nicotine replacement products, thereby potentially reducing consumption. Regulatory Restrictions and Legislative Initiatives. These include smoking bans, state excise tax increases and potential FDA regulation. For example, future FDA regulation could regulate nicotine content to non-addictive levels, potentially decreasing consumption materially more than forecasted in the Global Insight Base Case. Growth in NPM Market Share. At the time of the State’s Series 2003A and Series 2003B transactions, the market share of the NPMs was assumed to be 5%. The Virginia tobacco securitization scheduled to be marketed by Bear Stearns this week utilizes 6.2% as the NPM market share assumption. Potential NPM Adjustment. It has been reported that 11 of the 43 SPMs have placed a portion of their April 2005 payment into a Disputed Payments Account alleging an NPM adjustment. See below for a more detailed discussion. Additionally, with at least 32 states having adopted appeal bond cap legislation there is a reduced risk of bankruptcy due to an inability to satisfy appeal bond requirements (i.e., the Price Situation). ‰ NPM Adjustment. As you will recall, the NPM Adjustment is designed to reduce the payments of the PMs under the MSA to compensate the PMs for losses in market share to NPMs as a 1 result of the MSA. The complicated NPM adjustment formula is essentially equal to 3x the Market share of the NPMs in the year in question as adjusted for Base Market Share in 1997. In general, any Settling State that adopts, maintains and diligently enforces its Model Statute is exempt from the NPM Adjustment. California has diligently enforced its Model Statute and Section 63049.4 of the Authorizing Act contains a statutory pledge to diligently enforce the Model Statute which is reinforced in the Purchase and Sale Agreement. Although Complementary Legislation is NOT required to demonstrate diligent enforcement, California has nonetheless implemented stringent contraband statutes. ‰ ‰ ‰ Disputed Payments. Under the terms of the MSA, disputes concerning payments can be raised up to four years after the payment is due. At least one SPM also placed a portion of its April 2005 payment into a Disputed Payments Account alleging that the Attorneys General extended unauthorized favorable financial terms to General Tobacco (the single largest NPM who became an SPM in August of 2004). Catastrophic Risk-Payment Interruption ‰ ‰ Risks Related to MSA and Model Statute Enforceability. There have been four cases which challenge the MSA and the Model Statute, seeking, among other things, injunctive relief. The most noteworthy is Freedom Holdings which challenges the MSA, New York’s Model Statute and Complementary Legislation on Sherman Antitrust Act grounds. However, as we have previously noted to the State, a similar case in California, Sanders v. Lockyer, which sought injunctive relief against the State and monetary damages from the manufacturers under the Sherman Anti-Trust Act and Cartwright Act, respectively, was decided by the United States District Court for the Northern District of California in favor of the State. Manufacturer Litigation Risk. There are a number of consumer fraud “lights” cigarette cases pending in Illinois, Minnesota, Missouri, Ohio and Massachusetts seeking BEAR, STEARNS & CO. INC. Potential Bankruptcy. This issue was last raised in earnest in April 2003 when Philip Morris publicly stated there was a risk that an immediate enforcement of the original Price trial judgment would force a bankruptcy. ‰ ‰ Beginning in 2004, only cigarette brands listed in the AG’s California Tobacco Directory may be sold in the State. Only PMs and compliant NPMs are listed in the Directory. It is illegal to put a state tax stamp on cigarettes unless the brand is listed in the Directory. Violations of the law are subject to civil and criminal penalties, and products not listed in the directory can be seized as contraband. The heightened focus on a potential NPM Adjustment has been due in part to press reports that certain SPMs placed a portion of their April 2005 payment into a Disputed Payments Account alleging that an NPM Adjustment is warranted due to lack of diligent enforcement of the MSA. The States of Kentucky, Montana and Vermont have also indicated that they expect OPMs to divert a portion of their future MSA payments into the Disputed Payments Account. These three states assumed an NPM Adjustment of 18.6% in projecting their fiscal 2006 and 2007 MSA payments for budgetary purposes. 1 If the PMs’ actual aggregate market share is between 0% and 16 2/3% less than the Base Aggregate Participating Manufacturer Market Share, the amounts paid by the PMs will be decreased by three times the percentage decrease in the PMs’ actual aggregate market share. If, however, the aggregate market share loss from the Base Aggregate Participating Manufacturer Market Share is greater than 16 2/3%, the NPM Adjustment will be calculated as follows: NPM Adjustment=50% +[50%, (Base Aggregate Participating Manufacturer Market Share-16 2/3%) X [market share loss-16 2/3%]. 4 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION One of the difficulties in evaluating the risk of an NPM Adjustment is the fact that the tobacco securitization issuers such as GSTSC are not parties to the PriceWaterHouseCooper’s Report and the Attorneys General (“AGs”) of the Settling States have universally taken the position that releasing the report is a violation of the confidentiality provisions of the MSA. To address this reality on the Virginia transaction Bear Stearns facilitated due diligence calls between the AG’s office and the rating agencies and also highlighted the following points for the rating agencies. ‰ ‰ ‰ ‰ ‰ In order for an NPM Adjustment to be applied, all three of the following must occur. ¾ The aggregate market share of the PMs must fall more that 2% below the market share of the PMs in 1997. This has occurred. ¾ A nationally-recognized economic consultant (agreed to by the PMs and Settling States) must determine that the provisions of the MSA were a significant factor in contributing to the market share loss (the “Significant Factor Determination”). The economic consultant has been selected; however the Significant Factor Determination has not been made. ¾ It must be proven that the Settling State at issue has failed to diligently enforce it Model Statute. This has not been proven for any Settling State, including California. The court with jurisdiction over the MSA would make a determination on the issue of diligent enforcement. We have highlighted that Judge Ramos in New York state court ruled that arbitration is not the proper forum for resolution of a diligent enforcement dispute. The risk of an NPM Adjustment is not a new risk. By way of example, in January 2002, B&W alleged that a larger NPM Adjustment should have been applied to the 2001 payment because a majority of the Settling States were not diligently enforcing their Qualifying Statutes in 2000. This dispute was resolved in April 2002 with the release of monies placed into the Disputed Payments Account. It is unlikely that an NPM adjustment, if granted against any states, would be permanently levied in future years given the enhanced enforcement activities of the Settling States. Therefore, the risk of an NPM Adjustment creates a potential liquidity issue rather than a pure credit issue. While NPMs have gained market share, the Model Statute compliance efforts have been bolstered by the fact that fortyfour states, including California, have passed or are considering