NEW MEXICO TAX RESEARCH INSTITUTE

ANNUAL POLICY CONFERENCE

WE ARE NOT IN KANSAS ANY MORE

Implications of the Global Financial Crisis for Public Finance in New Mexico

April 30, 2009

Fiscal Strategies Group!

Independent Financial Advisors!
 Core Sources of State Level Capital Financing

  Quick overview of New Mexico bond programs and credit position.

  Core state bond programs represent a fraction of total state and local government debt
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Affordable Projected Debt Service Burden at State Level

  Debt service burden projected to remain

stable over time

  Transportation debt has been the major

source of cost increases to tax base

  Little debt service impact on General Fund

  GO debt secured by separate property tax

levy away from General Fund
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Key Measures of Credit Quality are Stable

  Overall debt ratios measuring debt to personal income

and debt per capita remain moderate over time even as
State borrowing continues

  Short debt average life supports credit

  Strong debt service coverage on severance tax bonds

  Significant cash funding of capital from severance tax

bonding fund and general fund limit reliance on bonds
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Bottom Line on New Mexico Credit

  Strong general fund financial reserve balances are

key to rating stability

  Weak economics and demographics compared to

highest rated states

  Improving management systems

  GO bonds have substantial tax base

  Revenue bonds have strong coverage and legal

protections
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Municipal Market Trends Before July 25, 2007

  For decades, the municipal bond market characterized by 50,000 individual credits.

  Historically, municipal bond market was cloistered domain of individual investors clipping coupons,
local banks and illiquid securities.

  Tax reform and federal regulation accompanied changes in investment practices let to reduced role
of local banks, bond registration and rise in mutual funds and money market funds.

  Use of bond insurance grew as market demanded fewer “names” and greater liquidity, to point
where over 50% of municipal bond volume was insured bonds.

  At the same time, underwriting fees declined substantially, by approximately 80% over twenty years.

  As municipal supply increased, new buyers entered municipal market and municipal issuers turned to
variable rate, synthetic debt, and increased use of derivatives in effort to reduce debt service costs.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

  Monoline bond insurance and development of auction rate securities both evolved from changes in
the tax-exempt market, and the declining relative value of long-term tax-exempt securities.

  Hedge fund and municipal arbitrage buyers also emerged as significant new buyers, pursuing
apparent opportunity to leverage municipal market “inefficiency.”

  By the dawn of the global financial crisis, the municipal bond market had changed dramatically, as it
evolved away from traditional fixed-rate funding of local credits toward reliance on bank credit
support, bond insurance and financial derivatives.

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 Credit Context of Municipal Bonds

  Based on Moody’s data, the 10-year default rate of comparably rated municipal issues was less
than 1/20th the rate on comparable corporate issues.

  “Moody's expects that nearly all performing municipal general obligation and essential service
revenue bonds would be rated Aa3 or higher if rated on the corporate rating scale.”

  With new buyers and increased use of derivative transactions, municipal credits became
increasingly exposed to larger capital markets.

  As municipal credits enter the global markets, they face the challenge of being:

  Small in a global market that prefers size

  Illiquid in a market that places a premium on liquidity

NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

  Revenue-based in a market that prefers asset-backed credits

  Government, in a market traditionally biased toward corporate credits

  But facts are facts:

“Since 1970, there have been no defaults among the roughly 16,900 Moody's-rated issuers
of general obligations bonds, water & sewer bonds, and public university bonds.”

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 Impact of Global Debt Market Turmoil on Municipal Market

  Four charts illustrate the dramatic circumstances affecting the evolution of the bond markets.

  First, domestic growth in GDP reflected increasing federal reliance on borrowed capital. This trend
paralleled municipal bond migration into global securities market and dependence on capital market
investors.

  As municipal credits compete in global markets, they will face significant and growing competition.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Overleveraging in Run-up to Collapse

  Second. State and local debt growth grew

modestly while every other sector
experienced exploding growth.

  Emergence of municipals into global fixed

income markets characterized by market
pricing of call options, growth in role of
derivatives and entry of hedge fund buyers.

