U.S. Department of the Treasury

Office of Debt ManagementAugust 3, 2010Presentation to theTreasury Borrowing Advisory Co
Agenda

2 

•Fiscal Developments•Auction Demand•Portfolio Metrics Update•Long-Term Challenges
FISCAL DEVELOPMENTS

3
Tax Receipts

4 

-60%-40%-20%

0%

20%40%60%

Mar-00

Jul-00

Nov-00

Mar-01

Jul-01

Nov-01

Mar-02

Jul-02

Nov-02

Mar-03

Jul-03

Nov-03

Mar-04

Jul-04

Nov-04

Mar-05

Jul-05

Nov-05

Mar-06

Jul-06

Nov-06

Mar-07

Jul-07

Corporate Taxes Withheld Taxes Nonw

Note: Adjusted for 9/11/01 Corporate Tax Receipts disruption

Quarterly Tax ReceiptsYear over Year Percentage Change through June 30, 2010

Note: Data plotted are ye

A closeCorporWithheNonwit
Recovery in Receipts Compared to Previous Recess

5

Data: Monthly Tre

Note: 2001 tax cuts lowered receipts versus ot

‐20%‐15%‐10%

‐5%

0%5%

10%15%20%

0 1 2 3 4 5 6 7 8 9 10 

Quarters Since Trough in GDP

Growth in Receipts From Each Recession's Trough in GDPPercentage Change in Receipts Adjusted for Inflation* from T=0

*4‐Quarter Mo

‐4%‐3%‐2%‐1%

0%

Recession 1957‐1958 1960‐1961 1970 1974‐1975 1980 1981‐1982 1990‐1991 2001 

Peak to Trough Change in Real GDP
TARP Repayments

6 

-$150-$125-$100

-$75-$50-$25

$0

$25$50$75

$100$125$150

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Repayments, Dividends, Interest (LHS) Cash Outflows (LHS) Cum

TARP Cash FlowsIn Billions $

The Automotive Industry Financing Program providedapproximately $80bn in loans and equity investment.

In June, over $68bn was repaid to the CapitalPurchase Program by JPMorgan, Morgan Stanley,Goldman, US Bancorp, AMEX, BONY, BB&T,Capital One, State Street, and Northern Trust.

In March, the Term Asset -BackedLending Facility , a joint venture with the Federal Reserve, was launched.

On October 14, 2008, the Capital Purchase Program is launched. By January 1, 2009, over $247bn in funds had been disbursed to U.S. banks.

In DeWells $90b
Cumulative Fiscal Budget Deficits Year-to-Date

7

Data: OMB for end of Fiscal Year, Mo

0

200400600800

1,0001,2001,4001,600

October November December January February March April May J

FY2008 FY2009 FY2010

Fiscal Year to Date DeficitsIn Billions $
Primary Dealer and Government Deficit Estimates

8

FY 2010-2012 Deficit and Borrowing Estimates 

Primary 

Dealers* 

FY 2010 Deficit Estimate 1,351 FY 2011 Deficit Estimate 1,207 

FY 2012 Deficit Estimate 997 

FY 2010 Deficit Range 1,250-1,500FY 2011 Deficit Range 995-1,400FY 2012 Deficit Range 642-1,200FY 2010 Marketable Borrowing Range 1,150-1,700FY 2011 Marketable Borrowing Range 950-1,479Estimates as of: Jul 2010 Ja*Based on Primary Dealer feedback on July 26, 2010. Deficit estimates a
AUCTION DEMAND

9
Auctions Continue to Exhibit Strong Coverage

$0

$200$400$600$800

$1,000$1,200$1,400$1,600$1,800$2,000

2000 2001 2002 2003 2004 2005 2006 2007 

Weighted Average Coverage Ratio on Notes and Bonds In Billions $, Coverage Ratio

Gross Private Issuance (LHS) Weighted Average Coverage R

Note: Excludes TIPS and Bills issuance.

10
Investment Funds Have Increased Coupon Auction P

Investment F

21%

Foreign

Internation

FYTD2010: Average In

SOMA, 11% Individuals, 1%

Primary Dealers, 55%

Other Dealers

& Brokers , 2%

Investment Funds ,

14%

Foreign

&

International , 17%

FY2004-09: Average Investor Class Allotments

Note: Excludes Bills

11
Domestic Accounts Have Exhibited Increased Overa

Households includes households, domestic hedge funds, and non-profits.Mutual Funds include Mutual Funds, Money Markets, Closed-end Funds, and ETFs.

Source: Federal Reserve Fl

Foreign

&

International, 60%

Households, 9% SOMA, 3%

Depository

Institutions, 1%

Insurance

Companies, 2% Pension Funds, 5%

Mutual Fund, 11%

Brokers

& Dealers, 3%

State

& Local Govt, 3% Other, 2%

Purchase of Net Issuance by Investor Type:FY2004-09Change in Holdings as a Percentage of Net Issuance

Hous

SOMA, 1%

Depository

Institutions, 10%

Insurance Companies,

2%

Pension Funds

10%

Mutual Fund, 2%

Brokers

& Dealers, 3%

State

& Local Govt, 2%

Purchase of Net Issuance bFY2010 through Q2Change in Holdings as a Perce

Net Issuance FY2004-09: 3.5 Trillion Net Iss

*Please note figures represent net changes in holdings accomplished via secondary market transactions as well as auction participation.

12
Bank Holdings of Treasuries Have More Than Double

0%2%4%6%8%

10%12%

1980 - Q1

1981 - Q1

1982 - Q1

1983 - Q1

1984 - Q1

1985 - Q1

1986 - Q1

1987 - Q1

1988 - Q1

1989 - Q1

1990 - Q1

1991 - Q1

1992 - Q1

1993 - Q1

1994 - Q1

1995 - Q1

1996 - Q1

1997 - Q1

1998 - Q1

1999 - Q1

2000 - Q1

2001 - Q1

2002 - Q1

Treasury Holdings as a Percentage of Assets (L) Treasury Holdings 

Treasury Securities Held by Commercial BanksPercentage of Total Financial Assets, In Billions $

Com$72 

S

13
Demand For Duration Has Led to a Growth in Longer 

170175180185190195200205210

2007‐01

2007‐02

2007‐03

2007‐04

2007‐05

2007‐06

2007‐07

2007‐08

2007‐09

2007‐10

2007‐11

2007‐12

2008‐01

2008‐02

2008‐03

2008‐04

2008‐05

2008‐06

2008‐07

2008‐08

2008‐09

2008‐10

2008‐11

2008‐12

2009‐01

2009‐02

2009‐03

2009‐04

2009‐05

2009‐06

2009‐07

Securities Held in STRIPS FormIn Billions $ Par, End of Month

Total Strips Outstanding (L) Strips Outstanding +15 Years to Matur

14
PORTFOLIO METRICS UPDAT

15
Nominal Coupons and Bills as a Percentage of the P

50%55%60%65%70%75%80%

Jan-00

May-00

Sep-00

Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Nominal CouponsPercentage of Total Portfolio

