Loop on PR

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This report is available on Bloomberg LPCM

Municipal Strategy ReportOctober 2013

1

The announcement that the Administration will nominateJanet Yellen to succeed Ben Bernanke as Chairperson of

the Federal Reserve should end a long and poorly executedhunt for a successor. This assumes that she passes Senateconfirmation, usually a non-event for most Fed Chairnominations, but not a given under the present politicalconditions. The decision was anti-climactic and providedno surprise and little market reaction. The Fed Chair se-lection process should be a slam dunk. There is a wellprescribed roadmap that, if followed, should produce anew Chair with minimal market disruption. Unfortunate-ly, the successful completion of any simple task can nolonger be taken as a given in Washington. The Best Prac-tices steps to finding and hiring a new Fed Chair are to(1) create a list of qualified (and unqualified) candidatesprivately, using all available channels of input; (2) shorten

the list to those that meet your political agenda (usuallythe unqualified ones); (3) have the Department of Presi-dential Leaks release a short list of the most probable can-didates; (4) Let the market stew and fume about it for sev-eral months while you interview the candidates in secrecy(although secrecy left town a longtime ago); and (5)make your choice knowing, but not necessarily acquiesc-ing to, the views of Wall Street. Instead, the Administra-tion badly fumbled the snap, tripped over their own feetfading back to pass, but nevertheless, managed to find theright receiver against all the odds they unskillfully createdfor themselves.

There is no doubt that Janet Yellen was the right candi-date all along. She has had a long and distinguished ca-

reer, succeeding big-time at every junction from GirlScouts to running the San Francisco Fed. She has seriousacademic chops, a lengthy Federal Reserve resume both inWashington and in the Regional Bank system, and hasserved in the political realm under President Clinton.From President Obamas perspective, she even has theright party affiliation. And, unlike Lawrence Summers,she has not, nor will she ever, be an embarrassment.What more could you possible want? It appears Obamawas cool on her candidacy from the start. Maybe therewas a concern about falling into the He only wants toappoint her because she is a girl trap set by Republicans.That Obama may have allowed this grade school politicalruse to influence his thinking is proof enough that we

should all be extremely fearful of his resolve in standingfirm in the face of the dangerous debt ceiling blackmailcurrently occurring in our nations capital.

Ms. Yellen may take considerable heat during her confir-mation hearings. She is a Democrat. Her lineage isKeynesian. She is both a monetary and a fiscal activist. Heracademic interest in wages, labor markets and unemploy-ment issues indicate a degree of sensitivity to the unem-ployed that may not go down well with a good portion ofthe Senate Banking Committee, which conducts the con-firmation hearings. Yellen is vulnerable on issues of bank

regulation and was a little late to the party in reacting tothe fallout resulting from the Great Recession on financial

institutions and on housing. As the President of the SanFrancisco Fed at the time of the collapse, she had jurisdic-tion over a number of states that were at the epicenter ofthe foreclosure crisis. This criticism lacks sufficientweight, however, to seriously impede prospects for herconfirmation.

Ms. Yellens depth of knowledge in quantitative easingand forward guidance are critically important to main-taining continuity now while Washington seems so intenton disrupting the financial markets and the economy. TheWSJ reports that she was the most accurate forecaster ofthe economy since 2008. She has great knowledge of howthe Fed works at all levelsstaff, governor, and vice-

Chair. She has had her ticket stamped as an economicadvisor to a president. She is well-liked (other than byRichard Fisher and Gene Sperling). Richard Fisher hasbeen wrong on the Feds policy impacts on inflation foryears. Fishers unwillingness to adjust his views in theface of reality is suggestive of why he himself was never inthe running for the job. Perhaps he should refrain fromthrowing stones.

Yellen will do a great job as Fed chair. She is dovish, butnow is the right time be dovish. Unemployment is stillhigh, inflation is too low, and Congress is threatening tokill the financial markets and the economy. A dove is thebird of choice. There is no reason to believe that shewould not respond to inflation that was accelerating

above the Feds target of 2.0% (which she herself champi-oned) and beyond the 2.5% level that was described bythe Fed as a demarcation point with respect to mainte-nance of stimulative monetary policy. Her own past rec-ord indicates a willingness to move to monetary restraintwhen conditions indicate a reason to do so. The financialmarkets and the economy do not need an inflexible ideo-logue in the Fed Chair (think Fisher) or a political miscre-ant (Summers). Barring a problem in getting confirmed,we will be fortunate to have a deep intellect with lengthyexperience at the highest levels and a pragmatic approachto monetary policy. And, thankfully, she has the addedvirtue of not being Lawrence Summers.

