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CITY OF SAN BERNARDINO
CITY ADMINISTRATOR'S OFFICE
INTEROFFICE MEMORANDUM
TO: Ways and Means Committee
FROM: Fred Wilson, City Administrator
SUBJECT: Next Steps Re: Pension Obligation Bonds (POB)
DATE: June 14,2005
COPIES: City Treasurer; Finance Director
As part of discussions regarding the FY 2005-06 budget, the issuance of POB's is being
considered as one option to provide General Fund budget savings.
In May, the PFM Group (the City's financial advisor) assisted in the preparation and distribution
of a Request for Proposals seeking underwriting services for a possible POB issuance. In
response, thirteen (13) proposals were received from potential underwriters. On June 8, staff
from this office and the Finance Department, as well as City Treasurer David Kennedy and
Councilmember McCammack, all met with Peter Shellenberger of PFM to discuss the proposals
and the qualifications of the various firms. Another meeting was held via conference call on
June 13 to discuss PFM's analysis and recommendations. Based on their experience and
qualifications, Lehmann Brothers was determined to be the best choice to serve as the
underwriter, contingent upon the satisfactory conclusion of negotiations concerning their fees.
The attached memo from PFM summarizes the proposals and their recommendations
(Attachment A).
Lehmann Brothers (underwriter), PFM (financial advisor), and Orrick Harrington Sutcliffe (legal
counsel) would then make up the City's financing team, along with City Treasurer and City staff.
The financing team will then begin to determine how the bond issuance should be structured to
achieve the most long-term savings while minimizing risk to the City.
At this point, it is recommended that the Committee approve the proposed financing team. That
recommendation will then be forwarded to the Mayor and Council for approval by motion. At a
later date, when the various documents are prepared for the bond issuance, a resolution will be
brought forward to formally approve the financing team along with other related actions.
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June 13, 2005
MEMORANDUM
To: Fred Wllson,City Adrninistr2tor
Lori Sassoon, Assist2nt City Administr2tor
CitY of San Btr1IIJ1'dino, CA
From: Peter Shellenberger, Senior Managing Consultant
Christine Johnson, Consultant
PllblK Finandal Mallflgt11l,III, In(.
Re: City of San Berrwdino Underwriter Proposal Summary
On June 3, 2005 the City of San Bernardino (the "City'? received proposals from 13 underWriting firms to
serve as Senior Manager or Co-Manager for the City's potential issuance of taxable pension oblig2tion bonds
("POBs" or the "Bonds"). The purpose of this memorandwn is to swnmarize the recommended strategies
and considerations from each of the proposing firms, as well as to compare the proposed underwriting fees
from the potential Senior Manager.
Summary
Many of the proposals recommended tr2ditional fixed-rate debt for the interest rate mode for the POBs.
Current interest bonds, the most common form of fixed rate bonds, were commonly proposed together with
a "make-whole" provision that allows bonds to be called and restructured, while ensuring the investor is not
harmed if the bonds are called. The "make whole" provision provides structural flexibility with cms, but
does not usually result in great savings at the time of restructuring.
Some firms also recommended that the City examine the issuance of capital appreciation bonds or variable
rate debt to achieve near-term debt service relief and/or additional flexibility. Though there was discussion
surrounding the term of the Bonds, the general consensus from the proposals was that the City should use a
30- year final maturity.
The recommended size of the POB issuance varied across proposals from a $40 million transaction to a $73
million transaction. The proposed bond par amounts correspond to varying recommended funding ratios for
the City's pension liability: ranging from a 90 percent funding ration to 100 percent. Most firms
recommended a debt service structure that results in level annual savings in comparison to the original 30-
year "fresh start" amortization of the UAAL.
Overview of Participating Firms
The City received nine proposals that asked for consideration as Senior Manager and/or Co-Manager, and
four proposals for Co-Manager only. The participating flMls are listed below.
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City of San Bernardino
June 13, 20<l)
Page 2
Citigroup Global Markets Inc.
)PMorgan, Chase & Co.
UBS Financial Services Inc.
E) De La Rosa & Co. Inc.
RBC Dain Rauscher
First Albany Capital
Morgan Stanley & Co. Inc
Stone & Y LLC
Piper Jaf&ay
Merrill Lynch & Co.