Complementary Legislation to further ensure that NPMs are making required escrow payments under the Qualifying Statutes. Although similar legislation has been challenged in New York State by a cigarette importer on both constitutional and antitrust grounds (Freedom Holdings), these same points have been ruled on favorably in Sanders v. Lockyer in California. Subsequent to mailing the POC on Virginia, the Virginia AG, as an MSA notice party, received three separate letters from each of the OPMs stating that in connection with the market share loss for calendar year 2003, they intend to seek an NPM adjustment should the economic consultant determine that the MSA was a significant factor contributing to the 2003 market share loss. The Commonwealth stated that it believes that these actions by the OPMs are a continuation of the process by which the significant factor determination will be made and represent, in effect, a reservation of rights on a part of the OPMs with respect to potential 2003 NPM adjustments. In order to clarify unfortunate rumors and BEAR, STEARNS & CO. INC. inaccurate press releases regarding this issue, the Tobacco Settlement Finance Corporation released a supplement setting forth this development. As lead manager on this financing, Bear Stearns is at the forefront of this issue and can offer the State unique insights into the nature of the potential adjustments and structural solutions to guard against a General Fund impact. In developing the State’s transaction, Bear Stearns has taken a structured approach to addressing each category of risk through coverage and reserves, as described in greater detail below. OVERCOLLATERALIZATION SCENARIOS Our analysis includes four scenarios, each designed with a different level of coverage to protect against specific risks. As shown in the following graph and highlighted in the discussion below, these scenarios clearly demonstrate the tradeoff between higher coverage and reserve levels, greater protection for the General Fund and lower budgetary benefit. 3.0 ($ Billions) NPM Reserve Budgetary Benefit 2.5 Average Coverage 2.0 1.00 (x Coverage) 1.5 1.24 1.38 1.17 1.2 0.9 1.5 1.0 0.5 1.8 0.81 1.37 0.6 0.07 0.74 0.50 Scenario 2 Scenario 3 Scenario 4 0.0 Scenario 1 0.3 1.00 Scenario 1 Structural Protection: Average Coverage: Budgetary Benefit: None 1.00x $1.37 billion Scenario 2 Structural Protection: Average Coverage: Budgetary Benefit: Additional Consumption Risk 1.17x $1.00 billion 0 Scenarios 1 and 2 use the appropriation credit to leverage the tobacco stream with little or no expected coverage. However, these structures fail to protect the State’s General Fund from potential payment interruption risk or the possibility of an NPM Adjustment, beyond the extent of the Liquidity Reserve Account. Recommendation. Bear Stearns suggests structuring the transaction to meet additional contingent risks, including payment interruption and a possible NPM Adjustment. Our recommendation is to pursue either: ‰ ‰ Scenario 3, which provides $742 million of budgetary benefit and addresses potential NPM Adjustment through an additional reserve; or Scenario 4, which generates a budgetary benefit of nearly $500 million, while addressing a potential NPM Adjustment with higher annual coverage levels. Scenario 3 is the optimal structure if the State believes the NPM Adjustment is only a risk in the near term. Scenario 4 is preferred if the State believes the NPM Adjustment may be an ongoing annual deduction from TSRs, or if the State wishes to 5 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION partially protect against invalidation of the Model Statute or other risks to the MSA Payments that may be identified in the future. Scenario 3 Structural Protection: Additional Consumption Risk Payment Interruption 2003 & 2004 NPM Adjustment 1.24x $742 million after NPM Reserve Average Coverage: Budgetary Benefit: The structural protection provided in Scenario 3 is described in detail below. Additional Consumption Risk. In Scenario 3, the State would be protected against greater than expected declines in consumption relative to the Global Insight Base Case forecast. Specifically, the Global Insight Base Case forecasts a 1.77% average annual consumption decline with a 50% confidence level (i.e., it is the statistical mean). We asked Global Insight to prepare a forecast with a 95% confidence level, which forecasts an average annual consumption decline of 2.60%. Global Insight Consumption Forecasts 400 Billions of Sticks 300 Payment Interruption. In addition to the more dramatic 2.6% average annual consumption decline, Scenario 3 is also structured to withstand the stress of a severe payment interruption. The payment interruption stress test conservatively assumes: ‰ ‰ ‰ As illustrated in the table below, the Scenario 3 average coverage of 1.24x enables the transaction to withstand a threeyear Philip Morris payment interruption as early as 2006. The bonds can survive a much longer default of 50% of revenues as the transaction is seasoned. The payment interruption would be managed through the Liquidity Reserve Account sized at approximately $239 million. It is important to note that the covenant to seek an appropriation, under the Enabling Legislation, covers only debt service and operating expenses and not a liquidity reserve replenishment. Therefore, a reserve funded at MADS protects the General Fund against a Philip Morris bankruptcy of the following duration. 2045 Base Case : 189 Philip Morris Default Begins In…… 2006 2010 2015 2020 2025 2030 200 2045 95% Confidence Leve l: 134 100 Base Case Fore cast 95% Confidence Lev el 0 2004 2008 2012 2016 2020 2024 2028 2032 2036 2040 2044 The 95% Confidence Level is based upon a statistical analysis of potential outcomes above and below the Base Case Forecast. As shown in the graph below for 2045, potential outcomes are assumed to follow a normal distribution around the mean Base Case Forecast of 189 billion cigarettes in 2045. There is 95% confidence or probability that the outcome in 2045 will be between 134 and 245 billion and there is only a 2.5% probability that the outcome in 2045 will be below 134 billion. Distribution of 2045 Consumption 1.5% 1.2% 0.9% 0.6% % of Obse rv ations 1 SD 70%: 161 1 SD 70%: 217 ‰ 2 SDs 95%: 134 2 SDs 95%: 245 ‰ 0.3% 0.0% ‰ 95 108 121 134 147 160 173 186 199 212 225 238 251 264 277 Outside of 2 SDs W ithin 2 SDs of Mean W ithin 1 SD of Mean In Scenario 3, we have structured the debt service so that TSRs would be adequate on a stand-alone basis even if consumption declines as rapidly as the 95% Confidence Level (i.e., 2.6% per year). Initial year coverage is set at 1.21x in order to ensure sufficient coverage in the event of an NPM Adjustment in 2006 without tapping any reserves. BEAR, STEARNS & CO. INC. Number of Years Transaction Survives 3 3 4 4 No Default No Default It is also worth noting that the specific circumstances we have modeled in the payment interruption stress test are highly unlikely. The rating agencies as well as most market participants have concluded that Philip Morris would probably not retain its market share were it to declare a Chapter 11 bankruptcy. Nonetheless, selecting a coverage level that can withstand the loss of 50% of the MSA revenues for an extended period actually provides “cushion” to cover a broad range of potential risks, including payment disputes and the potential for an NPM Adjustment. For example, when structured with a reserve funded at MADS and designed to survive the payment interruption stress test described above, the bonds can