  Derivatives have gained broad acceptance in

muni market since Orange County collapse.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Municipal Market Decline Preceded Fall 2008 Collapse

  Third. As crisis loomed, buyers exited municipals in flight to quality.

  Trading levels deteriorated, leading to collapse of hedge fund and arbitrage buyers.

Trading Levels of Tax-Exempt Bond vs. Treasuries

NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Fear and Risk Premiums Affected All Markets in Wake of Crisis

  Fourth. Financial crisis and flight to quality have resulted in dramatic quality spread in the
municipal market as in all other markets, effectively closing the market to one-third of issuers.

  Moody’s data on municipal defaults has done little to insulate municipal credits from severe credit
crunch or attract crossover buyers to strong after-tax yields.

Long Term Municipal Credit Spreads

NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Federal Response to Collapse of Municipal Bond Market

  Federal Reserve, which created Commercial Paper Funding Facility within weeks of market
collapse, ignored total shutdown of municipal market.

  No Federal response to date to loss of bond insurers and bank credit support.

  In ARRA, Congress has chosen to add new types of funding, rather than to fix current system.

  Build America Bonds and Recovery Zone Bonds seek to give higher value to tax-exemption,
along with tax-credit bonds.

  These new ideas will take time and money to work out. Meanwhile the rest of the municipal
bond market remains broken and credit spreads remain at historic highs.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 When the Dust Settles

  People forget that importance of bond insurance was credit homogenization.

  Need for hundreds of credit homogenization and credit support for variable rate obligations will
not be met within private markets.

  Monoline insurers have been largely destroyed.

  Letter of credit banks have lost funding capacity and appetite.

  Core demand for tax-exempt securities will not be sufficient to meet supply needs.

  AAA/AA credits can raise capital during any given week.

  Since October, no BBB-rated bonds sold for general government purposes over $50 million.

  Hedge fund and arbitrage buyers will not return to market.

NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

  Academic research undermines core premise of muni arbitrage, suggesting that municipal
market is not inefficient. (McCann, Liu and Deng, Wang, Wu and Zhang)

  Issuer vulnerability to risks in derivative products is more apparent than ever before.

  Financial derivatives were supposed to transfer risk to those best able to manage it. It turns
out that they transferred risk to those least able to understand it.

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 Public Policy vs. Market Reality in Value Recapture Financing

  New initiatives in local development financing push debt funding to the local level.

  Development district and tax increment financings seek financing based on value recapture.

  Increases investor risk by concentrating source of revenues.

  Reasonable public policy that sharpens ties between costs and beneficiaries may be at odds with
market trends.

  On the other hand, Federal initiatives in taxable financing will bring commercial banks back into
local finance market.

  Already seeing local debates over use of Federal rebates tied to new bonding program interest
cost subsidies.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

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 Implications of Financial Crisis for Public Finance

  50,000 credits will be hard pressed find homes in the global markets.

  State and local governments will increasingly raise capital in taxable markets.

  Challenges that this will create include the premium that taxable investors traditionally place on
size and liquidity, on asset-backed credits, in contrast to traditional attributes of municipal credit.

  New bond provisions should make local banks a primary buyer for local bonds.

  While market trends will be for fewer, recognizable names, TIDDs and similar value recapture
credits may benefit from increased role for regional banks in municipal funding.

  State funding banks will need to provide credit substitution that was once provided by bond
insurance. 
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

  New Mexico has developed centralized bonding entities.

  The State Board of Finance provides oversight of certain local finance activities and derivative
transactions.

  NMFA was created as a state bond bank.

  Going forward, all we know is there is no going back.

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 An Optimistic Vision of the Future

  Never include predictions in a presentation.

  As credit crisis abates, markets will adjust

  Credit spreads will narrow as investor fear subsides.

  Dollar will resume decline as flight to quality abates and foreign purchases moderate.

  Treasury rates will rise.

  Likely to see a number of sovereign defaults as weaker European countries fail to stem
capital flight and European central bank intervention struggles to find consensus.

  US will move toward budget balance faced with new market reality, muting long-term
growth prospects.
NEW MEXICO TAX RESEARCH INSTITUTE APRIL 30, 2009

  Toughest challenges will be for export driven economies, and ebbing of post-war
development theory.

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