Siebert Brandford Shank & Co.
Ca itall\Iarkets LLC
, Tradilicinal
Traditional
MBE/WBE
MBE/WBE
, Of the senior experience listed we should note that RBe Dain Rauscher, Morgan Stanley and Lehman
Brothers have all managed transactions for issuers in CalPERS and/or issuers participating in the California
Pooled Bond Program.
Traditional Fixed Rate Structure and Proposed Pricing
Each firm was asked to provide structuring alternatives for a traditional fixed rate issuance in addition to ideas
for an optimal structure in order to provide a relative assessment of current market conditions as well as a
base line to compare alternatives. For the traditional fixed rate structure, firms generally recommended the
use of current interest bonds ("CIBs''). Some flm1S suggested the use of capital appreciation bonds r'CABs")
to provide near-term cash flow relief since CABs do not require interest payments until maturity.
Most firms considered a 30-year term for the bonds and debt service structured as uniform annual savings
when compared to the City's VAAL amortization. The spread to Treasury for CIBs ranged from 10 basis
points ("bps'') in the I-year maturity to 95 bps in the 30-year maturity. Among ftrms proposing for Senior
Manager, lpreads for the 10-year maturity ranged from 59 to 80 bps, while spreads for the 30-year maturity
ranged from 60 to 95 bps.
The following table illustrates the estimated spreads to Treasury for current interest bonds provided by the
firms as of March 18,2005.
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City of San Bernardino
June 13, 200S
Page 3
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City of San Bernardino
JUlle 13, 2005
Page 4
In providing their financial analysis of both a traditional fixed rate financing and their optimal structures, all
firms provided a sense of the indicative borrowing costs to the City. These true-interest costs C'TICs") are
summarized below.
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-Finn sU8lJ't'h a rraditional fixed ate structure
(1) Loop sugt:sa using a mix of6xed and \'anablc debt' but docs not provide anal)'1is
The following table swnmarizes the structuring proposals for a traditional fixed rate financing.
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Term (Final Mlruriry) . i 2034. ;ms : 2014 i 201S! 2OlS' :Kl15 ; 201S! 2035. 2OlS; 2015; 2025 zm5 i 3134
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City of San Bernardino
June 13, 2005
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Optimal Structure
The City received many different proposals for structure and securities. In this section we compare and
contrast the proposals based on proposed interest rate mode (fi.'\:ed vs. variable rate), derivative products,
proprietary products, and amortization and structure. Many firms also included credit enhancements and
alternative structures in addition to their recommendation of the optimal structure proposals. A summary of
the recommended optimal structures are shown in the table below. We would of course recommend
additional due diligence prior to implementing any structure, including a detailed risk arWysis.
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Interest Rate Mode
Many firms leaned towards locking in fixed interest rates, which remain near historic lows, and recommended
a portion of the optimal roB structure include traditional fixed rate CIBs with some discussion of the use of
CABs. CABs carry an overall higher yield than corresponding CIBs and are generally used only when
necessary to meet revenue constraints. Most firms that suggested uniform savings to the amortized VAAL
contribution as their optimal strategy also suggested the use of CABs. Variable rate bonds were examined by
most firms as a component of the overall structure. Subject to the proprietary products discussed below,
which have some variable component, RBC Dain Rauscher, Citigroup, Merrill Lynch, Stone "
Youngberg, UBS, Loop Capital Markets, First Albany, EJ De La Rosa and Siebert Brandford Shank
" Co. all recommended a portion of the City's debt to be in variable rate.
Most firms ecamined the use of variable rate bonds as a method for increasing restructuring flexibility and
reducing the total borrowing cost. While variable rate bonds do entail rate fluctuation and uncertainty, they
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City of San Bernardino
June 13, 2005
Page 6
also result in lower borrowing rates than fixed rate bonds, on average. Perhaps more important than their
relative cost is the increased flexibility that variable rate bonds can provide the City. Most firms
acknowledged the advantages and disadvantages of variable rate bonds. Nearly every fltl11 recommended
Auction Rate Securities rARS") as the preferred variable rate instrument, versus variable rate demand
obligations ('VRDO~'). ARS are usually insured, but do not require a letter of credit, which must be
renewed every three to five years. A notable exception to this trend was RBC Dain Rauscher who
suggested the use of UBOR-indexed bonds.
