Wealth Management Research 22 February 2011

Municipal Bonds

Thomas McLoughlin, analyst, UBS FS February Municipal Update [email protected], +1 212 713 3914 Joseph Krist, analyst, UBS FS [email protected], +1 212 713 3959

Kathleen Mcnamara, CFA, CFP®, strategist, UBS FS • Market dynamics for the month have been dominated by the [email protected], +1 212 713 3310 low level of new issuance year-to-date and continued fund Kristin Stephens, analyst, UBS FS outflows. Outflows and muni prices showed some signs [email protected], +1 212 713 9854 of stabilizing more recently. • Developments in Washington continue to bear monitoring, as more fully described in the "Washington Watch" and "BABs Table of Contents Page Market Overview 2 Revival?" sections of this report. Washington Watch 3 • For investors interested in relative value opportunities, we BABs Revival? 4 compare select New York and California . Select examples of spread differentials 4 Detroit Gets Down to Work 7 • In addition to our regular market commentary, topics covered Pension Reform Debate in the Spotlight 12 in this report include updates on the city of Detroit, public Tobacco Bond Update 13 pension reform, tobacco settlement revenue bonds and S&P's Standard & Poor's Revisits Bond Insurer Ratings...Again 18 proposed criteria for rating insurers. Current state ratings and rating outlooks 20

Credit Updates • Our -focused commentary features an in-depth discussion of Detroit, including an update on fiscal and economic pressures underway and a review of some of the legacy issues that have contributed to the city's current condition.

• The debate surrounding pension reform is in the spotlight as the Governor of Wisconsin put forth a proposal to revisit current employee bargaining agreements and the state of Utah replaced its defined benefit program with an alternative for new employees similar to a conventional 401(k) plan.

• Tobacco settlement revenue bonds have captured attention recently on price volatility, rating actions and the first new issuance since 2008; we offer our thoughts on this higher-risk sector of the municipal market. Insurance Update • In closing, we consider S&P's proposed criteria for rating municipal bond insurers which, if adopted as proposed, would require all bond insurers to raise new capital or face further rating downgrades.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 22. Municipal Bonds

Market Overview Fig. 1: Visible Supply, Treasury and muni yields Yield in %, supply in USD thousands Primary market supply in January totalled just USD 12.7bn, the 4.5 22,500 lowest monthly issuance occurring since 2000. This sharp decline 4 in new issue volume was not entirely surprising given record 3.5 17,500 3 issuance of USD 432bn taking place in 2010 with a heavy 12,500 concentration in the fourth quarter leading up to the expiration Yield 2.5 2 7,500 of the taxable Build America Bonds (BABs) program. Year-to-date 1.5 through 18 February 2011, issuance at USD 22.6bn is running 1 2,500 under 50% compared to totals at this time last year. Forward Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 supply, as measured by the Bond Buyer’s 30-day Visible Supply, is AAA GO 10 yr (left side axis) starting to edge up at USD 10.2bn. (See Fig. 1). We expect new Treasury 10 yr (left side axis) 30-Day Visible Supply (right side axis) bond sales to accelerate in March and April. Source: Bloomberg, MMD Interactive, UBS WMR as of 18 February Turning to an important gauge for demand, the pace of tax- 2010 exempt municipal mutual fund outflows finally slowed to under USD 1bn for the week ended February 16, preceded by outflows of USD 1.2bn for the week ended February 9 and USD 1.07 bn for the week ended February 2, according to Lipper FMI. We have now seen 14 consecutive weeks of net cash outflows from Fig. 2: AAA muni yields muni mutual funds spanning the period fro m November 17 In % through February 16. Outflows peaked at a record USD 4 bn 6.0 during the week ended January 19. Over the same time frame, with the exception of December, taxable bond funds were 5.0 reporting net cash inflows. According to Municipal Market 4.0 Advisors (MMA) muni funds have now lost all their inflows since 3.0 January 1, 2011. 2.0 Since mid-January, yields on AAA munis at the 5-year maturity 1.0 point were little changed ranging from 1.82% to 1.89%. Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Greater fluctuations occurred in the intermediate and long-dated AAA GO 5 yr AAA GO 10 yr AAA GO 30 yr segments of the curve with yields bouncing within a 30bps range of 3.16% and 3.46% at the 10-year maturity spot. On 30-year Source: MMD Interactive, UBS WMR as of 18 February 2010 high grade securities, yields ranged between 32 bps, attaining a high of 5.08% (January 14), and a low of 4.76% (February 18 ), during the same time frame. As we go to press, AAA yields stand at 1.82%, 3.16% and 4.76%, respectively. (See Fig. 2)

Lower rated bonds exhibited greater yield movements on Fig. 3: AAA muni-to-Treasury yield ratios In % illiquidity and less demand helping drive credit quality spreads wider. We expect that pattern to continue when supply 200 eventually picks back up and stronger demand for high grade 175 bonds is likely. In the 10-year maturity area, spreads between 150 BBB general obligation (GO) bonds versus AAA GOs have increased 19bps to 207 bps from 188bps since January 19, while 125 yield differences in the higher rating categories of A versus AAA 100 rose 11bps to 109bps from 98bps and AA versus AAA spreads 75 were little changed to slightly tighter at 25bps. 50 2003 2004 2005 2006 2007 2008 2009 2010 2011 On a relative value basis, AAA muni-to-Treasury ratios moved AAA GO 30 Year AAA GO 10 Year AAA GO 5 Year notably lower at the front part of the curve to around 80% at Source: MMD Interactive, UBS WMR as of 18 February 2010 the 5-year maturity and less than 90% in the 10-year area. In contrast, muni yields on long-dated, high grade, 30-year municipal securiti es remain above comparably maturing Treasuries. (See Fig. 3) There continues to be a scarcity of buyers for long-duration tax-exempt securities. Also, selling pressures caused by long-term mutual fund withdrawals are helping keep long-term muni yields above more normal relative levels.

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Total return for munis year-to-date at -0.12 % is close to the broad taxable sector’s index return of -0.51 %. Month-to-date performance has turned slightly positive at 0.9%.

In credit news, there were two hi gh profile state rating actions. On February 9, S&P downgraded New Jersey‘s general obligation bond rating to AA- with a stable outlook from AA previously , while Moody’s revised the outlook on Arizona’s issuer’s credit rating of Aa3 to negative from stable.

In the near to intermediate term, we look for yields to rise on continued headline risks, an eventual uptick in new issue supply, and lackluster demand (particularly for long-duration tax-exempt securities).

Washington Watch

The first in a series of scheduled congressional hearings on the municipal market took place on February 9. Entitled “State and Municipal : The Coming Crisis?”, the House Oversight and Government Reform Committee invited testimony from market participants. The stated purpose of the hearing was to assess the severe fiscal stress that some state and local governments are facing and to examine whether legislation should be drafted to allow state . Despite heavy media attention leading up to the hearing, it was lightly a ttended by lawmakers on both sides of the aisle.¹ While the merits of allowing a state to enter into federal bankruptcy were debated at the hearing, it does not appear that the idea is gaining significant traction in Congress; we believe it unlikely that such legislation will be enacted.