A dove is still the bird of choice for today's macroeconom-ic environment.

FEATURED IN THIS ISSUE

Puerto Ricothe government is showing savvy,but is it enough to offset economic fundamentals?(Page 4)

Early results are inhow is the health insuranceexchange enrollment going? (Page 9)

Lipper muni mutual fund flowsready to go posi-tive? (Page 13)

Analytical Services Division

Chris Mier, Strategist

[email protected]

312.356.5840

Janet Yellin!


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Municipal Strategy Report October 2013

* 3 month average Source: Loop Capital Markets Analytical Services Division and Short-Term Desk** 30-Year MMD minus 7-Day SIFMA Black Text: Actual Gold Text: Forecast as of October 4, 2013

Economic and Interest Rate Forecast October 2013

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 Avg'12 Avg'13 Avg'14

Economic Forecasts

Real GDP 3.71 1.20 2.78 0.14 1.15 2.52 1.89 2.77 3.03 3.05 3.24 3.52 1.96 2.08 3.21

Domestic Final Sales 3.41 2.16 2.21 2.18 0.21 1.93 2.29 2.99 3.05 3.13 3.50 3.65 2.49 1.86 3.33

Exports 4.16 3.85 0.37 1.11 -1.32 8.57 5.60 6.88 6.64 6.68 6.82 7.03 2.37 4.93 6.79

Imports 0.71 2.46 0.49 -3.12 0.61 6.97 5.17 7.63 8.95 9.89 8.08 7.56 0.13 5.10 8.62

Consumption 2.91 1.89 1.69 1.67 2.26 1.76 1.85 2.92 3.88 3.98 4.07 4.13 2.04 2.20 4.01

Business Fixed Investment 8.60 4.75 2.68 11.57 -1.49 6.05 11.37 9.66 7.18 8.30 8.50 8.67 6.90 6.40 8.16

Residential Investment 22.95 5.68 14.22 19.80 12.53 12.89 31.31 32.80 17.81 34.89 31.84 29.18 15.66 22.38 28.43

Government -1.39 0.30 3.46 -6.53 -4.21 -0.95 -4.31 -1.22 - 1.18 - 1.36 -1.58 -1.79 -1.04 -2.67 -1.48

Core PCE Price 2.18 1.83 1.41 1.30 1.36 0.81 1.07 1.63 1.70 1.80 1.90 2.00 1.68 1.22 1.85

Unemployment Rate 8.27 8.17 8.03 7.83 7.73 7.57 7.33 7.19 7.05 6.96 6.90 6.88 8.08 7.46 6.95

Nonfarm Payrolls (chg in 1000s) 771 451 409 545 645 579 568 547 572 592 551 549 544 585 566

Housing Starts (mil) 0.71 0.74 0.78 0.90 0.96 0.87 0.98 1.09 1.22 1.39 1.57 1.84 0.78 0.98 1.50

Light Vehicle A uto S ales (mil) 14.17 14.24 14.43 14.92 15.25 15.47 15.70 15.88 16.15 16.52 16.82 17.07 14.44 15.58 16.64

Industrial Production (Annualized % Growth) 5.39 2.93 0.28 2.50 4.07 0.34 2.30 2.28 2.42 2.30 2.31 1.98 2.78 2.25 2.25

S&P 500* 1,347 1,350 1,402 1,418 1,515 1,610 1,675 1,690 1,705 1,715 1,725 1,730 1,380 1,622 1,719

WTI Oil* 102.89 93.48 92.27 88.16 94.35 94.22 104.95 106.76 107.66 107.65 107.81 107.81 94.20 100.07 107.73

Short-Term Interest Rates*

Fed Funds Target (%) 0.10 0.15 0.14 0.16 0.14 0.12 0.10 0.09 0.10 0.10 0.09 0.08 0.14 0.11 0.09

3-Month LIBOR (%) 0.51 0.47 0.42 0.32 0.29 0.28 0.26 0.27 0.29 0.29 0.28 0.26 0.43 0.28 0.28