otherwise withstand: ‰ M e an: 189 a Philip Morris bankruptcy for a period of at least three years; the loss of all of Philip Morris’ revenues for the bankruptcy period (50% of the MSA Payments); and a retention by Philip Morris of its market share during the bankruptcy period. an $88 million annual payment dispute lasting for up to three years (note an NPM Adjustment against all Settling States would result in approximately a $64 million annual adjustment); a 3.00% annual consumption decline over the life of the bonds (compared to the expected decline of 1.77%); an increase in the NPM market share to 20%, which is sustained over the life of the bonds while the Model Statute remains enforceable and there is no NPM Adjustment; or an NPM Adjustment of 18.54% in each year for the life of the transaction assuming static NPM market share of 8.2%. Potential 2003 & 2004 NPM Adjustment. As noted above, there is currently a heightened focus on the potential for an NPM In Scenario 3, this risk is addressed by Adjustment. structuring an extra taxable reserve (in addition to the liquidity reserve) that would be available to pay debt service in the event of an NPM Adjustment. Beginning in June of 2006, if no NPM Adjustment has been applied to the Pledged TSRs, the State would have the option to release the reserve to 6 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION the General Fund. If, in June of 2006, the State remains concerned about the risk of an NPM Adjustment, it can maintain the NPM Reserve until it is satisfied that the additional overcollateralization is unnecessary. In sizing an appropriate NPM Reserve, we note the following. ‰ ‰ ‰ ‰ ‰ The PMs have agreed with the Settling States not to allege a lack of diligent enforcement for any year between 1999 and 2002. Therefore, 2003 is the first year for which an NPM Adjustment can be alleged. California has had a strong record of diligently enforcing against NPMs and enhanced its enforcement in 2003 with the passage of Complementary Legislation to further ensure that NPMs are making required escrow payments. Although the economic consultants who will be responsible for making the “Significant Factor” determination have been selected, such a finding has not been made and is a prerequisite to any NPM adjustment. This fact is not altered by the notice to the Settling States from the OPMs regarding their participation in the NPM adjustment process. Given these factors and the State’s strong history of enforcement, it is unlikely that a failure to diligently enforce could be credibly asserted. However, in order to be conservative, we have modeled an NPM Adjustment in both 2003 and 2004. As shown below, an NPM Adjustment for 2003 and 2004 on the TSRs pledged to the Series 2003B Bonds would be approximately $64.34 million if the NPM Adjustment is levied against all of the Settling States1. 2003 $172,303,113 8.2% 18.54% $31,944,997 Pledged TSRs: NPM Market Share: NPM Adjustment: Adjustment in $: 2004 $174,711,412 8.2% 18.54% $32,391,496 We have assumed that the State would place $64.3 million in an NPM Reserve Account. As a result, the budgetary benefit of Scenario 3 (after funding the NPM Reserve) would be $742 million and would increase to $806 million if the NPM Reserve is not required to pay debt service. Scenario 4 Structural Protection: Range of Coverage: Average Coverage: Budgetary Benefit: Add. Consumption Risk Payment Interruption Annual NPM Adjustment 1.21x to 1.58x 1.38x $496 million Scenario 4 has annual coverage levels 0.13x higher than Scenario 3. In addition to surviving annual consumption declines of 2.6% and a loss of 50% of the Pledged TSRs for at least three years at any point in the life of the bonds, the 0.13x incremental coverage should be sufficient to cover an annual NPM Adjustment. We have assumed a static NPM adjustment of approximately 13% since NPM market share has declined to approximately 6.4% now that General Tobacco has joined the MSA. This alternative takes a more conservative approach to the potential NPM Adjustment Risk than Scenario 3, which has an incremental NPM reserve. 1 If the State would prefer to have additional protection against an NPM Adjustment, it could assume a potential adjustment levied against one-half of the Settling States (by allocable shares). The NPM Reserve would be funded at $128.6 million and would result in budgetary benefit after funding the NPM Reserve of $678 million. BEAR, STEARNS & CO. INC. Scenario 4 further insulates the general fund and addresses the potential for an NPM Adjustment Risk by creating enough annual cash flow coverage to withstand an NPM Adjustment in every year. We believe that it is highly unlikely that the State would face an NPM Adjustment in every year since any NPM Adjustment in one year would be followed by increased effort to diligently enforce the Model Statute. Nonetheless, the State may wish to structure for this additional protection in the event that the Model Statute is invalidated or new risks are identified in the future. PRODUCT MIX The results shown above assume that the bonds are sold on a fixed rate basis with up to $1.2 billion of bond insurance applied in optimal maturities. Please refer to Appendix C for the results of our insurance capacity survey. Given the availability of cost effective insurance for California today, we recommend considering various product enhancements to increase budgetary benefit. These options are summarized in the table below, where each alternative is shown with the incremental budgetary benefit it generates. Base Case Benefit BMA Swap % of LIBOR Swap Floating Rate Bonds CPI Bonds Stepped Coupon Bonds Scenario 3 ($ Millions) $742 million Scenario 4 ($ Millions) $496 million $67 million $252 million $304 million $3 million $3 million $58 million $229 million $198 million $3 million $3 million Swap Alternatives. The State has several options for issuing insured floating rate obligations and swapping them to fixed to avoid callable premium bonds and achieve a lower fixed rate cost of funding than would be available in the traditional fixed rate market. ‰ ‰ BMA Swap. In a BMA swap, the State would receive BMA and pay fixed. Since the BMA swap curve is 34 basis points better than fixed rate yields to call, the savings for the State comes from achieving lower yields and eliminating the callable premium bond pricing penalty. We estimate that a $1 billion BMA swap would save approximately $58 to $67 million on Scenario 3 or Scenario 4. % of LIBOR Swap. In a % of LIBOR swap, the State would receive a % of LIBOR and pay a fixed rate approximately 83 basis points lower than the BMA swap alternative. The differential represents compensation to the State for tax law risk and the result is approximately $229 to $252 million of economic benefit compared to a fixed rate transaction on Scenario 3 or Scenario 4. However, a percentage of LIBOR alternative exposes the State to tax law risk. Floating Rate Bonds. Alternatively, the State can incorporate insured floating rate bonds in the new money component of the structure. Assuming BMA remains at its 10-year historical average of 2.74%, structuring floaters in the 2041 to 2045 maturity range would increase budgetary benefit by approximately $304 million for Scenario 3 or $198 million for Scenario 4, where the new money component is considerably smaller. We note that with insurance, the floating rate obligations would be largely insulated from credit events in the tobacco sector. CPI Bonds. CPI Bonds are floating rate instruments where the rate of return to the investor is