On the same day, separate legislation requiring state and municipal pension obligations to be accurately disclosed to the federal government, first floated last December, was reintroduced by Reps. Devin Nunes (R-NC), Paul Ryan (R-Wis.) and Darrell Issa (R-Calif.), who chairs the full Oversight Committee. Under this potential legislation, a failure to accurately account for pension costs could prohibit that state or municipality’s ability to issue tax-exempt bonds. The UBS US Office of Public Policy believes that this pension-focused legislation is likely to pass the House but will face resistance in the Senate.

The second Congressional hearing before the House Judiciary Committee’s Subcommittee on Courts, Commercial an d Administrative Law took place on February 14 and was titled “The Role of Public Employee Pensions in Contributing to State and the Possibility of a State Bankruptcy Chapter”. In this case, testimony once again was not supportive of the enactme nt of a provision in US bankruptcy code to allow states to file for bankruptcy. Witnesses provided a variety of well substantiated legal and practical reasons for which this option would not be the best in terms of addressing the growing public pension pro blem, as well as offered data on the limited number of historical defaults and chapter 9 filings over time to illustrate the continued ability of the majority of high-grade borrowers to meet their debt service requirements on a timely basis. For

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readers in terested in further information, witness testimony is available at the following website: http://judiciary.house.gov/hearings/hear_02142011.html.

BABs Revival?

We have received a number of inquiries regarding the reinstatement of the Build America Bonds (BABs) program. As our readers will recall, the BABs program was authorized by the American Recovery and Reinvestment Act in early 2009. By any objective measure, the program was a resounding success. New investors were introduced to the municipal and the program provided an important source of fresh capital for municipal issuers. By allowing governments to issue bonds in the taxable market, fewer tax exempt bonds were made available to traditional investors, thereby limiting their supply and de pressing yields. According to Thomson Reuters, state and local governments used the BABs program 2,352 times with a total par value of USD 181.5bn of debt issued.

Despite widespread support from state and local governments, Congress allowed the program to expire as scheduled on December 31, 2010 as part of a larger compromise with the Obama administration. Media reports have trumpeted the introduction of new legislation in Congress to reinstate the program at lower subsidy rates. Rep. Gerald Connolly (D-VA ) introduced a bill to reinstate the BABs program for another two years, albeit at lower federal subsidy rates of 32% in 2011 and 31% in 2012. President Obama has submitted a separate proposal to Congress in his FY12 federal budget proposal ; the President is seeking to make the Build America Bonds program permanent at a relatively low 28% subsidy rate and also to expand its eligibility to include current refundings and provide 501(c)3 borrowers with access to the program . Both efforts appear destined to fai l in the face of Republican opposition in

Congress. Fig. 4: BABs versus Indus Corp spreads Rep. Dave Camp (R-MI), chairman of the House Ways and Means In bps Committee, has expressed his opposition to the BABs program in the past. Senators Chuck Grassley (R-IA) and Orrin Hatch (R-UT) 225 also are vocal critics of the program. While House Transportation 210 Committee chairman John Mica (R-FL) is more favorably disposed 195 towards the program, he does not appear to have widespread 180 support within the Republican caucus. We expect efforts to 165 resuscitate the program to continue but are not sanguine about 150 the prospects for success. Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 CI09 U.S Industrial Corp 10+yr OAS Spreads on Build America Bonds compared to s BABS Build America Bond Index OAS of similar maturities continue to improve on favorable demand/supply dynamics since the expiration of the program at Source: BofA/ML, UBS WMR as of 18 February 2010 the end of 2010. (See Fig. 4).

Select examples of spread differentials

Wider yield differences between credit rating categories and sectors are providing opportunities for investors willing to forgo some liquidity and accept an increase in volatility in exchange for

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higher yields. Also, bonds similarly rated are exhibiting varied offered yields in certain instances. We highlight a few examples of some notable pricing anomalies creating some relative value.

Nassau County, NY GO bonds versus Nassau Interim Finance Authority (NIFA) bonds Nassau’s GO bonds are secured by the full faith, credit and taxing power of the county. The bonds are rated A1 by Moody’s on review for possible downgrade. Despite NIFA’s imposition of a control period on the county’s finances at the en d of January, S&P affirmed its A+ rating and stable rating outlook on the County’s GO bonds on February 4.

NIFA’s bonds are secured by a lien on the revenues of the authority that are derived from sales and use taxes imposed by and within the County. The bonds carry a Aa1 rating from Moody’s and AAA ratings from each S&P and Fitch. The rating outlook is stable by all three rating agencies.

For a more in-depth perspective of the county’s credit profile and NIFA, please see our January Municipal Update report. As described therein, NIFA issued a control period over county finances after determining that the County’s budget had a deficit greater than the 1% which mandates a . More recently, Nassau officials filed a preliminary injunction to preve nt this course of action, and on February 18 a New York State judge stayed a requirement that the County submit a revised financial plan to NIFA while the injunction is considered.

As one might expect, NIFA bonds typically have traded at tighter spreads compared to Nassau County due to the difference in credit ratings and other factors . Over the course of the past two months leading up to a takeover of the county’s finances by NIFA, and negative rating action by Moody’s in early February, spreads on Nassau County ’s bonds had been steadily rising. Budget stress, negative headlines and reduced investor demand for bonds rated below ‘AA’ all helped place downward price pressure on the bonds. At the same time, pricing on NIFA’s bonds was fairly consistent with that of ‘AA’ New York credits.

We looked back a decade to assess the historical relationship between the two . When we compare yields at original issuance for both Nassau County and NIFA bonds, we noted that the 10- year maturity offered a yield difference of just 10bps to 15bps, with Nassau County pricing at the higher yield levels. As recently as 2009, the spread difference on new issue pricing was still in that range.

Current yield spreads versus the Municipal Market Data (MMD) benchmark between the two credits are significantly wider at roughly 40bps to 50bps for intermediate-term maturity bonds.

In terms of actual trading activity, a wide range of outcome s may occur. For example, according to MSRB trade data, Nassau County GO bonds with a 4.00% due 10/1/22 were sold at offer yields between 4.08% and 4.62% (4.49% after-tax) in early February. (Using Bloomberg analytics, we calculated the after-tax yield in this example to account for the special tax

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implications on ‘market discount’² munis.)

Close to the same time frame, a trade occurred on NIFA bonds with a 5.00% coupon maturing 11/15/22 at an offer yield-to-call of 4.19% and a 4.38% yield-to- maturity. In this comparison, less than 15bps of incremental on an after-tax basis was offered on the Nassau County bonds (4.49% after- tax.)

We believe a reasonable threshold of 40bps to 50bps and higher incremental yield on the lower rated Nassau bonds, other bond characteristics similar, may signal an opportunity for some investors.