Average 2000‐July 2007: 69%

20%25%30%35%40%

Jan-00

May-00

Sep-00

Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

BillsPercentage of Total Portfolio 

Average 2000‐July 2007Average 2000‐July 200: : 24%

16
TIPS Issuance Will Continue to Increase

17

$0

$25$50$75

$100

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 

TIPSCalendar Year Issuance in Billions $, Percentage of Portfolio

5‐Year (L) 10‐Year (L) 20‐Year (L) 30‐Year (L) Projected (L) 
Average Maturity of the Debt Continues to Lengthen

18

Note: This graph utilizes average matu

maturity prior to 1998 was calculated 

4045505560657075

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Fiscal Year

Average MaturityMaturity in Months, Percentage of Portfolio

Average Maturity without SFP Average Maturity of Marketable D

Statistics on Average Maturity since CY1980:Current 58 MonthsAverage 58 MonthsMin 42 Months in April 1980Max 71 Months in May 2001
Percentage of Debt Maturing in the Near-Term is at H

19

30%35%40%45%50%55%60%65%70%

Jan‐90

Jul‐90

Jan‐91

Jul‐91

Jan‐92

Jul‐92

Jan‐93

Jul‐93

Jan‐94

Jul‐94

Jan‐95

Jul‐95

Jan‐96

Jul‐96

Jan‐97

Jul‐97

Jan‐98

Jul‐98

Jan‐99

Jul‐99

Jan‐00

Jul‐00

Jan‐01

Jul‐01

Jan‐02

Jul‐02

Jan‐03

Jul‐03

Jan‐04

Jul‐04

Percentage of Debt Maturing in Next 12 to 36 MonthsFiscal Year

Maturing in 12 Months Maturing in 24 Months Maturing in 
LONG-TERM CHALLENGES

20
OMB FY2011 Mid-Session Review Deficits

21

-$1,600-$1,400-$1,200-$1,000

-$800-$600-$400-$200

$0

$200$400

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Budget Surplus/DeficitIn Billions $, Percentage of GDP

Surplus/Deficit $ (LHS) Surplus/Deficit Percentage of GDP (
OMB Long-Term Debt Metrics

22

$0$5

$10$15$20$25$30

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Outstanding Debt In Trillions $, Percentage of GDP

Held by Public (LHS) Held by Government Accounts (LHS) Government Accounts As a % of GDP (RHS) Public 

$0

$100$200$300$400$500$600$700$800

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

Interest ExpenseIn Billions $, Percentage of GDP

Interest Expense (LHS) Interest Expense as a % 

Note: Interest costs based on net interest on Treasury debt minus interest on trust funds and other income.
23 

What adjustments to debt issuance, if any, should Treasury m

consideration of its financing needs in the short, medium, an

Comparing July and April levels of issuance, Treasury has cut $232 bborrowing capacity.

2Y Note 3Y Note 5Y Note 7Y Note 10Y Note 

April Coupon Issuance $44 $40 $42 $32 $25/$21/$2

July Coupon Issuance $38 $35 $37 $29 $24/$21/$2

% Change April‐July ‐14% ‐13% ‐12% ‐9% ‐2% 

Annualized Cuts From July $72 $60 $60 $36 $4 
Treasury Borrowing Advisory Commi

Presentation to Treasury

Charge #2

August 3, 2010
TBAC Charge Number 2

Municipal Bond MarketWe would like the Committee to provide an update on state and municipal debt markets and the ability of municip

capital markets. Please provide detail on current market dynamics, and whether overall financing costs and strategHow have these dynamics affected the Treasury market, and fixed income markets more broadly? 
Table of Contents

I. Municipal Bond Market CharacteristicsII. Cash Market Update, Financing Strategies, and Cost Trends

III. Investor Concerns and Major Risks

IV. Supplemental Slides
Municipal Bond Market Characteristics

 Diverse Issuers: States, local governments, hospitals, public housing, non‐profits

 Size: $2.8 trillion with annual issuance in the $400 billion range

 Quality: Generally high with low historical default rates and high recovery Bond Security:

 General Obligation, Revenue, Lease Obligation, Appropriation

 Credit Enhancement (bond insurance, letters of credit) declining in import

 Tax Policy: Federal and generally state tax‐exempt, BAB issuer subsidy through 2

 Buyer Base: Long‐only, retail dominated. New institutional buyer base due to th Hedging Vehicles: Very limited
US Bond Market ($34.7trn outstanding 

Size of the Municipal Market

The municipal (tax-exempt) bond market has grown dramatically over the past few decades, totaling 

December 31, 2009.The market is ~60% smaller than the US corporate debt market and is roughly comparable in size to 

Federal Agency debt outstanding.

Outstanding Municipal Securities (1945 – 2009, $trn) 

Note: The $2.8 trillion of municipal bonds is composed of $2.3 trillion of debt issued by state and local governments

nonprofit organizations, and $200mm of industrial revenue bonds.

Source: Federal Reserve, SIFMA
Quality

The municipal bond market has a higher average credit rating than the corporate bond m

 Taxing authority, secure revenue streams Low historical default rate Conservative debt profiles

Moody’s and Fitch recalibrated municipal bond ratings in April 2010

Ratings as a % of Corporate / Muni Market (as of July 2010)

Source: Bond Buyer, Bank of America, Moody’s

Note: In left chart, Corporate Bond and Municipal Bond markets represented by the BofA Merrill Lynch U.S. Corporate and Municipal Master Index, res

10-Year Cumulative Default Rates by M

10 Year Cumulativ

Moody's (19

Municipalities 

Aaa 0.00% 

Aa 0.03% 

A 0.03% Baa 0.16% Ba 2.80% 

B 12.40% 

Caa 11.60% 
Municipal Bond Investor Base

Investor Type

12/31/2009

Ownership

(%)

12/31/2009

Ownership

($bn) Comments

Households 36% 999 Includes hedge funds

Mutual Funds & ETFs 20% 568 Municipal mutual fund AUM at an all‐time high

Money Market Mutual Funds 14% 401 Experiencing large outflows (as are taxable mone

P&C Insurers 13% 369 Demand varies with underwriting cycleCommercial Banks 8% 219 Tax Reform Act of 1986 made tax‐exempt bonds Other 4% 114 Primarily brokers/dealers and GSEs

Life Insurers 3% 73 Large purchaser of BABs (own over 50% of many 

International 2% 61 Gaining comfort with taxable munis (net purchas

Ownership of Municipal Securities (1945 – 2009)

Source: Federal Reserve, Bloomberg

70% Retail / Retail Equiv.
Constraints on Hedging and Shorting the Municipal 

The municipal bond investor base has traditionally been long-term real-money investorsRepo Market for Tax-Exempt Municipal Bonds

 Market makers indicate that borrowing in the repo market to cover short tax-exempt bonds 

 Market structure (large number of small deals) is a roadblock to large-scale repo activity Traditional repos are economically impractical because the lender of the security collects ta

from the municipality but owes taxable interest to the repo counterparty

Repo Market for Taxable Municipal Bonds

 The repo market for taxable municipal bonds is immature but growing and is currently limit

largest issuers (CA, IL, etc)

 Even for large issuers, market participants are unwilling to short more than $10-$25mm of b

Shorting Municipal Bond Closed-End Funds or ETFs

 Liquidity is limited  Short-interest is currently very low

Total Return Swaps

 Can be issued on a single bond or a portfolio of bonds Liquidity is limited

Municipal CDS

 Liquidity is limited

Source: JP Morgan, conversations with market makers
* The State of New Jersey’s debt mix consists of a higher proportion of non-GO bonds than the other states listed above. 