Treasury Interest Rates*

2-Year Treasury (%) 0.29 0.29 0.26 0.27 0.27 0.27 0.37 0.50 0.64 0.74 0.80 0.77 0.28 0.35 0.74

3-Year Treasury (%) 0.42 0.40 0.35 0.36 0.39 0.44 0.71 0.90 1.01 1.16 1.27 1.28 0.38 0.61 1.18

5-Year Treasury (%) 0.90 0.79 0.67 0.69 0.83 0.92 1.51 1.63 1.70 1.93 2.11 2.21 0.76 1.22 1.99

7-Year Treasury (%) 1.44 1.24 1.08 1.12 1.32 1.39 2.12 2.24 2.30 2.57 2.78 2.94 1.22 1.77 2.65

10-Year Treasury (%) 2.04 1.82 1.64 1.71 1.95 2.00 2.70 2.87 3.01 3.24 3.52 3.73 1.80 2.38 3.38

30-Year Treasury (%) 3.14 2.94 2.75 2.86 3.14 3.15 3.72 3.91 4.03 4.23 4.49 4.66 2.92 3.48 4.35

Municipal Interest Rates

7-Day SIFMA (%) 0.19 0.18 0.18 0.13 0.12 0.06 0.07 0.15 0.15 0.20 0.20 0.20 0.17 0.10 0.19

30-Year MMD (%) 3.39 3.16 2.85 2.83 3.09 3.83 4.12 4.30 4.40 4.52 4.71 4.80 3.06 3.84 4.61

Muni Yield Curve ** 3.20 2.98 2.67 2.70 2.97 3.77 4.05 4.15 4.25 4.32 4.51 4.60 2.89 3.74 4.42

We have changed our macroeconomic forecasting model. This is the first forecast with the new model, which has an advantage of more explicitly tyingthe real economy and financial markets. Consequently, the interest rates generated by the model are more consistent with the economic variables.

Factors Supportive of Higher RatesFactors Supportive of Lower Rates

The Fed decided not to taper in September, and may be on holdfor a while longer given the debt ceiling and budget fight inCongress. The fed funds rate is expected to stay near zerothrough the end of 2014.

Core PCE is at 1.2%, well below the 2% target, giving the Fedthe latitude to continue to lean hard on interest rates withoutfears of generating inflation.

Mortgage rates have declined since the Feds September meeting,but the generally higher levels may begin to affect the level ofactivity in the housing industry.

The S&P 500 and the Dow have fallen in recent weeks afterreaching all time highs. Weakness in stocks could boost bondprices, unless the United States defaults, in which case every-thing may be offered against no bid.

Having a stable, highly competent, experienced individual atthe helm of the Fed has to be good for the bond market, or atleast less bad.

Congressional hijinks over the debt ceiling could be damagingto US credit quality, financial market conditions, business con-fidence, and, ultimately, the US economy.

Fiscal drag will begin to subside as we move into 2014.

Consumer confidence remains close to the highest level since2008, despite Washingtonian misbehavior of epic proportions.

The ISM Index showed improvements in the manufacturingsector for the past four months and is at its highest level of theyear as of the September reading.

The housing market continues to improve, although the rise inmortgage rates has begun to slow activity somewhat.

Auto sales are strong, with an aging fleet and gas-saving tech-nologies fueling demand. Sales dropped in September becauseof the timing of the Labor Day weekend, but are expected toreturn to previous levels.

Recent economic data from the Eurozone and the U.K. hasbeen surprisingly positiveencouraging for U.S. exports.


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Municipal Strategy Report October 2013

Data Diffusion Index

We calculate the Data Diffusion Index based on 30 different weekly and monthly economic releases, such as construction spending,capacity utilization and new home sales. If the number came above the consensus estimate (which is positive for economic growth)the index would increase by one, and vice versa. The Treasury yield is expected to track the data diffusion index (the yields wouldincrease as the economy expands and decrease as the economy contracts).