California (CA) state GO bonds versus CA lease revenue bonds California’s state general obligation bonds are backed by the full faith, credit and taxing power of the state. CA’s bond ratings are A1 by Moody’s, and A- by Standard & Poor’s and Fi tch. Moody’s and Fitch maintain a stable rating outlook, while S&P’s outlook is negative.

California’s lease revenue bonds are secured by lease payments made by the state on behalf of its operating departments. The bonds are subject to abatement in the event the state does not have beneficial use and possession of the leased assets. We believe the risk of abatement is slight, and much less of a risk than at the city or county level. The bonds carry ratings one notch below that of the state’s general oblig ation bonds to reflect this abatement risk. (A2/stable outlook by Moody’s, BBB+/negative outlook by S&P, and BBB+/ stable outlook from

Fitch).

The State Public Works Board (SPWB) lease revenue 10-year bonds currently offer investors an incremental 50bps o f yield compared to California’s state GO debt, according to Municipal Market Data (MMD), in compensation for the lower priority of payment and abatement risk. We believe this is justified and the bonds offer reasonable value (on a relative basis) at these levels. Any spread compression between the GO and the Lease Revenue

Bonds would lead us to favor the GO Bonds.

Note that actual spreads vary depending, among other things, on coupon structure, callability and lot size. For example, according to a recent Municipal Securities Rulemaking Board (MSRB) trade report, a block of USD 235,000 California SPWB lease revenue bonds with a 5.5% coupon due 6/1/2023 traded at an offer yield of 5.90% (5.82% after-tax yield), a spread of 86bps above the comparable maturit y CA state GO benchmark yield of 4.96%. At that level, we believe the trade represented good value for the buyer.

Keep in mind that many factors go into comparing two bonds, particularly the descriptive features of the bond, including the call option and its perceived value in the market. Other considerations that need to be weighed include tax treatment, credit quality, sector, price/yield, maturity and coupon.

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Detroit Gets Down to Work

We discussed the possibility that a high profile municipality might on its debt in 2011 in WMR’s 2011 Outlook report, “On Schedule, but Over Budget”, published on 8 December 2010. We believe that local governments by and large are endeavouring to make the necessary operational adjustments to ensure the timely paym ent of debt service. That being said, we were obliged to concede the possibility of an idiosyncratic default and to distinguish it from the idea of systemic defaults that we believe unlikely. The degree of fiscal stress now exerted on local government is c ertainly substantial but the likelihood of pervasive defaults on general obligation debt is remote, in our view.

In the 2011 Outlook, we mentioned the City of Detroit as a local government that might see interruptions in its ability to meet debt service o bligations on a timely basis. Consequently, it seems appropriate that we review the c ity’s credit in more detail to assist investors in their effort to establish the probability of such an event and whether or not such speculation creates an opportunity fo r municipal bond investors with a higher risk tolerance.

Detroit has been operating under conditions of severe fiscal stress since the late 1990’s. The economic and demogra phic trends that undermine the c ity’s credit have been underway since the late 1960 ’s. They include the loss of population and jobs, declines in relative measures of wealth and income, steadily lowering property values, and shifts in investment out of the c ity to other parts of the greater Detroit metropolitan area. All of these trends w ere underway before larger macroeconomic factors began to overwhelm the city’s economy.

The woes of the automobile industry, the primary pillar of the local economy, are well documented. We will not dwell on them here. Clearly their effects have been devastating for the c ity. As Detroit absorbed their impact over the years, local political leadership was based more on charismatic qualities than on demonstrable management skills. Public policy decisions often were based upon the likelihood of receiving sta te and federal financial support rather than on the development of sustainable local economic development initiatives.

This inordinate dependence on state and federa l sources of aid permitted the c ity to allow its operations and service levels to be les s and less reflective of local resource levels. When the recession took hold at the end of the last decade, the c ity was in a vulnerable position, as the recession’s depth impacted not only the city but the s tate of Michigan as a whole. Consequently, a mod e of operations that was scaled to a larger resource base than the city could generate, quickly became unsustainable.

Detroit has consistently battled to maintain its financial position and credit rating in the investment grade category for the last 40 years. In 1970, per capita incomes in the c ity were at 101.9% of the national rate and median family incomes were 104.7% of the national rate. Ten years later, in August 1980, those figures dropped to 85.2% and 85.5% of national rates, respectively. By

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1990, per capita and median family incomes had further declined to 65.5% and 64.1%, respectively.

The national economic expansion of the mid-1990’s allowed the city’s auto industry to recover some what, but income levels in the city remained stagnant. Detroit’ s share of manufacturing production had declined, and with it, the higher wage manufacturing jobs that accompanied it. Aging plants were abandoned in favor of more modern facilities elsewhere in the country, often financed through costly tax incentives. Th ese factors continued to pressure local income levels and created more costly social service demands.

As auto manufacturing weakened as a central pillar of the economy, efforts were made to diversify the economy away from Fig. 5: City of Detroit Ratings History manufacturing. One was to redevelop certain sections of the c ity, primarily the Greek Town redevelopment project; the project was Date Rating designed to attract visitors with higher leve ls of disposable Oct-70 Baa income to the city. Other entertainment-based redevelopment such as the refurbishment of the Fox Theater and the Aug-80 Ba construction of sports venues for the c ity’s MLB and NFL Nov-86 Baa franchises were undertaken. These efforts were complemented by the introduction of limited casino gambling. Revenue from Jul-92 Ba1 these activities, while substantial, has failed to meet Oct-96 Baa expectations. This trend continues into the current fiscal year. Jul-97 Baa2

Detroit’s general obligation debt was rated Baa by Moody ’s in Oct-98 Baa1 1970 when incomes in the city wer e above the national rate. The Nov-05 Baa2 city lost its investment grade rating ten years later but regained i t in 1986 as national economic conditions improved and demand May-08 Baa3 for automobiles revived. The recession of the early 1990’s Jan-09 Ba2 pressured the c ity’s finances again and the rating dropped back Aug-09 Ba3 to Ba1 in 1992. Through the last decade, declines in major sources of revenue began to exert further pressure on the c ity’s Source: Moody's Investors Service, as of 18 February 2011

General Fund operations. The result: three downgrades of the City’s general obligation bond rating in a 17 month period, beginning in May 2008. Currently, the city’s GO debt is rated Ba3 by Moody’s and BB by S&P. (See Fig. 5). The relatively low levels of income relative to national averages have impact ed not only the ability of the c ity to raise revenues, but also the ability of residents to maintain and develop property values through homeownership.

The long-term decline in the c ity’s property tax base can be seen not only in the lack of value in former manufacturing production sites but also through significant levels of home foreclosures and abandonment. It is estimated that one third of the city’s ho using is vacant. This impacts not only the value of those homes, but also the value of adjacent properties in steadily deteriorating neighborhoods. Lower values lead to lower property taxes which, in turn, lends to higher millage rates that increase carrying costs and result in more abandonments and foreclosures. Property values continue to track lower. The c ity has not yet been able to devise a means to extricate itself from this insidious cycle.