based upon a fixed spread plus inflation. Most issuers swap their CPI bonds back to fixed to generate all-in savings of 10 to 15 basis points. Our analysis assumes approximately $58 million of CPI Bonds in the 2021 7 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION maturity with a swap back to fixed to generate an incremental $2.5 million to $3.3 million in budgetary benefit. Alternatively, the State could issue unhedged CPI Bonds since the MSA provides for an Inflation Adjustment on TSRs that provides a natural hedge against rising inflation. Stepped Coupon Bonds. Although stepped coupon bonds are a relatively new product, they are gaining attention among major issuers as a vehicle for eliminating callable premium bond pricing and obtaining an early call option. Under this alternative, approximately $30 million would be structured in the 2021 maturity. The coupons would be set as follows. From Issuance 2010 2014 2018 To 2010 2014 2018 Maturity Coupon 3.75% 4.39% 4.89% 5.41% Spread to Golden State Scale + 50 + 62 + 85 + 125 The Stepped Coupon Bonds would be sold with a five year call and would be dollar priced at par. The Stepped Coupon Bonds increase budgetary benefit by approximately $3 million because they are more cost effective than callable premium bonds in achieving the early call structure we have recommended to redeem bonds from Surplus TSRs. the State can only appropriate for debt service and operating expenses. Without state backing for reserve replenishment, no surety policy can be obtained for the liquidity reserve. Escrow Investments. The Series 2003B Bonds will be escrowed to call with over $1.87 billion of US Agency securities required on June 1, 2013. Since only $9.9 billion of agency securities are outstanding in large, liquid maturities coming due on or before June 1, 2013, the State will face a liquidity issue in purchasing optimal escrow securities. Bear Stearns’ recommendation is detailed below. ‰ ‰ ‰ TRANSACTION IMPLEMENTATION Tax Considerations. The restructuring has two components: an advance refunding and a new money issue. ‰ The new money piece will fund either capital projects or budget relief. If budget relief, it will be subject to the “Proceeds Spent Last” rule as well as an ongoing Deficit Analysis. Either way, this component of the financing can be structured with tax-exempt capitalized interest and floating rate bonds1, if desired. ‰ The advance refunding will require taxable capitalized interest and can not be structured with unhedged floating rate bonds due to the need to establish a fixed rate arbitrage yield for the escrow. Rather than purchasing securities in the secondary market, an escrow portfolio can be tailored with customized “Aaa / AAA” rated Government Sponsored Agency securities. By customizing the securities, the State can overcome the lack of agency supply in the secondary market. Custom agencies would satisfy tax law requirements as long as the fair market value of the portfolio can be established and we can demonstrate that the custom agencies cost less than SLGS or open markets. Running a bid among the agencies to provide the custom securities would alleviate many of the fair market value concerns. While there is a slight yield reduction for customized agencies relative to agencies purchased in the secondary market, the custom maturity structure eliminates “dead time”, thereby offsetting the lower yields. Presented below is a summary of the five largest and most frequent agency issuers, together with their capacity and pricing levels under current market conditions. The comparable US Treasury Bond (3.625% of 5/15/2013) is presented for comparison. Agency Fannie Mae Freddie Mac FHLB FFCB TVA UST Yield 4.47% 4.44% 4.47% No Interest No Interest 4.06% Spread LIBOR – 12 LIBOR – 15 LIBOR – 12 No Interest No Interest LIBOR - 53 Comments $4 billion OK $4 billion OK $4 billion OK Rarely > 5 yrs Too Big For Comparison In addition, Scenario 3 incorporates an NPM Reserve Account that would be funded from bond proceeds. Since the Liquidity Reserve, funded at MADS, together with the NPM Reserve would exceed 10% of the sale proceeds of the Bonds, we have assumed the NPM Reserve would be funded taxably. While it is true that a reserve funded at one half of MADS would alleviate the need to fund the NPM Reserve taxably, we don’t recommend that strategy as it dilutes the structural protection that Scenarios 3 and 4 create for the General Fund. Indenture Strategy. As the State is aware, the existing $5 billion statutory authorization can be applied to this transaction if: Reserve Strategy. Although the $201.6 million existing reserve fund agreement can be broken at market at any time, we suggest transferring it to the restructurings since the cost of breakage would potentially be high under current market conditions. This strategy eliminates any transaction costs associated with breaking the agreement at market and entering into a new investment. Since the reserve on the restructuring would be funded at $219 million to $239 million, a second agreement can be structured for the incremental investment. Dan Keating, a Senior Managing Director and Public Finance Department Head, will provide project oversight. Frank Quinn, a managing director in Public Finance will serve as the relationship manager. The day-to-day contacts will be Kym Arnone, a Senior Managing Director in Public Finance, Dan Hartman, a Managing Director in Bear Stearns’ San Francisco’ Public Finance office, Juan Pittman, a Managing Director in Bear Stearns’ Los Angeles’ Public Finance Office and Ira Wagner, a Senior Managing Director in Bear Stearns' Asset-Backed Department. Ms. Arnone and Mr. Wagner run the firm’s Tobacco Securitization Group. Our quantitative analysis team is led by Amy Kessler, a Managing Director in the Public Finance Department. Larry Cohen, Senior Managing Director in the Financial Analytics and Structured Transactions (“FAST”) Group is responsible for Monte Carlo analysis. John Suh, will provide quantitative and banking support. Sales and marketing will be coordinated from our municipal bond desk by Dan The only circumstance where we would only recommend breaking all or a portion of the existing reserve fund agreement is if it could be replaced with a surety policy. While surety policies would be commercially available and cost effective if the reserve fund were replenished under the State’s appropriation pledge, 1 Assumes 15 days between fixed rate and floating rate pricings. BEAR, STEARNS & CO. INC. ‰ ‰ the State defeases all of the outstanding bonds; while maintaining the existing Indenture. Bear Stearns’ proposal is designed to achieve this objective. 4. Assigned Personnel 8 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION Keating, Head of Municipal Finance, who will be assisted by As outlined in John Young, Senior Managing Director. Attachment A, each of these individuals has relevant expertise for the proposed restructuring. Bear Stearns has a strong record of service to the State of California. As in all of our previous engagements, the State will be a top priority and the professionals working on this engagement will be available to the State at all times. Further, the experience of the team will result in an efficient and streamlined financing process. In addition to the State’s own experience working with Bear Stearns on large and complex financing programs, we suggest that the State contact the tobacco securitization issuers identified in Question 1 to confirm Bear Stearns’ dedication of senior personnel throughout the entire tobacco securitization financing process. Underwriting Expense Breakdown $/$1,000 $0.00799 Travel and Roadshow $0.00202 Good Faith Interest $0.06000 Dalcomp/ Dalnet $0.00319 Advertising (Net Roadshow) $0.00160 Communications 3 $0.06389 Underwriter’s Counsel $0.02778 Day Loan $0.00096 CDIAC $0.00022 Other (Cusip & DTC) $0.16811 Sub-Total Expenses $ Amount $25,000 $6,319 189,265 $10,000 $5,000 $200,000 $86,951 $3,000 $703 $526,239 1 Bear Stearns’ share only. Bear Stearns proposes a takedown of $3.75 through 2015 and $5.00 thereafter. 