Data Diffusion Index vs. 10-Yr Treasury Yield

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

-140

-120

-100

-80

-60

-40

-20

Dec-07 Jun-08 Nov-08 Apr-09 Oct-09 Mar-10 Aug-10 Jan-11 Jul-11 Dec-11 May-12 Oct-12 Apr-13 Sep-13

Yield

Index

Data Diffusion Index 10-Yr Treasury YieldSource: Bloomberg

September 2008 -Lehman collapses

March-April 2009Economy bottoms

QE2 Announced

Eurozone Debt Crisis

QE3 TaperingConcerns

Yields are fallingto the postpone

of tapering anddamage anticifrom the budgetdebt ceiling probThe data has slightly weaker expected, also tributing to thcline in rates.

Aruoba-Diebold-Scotti Business Conditions Index (12/31/2007- 09/28/2013)

For dates to the left of the left line, the ADS index is based on observed data for all six underlying indicators. For dates between theleft and right lines, the ADS index is based on at least two monthly indicators (typically employment and industrial production) andinitial jobless claims. For dates to the right of the right line, the ADS index is based on initial jobless claims and possibly one month-ly indicator.

The ADS iwhich is publishPhiladelphia Fedshown surprstrength, despitehandling of tapby Bernanke andceiling concerns

how long will it l


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Municipal Strategy Report

4

Puerto Rico Open Issues, Concerns, and Prospects

The Economic ChallengesHistorical

The economic challenges confronting the island havebeen long-standing, well-identified concerns:

1. Significant cost disadvantages arising from over-dependence on oil and very high electricity costs.

2. Poor incentives for businesses to hire given theislands minimum wage, which is set at the USrate, despite the fact that the standard of living isvastly below even the poorest US state.

3. Poor incentives to seek employment since entitle-

ments are set at a level much closer to per capitaincome than in the US and tax policy on the is-land imposes a high marginal tax on wage incomeabove entitlement income.

4. Outdated USimposed requirements that inflatecosts and reduce competitiveness, like the JonesAct which requires US ships, US flags, and US em-ployees on all ships transporting goods betweenUS ports. As an island, Puerto Rico depends muchmore on shipping than any US port city, and hasbeen hurt proportionally that much more as aresult. Curiously, the US Virgin Islands have beenexempted from the Jones Act since 1992.

5. A poor transportation grid on the island with fewrailroad tracks, and over-reliance on truckingacross a system of poorly maintained roads.

6. Productivity that ranks among the worst in theworld, according to the World Bank.

7. A weak banking system with impaired capital andover-reliance on external financing rather thandeposit gathering. The weak banking sector limitsthe availability of financing to businesses, makingthe availability and cost of capital for businessexpansion problematic.

8. A system of business regulation that makes basicactivities like acquiring a business license, an ex-cessively long, difficult, and expensive proposi-tion. The US mainland is a model of efficiency bycomparison.

In this list of economic ills, Puerto Rico has major dis-advantages in the cost of producing goods, the trans-portation of goods, the incentives to hire workers, andthe incentives for people to seek employment. PuertoRico has a government that is large even by Europeanstandards (although a little smaller now), significant

poverty, corruption, and underground activities thatvastly exceed US proportions. The removal of the lasttax incentives for US corporations to operate in Puer-to Rico in 2006 was another nail in the economic andfiscal coffin for the island. Finally, Puerto Rico hasmuch less significance to the US as a Caribbean show-case of the power of capitalism to raise living stand-ards than it did in the post-Soviet world.

The solutions to these problems would be difficultunder the best of circumstances. The fact that PuertoRicos unique situation requires various legislation,

some of which has to go through San Juan and somethrough Washington, adds significantly to the degreeof difficulty in securing needed legislative solution.

The Ongoing Concern Issue

Auditors who provide opinions on both public andprivate sector entities are governed by the sameguidelines with respect to going concern determi-nation. While the topic comes up with relative fre-quency for corporations, it is not very common forgovernmental issuers of municipal bonds, owing tothe historically low rates of default that have been a

feature of general government finance for state andlocal entities.

The Commonwealth of Puerto Ricos Auditor,Deloitte & Touche LLP, did not address the goingconcern issue in their most recent ComprehensiveAnnual Financial Report. The omission is significant,because Puerto Rico has recorded General Fund oper-ating deficits for 11 consecutive years. While currentlaw does not permit a Chapter 9 bankruptcy, the issueof the Governments ability to continue timely pay-ment on about $87 billion worth of bonded debt andpension liabilities is of great interest to the bond mar-ket.