Detroit also faces the challenge of replacing or mai ntaining its aging capital plant. Fortunately, regional enterprises are responsible for financing some of the most crucial infrastructure

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needs. Water, sewer, solid waste disposal and airport enterprises all serve a regional population. The authorities res ponsible for these services are able to rely upon the four-county metropolitan area for revenue and have been able to maintain better market access and credit ratings than the city itself.

In contrast, Detroit’s own direct capital base and financing need s are dependent upon a shrinking economic base characterized by relatively weaker income and wealth levels inside the city. The deep national recession has only served to exacerbate the relatively weaker position of the c ity amid political upheaval in the local government. For a quarter century, the occupants of the mayor’s office were widely viewed as either charismatic or as having strong managerial ability, but rarely both. More recently , the current mayor - local sports celebrity and successful businessman Dave Bing (elected in 2009) - has exhibited both strong leadership and a willingness to consider unconventional Fig. 6: Detroit General Fund (GF) Revenues and approaches to balance the city’s budget. Available GF Balance Trends, FY05-FY09 In USD thousands. Revenue on lhs, available GF balance on Detroit needs to address a variety of pressing financial issues. rhs. Primary among these is the need to reduce the city’s short-term borrowing as a source of liquidity. Historically, cities have flirted 1,550 -150 with default when they have incurred large amounts of short 1,500 -200 term debt that needs ongoing market access for regular 1,450 refinancing. Detroit issues notes in ant icipation of both tax 1,400 -250 receipts and other types of revenue, known as tax anticipation 1,350 notes (TANs) and revenue anticipation notes (RANs), respectively. -300 1,300 Note borrowing had grown significantly in the last five years – from USD 54mn in FY 2005 to USD 224mn in FY 2009. One of 1,250 -350 2005 2006 2007 2008 2009 the initial steps taken by the Bing administration w as to General Fund Revenues Available general fund balance effectively bond out the c ity’s existing note exposure through the issuance of approximately USD 250mn of fiscal stabilization Source: Moody’s Investor Service, UBS WMR, as of 14 February 2011 bonds backed by a pledge of the distributable state aid received annually from the State of Michigan.

The c ity is working to adopt other budgetary changes to reduce its reliance on short-term borrowing. The best way for the City to improve its liquidity would be to adopt a structurally balanced Fig. 7: City of Detroit Tax Revenue Trends: FY07- budget. Over the 2001 – 2007 period, the City’s General Fund FY10 In USD millions incurred only one operational surplus and its unreserved general fund balance declined from USD 69.6mn to a deficit of USD 300 155.6mn. The general fund had a USD 91.1mn deficit at 30 June 2010, a USD 175.6mn dec rease from the USD 266.7mn deficit 270 reported at 30 June 2009. The FY10 general fund balance 240 includes an unreserved deficit of USD 155.7mn, a USD 176.2mn 210 decrease from the USD 331.9mn unreserved deficit at the end of FY09. The decrease in the deficit in FY10 was mainly due to the 180 USD 249.8mn of revenue provided from the issuance of the fiscal 150 stabilization bonds previously mentioned in March 2010. FY2006-07 FY2007-08 FY2008-09 FY2009-10 Without this issuance , the deficit would have grown by USD Income Tax Revenues Current Property Tax Revenue 74.2mn. (See Fig. 6). A trend of generally flat revenu es and Source: City of Detroit Deficit Elimination Plan, UBS WMR, as of 14 declines in income tax and state revenue sharing payments h as February 2011 had a substantial impact on c ity finances. Declining property tax collections had formerly been funded by Wayne County but regional economic woes have forced the county to charge the city for past funded delinquencies. (See Fig. 7).

One of the complicating factors in any analysis of the city has

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been its inability to provide timely and accurate information regarding its financial operations. Detroit has struggled with the delivery of routine information and unqualified audit opinions , a trend which only ended with the release of the FY10 audit . This is reflective of the quality of information available as well as variability in the level of willingness to produce disclosure depending on th e administration in power at the time. Four consecutive audits were released on a delayed basis. This caused the State to withhold revenue sharing in FY 2008. These administrative factors have occurred during a period of mixed success in the effort to revive and diversify the city’s core economy.

Unfortunately, disposable incomes have been one of the most vulnerable segments in this recession on both a local and regional level. The high rates of local and regional unemployment have reduced current earned income levels. The impact on operations at GM and Chrysler associated with their respective aggravated the situation. The impact of personal debt has been reflected in the Detroit metropolitan area’s foreclosure rate, which has been among the highest in the country. This loss of income and wealth among the city’s population in particular has coincided with higher poverty levels and more demand for social services. The lack of measurable success in raising local income levels with economic devel opment initiatives has been disappointing.

As Detroit’s ability to raise revenue has diminished, it has turned to the use of debt to fund certain longer term expenses. These include some USD 1.4bn of pension funding expenses that were financed though the issuance of certificates of participation (COPs). While this issuance has put the c ity in a relatively good position in terms of its unfunded accrued actuarial liability for its future pension obligations, it has contributed to a high debt burden. When co mbined with a declining population and weak property values, the debt burden and per capita debt ratios are unattractive from a ratings perspective.

Currently, the c ity has approximately USD 497.7mn of unlimited tax and USD 518.7mn of limited tax general obligation debt outstanding. When the pension obligation certificates of participation are included, the c ity’s total debt rises to USD 2.5bn. Debt service as a share of spending is above the 10% threshold, which has historically been a prime indicator of fiscal stress, and the extensive use of rate swaps exacerbates the credit risk associated with a high debt burden, in our view . These swaps have enabled the c ity to issue fixed rate debt but pay lower floating rates under the terms of the swap agr eements. Should certain events (primarily related to credit ratings) occur, the swaps could be subject to termination resulting in significant termination fees payable to counterparties. Moody’s has estimated the value of these payment obligations at USD 294.4mn as of June, 2010.

Working in favor of bondholders is the fact that the current administration has decided to pursue a course of fiscal reform that attempts to address these many issues in a straightforward manner. A four year plan adopted by the ci ty uses realistic

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assumptions of revenues – property, income, and gaming taxes are all projected to decline. Some one-time revenues are used to finance a transition to a more realistic ongoing revenue structure. They include various payments from utilities and a settlement agreement associated with a casino bankruptcy. The expense side of the budget anticipates layoffs and furloughs and a transfer of operating responsibilities for the COBO Hall complex to a private operator. The plan projects balanced opera tions in FY 2012.

The success of the plan depends on a number of variables. These include the realization of anticipated revenue and expense reductions, and some improvement in the local and regional economy. Continued timely and full disclosure of finan cial results must occur. If financial balance is sustained, liquidity can be improved. All of these would lay the foundation for more stable ratings and diminish concern about insolvency and bankruptcy. The current administration is indicating the willingn ess to pay, now they must use that will to generate the resources necessary to support the ability to pay. We believe that the plan laid out by the Bing administration is a responsible one and offers the city the best chance at avoiding a default. In the e vent that the Bing administration’s efforts are not enough on their own, investors are likely to look to the State of Michigan to intervene in the reform process.