3 Fee quote from Hawkins Delafield. Assumes Disclosure Counsel prepares OS. 2 6. Updated Licensing, Registration, Disciplinary Action, and Litigation Matters Investment Banking Kym Arnone Senior Managing Director Relationship Manager Dan Keating Department Head Project Oversight The firm has two items to add since the filing of its last quarterly report: Senior Day-to-Day California Banker Dan Hartman Managing Director Frank Quinn Managing Director Juan Pittman Managing Director Structuring & Quantitative Analysis John Suh Associate Amy Kessler Managing Director Asset Backed Securitization Ira Wagner Senior Managing Director Larry Cohen Senior Managing Director Marketing & Underwriting* Dan Keating Senior Managing Director John Young Senior Managing Director Research Don Lipkin Managing Director Gyan Sinha Senior Managing Director Chris Durso Senior Managing Director In February 2005, Bear Stearns received a notice that the Office of the Secretary of State, Illinois Securities Department, had named Bear Stearns as a respondent in a hearing to determine if an order should be entered imposing a monetary fine and/or revoking Bear Stearns’ registration in the State of Illinois because of an alleged failure to respond to a subpoena by its due date. Bear Stearns presently has produced the documents subpoenaed, and intends to appear at the hearing to defend itself. This matter is unrelated to the investigation being conducted by the SEC and requests for documents received from various regulatory authorities concerning Bear Stearns’ municipal underwriting business. * Pricing and Syndication. 5. As previously disclosed, Bear Stearns has been cooperating with certain state and federal investigations or inquiries concerning its municipal underwriting business conducted through its Chicago office. On or about May 9, 2005, a federal grand jury issued an indictment against three individuals, including a former employee of Bear Stearns' Chicago office, which included allegations of mail fraud, wire fraud, and extortion in connection with the building and financing of medical facilities in Illinois. The indictment does not charge Bear Stearns with any unlawful conduct. Bear Stearns continues to cooperate with these inquiries or investigations. Proposed Compensation Structure b. The table below presents Bear Stearns’ proposed compensation structure assuming a $3.13 billion issue (Scenario 4), generating $496 million of budgetary benefit. We wish to emphasize that while we have presented a fee structure that we believe is reasonable, we would rather negotiate our fees than lose an opportunity to serve the State. Proposed Underwriter’s Spread $/$1,000 Structuring Fee $0.120 1 Average Takedown2 $4.930 $0.168 Total Expenses $5.218 Total Gross Spread BEAR, STEARNS & CO. INC. $ Amount $375,000 $15,432,133 $526,239 $16,333,372 Litigation, Arbitration, and Disciplinary Actions As a full-service broker-dealer, Bear Stearns is from time to time, including the past 24 months, involved in litigation, arbitrations, and regulatory matters that arise other than from the firm’s underwriting practices or management, or the purchase, sale or distribution of taxable or tax-exempt municipal securities. For example, at any given time, the firm may be subject to an arbitration brought by an individual investor relating to the conduct of a broker. Matters deemed material are disclosed in The Bear Stearns Companies Inc.’s periodic reports filed with the SEC. During the past 24 months the firm has been in compliance with the STO’s mandate for filing its quarterly updates for pool membership. Material issues related to litigation, arbitration, disciplinary and other official actions arising from all business areas of the firm, including the tax-exempt and taxable municipal securities business, have been previously disclosed in such 9 GOLDEN STATE TOBACCO SECURITIZATION CORPORATION reports filed with the SEC and the STO and are included herein by reference. c. Legal structure and/or ownership of the firm Bear Stearns does not expect any change in legal structure and/or ownership of the firm. d. Completed Legal (Attachment B) Disclosure Certification Please see Attachment B. e. Tobacco Manufacturer Relationships Bear, Stearns & Co. Inc. has no relationships with any tobacco manufacturers and therefore no conflicts of interest in fact or appearance. If selected as senior managing underwriter for the GSTSC financing Bear Stearns is willing to refrain from performing any paid or unpaid work or providing any advice for a tobacco manufacturer involving interpretation of payment criteria under the Master Settlement Agreement or advice regarding the level of payments due under the MSA. See Attachment C. BEAR, STEARNS & CO. INC. 10 Attachment A Firm: Bear, Stearns & Co. Inc. STATE OF CALIFORNIA OFFICE OF THE STATE TREASURER Assigned Personnel Identify key personnel (including Investment Bankers, Underwriters, and Traders) who will be directly involved in the financing. How Long In Current Position? How Long Employed at Current Firm? How Long in Municipal Finance Practice? 13 Years 30 Years 33 Years Oversees all of the Firm’s municipal underwriting commitments and the pricing of all municipal issues. Yes Title Office Location SMD New York Underwriting GTSC bond issues; Head of Municipal Bond Department Frank Quinn MD New York Relationship Manager 4 Year 4 Year 32 Years Oversees Bear Stearns’ relationship with the State of California Yes Kym Arnone SMD New York Senior Day-to-Day Securitization Banker 5 Years 14 Years 19 Years Manages firm’s municipal securitization practice for Public Finance Yes Dan Hartman MD 3 months 3 months 14 years Day-to-day senior banker to the State of California Yes Juan Pittman MD Los Angeles Senior Day-to-Day California Banker 9 month 9 month 13 Years Day-to-day senior banker to the State of California Yes Amy Kessler MD New York Quantitative Analysis and Structuring Banker 7 Years 9 Years 15 Years Develops optimal structures for all of Bear Stearns’ securitization transactions Yes John Suh AS New York Quantitative and Banking Support 2 years 2 years 2 years Provides quantitative and analytical support for Bankers Yes Ira Wagner SMD New York Asset-Backed Securities Expert 1 Year 6 Years 21 Years Manages firm’s tobacco securitization practice for AssetBacked Securities Yes Larry Cohen SMD New York Monte Carlo Simulations and Rating Agency Stress Tests 1 Year 16 Years 16 Years Runs the ABS Department’s Financial Analytics and Structured Transactions Group Yes MD New York Credit Research Specialist 13 Years 13 Years 20 Years Head of Municipal Research Yes Name Daniel L. Keating Don Lipkin Role San Francisco Senior Day-to-Day California Banker Relevant Experience Availability Gyan Sinha SMD New York Asset-Backed Credit Specialist 4 Years 8 Years 11 Years Head of Asset-Backed Research Yes Chris Durso SMD New York Trader 6 Years 20 Years 20 Years Senior Tobacco Bond Trader Yes SMD = Senior Managing Director MD = Managing Director AS =Associate ATTACHMENT A –ASSIGNED PERSONNEL & RESUMES