As requested, all firms briefly discussed the impact of the most recent occurrences on the ARS marltet. As a
recap, in 2004 the SEC began to investigate possible pricing inequalities in ARS auctions for the municipal
market. In addition, a major accounting firm revised its stance on investor's accounting treatment of auction
rate securities leading to fears that there could possibly be a major sell-off. Most firms agreed that the taxable
ARS marketplace was still a very viable option for municipal variable rate debt. Citigroup recommended
that the City consider using a 28-day periodicity should it choose to incorporate ARS into its financing
strategy.
Derivative Products
Some fltms recommended hedging a portion of the City's variable rate debt with an interest rate swap as an
alternative financing strategy, with RBe Dain Rauscher suggesting a Floating to Fixed interest rate swap as
a part of its optimal strategy. Derivative products were seen by most firms as a potential to hedge against
higher interest rates in the future, given the potential appreciation of a fixed payer swap in a rising rate
environment. At the same time, there was some general disagreement as to the actual economic benefit in
the current market between fixed and synthetic fIXed rate bonds. Morgan Stanley argued against the use of
synthetic fixed rate bonds in the current market citing higher swap rates (based upon 3-month LIBOR) in
relation to yields on insured taxable fixed rate bonds across the entire yield curve.
One fltl11, Merrill Lynch & Co. suggested the use of a Fixed to Floating interest rate swap as a method of
creating synthetic variable rate debt. 1bis was suggested should the City want to include variable rate exposure
in its issuance with the possibility of achieving an overall lower cost of funds.
Proprietary Products
JP Morgan Chase suggested the use of their Equity Pension Obligation Structure (EPOSl). The City
would use this structure in lieu of the issuance of POBs. The City would enter into a total return swap with
JP Morgan in which it would select certain investments, and receive any appreciation. The City would pay JP
Morgan a fixed spread to LIBOR plus any depreciation in the investments. The City would deposit a note
into the Pension System in the same amount as the swap. As the swap amortizes every year, JP Morgan
would deliver a portion of the securities to the City.
Structure and Final Ma tunty
Proposed structures for the POBs fell into two main categories: level debt service for the POBs, ascending
debt service with a fIXed spread to the VAAL (uniform). Although rmst firms recommended that the City
amortize the POBs over a 30 year period, Sieben Brandford Shank & Co. considered a final maturity of
2025 for the optimal structure. We should note that the City would be justified in choosing any of the
reconunended structures and would need to determine the fuuU structure based on policy as well as financial
considerations.
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June 13, 2005
'Page 7
Proposed Fees
Firms submitting proposals for Senior Manager were required to submit a fee proposal for both a traditional
fixed rate issuance and a variable rate issuance. These firms provided very aggressive bids (including expenses
and counseQ ranging from $3.37 to $6.37 per bond for a traditional fIXed rate issuance with a par amount of
$40 million The average fee was $5.071 per bond. While management fees are normally common for
pension obligation issuances, only four firms proposed a management fee for this issuance. Although
Lehman Brothers presented one of the stronger proposals, they also proposed the highest fees in the group at
a combined cost of $6.37 per bond. The fee proposals for a traditional fixed rate issuance are JXOVided
below:
Fixed Rate
Average Takedown
MaIl8g8lllent Fees
~Fees
ExpenMs
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0.250' 0.8501 G.S58j
-1
0.323i
0.7811
5.071'
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5.0001 2.000j 4.0001 3.98_~i
0.6301 -' --,
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0.360: 0.352: 0.207! 0.360;
!
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0.220;
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0.270!
Not all firms submitted bids for variable rate securities due in part to their experience and proposed structure.
Although lrven firms submitted bids for VRDOs, only one firm, Stone & Youngberg suggested VRDOs
within their optimal structure and three other firms merely mentioned VRDOs as a possible option for
variable rate securities. Conversely, two firms, Cirigroup and E.J. De La Rosa suggested ARS as part of
their optimal strategy and seven other firms suggested ARS should the City want to incorporate variable rate
securities. An exception to this trend was RBC Dain Rauscher who provided fee bids for both VRDOs
and ARS but discouraged the use of either in favor of LlBOR-indexed notes for a fee of $5.00 per bond.