Public Act 72 of 1990 - the Local Fiscal Responsibility Act - allows the Governor to declare a financial emergency to exist in a unit of local government to respond to a request for assistance. If a financial emergency is declared, the Governor assigns responsibility for managing the financial emergency to the Local Emergency Financial Assistanc e Board, which consists of the State Treasurer, the Director of the Department of Management and Budget, and the Director of the Department of Labor and Economic Growth. In turn, the Board appoints an emergency financial manager to exercise authority under the Act for the purpose of resolving the financial emergency.

Under the law, while emergency financial managers are authorized to renegotiate labor contracts, they are not authorized to abrogate such contracts, or other obligations. This provision is the subject of current legislative proposals which would allow for the abrogation of existing contracts. Importantly, for a city in Michigan to declare bankruptcy under Chapter 9, the only such authorization is Section 22 of Act 72, which authorizes eme rgency financial managers to proceed under the Bankruptcy Code after giving notice to the Board, unless the Board disapproves. We view these as significant impediments to a declaration of insolvency or a bankruptcy by the s tate’s largest and best known city.

The state oversight process has been tested over time in Michigan. Seven Michigan municipalities have seen the appointment of Emergency Financial Managers since the law was enacted in 2000. Three of them are still in place. All of them avoided default on their outstanding general obligation debt. These structures, the record under Public Act 72 to date, and the apparent willingness of the Bing administra tion to come to grips

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with the c ity’s fiscal reality all support a belief that the c ity has the willingness to avoid default and bankruptcy.

Detroit remains inextricably linked to the economic fortunes of the U.S. automobile industry. Although the current mayor has exhibited a willingness to make dif ficult decisions to ensure the city’s solvency, Detroit has only recently been able to disseminate its annual financial statements in a timely manner . We believe the c ity’s current administration intends to honor all of its obligations and that the administration’s willingness to pay its obligations is evident. We are less confident in the city’s ability to do so absent further state support.

Pension Reform Debate in the Spotlight

In prior reports, we have postulated that state and local governments will be obliged to address their unfunded pension liabiliti es by adopting overdue reforms to current retirement programs. Over time, we believe traditional defined be nefit programs will be abandoned in favor of hybrid programs closer in character to those adopted by the private sector for its employees. In most st ates, existing plans will remain in place but current state and local government employees will be asked to contribute more of their salary towards their pension benefits and family medical coverage. Prospective employees are more likely to be enrolled in defined contribution programs similar to (but more generous than) those prevalent in the private sector.

The current protests by public sector union members in Madison, Wisconsin have triggered national media coverage by focusing another national spotligh t on the structural deficits bedevilling most state governments. After winning his gubernatorial election in 2010 on a platform of lower taxation and budgetary reform, Wisconsin Governor Scott Walker submitted a proposal to the legislature to restrict the collective bargaining rights of public sector workers and require higher employee contribution levels towards pensions and health care premiums. The Governor’s proposal would prohibit the state from deducting union dues from employee paychecks and ties fut ure raises to the consumer price index.

The reaction among unionized state and local employees has been defiant. Protesters have swarmed the state capitol in an effort to slow the passage of legislation. Passage seemed assured until Senate Democrats dec amped for Illinois in a parliamentary manoeuvre to deny the Republican majority the necessary quorum to enact the changes. At this point, both sides seem disinclined to strike a compromise. Union members from outside of Wisconsin also appear to be taking a n active interest in developments in Madison because of the state’s long history of support for union labor and progressive causes. The American Federation of State, County, and Municipal Employees was founded in the state in 1932, for example. We expect p olitical pressure to build on striking teachers as school closings become more widespread throughout the state. Democratic legislators also may face more criticism if their absence from the capitol continues indefinitely. The precise outcome of the Wiscon sin legislation is not certain but we believe the newly elected

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governor is unlikely to compromise and will achieve most of his principal objectives. We also expect the vast majority of states to revisit current employee bargaining agreements despite the protests in Madison. Expect more contentious political battles around the United States in the next six months.

For states that are looking for another roadmap for public pension reform , the State of Utah just provided one. The Beehive State has replaced i ts defined benefit program with a retirement program similar to a conventional 401(k) plan for new employees. The sponsor of the legislation that created the new program, Senator Dan Liljenquist, was motivated by the decline in the state’s pension funding ratio due to stock market volatility in late 2008 and early 2009. Utah was employing a 7.75% discount (assumed investment) rate to calculate its pension liabilities. Based on information provided by the state retirement system, a 6% return over the next 25 years (instead of a 7.75%) would trigger a USD 14.4bn future unfunded liability.

Rather than rely on improved performance of equity markets to provide such a return and thereby restore the funding ratio, Senator Liljenquist convinced his fellow legislato rs to introduce a new program to limit its future liability. His proposals also were met with resistance from employee unions but the legislature proceeded to adopt the legislation. Utah now will contribute 10% of each new worker's salary (12% for public s afety workers and firefighters) to a retirement account in the employee’s name. Employees are not permitted to borrow from the retirement account and are subject to certain investment parameters. They can also opt out of the program entirely, in which case the State simply contributes the 10% to the individual’s traditional 401(k) plan. Existing employees are unaffected by the change because the state constitution prohibits any radical changes to the retirement plans of existing employees, absent an overrid ing fiscal emergency.

The state’s contribution under the new plan is generous by any private sector standard but it serves the best interest of the state and its taxpayers by limiting the obligation to the current year’s payment. In effect, the state’s o bligation becomes a fixed annual one and – for new employees – is not subject to change due to poor investment returns, greater life expectancy, or more years of service for the average employee. The new program also may encourage individuals to enter gove rnment service later in their careers and for a shorter tenure; the system is no longer constructed in such a way as to encourage individuals to join the government payroll in relative youth and remain there for 30 years to enhance their pension benefits. We believe more states will adopt programs similar to the one enacted by Utah and will endeavour to report back on these initiatives as 2011 unfolds.

Tobacco Bond Update

Tobacco settlement revenue bonds have captured investor attention in recent months f ollowing bouts of dramatic price volatility, sweeping changes in rating agency criteria, and the sale of the first new tobacco deal since 2008 for Illinois’ Railsplitter

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Tobacco Settlement Authority in late 2010. The tobacco settlement revenue bond sector is considered one of the most speculative in the municipal bond market, with many of the longest dated bonds assigned non-investment grade ratings, and as such is not considered to be appropriate for the majority of conservative buy-and-hold investors, in our view.

Most outstanding tobacco bond were structured with a combination of shorter duration serial maturities coupled with one or more long-dated “turbo” term bond maturities. At offering, the longer dated turbo term bonds were expecte d to have a shorter average life than the legal final maturity date would otherwise imply based on the expectation that Master Settlement Agreement (MSA) payments received each year for repayment of the securities would be in excess of annual debt service requirements due. The long dated term bonds therefore were described as having a “turbo” amortization schedule, given the requirement under the associated bond documents that excess MSA revenues would be directed towards the early redemption of bonds.