Note: GO Debt outstanding as of FY2009 for all issuers.

Municipal CDS Market

History of the Market

 Began active trading in 2003; liquidity significantly increased in 2007 and continued to grow in 20

 Participation diminished in 2009 and remains muted in 2010

General Characteristics

 Major participants in the market are: hedge funds, counterparty hedging desks, insurance companie

dealer desks, and banks

 Only a handful of issuers actively trade (e.g. California, Illinois, NYC) with most liquidity in the 10

 Market standard recovery rate is 80%, compared with 40% in corporate CDS As of July 23, 2010, only 6 of the top 1,000 CDS reference entities were states or local government Only $105mm of single-name muni CDS traded over the past week. For comparison, $144bn of CD

top 1,000 reference entities (corporates, sovereigns, and municipals).

Headwind to Popularity: No Natural Seller of Protection

 Traditional tax-exempt investors are not interested in trading a taxable product Real-money taxable-debt investors may favor the higher spread and interest rate duration of BABs

 Basis: Positive basis packages are difficult to implement because it is hard to short cash bonds

The Municipal CDS market is small, illiquid, and has many forces working against its growth 

Source: Conversations with MCDS market markets, DTCC, State financial statements

Net 

Notional 

($MM)

Net Notional as 

% of GO Debt

Prior Week 

Trading Volume 

($MM)

Prior Week # 

Entity Contracts Traded State of California 1,303 1.9% 40 3City of New York 476 1.2% 10 1State of New Jersey* 409 16.2% 10 2State of Illinois 335 1.7% 10 1State of Florida 307 2.3% 35 3State of Texas 176 1.8% 0 0

Total 3,005 1.9% 105 10
MCDX Index

What is the MCDX?

 Index containing 50 equally weighted constituents launched by Markit in 2008 State & Local Government and Revenue issuers rated BBB- or above with greater than $250mm of unins

outstanding

 5 or 10-year maturities actively quoted with coupon payments quarterly Upon credit events for MCDX constituents, an auction is held and protection buyers are compensated in 

deemed recovery amount.

Current Market Statistics as of 7/23/2010

 MCDX net notional outstanding was ~$3.8bn (vs $300bn+ for the CDX.IG investment grade corporate in

 MCDX is currently pricing in an enormous risk premium. The implied 5-year cumulative default rate (us

~42%.

MCDX Spread in Not a Strong Indicator of Credit Risk

 The MCDX may be a poor indicator of market-perceived credit risk in the muni market.  Trading in the index is not continuous or reliable due to inconsistent market making and unpredictable in

Source: JP Morgan, Markit
Cash Market Update, Financing Strategies, and Cost 
Cash Market Update

10-year Tax Exempt YieldsRating 7/30/2010 12/31/2009 12/31/AAA 2.57 3.00 3.52AA 2.76 3.19 3.65

A 3.37 3.85 4.95BAA 4.44 5.14 6.69

Source: Thomson MMD10-year Yield Comparison as of 7/30/10

Tax Exempt

Federal 

(35%) 

Taxable Equiv Corpor

AAA 2.57 3.95 3.76 

AA 2.76 4.25 3.85 A 3.37 5.18 4.01 

BAA 4.44 6.83 4.74 

*Bloomberg US Industrial Corporate CompositesSource: Bloomberg, Thomson MMD30-year Taxable Spread Comparison as of 7/30/10

California 

(A1/A-)

Illinois 

(A1/A+) BAB Ind

Spreads 260 300 190 *BAB Index is an equal weighted average of all non-callable Bmaturities >20-yr and minimum maturity sizes of at least $25** OAS for >10yr Industrials in Barclays US Credit Index

2010 Issuance to Date: $232bn (up 13% from 2009) Tax-exempt: $158bn Taxable: $74bn ($60bn of which are BABs)Visible 30-day Supply: $7.34bnRecent Tax-Exempt Deal: $800mm NYC GO (AA) deal was upsized to $963mm (serial maturities 2011-2030). Shorter maturities demanded more concessions due to very low yields. The 2014 maturity was the widest spread at AAA MMD +62 (1.49%).Week of 7/26 Notable BAB Deals (>$50mm):Top 5 Issuers 2010 Year to Date:

Rank Issuer Amount Issues

1 Illinois (State) 7,778 102 California (State) 6,019 6

3 Puerto Rico Sales Tax Financing Corp. 3,625 4

4 New York State Dormitory Authority 3,094 195 California Department of Water Resources 2,993 1

Issuer Ratings Size ($mm) Maturity Yield SpreadTexas Dept of Transportation Aaa/AAA/AAA 1204 2030 5.18% 115

Texas Dept of Transportation Aaa/AAA/AAA 296 2026 5.03% 100

Oklahoma Municipal Power A2/A/NR 52 2045 6.44% 233Source: Bloomberg

Source: Bond Buyer, Goldman Sachs, Thomson MMD, Bloomberg, Barclays Capital
Characteristics of Recently Issued Bonds

Bond Issuance by Issuer Type (1st Half of 2010) Use of Bond Proceeds (1st Half of 2010)

State and local authorities accounted for nearly half of municipal issuance during the first halThe largest specified uses of proceeds were education (24%), transportation (13%), and health 

Source: Bond Buyer
Largest Municipal Issuers

Largest Issuers 2004-2009Issuer

Issuance 

2004-2009 

($mm) Moodys S&P GO/Rev Recent BAB Issue Maturity

State of California 74,200 A1 A- GO $1.25bn - 3/10 2040 

City of New York 28,589 Aa2 AA GO $355mm - 10/09 2031 

New York State Dorm Authority 25,801 Aa3 AA- REV $345mm - 5/10 2040 (c.31) Commonwealth of Massachusetts 13,869 Aa1 AA GO $756mm - 12/09 2039 

State of Connecticut 13,563 Aa2 AA GO $250mm - 12/09 2029 

New York State Thruway Authority 12,902 Aa3 AA REV $156mm - 3/10 2030 (c.27) 

New York City Transitional Finance Authority 11,279 Aa1 AAA REV $472bn - 10/09 2036 

New York City Municipal Water 11,098 Aa2 AA+ REV $325mm - 6/10 2042 

New Jersey Transportation Trust Fund 9,974 Aa3 AA- REV $500mm - 1/10 2040 

Los Angeles Unified School District 9,956 Aa2 AA- GO $1.25bn - 2/10 2034 

Largest Issuers 2010 YTDIssuer

Issuance 

2010 YTD 

($mm) Moodys S&P GO/Rev Recent BAB Issue Maturity

State of Illinois 7,778 A1 A+ GO $468mm - 7/10 2035 State of California 6,019 A1 A- GO $1.25bn - 3/10 2040 Puerto Rico Sales Tax Financing Corp. 3,625 A1 A+ REV Less than $100mm issue 