RESUMES Department Head/Project Oversight Daniel L. Keating, Senior Managing Director. Dan is a Senior Managing Director for Bear, Stearns & Co. Inc. Dan is in charge of all Tax-Exempt Fixed Income, as well as being co-head of the Municipal Derivatives Group. Dan joined Bear Stearns in 1975 as a municipal institutional salesman and in 1983 was promoted to General Partner. Mr. Keating is a member of the Board of Directors of the firm’s broker/dealer subsidiary as well as a past Chairman of the firm’s President’s Advisory Committee. He is on the Board of Directors for the Bond Market Association and is serving as Chair of the Municipal Securities Division. He is a former Chairman of the Municipal Securities Rulemaking Board. He is a graduate of St. Peter’s College in New Jersey. INVESTMENT BANKING – PUBLIC FINANCE Francis J. Quinn, Managing Director. Mr. Quinn joined Bear Stearns in 2001 as a Managing Director in the Firm’s New York Public Finance office. He has primary responsibility for the Firm’s relationship with the California State Treasurer’s Office. During the past 13 years Mr. Quinn has senior managed four transactions for the State of California, including two transactions totaling $462 million for the State Public Works Board, the $300 million California Infrastructure and Economic Development Bank’s SRF Leveraging program and the $3 billion Golden State Tobacco Securitization Corporation transaction. He is also responsible for the Firm’s participation as a cosenior manager in connection with the Department of Water Resources Power Supply financing program as well as the State General Obligation VRDO program. In addition, he has served as a banker for a number of co-manager assignments for the State and its financing authority issuers. During his 32 year career he has participated in the financing of a broad range of tax-exempt and taxable debt transactions throughout the country, including a number of special tax and general fund supported financings. Mr. Quinn is a graduate of Providence College and received an MBA from Boston College. He has NASD Series 7, 53 and 63 licenses. Kym Arnone, Senior Managing Director. During her 19 year career, Ms. Arnone has senior managed over $20 billion of financings for major issuers across the nation including the State of California. Ms. Arnone is the Firm’s leading tobacco securitization expert. Ms. Arnone worked with Ira Wagner on New York City’s TSASC financing -- the nation’s first securitization of the Master Settlement Agreement with the major cigarette manufacturers. Ms. Arnone’s tobacco transactions include the first multi-lien transaction, the first 100% full turbo tobacco securitization, the first taxable transaction and the first senior/subordinate tranche. Ms. Arnone was responsible for senior managing the State’s $3 billion Golden State Tobacco Securitization Corporation offering and leading our team on the Series 2003B transaction. In addition, she has since senior managed tobacco securitizations for the States of Alaska, Louisiana, New Jersey, New York, Oregon, South Carolina, South Dakota, Wisconsin and Virginia as well as Erie County and Puerto Rico’s Children’s Trust. In addition to appropriation enhanced tobacco bond experience, Ms. Arnone has lead over $4 billion of appropriation backed bonds for Indiana, Ohio and New York City. Ms. Arnone received a Bachelor's degree in finance from St. John's University. Ira Wagner, Senior Managing Director. Mr. Wagner will provide senior Asset Backed Securities expertise to the Golden State Tobacco Securitization Corporation. Mr. Wagner began his career as a housing finance banker in 1981. Since that time he has developed a broad background in mortgage and asset securitization. He joined Bear Stearns in 1996 and has been responsible for bringing a number of new asset classes to the ABS market. Mr. Wagner and Ms. Arnone have co-led the Firm’s pursuit of esoteric future receivable securitizations that involve municipal issuers. His tobacco securitization experience includes the first transaction for TSASC as well as subsequent securitizations for Nassau County, New York, Erie County, New York, the States of Alaska, South Carolina and Louisiana and Puerto Rico’s Children’s Trust. Mr. Wagner has also structured the first securitization of future film receivables for DreamWorks and the first securitization of future revenue rights for the Pepsi Center Sports Arena in Denver. Mr. Wagner is also a specialist in the structuring and distribution of CBOs – transactions backed by pools of corporate obligations. Prior to joining Bear Stearns, Mr. Wagner was a Senior Vice President at Donaldson, Lufkin & Jenrette managing securitizations of sub-prime residential mortgages, commercial mortgages and small business loans. He received a B.A. in Government from the University of Virginia and his M.B.A. in Finance from the Wharton School of the University of Pennsylvania. Dan Hartman, Managing Director. Dan Hartman is a Managing Director in Bear Stearns’s San Francisco office. Prior to joining Bear Stearns, Mr. Hartman spent 14 years working at Citigroup and Public Financial Management, where he was a Managing Director. Mr. Hartman’s experience includes over $15 billion of municipal bond issuance, in the role of senior manager or financial advisor. Mr. Hartman has substantial experience in project financing and securitization financings, as well as state appropriation credits. This experience includes the completion of several tax lien securitizations for a number of municipalities and extensive evaluation of securitization financings for public power issues relating to stranded costs and federally mandated projects. As part of these engagements, Mr. Hartman has overseen the implementation of a broad array of financing structures, including debt restructurings and derivative product applications. Mr. Hartman graduated from the University of North Carolina – Chapel Hill and the London School of Economics. Juan Pittman, Managing Director. Mr. Pittman joined Bear Stearns in 2004 as a Managing Director in the firm's Los Angeles office. Prior to joining the Firm, Mr. Pittman worked at UBS Financial Services for five years following an additional five years of public sector service with the City of Los Angeles. Mr. Pittman has extensive experience with California GO, lease revenue, COP and sales tax issuers. Mr. Pittman began his career as a bond counsel lawyer and has been responsible for over $12 billion dollars in financings in capacities ranging from Bond Counsel Attorney, Senior Financial Officer, Assistant Deputy Mayor and Investment Banker. In his banking career, he has provided senior and co-senior managed banking services to a number of clients, including the State of California, the County of Alameda, City of Anaheim, the City of Los Angeles, the City of Long Beach, the Los Angeles Department of Water and Power, the Los Angeles Harbor Department, the Los Angeles County Metropolitan Transportation Authority, the Metropolitan Water District of Southern California, the Sacramento County Sanitation District and the City of Oakland. Mr. Pittman graduated from George Washington University (J.D.) and Howard University (B.A.). He has NASD Series 7, 24, 53, and 63 licenses. QUANTITATIVE ANALYSIS Amy Kessler, Managing Director. Ms. Kessler is responsible for structuring Bear Stearns’ tobacco securitizations. Ms. Kessler is Bear Stearns' municipal linear optimization specialist and has designed and built our proprietary linear optimization models to structure a variety of complex transactions and