De clines in domestic cigarette consumption at a higher rate than originally projected at the time of sale and concerns regarding the outlook for consumption going forward have rendered the notion of investors being repaid in line with the accelerated amortiz ation schedule considerably less likely in many instances. In some cases, repayment even at final term bond maturity is viewed as speculative based on more recent consumption trends. As this commentary implies, the risk of repayment increases the farther o ut in duration one’s investment in the sector might be. Rating agencies have recognized this by assigning higher ratings to serial bonds that mature in the near future and are less likely to be affected by future MSA payment declines. Serial bonds, however , generally comprise only a small percentage of the total deal structure. In contrast, long-dated term bonds, which represent the majority of outstanding debt, have suffered the most rating pressure. Additionally, there are structural differences across tr ansactions that make some better equipped to withstand a higher level of stress scenarios than others. All three major rating agencies have recently downgraded various classes of tobacco settlement bonds or alternatively placed the same on review for downg rade based on either their revisions of the cash-flow assumptions used to structure the transactions or the performance of certain transactions under existing assumptions, along with other factors.

Illinois’ Railsplitter Tobacco Settlement Authority tran saction was structured to circumvent the duration concerns associated with prior transactions. The roughly USD 1.5bn offering featured a 17 year final maturity, much shorter than that used in predecessor transactions. Additionally, the structure allows it to withstand more significant declines in consumption – specifically, a 10% year-over-year drop – relative to prior transactions which largely were structured to withstand a roughly 4% year-over-year decline. Given this and other structural enhancements, t he transaction was assigned a rating of A to A- by S&P, depending on the maturity, and BBB+ by Fitch; currently the highest possible ratings for an unenhanced tobacco bond, despite the bond

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structure lacking the turbo feature to accelerate amortization used in prior transactions.

By “unenhanced”, we are referring to those tobacco settlement revenue bonds supported only by dedicated payments under the MSA without any contingent support from the associated state. In limited instances, states have provided t heir conditional backstop; in these cases, the tobacco settlement bonds assume that state’s appropriation bond credit rating, and the state is looked to as the primary source of repayment in the event of any insufficiency in pledged revenues. Also of note, Fitch’s methodology for rating tobacco settlement bond transactions reflects the lower of its rating of the tobacco industry plus one notch (currently BBB+) or the transaction’s cashflow performance under stressed payment scenarios. On this basis, the BBB + Fitch rating assigned to the Railsplitter transaction is tied to its rating of the tobacco industry; Fitch’s “de-linked” rating of the transaction (with “de-linked” indicating the level of stress the bonds could withstand without linkage to the tobacco i ndustry rating) is A for the longest maturity and higher than A on certain shorter maturities.

The primary buyers of long-dated tobacco bonds historically have been high-yield municipal bond funds. Increased selling pressure in connection with this univer se of buyers became evident around the time that S&P‘s revised cash flow assumptions it applies to its rating analysis of the transactions led to a wave of rating downgrades in November. Prior to the S&P action, a 2047 maturity of Ohio’s Buckeye Tobacco Se ttlement Financing Authority Series 2007 senior turbo term bonds with a 5.875% coupon had a yield of roughly 8%, a spread of 388bps to MMD. Credit spreads widened through mid-January at which point the spread to MMD was approximately 485bps. These levels h ave since narrowed; at the end of last week the yield on the same maturity was slightly under 9%, equal to a spread of 417bps to MMD. The bond is currently rated Baa3 by Moody’s, BB- by S&P and BBB- by Fitch. As a point of reference, on its sale date in la te October 2007, the bond was priced at an original yield of approximately 6%, a spread to MMD of 178bps.

Extreme price volatility and bouts of illiquidity are common challenges associated with the sector. In addition to the rating activity, the recent w ave of selling was attributed to concerns that longer maturities might be restructured, consumption decline trends would continue, and pure duration issues. Nevertheless, at such robust tax-exempt yields, some investors have inquired as to whether it makes sense to consider having some exposure to this part of the municipal market. Our stance on this remains cautious. While the higher yields on offer may create an attractive risk/return proposition for investors that understand the risks associated with the se securities; in our experience, the typical conservative income-oriented investor is often not interested in the duration risk associated with longer dated bonds, the non-traditional type of credit risk involved which is more corporate-like in nature, th e risk of these transactions being unable to make timely debt service payments under certain scenarios, and the high level of associated price volatility and illiquidity, among other factors.

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Given that valuations can move rapidly and thus offer total return investors, who understand the risks involved, periods of opportunity, we suggest this as a potentially more interesting alternative; however, it would require regularly following the trading patterns and other factors associated with this complex grou p of securities. Investment in a high yield municipal bond fund might be considered as a more straightforward approach to participate in this market; it additionally would offer the benefit of diversification and a staff of experienced analysts and portfol io managers watching the very trends described herein. While spreads on tobacco bonds have narrowed from recent highs, we would not be surprised by a further sell-off in the months ahead as overall municipal supply is expected to increase and also if other issuers bring new tobacco settlement revenue bonds to market that are more conservatively structured, along the lines of Illinois’ Railsplitter transaction. A supportive factor would be if the upcoming 2011 MSA payment reflects a level of consumption decl ine that is more in line with the historic norm; however, any deviation from this expectation could lend to further pressure.

Background on the MSA As a refresher for our readers unfamiliar with this area of the municipal market, tobacco settlement reven ue bonds are secured by payments made by participating tobacco manufacturers (PMs) under the Master Settlement Agreement (MSA) and the earnings from any invested funds in the trust estate. The MSA was signed in 1998 and settled various lawsuits filed by 46 states, the District of Columbia, and several US territories against the four major cigarette manufacturing companies, known as original participating manufacturers (OPMs). The OPMs were Philip Morris, RJ Reynolds, B&W and Lorrillard. RJR subsequently acq uired B&W, leaving only three OPMs today. More than 40 smaller manufacturers later joined the MSA. These companies are referred to as the subsequent participating manufacturers (SPMs).

Under the terms of the MSA, the PMs are required to make payments to each state annually, in perpetuity. Annual payments are set by a formula that considers the volume of domestic cigarette sales, inflation, and PM market share. Each state’s share of the annual payment is a fixed percentage set by the MSA. The annual MSA pa yments are made each April 15, are calculated by an independent auditor, and are subject to numerous adjustments that can impact projected revenues.

The NPM provision The most significant of these is the non-participating manufacturer (NPM) adjustment. Un der this provision, PMs can reduce their annual MSA payment to adjust for competitive disadvantages believed to be created by the MSA relative to manufacturers that do not participate in the MSA. Specifically, a market share loss of at least 2% relative to 1997 levels must occur, a nationally recognized economic consultant must determine that the MSA was the cause of this loss, and states must be proven to have failed to diligently enforce the terms of the MSA in the year in question. Under this statute of the MSA,

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states are required to collect payments from NPMs to keep the competitive playing field even.