New York State Dormitory Authority 3,094 Aa3 AA- REV $345mm - 5/10 2040 (c.31) California Department of Water Resources 2,993 Aa3 AA- REV No BAB Issuance

Georgia Municipal Electric Authority 2,796 A2 A+ REV $1.22bn - 3/10 2057 Puerto Rico Electric Power Authority 2,530 A3 BBB+ REV $320mm - 4/10 2040 

Los Angeles Unified School District 2,327 Aa2 AA- GO $1.25bn - 2/10 2034 

New York City Transitional Finance Authority 2,069 Aa1 AAA REV $472mm - 10/09 2036 Chicago, Ill.. 2,051 Aa2 AA- GO $133mm - 1/10 2040 

Source: Bloomberg

The largest municipal issuers currently have continuous access to the market – loss of that accertainly create a large disruption and would have follow-on effects in other markets. 
10‐Year Tax‐Exempt GO Spreads to AAA GOs

Source: Bloomberg

Spreads versus AAA-rated GO bonds have widened over the past month
Financing Costs

In absolute terms, municipal interest rates are at multi-decade lows. The percentage of revenues spent by state and local governments on interest payments 

2009, which is in line with historical averages.However, municipal bond yields remain elevated relative to Treasury yields. The yield Buyer 11 index is currently ~110% of Treasuries vs 86% long-term average.

Source: Bond Buyer, Federal Reserve, U.S. Treasury, Barclays Capital

Note: The Bond Buyer 11 Index consists of 11 20yr GO bonds with a composite rating of approximately AA

Bond Yields and Average Interest Rates (1947 – 2010) Bond Yields as Percentage of Treasury Y
Market Structure Changes

As a result of the Build America Bond (BAB) program’s introduction in early 2009, thtaxable municipal bonds has increased dramatically. To date, over $120 billion of BABs have been issued, with all of the proceeds (per statucapital expenditures.

Historical Municipal Issuance (1986 – 2009) Historical Municipal Bond Issuance (20

Note: Municipal notes have original maturities of less than 13 months, while bonds have maturities greater than 13 m

2010 figures are as of 6/30/2010

Source: Bond Buyer
Credit Enhancement

Long-term DebtBond insurance has declined dramatically over the past five years

 The percentage of bonds issued with bond insurance has declined from over 50% to under 10% Assured Guaranty is the only insurer that is writing new business

 Bond insurance is more frequently used by smaller issuers (whose primary investor base is retail)

 In 2009, 19% of total issues had bond insurance but only 8.5% of total par was insured

Utilization is unlikely to return to previous highs

 Historically, insurance was important to unify a disparate market – less focus on underlying credit q

 Bond insurers (and the rating agencies who rated them AAA) have lost credibility among institution

 Number of insurers has declined – one major insurer (Assured Guaranty) remains

 Due to the low cost of obtaining bond insurance prior to the financial crisis, many highly rated deal

 Insurers are now charging a higher percentage of the spread savings (>50% now vs 40% in 2007), 

Putable/Re-marketable DebtOther forms of credit enhancement include letters of credit (irrevocable) and standby purchase agreements (certain credit events).

Source: Bond Buyer, Assured Guaranty

Credit Enhancement Among New Bond Issues (% of Par, 1986 – 1st Half 2010)
Short-term notes play an important role in municipal finance

Characteristics

 Original maturity of 13 months or less Generally used to smooth cash flow timing mismatches (Tax and Revenue Anticipation Notes)

 Timing mismatches frequently exist even if the budget is perfectly balanced on a fiscal-year 

 Usage typically increases during recessions

 Increased budget deficits / cash flow mismatches / tax delinquencies Delays in state aid (for local governments)

 Typically issued near the beginning the fiscal year

 Strong seasonality of issuance could be problematic if investor confidence declines

Usage of Short‐Maturity Debt

Notes as % of Total Outstanding Muni Debt (1947 – 2009) Note Issuance by Month (average of 200

Shaded areas are recessions

Source: Federal Reserve, NBER, JP Morgan, Bond Buyer
Investor Concerns and Major Risks
Current Municipal Investor Concerns

Low yields / low risk adjusted return potential could lower demand as risk appetite increasesBudget Imbalances

 Although most states have balanced budget requirements, budget solutions are often one-tim

nature. Credible revenue and expense solutions are not apparent for the largest GO issuers (

 Finding expenditures to cut becomes more challenging as pressure on extremely cyclical rev

continues

Liquidity Access & Management

 Rollover risk exists in the evolving short-term markets (~$100bn of letters of credit maturin

for VRDOs)

 Downgraded issuers may experience diminished access (particularly in the short-term mark

new 2a-7 rules)

 Cash management in the wake of protracted budget negotiations may require extraordinary 

(voucher issuance, delayed payables) 

Price Volatility Related to Headline Risk

 Retail-based market leads to greater sensitivity to negative news flow with less regard for un

fundamentals

Uncertainty Surrounding Pensions

 What is the actual size of the liability? Will states/cities fund their pension obligations as req

actuarial accounting or delay contributions, further decreasing funded status?

 Will issuers continue to rely on the debt markets to finance contributions? If so, at what cos

 How will the courts rule if pension payments are missed and a “work-out” is the only answe

Municipal investors are concerned about credit fundamentals as well as hot-button news items 
Major Risks to Municipal Issuers

Market AccessHigh Profile Default

 A default by a large municipal issuer could conceivably result in the new issue market shut

 A State GO default seems unlikely.

 Willingness to Pay. High

 Ability to Pay. Driven by:

1. Fiscal powers (taxing authority)2. Debt profile generally good (low debt/GDP and debt servicing costs, ladde

and long average maturity)

3. High debt payment priority4. Expense reductions (layoffs, furloughs, project delays)

5. Accounting adjustments to balance budget (important for access to ST mar

6. Alternate source of funding - asset sales, revenue stream securitizations7. Rainy day reserve funds

Liquidity

 Closure of the short-term market would be disastrous – access is crucial to smooth cash flo

Cascading Impact of Smaller Defaults

 Another path to distress could be the sequential failure of several smaller issuers that cause

in the new issue market if the method of resolution is not well received

 Local governments do not possess the same fiscal powers as states – generally more stable 

Risks for municipal issuers can be grouped into two broad categories – market access and new 
Major Risks to Municipal Issuers

Pricing / Market DepthNegative Changes in Tax Policy (BABs, Tax Exemption) + Tax Rates

 The BAB program has been favorably received by taxable buyers worldwide and has been 

the largest muni issuers. Failure to extend the program, or renewal for a very short period orates, could put significant stress on the tax-exempt market in terms of access and funding 

 The continuation of tax-exempt status for most munis is an essential driver of retail deman

market)

 Offset: Higher marginal tax rates would increase demand for tax-exempt bonds

Worsening Credit Quality – Long-term Concern

 The municipal sector is highly rated (62% rated AA and above vs. 18% for U.S. corporates

flow and ratings drift affecting the largest municipal issuers would increase funding costs arestrict access. This is a bigger risk for smaller issuers.