financing plans nationwide. Ms. Kessler was responsible for structuring the State’s $3 billion Golden State Tobacco Securitization Corporation offering. Her tobacco securitization experience also includes serving as a senior manager to the States of Alaska, Louisiana, New Jersey, New York, Oregon, South Carolina, South Dakota, and Wisconsin as well as Erie County and Puerto Rico’s Children’s Trust. In addition, Ms. Kessler is currently working on structuring the Commonwealth of Virginia’s $428.5 million tobacco securitization offering. Significantly, Ms. Kessler led Bear Stearns’ analytical team in the successful rating agency process that resulted in the nation’s first multi-lien tobacco securitization, the nation’s first full turbo transaction and the largest tobacco issues ever completed. She has also senior managed four municipal asset securitizations for the New York City Transitional Finance Authority. Ms. Kessler has been with Bear Stearns for six years of her fifteen-year career. She holds a B.A. in Economics and an M.A. in International Economics & Finance from Brandeis University, where she is a member of the Board of Overseers of the Graduate School and a frequent guest lecturer in quantitative methods in finance. Larry Cohen, Senior Managing Director. Mr. Cohen runs Bear Stearns’ Financial Analytics and Structured Transactions Group for Asset-Backed Securities. He designed and built Bear Stearns’ proprietary, multi-lien, stochastic models used in the simulation of tobacco settlement revenues. He is responsible for all Monte Carlo simulations and stress testing for all tobacco securitization transactions underwritten by the Firm. Mr. Cohen also has experience securitizing home equities, subprime mortgages, credit cards and auto loans. In addition, he has extensive experience in the valuation and trading of issuer retained interests in these transactions. Prior to joining Bear Stearns in 1985, Mr. Cohen worked as an Engineer at Sperry Systems Management in Great Neck, New York. He received his B.A. in Computer Science from Columbia University. John Suh, Associate. Mr. Suh joined Bear Stearns in August of 2003. His responsibilities include providing quantitative and analytical support for senior bankers. Mr. Suh holds a Master of Science in Computational Finance from Carnegie Mellon University and a Master of Science in Mathematics from the University of Illinois Urbana-Champaign. RESEARCH Don Lipkin, Managing Director and Head of Municipal Research. Mr. Lipkin is widely regarded as the authority on Tobacco Settlement Revenue Bonds. He has published extensively on all aspects of the Tobacco Bond sector, publishing over 20 formal reports in the last 15 months, as well as numerous research notes. He has also hosted investor conference calls, the last attracting over 80 investor, issuer representatives and our competitors to hear his thoughts on the sector. He is relied on by the investor community for his independence and expertise in this area. This year, he was again named an All-Star Municipal Analyst by Smith’s Research and Ratings Review for his work on Tobacco Settlement Bonds. In addition, he was named by Institutional Investor as the number two Municipal Generalist among all sell-side analysts. Mr. Lipkin joined Bear Stearns in 1991 and concentrates on the high-grade municipal sector. He is a generalist who has studied all areas of the municipal market. He and his colleague, Jerry Solomon, provide timely trade support for the buy-side community. Mr. Lipkin came to Bear Stearns from the First Boston Corporation, where he was a vice president of municipal research specializing in tax-backed and housing bonds. He has worked in the Public Finance department of Squire, Sanders & Dempsey, Bond Counsel. He is a Chartered Financial Analyst and has graduate degrees from the State University of New York at Albany, the University of Maryland, and the State University of New York at Buffalo. He is a past chair of the Credit Committee of the Bond Market Association, and has been one of their representatives to the Muni Council, an industry-wide group working to improve disclosure in the Municipal Bond Market. Mr. Lipkin is also an active member of the National Federation of Municipal Analysts. Gyan Sinha, Senior Managing Director. Mr. Sinha heads the Asset-Backed and CDO Research groups. Prior to joining Bear Stearns, he was a Vice President at CS First Boston in the Mortgage Research area. Mr. Sinha was an Assistant Professor in the Faculty of Commerce at the University of British Columbia from 1991 to 1993. Mr. Sinha has been ranked in the Institutional Investor’s All-American survey for his work in Asset-Backed Securities Prepayments for the last seven years. Mr. Sinha’s team ranked first in the 2004 rankings for ABS Prepayments, first in CDO and was runner-up in the ABS real-estate categories. Mr. Sinha received a Bachelor’s degree in Economics in 1985 from Delhi University and a Ph.D in Economics from Syracuse University in 1991. Mr. Sinha has been at Bear Stearns for 7 years. TRADING AND UNDERWRITING Christopher Durso, Senior Managing Director. Mr. Durso has over 20 years’ experience trading municipal securities at Bear Stearns. For the past six years he has been the senior long bond trader and in that capacity has been responsible for trading, among other credits, the firm’s tobacco bond position. He has traded both series of the long-term Golden State Tobacco Securitization Corporation’s bonds since their inception in 2003 and is well acquainted with their trading characteristics in all market conditions. Mr. Durso is a graduate of Pennsylvania State University. John Young, Senior Managing Director. Mr. Young, in his 30th year in the industry, has a broad range of experience in the underwriting and marketing of municipal securities, with a particular emphasis on tobacco securitization bonds. Mr. Young is also the sales and marketing manager for the municipal bond department. In this capacity, he is responsible for the design and execution of all investor tours and investor relations programs as well as the production and distribution of all marketing materials, including credit summaries, trade ideas, and relative value analyses. Prior to joining Bear Stearns, Mr. Young worked for Citicorp/Citibank for 15 years serving at various times as head of its municipal securities commitment desk and as manager of both tax-exempt and taxable fixed income underwriting. Mr. Young has a Bachelor of Arts from Hamilton College. Attachment B Legal Disclosure Certification I, Daniel L. Keating, Senior Managing Director, certify as follows: I am the Senior Managing Director of Bear, Stearns & Co. Inc. (the “Firm”) and am authorized to execute this Certification on its behalf. The firm is interested in providing underwriting services to the State of California and has submitted a Supplementary Statement of Qualifications to the State Treasurer's Office for the Golden State Tobacco Securitization Program in order to be considered for appointment to provide such services. In the Statement of Qualifications, the firm has responded to questions regarding legal proceedings against the firm, as specified, in connection with offerings of municipal securities in California transactions and nationwide. The Request for Statement of Qualifications requires that the firm notify the State Treasurer's Office regarding changes to the legal information submitted with the Statement of Qualifications, as well as information about legal proceedings originating after submission of the Statement of