The PMs have experienced market share loss every year since 1999. When PMs have argued that annual MSA payments should be adjusted downward under the t erms of the NPM adjustment, The Brattle Group has served as the economic consulting firm determining if the MSA was a primary driver of the market share loss. The Brattle Group determined that the MSA was a significant factor for the 2003 and 2004 calendar years. The MSA does not define diligent enforcement, so no determination has been made on this matter.

Resolution of the diligent enforcement matter could take years as it works its way through the courts. Disputed payments are expected to be held in es crow until that time with the exception of a one-time release of funds that occurred in 2009 when roughly USD 540mn of disputed payments were released in exchange for the states agreeing to submit to arbitration on 2003 disputed payments to the logistical benefit of the PMs, which would then be able to present the case in a single venue instead of having it heard across a number of state courts. The states, in turn, used the released funds to pay down principal on outstanding tobacco settlement revenue debt.

Consumption declines A 9.3% decline in 2009 shipments and a roughly 8% NPM adjustment caused the 2010 MSA payment to fall by roughly 16% to USD6.4bn. The largest annual drop in shipments prior to this was a 4.77% reduction in 2007. This above average le vel of stress in 2009 was tied to lower cigarette sales driven by anti- smoking campaigns, smoking bans, the recession, the U.S. Food and Drug Administration regulation of the industry, and tax increases at the state and federal level. The increase in the federal excise tax in April 2009 to about USD 1 per pack from 40 cents per pack previously continued to be a factor in the outsized decrease for the year, but also important were general economic trends and a high number of state excise tax increases which amounted to an increase of roughly 13.25% from 2009 levels, according to S&P.

While we are not aware of any rated transactions that drew on cash reserve accounts in 2010, debt service coverage levels declined substantially for the year. Moody’s notes tha t historical consumption declines have ranged from 2-4% per year; going forward it is anticipating drops of 3-4% annually and more if a shock occurs, such as additional tax increases or limits on the sale of menthol products. S&P estimates a 5% drop in volume for the year, only slightly above the historical rate, and expects cigarette shipments to return to the 3-4% rate of decline in 2011.

Litigation outlook continues to improve In the backdrop of the more challenging news associated with cigarette consum ption, the litigation outlook appears to have improved. The tobacco industry’s track record in defending itself against some of the more significant product liability and consumer fraud class action cases has generally been strong but litigation remains an ongoing permanent risk associated with the

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pledged revenue stream. Recently, however, a key case known as Freedom Holdings was resolved. Freedom Holdings was a legal challenge to the MSA itself – the plaintiffs alleged that the MSA and New York’s implemen ting legislation violated federal antitrust law and the Commerce Clause of the U.S. Constitution. A district court judge in the Southern District of New York in the Second Circuit dismissed the plaintiff’s claims on all counts in November 2008 and this dec ision was upheld by the Second Circuit Appellate Court in October 2010. The resolution of the Freedom Holdings case thereby upholds the integrity of the MSA and should protect it from these types of legal challenges in the future. The case emerged as a con cern in 2004, at which time Moody’s assigned a direction uncertain to its rating outlook of all tobacco settlement revenue bonds. With the case resolved and a more favorable litigation outlook for the industry overall, Moody’s removed this outlook from its ratings in December.

Standard & Poor’s Revisits Bond Insurer Ratings … Again

When Standard & Poor’s revised the financial strength rating of Assured Guaranty Corp. (and sister company Assured Guaranty Municipal) from AAA to AA+ on October 25, most marke t participants accepted the rating as a verdict on the industry as much as it was on the company. In fact, S&P cited limited demand for credit enhancement as an important factor in its decision to reduce the rating. The rating agency’s accompanying stable outlook on Assured led most market participants to anticipate at least a brief respite from further rating action.

The interlude of stability was shorter than expected. Less than three months after assigning a stable outlook to Assured, S&P proposed a new set of criteria for its ratings o n all municipal bond insurers. If the agency adopts the new criteria as now proposed, all bond insurers would be obliged to raise new capit al or face further downgrades. Among other changes, the rating agency proposes to r aise the capital charges associated with municipal credits, reduce the single-risk limit for individual municipal bond exposures, and impose a new leverage test for financial guaranty companies.

Not surprisingly, Assured Guaranty responded to the proposal with a sense of exasperation and promptly highlighted per ceived flaws in S&P’s approach. Assured asserts that the new leverage test imposes similar limitations for AAA-rated securities as it does for BBB-rated securities and thereby fails to give proper c redit for the relative quality of an insured portfolio. The company also objects to the exclusion of the statutory unearned premium reserve in the new leverage test as an abrupt departure from past practice.

S&P has imposed a deadline of March 25 for industry comments. Meantime, the proportion of municipal bonds being sold with insurance continues to decline and now represents less than 3% of the new issue market.

In the absence of another means of commoditizing an otherwise disparate market, we have conc eded the utility value of bond insurance for a small segment of the market. Smaller local

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governments and those municipalities whose bonds are rarely traded were expected to be good candidates for bond insurance. The recent announcement by S&P is another s evere blow to the bond insurance industry. Unless the rating agency reconsiders its proposal, and thereby eliminates the necessity for additional capital, S&P’s financial ratings of the bond insurers are likely to sink further, causing the credit enhanceme nt provided by the bond insurance product to make less economic sense to issuers and further reduce its utility for fixed income investors.

End Notes

¹ Source: SIFMA Legislative Report, “State and Municipal Debt: The Coming Crisis?” House Oversight and Government Reform Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, 9 February 2011. ² UBS WMR Education Note, “Tax implications for discount munis”, 3 November 2008.

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Table 1: Current state ratings and rating outlooks⁴ State Moody’s Outlook Last Rating/ S&P Outlook Last Rating/ Fitch Outlook Last Rating/ Rating OL change³ Rating OL change³ Rating OL change³