Regulatory Reform

 Regulatory reform could reduce the attractiveness to banks of providing letters of credit by 

to higher risk-weighting, which could increase issuers’ cost of short-term funds

Risks for municipal issuers can be grouped into two broad categories – market access and new 
What is the Systemic Risk of a Municipal Market C

The Follow-On Effects of a Comprehensive Failure of the Municipal Funding Markets Would Be Su

Immediate Effects – Operational

 Funding shortfalls / delayed vendor payments are more likely than a failure to pay debt obligation For GO issuers, the failure to fund normal government expenditures to state workers and vendors local economies and create a cash crunch among those who depend on state funds. State and local gaccount for 13% of US GDP.

 Needs to be resolved quickly

Secondary Effects – Increase of Risk Premia for Municipal Bonds and Other Risk Assets

 The market value of municipal bonds would likely decline and the 70% of the municipal market t

individuals would come under pressure. A major unknown is how these holders will react to larg

value of the their holdings.

 Mitigant: Muni holders are generally unlevered tax exempt investors. Involuntary u

holdings are unlikely.

 As we saw during the credit crisis in 2007/08, the widening in spreads for ABS/RMBS quickly sp

risk assets. A major disruption of the municipal markets could result in similar spread widening a

dislocations in other risk assets, which could spread into a systemic problem.

 Mitigant: The muni market is much smaller than the corporate, Treasury or MBS/A

less spread throughout the financial system.

Secondary Effects – Weakened Economies and Tax Base - Procyclical

 Personal income declines, reduced retail sales and income tax/sales tax receipts and home price d

predictable results of impaired municipalities. Increased unemployment and loss of essential/valuresult in population shifts.

Source: Citi
What is the Systemic Risk of a Municipal Market C

Secondary Effects – Banking System Exposure

 Banks that hold municipal paper could have their capital levels compromised 

municipal debt declined precipitously, increasing capital requirements, reducimunicipal risk and potentially curtailing other lending.

 Mitigant: Losses on contingent liquidity backstops for municipal debt ha

almost nonexistent

Government Response

 The Federal Government would likely need to intervene in the municipal ma

market stopped functioning.

 Emergency support could come in the form of direct purchases, funding facil

guarantees. 
Conclusion

Near term, there is a low probability of a major default / market dislocation

 Low probability of state level default, but price volatility is likely Increasing probability of defaults at local government level, but unlikely to be widespread

Market fundamentals in good shape in the near term. 

 Low absolute cost of funding – multi-decade lows Access to funding is high / expanded investor base via BAB program Demand currently robust: flows into bond funds, direct retail demand

 Tax policy appears stable / BAB extension likely

Longer-term deterioration in credit fundamentals / investor preference

 Deterioration in credit profile likely (economic growth dependent) Funding costs likely to increase from a low base (fundamentals / investor risk tolerance)

No major change to funding strategies with exception of BABs program

 BABs provide crucial funding – absence of program would lead to higher funding costs, esp

quality issuers

 Lower use of credit enhancement in bond market Greater reliance on letters of credit for putable debt

Derivatives (CDS) do not currently play a large role in the municipal market and are unlikely Systemic risks exist but low probability in near term

 Large unlevered investor base Bank exposure manageable The Federal Government would likely need to intervene in the municipal markets if the mar

functioning
Supplemental Slides
Overview of Municipal Bonds

General Obligation Revenue Appro

Secured by a pledge of full faith, credit &taxing power

Secured by a specific stream of revenues Secured by a “promis

legislatively approved 

All sources of revenue available for debtservice unless specifically excluded

Issued to finance specific enterprises or

projects, and usually secured solely by taxes

or fees generated from those projects

No direct recourse to one notch below issu

Primary sources of revenue:States – Income, Sales & Corporate taxLocal Governments – Property & Sales

tax, as well as state aid

Sectors:Water/Sewer, Public Power/Utilities,

Transportation, Higher Education, HealthCare, Housing Agencies

Examples:Certificates of Particip

Revenue Bonds (LRBs

Credit ConsiderationsEconomy Durability and diversification of local tax base (population, income levels, property values) Key industries and employersFinance Cash management flexibility and techniques Track record of balancing budgets; history of reserve fundsDebt Growth in debt obligations and structure relative to financed asset’s useful life Unfunded pensions and OPEB liabilitiesManagement/Governance Member selection process and budget process Political environment and legal requirements to enact changes

Source: Barclays Capital, Moody’s
Build America Bonds

In February of 2009, the Build America Bond (BAB) program was established under the American Recovery and Rprovide much-needed funding for state and local governments. Municipal Issuers can issue taxable bonds with a Fe

rebate of 35% of the interest expense resulting in attractive funding cost. The program helps states and localities pursuch as infrastructure development and public school construction.Impact on the Market – $124 billion issued to date with the expectation of another $40-90bn by year end BABs have helped expand the “taxable” proportion of municipal issuance to ~30% (YTD from ~6% pre-BAB pro Investor’s perceive BABs as a viable alternative to other long duration instruments (Corporate, Agency, Treasury) International buyers are becoming more and more comfortable with BAB issuers No limit on the amount of bonds that can be issued under the program, but the program is currently set to expire o

– a 2-year extension seems likely, but at a reduced subsidy %

 Currently 9.4% of Barclays Long Credit Index (projected to grow to 17.3% by year end)Issuance has been well-received due to a number of factors including: Credit diversification Attractive yields  High issuer credit quality Long durationRisks and Uncertainty Liquidity concerns associated with “Orphan” risk if program is not extended Credit Concerns with specific issuers Firms hesitant to add research staffing IRS netting of payments 

Source: U.S. Treasury, Bloomberg, Citigroup, Goldman Sachs

Issuers are relying heavily on the BAB program

Total Issuance was $117bn as of June '10

YTD 

State Total Municipal Issuance Total BAB Issuance Mun BAB % of Total icipal Issuance Total MIssu u

a

California 29,794 9,867 33% 97,4

New York 16,936 7,533 44% 57,4

Texas 14,342 2,509 17% 46,2

Illinois 15,365 4,896 32% 28,1Washington 5,739 2,374 41% 15,1

Estimated BAB 
BAB Issuer Savings

8/11/2009Texas (Aa1/AA) 2029 (call '19) - $60.5mm maturity size

New Issue

Yield

Federal Subsidy 

@ 35% Net Issuer Cost

Actual Tax-Exempt 

Yield Issuer Savings

6.07 2.12 3.95 4.38 43 bps

7/30/2010Texas (Aaa/AA+) 2029 (call '19) - $60.5mm maturity size Break-even Subs

Secondary Market 

Yield

Federal Subsidy 

@ 35%

Notional Issuer 

Cost

Actual Tax-Exempt 

Yield

Notional Issuer 

Savings

Issuer 

savings @ 

32%

Issuer 

savings @ 

30%

sa

5.67 1.98 3.69 3.81 12 bps -5 bps -16 bps -

10/8/2009California (Baa1/A) 2039 (non-call) - $1.75bn maturity size

New Issue 

Yield

Federal Subsidy 

@ 35% Net Issuer Cost

Actual Tax-Exempt 

Yield Issuer Savings

7.3 2.56 4.75 5.2 46 bps

7/30/2010California (A1/A-) 2039 (non-call) - $1.75bn maturity size Break-even Subs