Qualifications. I certify that I have reviewed the requirements for updating the State Treasurer's Office regarding legal proceedings, and I agree, on behalf of the firm to fulfill the requirements outlined. ____________________________________ Daniel L. Keating Senior Managing Director Bear, Stearns & Co. Inc. Dated: May 10, 2005 Attachment C STATE OF CALIFORNIA OFFICE OF THE STATE TREASURER Conflict of Interest Firm: Please identify and describe below any of your firm's past or current relationships which may be considered an actual or potential conflict of interest including, but not limited to, 1) current or prior relationships with tobacco manufacturers, and 2) clients that have or seek interaction with the State Treasurer's Office or the boards, commissions or authorities chaired by the Treasurer. (Please use as much space as needed.) Do not rely upon other, previously submitted, disclosures. Company Relationship (Please be specific*) None None * Please include, at a minimum, a description of the nature and subject of the relationship, and the beginning and ending dates of the relationship. Appendix A Tobacco Rankings as of 5/4/2005 Source: Thomson Financial BEAR STEARNS Tobacco Rankings 5/4/05 Book Runner Full to Book Runner (Equal if Joint) Par Amount (US$ mil) Rank Mkt. Share Number of Issues Bear Stearns & Co 10,927.7 1 40.7 20 Citigroup 10,750.2 2 40.0 22 J P Morgan Securities Inc 2,171.7 3 8.1 3 UBS Financial Services Inc 1,486.0 4 5.5 19 Merrill Lynch & Co 570.6 5 2.1 2 First Albany Capital Inc 505.4 6 1.9 6 M R Beal & Co 220.5 7 0.8 1 Morgan Stanley 166.1 8 0.6 5 50.0 9 0.2 1 26,848.1 - 100.0 77 0.0 - 0.0 0 26,848.1 - 100.0 77 Merchant Capital LLC Subtotal with Book Runner Subtotal without Book Runner Industry Total (*):tie Source: Thomson Financial 1.973.622.5200 Date: 05/04/2005 Page 1/1 Appendix Detailed Summary of Refunding Results BEAR STEARNS APPENDIX B Summary of Results (Refunding of Series 2003B) Scenario 1* Scenario 2 Scenario 3 Scenario 4 PV of CABs Current Interest Bonds Issue Size $492,379,595 $3,619,897,247 $4,112,276,842 $55,234,353 $3,603,562,318 $3,658,796,671 $51,259,867 $3,423,663,342 $3,474,923,209 $99,282,553 $3,030,968,095 $3,130,250,648 Transaction Net Proceeds Existing Reserves Cash On Hand (DSA) Total Sources of Funds $4,262,189,535 $201,647,981 $67,792,444 $4,531,629,960 $3,805,673,137 $201,647,981 $67,792,444 $4,075,113,562 $3,610,952,147 $201,647,981 $67,792,444 $3,880,392,572 $3,244,319,141 $201,647,981 $67,792,444 $3,513,759,566 Escrow Deposit Credit Enhancement Fee to State Capitalized Interest Fund Costs of Issuance Bond Insurance Reserve Fund Capitalized Operating Expenses Total Uses of Funds $2,664,140,578 $1,367,049,706 $93,912,175 $28,785,940 $34,748,798 $342,842,763 $150,000 $4,531,629,960 $2,664,140,578 $1,006,943,253 $92,940,525 $25,611,578 $33,390,143 $251,937,485 $150,000 $4,075,113,562 $2,664,140,578 $806,222,543 $109,789,320 $24,324,464 $36,515,681 $239,249,986 $150,000 $3,880,392,572 $2,664,140,578 $496,467,877 $77,593,436 $21,911,757 $34,708,104 $218,787,814 $150,000 $3,513,759,566 Increase In General Fund Exposure Efficiency Ratio $1,607,581,842 85.01% $1,154,101,671 87.25% $970,228,209 83.10% $625,555,648 79.35% Cost of Funds Escrow Yield Negative Arbitrage 5.004% 4.327% 68 basis points 4.942% 4.327% 62 basis points 4.940% 4.327% 61 basis points 4.947% 4.327% 62 basis points Amount Refunded Rated Final of Refunded Expected Final of Refunded $2,504,695,000 2043 N/A $2,504,695,000 2043 N/A $2,504,695,000 2043 N/A $2,504,695,000 2043 N/A 1.00x to 1.00x 1.00x 1.00x to 1.36x 1.17x 1.06x to 1.43x 1.24x 1.21x to 1.58x 1.38x 2045 2045 2045 2037 2045 2034 2045 2030 Range of Coverage Average Coverage Rated Final of Refunding Expected Final of Refunding * Potential budgetary benefit from Scenario 1 is limited by a $1.5 billion FV constraint on the amount of CABs that can be marketed at one time. Summary of Results (Refunding of Series 2003A) Scenario 1* Scenario 2 Scenario 3 Scenario 4 PV of CABs Current Interest Bonds Issue Size $484,178,067 $4,735,628,797 $5,219,806,864 $71,727,381 $4,683,694,836 $4,755,422,217 $66,355,478 $4,441,109,175 $4,507,464,653 $128,302,531 $3,925,231,982 $4,053,534,514 Transaction Net Proceeds Existing Reserves Cash On Hand (DSA) Total Sources of Funds $5,415,421,946 $249,240,937 $94,901,131 $5,759,564,014 $4,946,548,010 $249,240,937 $94,901,131 $5,290,690,078 $4,681,466,359 $249,240,937 $94,901,131 $5,025,608,427 $4,199,047,517 $249,240,937 $94,901,131 $4,543,189,585 Escrow Deposit Credit Enhancement Fee to State Capitalized Interest Fund Costs of Issuance Bond Insurance Reserve Fund Capitalized Operating Expenses Total Uses of Funds $3,308,100,670 $1,829,141,370 $123,437,722 $36,538,651 $26,282,164 $435,913,437 $150,000 $5,759,564,014 $3,308,100,670 $1,463,576,211 $121,117,647 $33,287,956 $36,294,952 $328,162,642 $150,000 $5,290,690,078 $3,308,100,670 $1,196,613,971 $143,148,558 $31,552,254 $34,406,508 $311,636,466 $150,000 $5,025,608,427 $3,308,100,670 $787,771,777 $101,023,200 $28,374,744 $33,160,333 $284,608,861 $150,000 $4,543,189,585 Increase In General Fund Exposure Efficiency Ratio $5,219,806,864 35.04% $4,755,422,217 30.78% $4,507,464,653 26.55% $4,053,534,514 19.43% Cost of Funds Escrow Yield Negative Arbitrage 4.988% 4.336% 65 basis points 4.947% 4.336% 61 basis points 4.954% 4.336% 62 basis points 4.961% 4.336% 62 basis points Amount Refunded Rated Final of Refunded Expected Final of Refunded $2,904,600,000 2042 2022 $2,904,600,000 2042 2022 $2,904,600,000 2042 2022 $2,904,600,000 2042 2022 1.00x to 1.00x 1.00x 1.00x to 1.36x 1.17x 1.06x to 1.43x 1.24x 1.21x to 1.58x 1.38x 2043 2043 2045 2037 2045 2034 2045 2030 Range of Coverage Average Coverage Rated Final of Refunding Expected Final of Refunding * Potential budgetary benefit from Scenario 1 is limited by a $1.5 billion FV constraint on the amount of CABs that can be marketed at one time. Appendix Insurance Capacity Survey BEAR STEARNS APPENDIX C –INSURANCE CAPACITY SURVEY Insurer Capacity Premium MBIA Although they have $150 to $200 million of capacity for GO or regular appropriation. They’d rather hold it for a simpler deal. 55 – 60 basis points on normal appropriation. AMBAC $320 Million freed up from refunding the 2003B plus incremental capacity assumed at $500 - $700 million all in, including free-up. Recent bid for state approp. was 90 bps – use 100 bps. Reinsurance 2003 Bonds & Credit For Amounts Paid Did not insure 2003 B Not sure where it is now. Insured $320 Million 2038 and 2043 Bonds Credit For Old Premium: No. CIFG Not Licensed in CA Secondary Market only. FGIC None. FSA $250 million of capacity, including the $100 million free-up from the Series 2003B. 100 bps. Radian Would have a small amount of capacity. 20 – 40 basis points but 5 to 7 bps spread between Radian insured and uninsured Is a reinsurer….capacity offered for reinsurance is the same as capacity offered to state in primary. Didn’t bid but has insured bonds in the secondary and has done some as reinsurance. XL Capital Assurance $100 - $200 million, possibly $300 - $400 million with reinsurance. 100 basis points, a little higher if reserve is ½ MADS (adds 20 – 25 bps). Familiar with the credit but has not participated in the secondary market. Would prefer to use insurance on a more vanilla appropriation deal. Reserve is important on this credit appropriation Capacity is tight. Looking at it as a State of California credit and is capacity constrained. CIFG might do it as reinsurance. TOTAL: $1.05 - $1.35 BILLION 100 bps reflects credit for $100 million insured on 2003Bs.