Alabama Aa1 Stable 4/16/2010 AA Stable 8/3/2007 AA+ Stable 4/5/2010 Alaska Aaa Stable 11/22/2010 AA+ Stable 3/27/208 AA+ Stable 4/5/2010 Arizona Aa3 2 Negative 2/09/2011 A+ 2 Negative 12/23/2009 Arkansas Aa1 Stable 4/16/2010 AA Stable 1/10/2003 California A1 stable 4/16/2010 A- Negative 1/14/2010 A- Stable 4/5/2010 Colorado AA 2 Stable 7/10/2007 Connecticut Aa2 stable 4/16/2010 AA Stable 9/26/2003 AA Stable 6/3/2010 Delaware Aaa Stable AAA Stable 2/22/2000 AAA Stable 4/13/2006 Dist. of Columbia Aa2 Stable 4/16/2010 A+ Stable 6/6/2007 AA- Stable 4/5/2010 Florida Aa1 Stable 4/16/2010 AAA Negative 1/14/2009 AAA Negative 4/5/2010 Georgia Aaa Stable AAA Stable 7/29/1997 AAA Stable 4/13/2006 Hawaii Aa1 Negative 4/16/2010 AA Stable 1/29/2007 AA+ Negative 4/5/2010 Idaho Aa1 2 Stable 4/16/2010 AA 2 Stable 7/20/2009 AA-1 Stable 2/13/2007 Illinois A1 Negative 9/23/2010 A+ Negative 12/10/2009 A Negative 6/11/2010 Indiana Aaa 2 Stable 4/16/2010 AAA 2 Stable 7/18/2008 AA+ 1 Stable 4/5/2010 Iowa Aaa 2 Stable 4/16/2010 AAA 2 Stable 9/11/2008 AAA Stable 4/5/2010 Kansas Aa1 2 Stable 4/16/2010 AA+ 2 Stable 5/20/2005 Kentucky Aa1 2 Negative 4/16/2010 AA-2 Stable 6/23/2009 AA 1 Negative 4/5/2010 Louisiana Aa2 Stable 4/16/2010 AA- Stable 10/9/2009 AA Stable 4/5/2010 Maine Aa2 stable 4/16/2010 AA Negative 3/10/2010 AA+ Stable 4/5/2010 Maryland Aaa Stable AAA Stable 5/7/1992 AAA Stable 4/13/2006 Massachusetts Aa1 Stable 4/16/2010 AA Stable 3/15/2005 AA+ Stable 4/5/2010 Michigan Aa2 Stable 4/16/2010 AA- Stable 5/22/2007 AA- Stable 4/5/2010 Minnesota Aa1 Stable 4/16/2010 AAA Stable 7/24/1997 AAA Stable 4/5/2010 Mississippi Aa2 Stable 4/16/2010 AA Stable 11/30/2005 AA+ Stable 4/5/2010 Missouri Aaa Stable AAA Stable 2/16/1994 AAA Stable 4/13/2006 Montana Aa1 Stable 4/16/2010 AA Stable 5/5/2008 AA+ Stable 4/5/2010 Nebraska Aa2 1 Stable 4/16/2010 AA+ 2 Stable 10/11/2006 Nevada Aa1 Negative 11/10/2010 AA+ Stable 6/23/2006 AA+ Stable 4/5/2010 New Hampshire Aa1 Stable 4/16/2010 AA Stable 12/4/2003 AA+ Stable 4/5/2010 New Jersey Aa2 Negative 9/22/2010 AA- Stable 2/09/2011 AA Stable 4/5/2010 New Mexico Aaa Stable 4/16/2010 AA+ Stable 2/5/1999 New York Aa2 Stable 4/16/2010 AA Stable 9/14/2004 AA Stable 4/5/2010 New York City Aa2 Stable 4/16/2010 AA Stable 6/5/2007 AA Stable 4/5/2010 North Carolina Aaa Stable 1/12/2007 AAA Stable 6/25/1992 AAA Stable 4/13/2006 North Dakota Aa1 2 Stable 4/16/2010 AA+ 2 Stable 3/17/2009

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Ohio Aa1 Negative 4/16/2010 AA+ Negative 9/23/2009 AA- Stable 4/5/2010 Oklahoma Aa2 Stable 4/16/2010 AA+ Stable 9/5/2008 AA+ Stable 4/5/2010 Oregon Aa1 Stable 4/16/2010 AA Stable 8/23/2007 AA+ Stable 4/5/2010 Pennsylvania Aa1 Negative 4/16/2010 AA Stable 11/6/1998 AA+ Stable 4/5/2010 Puerto Rico A3 Negative 8/10/2010 BBB- Positive 11/29/2010 BBB+ Stable 1/19/2011 Rhode Island Aa2 Stable 4/16/2010 AA Negative 3/9/2009 AA Negative 4/5/2010 South Carolina Aaa Stable 3/23/2007 AA+ Stable 7/11/2005 AAA Stable 4/13/2006 South Dakota A1 1 Stable AA 2 Stable 12/21/2006 AA 1 Stable 4/5/2010 Tennessee Aaa Stable 4/16/2010 AA+ Stable 10/12/2006 AAA Stable 4/5/2010 Texas Aaa Stable 4/16/2010 AA+ Stable 8/10/2009 AAA Stable 4/5/2010 Utah Aaa Stable AAA Stable 6/7/1991 AAA Stable 4/13/2006 Vermont Aaa Stable 2/2/2007 AA+ Stable 9/11/2000 AAA Stable 4/5/2010 Virginia Aaa Stable 5/27/2004 AAA Stable 11/11/1992 AAA Stable 4/13/2006 Washington Aa1 Stable 4/16/2010 AA+ Stable 11/12/2007 AA+ Stable 4/5/2010 West Virginia Aa1 Stable 7/9/2010 AA Stable 8/21/2009 AA Positive 4/5/2010 Wisconsin Aa2 Stable 4/16/2010 AA Stable 8/15/2008 AA Stable 4/5/2010 Wyoming AA+ 2 Stable 6/30/2008 Source: Moody's, S&P and Fitch as of 18 February 2011. 1 = Lease rating 2 = issuer credit rating: a rating equivalent to a General Obligation (GO) rating for states with no GO debt 3 = Last rating change or outlook revision. Does not reflect an affirmation. 4 = Moody’s and Fitch recalibrated ratings on US municipal bond issues and issuers in April 2010.

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Appendix

Statement of Risk Municipal bonds: Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely following the particular bond’s sector. Additionally, all municipal bonds feature , return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor’s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market.

Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition GO General Obligation Bond TEY Taxable Equivalent Yield (tax free yield divided by 100 minus the marginal tax rate) MMD Municipal Market Data Rating Agencies Credit Ratings S&P Moody's Fitch/IBCA Definition

I AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. n AA+ Aa1 AA+ Issuers have very strong credit quality. v e AA Aa2 AA s t AA- Aa3 AA- m e A+ A1 A+ Issuers have high credit quality. n t A A2 A A- A3 A- G r BBB+ Baa1 BBB+ Issuers have adequate credit quality. This is the lowest Investment Grade category. a d BBB Baa2 BBB e BBB- Baa3 BBB- BB+ Ba1 BB+ Issuers have weak credit quality. This is the highest Speculative Grade category.

N BB Ba2 BB o n BB- Ba3 BB- - B+ B1 B+ Issuers have very weak credit quality. I n B B2 B v e B- B3 B- s t CCC+ Caa1 CCC+ Issuers have extremely weak credit quality. m e CCC Caa2 CCC n CCC- Caa3 CCC- t CC Ca CC+ Issuers have very high risk of default. G r C CC a d CC- e D C DDD Obligor failed to make payment on one or more of its financial commitments. this is the lowest quality of the Speculative Grade category. UBS FS and/or its affiliates trade as principal in the fixed income securities discussed in this report.

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Appendix

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Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG, authorised and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate.Version as per October 2009. © 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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