Secondary Market

Yield

Federal Subsidy 

@ 35%

Notional Issuer 

Cost

Actual Tax-Exempt 

Yield

Notional Issuer 

Savings

Issuer 

savings @ 

32%

Issuer 

savings @ 

30%

sa

6.63 2.32 4.31 5.17 86 bps 66 bps 53 bps 

 BAB issuers have generally realized savings of 40-70 bps at new issue over comparable tenor ta

 Lower quality issuers realize greater savings Post-new issue, relative secondary market trading levels of tax-exempt bonds and BABs have be

the higher credit sensitivity of taxable investors, the lower liquidity of tax-exempt issues, relative the changing expectations of tax increases within individual states.

Source: Thomson, Bloomberg
Drivers of Supply and Demand for Municipal De

Drivers of Supply

 Volume of refunding issuance and new capital projects Shape of the yield curve (longer-term issuance is avoided in a steep yield curve environme

Drivers of Demand

 Market yields / return opportunities Perceived volatility and returns of competing asset classes (corporate bonds, MM funds)

 Marginal tax rates for individuals Retail demographics (age/income)

Municipal issuance has been fairly stable by volume and type for several years. These trends 

Source: Bond Buyer
Municipal Mutual Funds and ETFs

Rolling 3-month Fund Flows ($bn)

Despite low yields and deteriorating credit fundamentals, long-term municipal mutual funds recently time high of assets under management (over $500 billion). Trends vary by state, with some states (lseeing assets decline. The pace of inflows is slowing from record levels in 2009 (~$70bn in 2009 vs Tax-Exempt Money Market Funds, meanwhile, have experienced ~$100 billion of outflows over the months.Municipal ETFs are a fast growing segment on the market but remain relatively small ($5.9bn as of $2.3bn as of 12/31/08).

Source: ICI
Pension Funding

Where we are and how we got here?

 Large Unfunded Pension Liability estimates for the states range from ~$450 billion to over $3 trill Funding ratios have fallen sharply with equity market declines and lower interest rates leading to l Budget pressures (failure to make the entire ARC) and asset value declines have contributed to the  Illinois has the lowest funding status: ~50% as of 6/30/09 (~39% using market values rather than s

How do we get out?

1. Benefit reductions

 Several states have recently taken action by increasing retirement ages and adjusting formula Many states are seeking concessions from unions that dominate the public sector workforce (

Schwarzenegger recently agreed to new terms with several unions in California) 

2. Economic / market recovery3. Funding increases (contributions to plans from

4. Accounting changes

 The Governmental Accounting Standards 

Board (GASB) is discussing accounting changes that would create broad standardization for pension fund forecasting

Pension underfunding will gradually increase in budget impact. At current asset and benefit lelikely unsustainable. Over the long-term, constructive reform needs to be enacted.

Source: Moody’s, American Enterprise Institute, Pew Center, Barclays Capital, Citi

Note: Tax-Supported Debt as of 2009, GDP as of 2008

operating budget)
Short‐Term Variable‐Rate Debt

The structure of the short-term variable-rate debt market changed dramatically, particularly during The Auction Rate Securities market faced well-publicized difficulties

 Despite their long final maturity dates, auction rate securities were viewed by many investors as cash equiv

frequent, historically successful re-marketings/auctions

 When auctions failed, investors were forced to hold the illiquid long-term securities and issuers forced to p

 Current investor base includes hedge funds and banks

Auction Rate Securities were refinanced with Variable Rate Demand Obligations (VRDOs)

 Unlike auction rate securities, VRDO’s are putable on a regular basis Many issuers (particularly those rated below A-1/P-1) obtained Letters of Credit (LOCs) from banks. These 

banks to purchase bonds if the put option was exercised and to guarantee principal and interest payments

 This shift greatly increased the contingent liquidity risk faced by banks

 Primary investor base is money market funds and short mutual funds

Tender Option Bond (TOB) programs faced unwinds

 In a TOB structure, a trust issues putable floating-rate debt and uses the proceeds to purchase long-term mu The holder of the residual (typically a bank or hedge fund) hopes to profit by arbitraging the yield curve A bank typically provides a liquidity facility to meet the put obligations and serves as re-marketing agent Due to dislocations during the financial crisis, many TOBs were forced to liquidate While the TOBs outstanding have declined, the remaining structures typically have lower leverage than pre Primary investor base is money market funds and short mutual funds

Amount Outstanding ($bn, 2005 – 2009)

Source: JP Morgan
Short‐Term Variable Rate Debt  ‐ Risk Profile

Floating rate debt is an important slice of the U.S. municipal market.  At the end of 2009, there was $615bn of variable rate municipal debt outstanding compared to $

aggregate municipal debt. The variable rate market has contracted in size by 31% since 2007.

 Lower rated issuers of variable rate debt use liquidity facilities, in the form of bank-supplied let

and standby purchase agreements, to backstop the put and remarketing features embedded in the

 $200 billion of LOCs are scheduled to expire during 2010/2011 (of which $30 billion may be dif

estimate of JPM).

 More restrictive terms Higher cost (both for credit reasons and to reflect potentially higher risk weightings) Less availability for lower-rated issuers

 The effect of these changes could be higher budget/liquidity pressure on issuers of variable rate 

usage of LOCs. LOC-backed debt declined from 18.4% in 2008 to 5% in 2009.

 Issuers may term out more debt if possible, which would increase funding costs and decrease th

rate debt outstanding

 Example: Cal Dep’t of Water = $3bn fixed rate issue to redeem $2.7 billion of VRDOs

Source: Bond Buyer, JP Morgan
Commercial Bank Holdings of Municipal Debt

Prior to the Tax Reform Act of 1986, commercial banks were major purchasers of tax-exempt bonds. As a result of 

longer able to deduct the carrying costs of tax-exempt bonds. The main exception to this rule is that banks may dedcosts of bank-qualified bonds. By definition, bank-qualified bonds are issued by small issuers (<$10mm issuance p$30mm by ARRA for 2009 and 2010).Given their focus on bank-qualified bonds, municipal bond portfolios at banks may behave differently than the bromarket. Unfortunately, disclosure regarding the contents of these portfolios is limited.The figures below are based on municipal bonds held in commercial bank investment portfolios. They do not incluoutside of the bank, trading securities, counterparty exposure, derivatives, or off-balance sheet items (letter of credliquidity commitments, etc)While smaller commercial banks have a higher exposure to municipal securities (as a % of Tier 1 Capital) than largof municipal letters of credit have been extended by larger banks. 