Hence, we have only included fee proposals for ARS within this memo. Estimated costs for ARS ranged
from $1.84 to $5.12 per bond.
City of Sail Bemardillo
June 13, 2005
'Page 8
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Ongoing Auction Rate Fees
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(1) RBe ijsted two values for lakedown. The higher one i. tisted here.
No fee proposals were made for interest rate swaps. Those firms that proposed their possible use indicated
that swap pricing could be negotiated at a later date.
Additional Considerations
The proposals varied in the strength of their discussion of additional considerations for the City but
coUectively they covered the majority 0 f the issues that the City should consider.
There was much discussion as to methods of increasing the City's flexibility to restrUcture or caU the debt at
some point in the future should such a decision be timely in the marketplace. The majority of the firms
suggested incorporating some variable rate debt into the issuance to offset the relative inflexibility of taxable
fixed rate debt The ratios of fixed rate to variable rate debt proposed ranged from 75/25 to SO/SO. Some
ftuns discouraged the City from pursuing variable rate debt arguing that the small size of the transaction and
the newness of the City's credit in the taxable POB market warrant conservative financing strategies. In
addition to the issuance of variable rate debt, some firms suggested methods of creating call flexibility for the
fixed rate debt Firms suggested lO-year par calls as well as "make-whole" calls as methods of creating
flexibility for traditional fixed rate debt. E.]. De La ROla and Lehman Brothers both argued for an
increase of the VAAL to be funded by a potential POB issuance. Although the currendy proposed funding
amount does bring the City to a prudent 90% funding ratio, Lehman Brothers cited the changes in CalPERS
actuarial calculation methodology to argue that a higher funding amount would most likely not lead to a
situation of "over funding".
Most firms did not recommend obtaining a corporate rating for the proposed POB issuance with the
exception of one firm. A corporate rating is often viewed as marketing strategy for international investors.
However, obtaining a corporate rating is cosdy and may not provide benefit for the City given the smaller size
of its proposed transaction. Corporate ratings are most often useful for transactions with a par value greater
than approximately $500 million. Most firms agreed that the City should instead opt to assess the economic
value of obtaining bond insurance at the time of pricing.
In terms of a targeted marketing strategy for the POB issuance, most firms were able to cite their ability to
market to international investors and major American institutional investors. Taxable POBs do not usually
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City of San Bernardino
June 13, 200;
Page 9
playa substantial role in the local retail market hence, the City should focus its attention on underwriters who
will be able to garner attention for the City's issue through its marketing methods.
Final Analysis
While the final recommendation and selection should come from the City, we can provide some opinion on
how to narrow the field based upon our reading of the proposals. In terms of the combination of POB
financing experience, structuring recommendations and discussion of other issues pertinent to the City's
proposed financing we feel that the top three firms are Morgan Stanley, Lehman Brothers, and UBS. The
City may also want to consider E.]. De La Rosa as an alternative. However, this firm is a regional California
firm and based upon their representation of marketing capabilities, may not be the strongest candidate for a
sole manager position for this financing.
Next Steps
We believe that the proposing underwriter's have provded enough decision-making information that oral
interviews should not be necessary. We therefore propose that the City narrQwtheir choices based on these
three major factors 1) the thoroughness of the discussion of the issues pertinent to the City's POBs, 2) the
ability to connect these issues into a coherent plan and strategy and 3) cost proposals. The City may also wish
to consider firms whose proprietary products or strategies have sparked interest.
Based upon a successful choice of underwriter this week, the City should take note of the following major
milestones for this transaction.
· June 16th - City Council meeting to formally select underwriter
· Week of June 20th - Finance team kick-off meeting
· Week of June 27th - Plan of Finance delivered to working group
· Week of August 1st - Meetings with Rating Agencies
· August 15th - City Council approval of financing
· August 31st - Pricing
· September 13th - Close
We hope that you have found this summary of the Underwriter Proposals received by the City usefuL We
look forward to working with you on choosing an underwriter and beginning this transaction. Should you
have any questions or comments, please call me at (415) 982-5544.
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