Commercial Banking Sector (as of 3/31/2010) Historical Muni Exposure (19

Source: FDIC

0%

20%40%60%80%

100%120%140%160%180%200%

1930 1940 1950 1960 1970 

Muni Securities as % of ShaMuni Securities ($bn, Right A
CDS Spreads vs Taxable Cash Spreads

The Illinois basis has recently turned negative The average PIIGS basis has usua

MCDX has been more volatile than municipal cash 

spreads 

The IG corporate basis has remain

Source: Barclays Capital, Bank of America

(Major established CDS market)

(Small CDS market compared to c
Case Study: The State of California

The State has failed to enact a budget on time for all but three of the last twenty years and budgetary gridlock is the Delays cause uncertainty and uncertainty provokes investor concern. In addition, unfunded pension and OPEB liab$100bn long term problem that doesn’t seem to have an imminent solution. These negatives are counteracted by a large, robust and diverse underlying economy.Positives Backed by Full Faith and Credit and taxing authority of the biggest economy in the U.S. (GDP=$1.8 trillion, 38m

exports, diverse revenue sources)

 Constitutionally mandated debt service appropriation , which is a relatively modest 6.75% of expenditures

 Many levers to pull in times of crisis (e.g. tax increases, borrowing, project delays, layoffs/furloughs) Reserve funds that can be drawn upon in event of shortfallRisks Legislative process causes delays in passing a balanced budget which creates uncertainty surrounding cash mana Long-term unfunded liabilities have grown throughout the current economic downturn Highly cyclical revenue stream due to progressive tax system and reliance on capital gains tax Subordination risk to GO holders if certain revenue streams are securitized

Although negative headlines continue to pressure state borrowing costs, lawmakers have a history of passing balan

avoiding complete shutdown or inflicting serious damage to the issuer’s reputation. 

Being the largest issuer of municipal debt drives intense focus on the state as a bellwether for the Municipal 

State of California Finances: Priority of payment provision limits default probability
Case Study: The State of Illinois

Illinois is a state with challenges similar to those of California, including large and growing pension liabililack of political will to make structural changes and an economy in recession, with less underlying strengt

California’s. Positives Full, Faith & Credit Issuer – Illinois GO debt service is 1st priority (vs. California where it is 2nd to edu Tax base is strong, centered around the major city of Chicago and not likely to migrate Tax burden is low (3% flat personal income tax). Potential support for tax increases.Risks Unlike the State of California, the Illinois legislature considers bridging a budget deficit via external bor

term as well as longer-term pension obligation borrowing) as balancing the budget - higher debt burden / 

 Backlog of unpaid bills and fund transfers stood at $4.7bn at the end of the 2010 fiscal year and is growi Pension Obligations are enormous; the funded ratio fell to 50.6% as of June 30, 2009 (using five year sm

value), and remains the lowest among all states.

Illinois’ recent budgetary and pension funding issues contribute to high relative funding costs

Assumptions:: All future pension contributions beyond FY2011 are funded entirely via the issuance of 25-year level-amortization pension obligation bcost of 6%. Since it has already been proposed, the potential $3.7bn POB this fall is included under “Old POB GOs” and is modeled based on the prop

The State issues BABs to fund their capital plan based on their 6yr annual issuance forecast (assume 25-year amortization and 6% cost of debt less 35% General Fund annual revenue growth of 2.5% after 2011. 

Forecast of Illinois’ GO Debt Burden if All Pension Contribution Are Funded with G
Treasury Borrowing Advisory Co

Presentation to Treasur

Charge #3

August 3, 2010
TBAC Charge # 3What are the forces that are underpinning demand for long-duration What factor should Treasury consider as the average maturity of ou

to gradually extend?
Global Equities

2010

0

2,0004,0006,000

Jan Mar May Jul

9,00010,00011,00012,000

0

1,0002,0003,0004,0005,0006,0007,000

00 02 04 06 08 10

Basis Points

5,00010,00015,00020,000

S&P 500 E-STOXX FTSE 100 Nikkei 225 (right scale)

Currencies

2010

60708090

100

Jan Mar May Jul

0.91.01.11.21.31.41.5

8090

100110120130140

00 02 04 06 08 10

Basis Points

0.60.81.01.21.41.61.82.0

Sovere

01234567

00 02 04 06 

Yield

2 Yr UST 10 Yr UST 2 

10 Year Spr

Financial Markets have been Retracing their 

Credit Crisis and the More Recent Sovereig

(50)

50

150250350450550650750850

00 02 04 06 

Basis Points

Greece Spain 

EUR/USD (left scale) USD/CHF USD/JPY

As of July 23, 2010 Source: Bloomberg, J.P. Morgan and Presenting Member’s Firm

2 and 10 YR JGB (right scathe others left scale)
Funding Spreads

2010

0

20406080

100

Jan Mar May Jul

(60)(50)(40)(30)(20)

(10)

1030507090

110130150170190210

00 02 04 06 08 10

Basis Points

(140)(120)(100)(80)(60)(40)(20)020

2Y EURSwap Spd

2Y USDSwap Spd

EUR FRA-OIS Spd

USD FRA-OIS Spd

C

0

400800

1,200

10

Basis Points

JULI Spdto TSY

JPM US HY E

S

. . .Funding and Other Risk Premiums Have SuRetraced Significantly

Best/Worst Since 12/09 & Retracement from Worst Lev

S&P 500 (Level) 1,102.7 1,217.3 1,022.6 

E-Stoxx (Level) 2,719.1 3,017.8 2,488.5 10Y US Treasury Yield (%) 2.99 3.99 2.89 10Y German Bond Yield (%) 2.7 3.39 2.51 10Y Spain Spread to Germany (b.p.) 165.1 56.6 223.1 2Y USD Swap Spread (b.p.) 21.6 10.2 49.5 2Y EUR Swap Spread (b.p.) 60.1 43.2 86.1 EUR/USD (Level) 1.28 1.47 1.19 JULI Spread to Treasury (b.p.) 167.9 126.6 188.1 

Current Best Worst % Ret

As of July 23, 2010 Source: Bloomberg, J.P. Morgan and Presenting Member’s Firm

1Y EUR-USDxccy basis (right scale)

JPM US HY(right scale,the others left scale)
Inflation Expectations Have Steadily 

FOMC Central Tendency Forecasts (%) Consensus CPI ForecasSource: Blue Chip Economic Indicators
. . .Driving a Fall in Policy Rate Expectation

Yields

3M/2Yx3M USD OIS Rate Curve versus

10-year Treasury Yield (%) 

3M/2Yx3M EUR OIS RatBond Yield (%) 
Several Factors Have Muted the Mortgage Hedthe Fixed Income Market

27% of the outstanding 30-Year Agency MBS Universe is currently h

sheet

Capacity constraints of tighter credit standards have reduced payme

Strategic underweight to MBS by real money managers led to contr
Fed Purchase Activity of MBS has Changed 

Falling Rates and Hedging Activi

• 27% of the outstanding 30‐year Agency MBS universe first held o• The Fed’s holdings are concentrated in the lower coupons

0 200 400 600 800 1

9.08.58.07.57.06.56.05.55.04.54.03.5

Coupon (%)

Total Outstanding ($ Bil.)

Fed Holdings Total Outstanding

14%73%54%12%3%1%25%

% Held by Fed

0%0%0%0%0%
Mortgage Convexity Risk with and without th

Rate Shift Price OAD 10YrEquiv Rate Shift 

(b.p.) ($) (Yrs) ($ Bil.) (b.p.) 

-300 106.21 0.29 -1004 -300 1

-200 106.49 -0.05 -1208 -200 1

-100 107.41 -0.32 -1373 -100 1

-50 107.5 0.64 -790 -50 1

-25 107.26 1.29 -394 -25 

0 106.82 1.94 0 0 1

25 106.22 2.52 342 25 1

50 105.48 3.07 660 50 1

100 103.61 3.98 1167 100 1

200 98.96 4.99 1630 200 1300 93.92 5.36 1682 300 

 Hedging Needs are considerably lower while the Fed holds 27% of the outstanding 30yrs w Hedging needs will increase if pay-downs are not re-invested and new issuance (from refis

hedge.

 Actual Hedging needs will also depend on how actively the GSEs hedge their portfolios

 Hedging needs also arise from mortgage servicing rights, but they are unaffected by the FTotal MBS Universe MBS Universe Minus Fe

Source: Barclays Capital; June 2010 
Traditional Managers Were “Crowded Ou

Resulting in Contrarian Hedging Flo

Percentage of investors reporting underweight MBS positions in 

the J.P. Morgan MBS Investor Survey (%) versus cumulative Fed 

purchases of Agency MBS ($bn)

Percentage of investors rep

J.P. Morgan MBS Investor 

weekly changes in 5-year 

changes 

 A significant underweight on the part of mortgage investors has turned convexity hedging f

underweight investors to receive as rates rise and the duration of the benchmark extends, duration of the benchmark shortens.

 These “voodoo” mortgage hedging flows are acting as a strong offset to the traditional con

that normally cause spreads to be positively correlated with yields
Capacity constraints and tight credit conditions have kept prepays 

result, servicers have a limited need to adjust the size of their dura

Quarterly aggregate change in the MSR fair value for two of 

servicers regressed against the quarterly change in 10-year s

(4Q:08–2Q:10) ($ bil.)

Quarterly Change in 10-year Swap Yields (b.p

Source: J.P. Morgan
However, callable redemptions have increased on th

resulting higher callable gross issuance and grea

Callable Gross Issuance ($ bil.) and Agency Debt Duration Supply* ($ bil. 10-yr equivalents) 

*July number represents estimates for the entire month, assuming that the pace observed thus far persists for the remainder of the month

FNMA, FHLMC, and FHCall Date and Moneyne

If rates remain at current levels, we estimate that 90% of European 

the next two months are in-the-money to be called
Treasuries will Continue to Dominate the Su

(1,500)(1,000)

(500)

0

500

1,0001,5002,0002,500

2004 2005 2006 2007 2008 2009 

Dollars ($)

IG Corporates HY Corporates EM Corporates Non-Agency MBS Agency MBS CMBS CLOs Agent Debt Long-term Treasu

Net Issuance History and Forecast 

Source: J.P. Morgan North America Credit Research: High Grade Bond and CDS 2H:10 Outlook: June 25, 2010
Where Does The Demand For Fixed Inc
Bank Demand For Assets Likely to St

Total deposits—Total Loan vs Holding of Treasury and Agency Debt for US Banks ($ Bil.)

Assets Under ManagemMoney Market Funds ($ 

Source: Federal Reserve H.8 Release and iMoneyNet
While the Funding Gap has Improved from t

2008, the Current State is Friendly to Fixed I

0

102030405060708090

100

2006 

Percentage

Equities 

Top 150 US Corporate Pension Plans Asset Allocation Source: Corporate filings and Presenting Member’s Firm

Total Assets ($ Mil.) $1.236 $1.319 $0.963 $1.103Total Liabilities ($ Mil.) $1.257 $1.259 $1.237 $1.351Total Contributions ($ Mil.) $0.386 $0.279 $0.292 $0.556Contributions/Prior Year's Assets 3.6% 2.0% 1.9% 5.0% Liabilities/Market Cap 25.0% 29.0% 46.0% 36.0% Pension Deficit/Cash from Ops 23.0% 17.0% 58.0% 49.0%

2006 2007 2008 2009
Fixed Income was the Beneficiary of Retail F

the Crisis

(200,000)(100,000)

0

100,000200,000300,000400,000500,000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

0

20,00040,00060,00080,000

100,000120,000140,000160,000180,000200,000

2001

2002

2003

Mutual Funds: Historical Flows ETFs: Historical Flows 

Equity Taxable Fixed Income Tax-Exempt Fixed Inco
Low Absolute Yields Have Been Encouraging Incremen

Taking and a Move from Government to High Inc

(20,000)

20,00060,000

100,000140,000180,000220,000260,000300,000

2001

2002

2003

2004

2005

2006

2007

2008

2009

10-May

$ in Millions

Govt/Mortgage Investment Grade CorpGlobal/Int'l High YieldEmerging Markets General Bond

Mutual Funds 

(5,000)

0

5,000

10,00015,00020,00025,00030,00035,00040,000

2001

2002

2003

$ in Millions

Govt/Mortgage Global/Int'l Emerging Markets 

Source: Lipper and Presenting Member’s Firm
The Negative Convexity of Insurance Company Assets vs th

Caused Duration Decay and May be a Catalyst for Further L

Duration and Portfolio Yields Maturity Profile of Inves

AFL

AMP CNO

DFG

HIG GNW

LNC

MET PFG

PNX PL PRU

RGA

SFG

TMK

UNM

2.0%3.0%4.0%5.0%6.0%7.0%8.0%

2 4 6 8 10 12 14

Duration

Yield

Comparable Duration A-Rated Corporate Bonds

Comparable Duration BBB-Rated Corporate Bonds

0%

20%40%60%80%

100%

AFL

AMP

CNO

DFG

GNW

Percent of General Account Assets

2010 
The Average Maturity of U.S. Treasury Debt 

Extend

0

1020304050607080

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

Jun-10

Months

Weighted Average Maturity (In Months)* Weighted Average Matu*All data as of June 30, 2010 except Japan which is as of March 31, 2009Source: US Treasury, J.P. Morgan and Presenting Member’s Firm

Japan

USUK

Ireland

Finland

Portugal

Greece

Austria

Belgium

Holland

Spain

Italy

France

Germany

0 
Demand for Treasury Debt Has Remai

The bid-to-cover / size rthe 10-yr sector 

3-month average of monthly 2-, 5-, and 10-year notes gross issuance ($ bil.) versus the 3-month weighted average bid-to-cover ratios Source: US Treasury and J.P. Morgan
SummaryDemand for U.S. Treasury debt has been strongSupply from competing fixed income sectors remains low by historic Relative to other sovereign borrowers US debt profile has room to eThat said, longer term structural deficits will influence/drive yield and 

From a strategic asset/liability management perspective the trend to

should remain in tact