To what extent should investors pay attention to Au-ditors opinion in this regard is not clear. The auditstandards change in two years, placing the determina-tion upon the entity getting the opinion. The omis-sion of the going-concern discussion in this casecould be consoling or troubling, depending on yourview of Puerto Ricos prospects.

October 2013

Puerto Ricos problems are fundamentally more economic than fiscal. The sheer number and severity of the economic hurdles thatthe island has had to deal with over the last couple of decades is what has driven the accumulation of debt and the formation of a

structurally imbalanced budget. While the fiscal problems can be resolved, failure to address the fundamental economic issuesconfronting Puerto Rico will return their finances to structural imbalance again in a matter of a few short years.


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The Economic ChallengesProspective

Our concerns about Puerto Ricos creditworthiness areprimarily based upon the application of a straightfor-ward economic argument. The basic cornerstones ofthe argument rest on the application of some basicprinciples:

1. Population growth is an essential ingredient forlong-term economic growth.

2. Puerto Ricos low productivity growth is a con-straint on growth.

3. The magnitude of the demographic challengesregarding retirement and health costs indicatethat the degree of relative stress on long-term fis-cal health is greater than even the US.

4. Increased tax revenue and/or expenditure cuts onstructurally imbalanced budgets impose signifi-cant fiscal headwinds to economic growth.

5. Restoration of long-term fiscal stability requiresbudgets that grow slower than the rate of growthin the economy.

6. Economic development efforts through tax incen-tives, tax credits, tax abatement, and other tech-niques increase costs before benefits are everachieved (if at all);

7. Cuts in pension benefits can provide significantlong-run savings that make the difference be-tween solvency and fiscal ruin; however, the ben-efit of any actions taken typically require a num-ber of years before savings become significant inany given years budget.

The Basic Argument

The basic economic dynamics in Puerto Rico arestrongly negative. The World Bank forecasts a 40 yeardecline (starting from 2010) in Puerto Ricos popula-tion at a rate of 0.3% per year. Arresting that declinewill be extremely difficult given the ease with whichPuerto Ricans can legally relocate to the US, and thestrong economic incentives to do so for better eco-nomic opportunities. There is scant evidence of anywestern government who successfully stemmed popu-lation loss through tax or economic initiatives. Japanand Germany are two examples of nations with vastly

greater wealth and economic maneuverability whohave suffered as a result of aging population and de-clining population growth. In Puerto Rico we havevery low wealth and negative population growth.The expected decline of population and the likelihoodthat trend productivity will be below US rates suggesta trend economic growth rate of less than 1% (-0.3%population growth + 1.0% productivity growth).

Even a generous evaluation of the current structuralimbalance in the budget of $1 billion suggests thatbalancing the budget with expenditure cuts of thatmagnitude would produce fiscal headwinds of about1.5% annually ($1 billion divided by Puerto RicosGross National Product of $61 billion). Trend growthof the economy with structural balance thus impliestrend growth that is negative. The lack of economicgrowth severely limits the options available to thegovernment given that sound fiscal management inthe long-run requires budget growth at or below thetrend growth rate of the economy in real terms.Thus, Puerto Rico will not have the best tool availableto heavily indebted entitiesthe ability to grow theirway out of the problem by leaning on the help pro-vided by growth in the economy in excess of the rateof growth in debt. However, even if this strategy wereavailable, there is no guaranty of its success.

Demographics impose a heavier burden on PuertoRico then on the US. Puerto Rico has a cohort of 65+year olds that is 2% larger relative to same cohort inthe US. The citizens of Puerto Rico also enjoy greaterlongevity than US citizens. The fiscal stress frommanaging retirement and health care costs is signifi-cantly worse than in the US on a relative basis.

Management has done a great job of reducing pen-sion costs, confronting market concerns with greatertransparency, deferrals of some planned debt issuanc-es scheduled for the remainder of 2013, and craftingnew bond structures to ensure the availability of a

financing tool that is rated investment grade. Ourexpectation is that management will continue tomake progress. Unfortunately, the long-term prob-lem is currently beyond the scope of their ability tomanage.

Below is a partial list of scenarios that we have identi-fied for the long-term. No doubt there are more sce-narios that we have not thought of. We start from avantage point of assuming the worst and evaluatingin general terms what avenues might be available tomanagement to resolve the dilemma. This should notbe interpreted as a prediction of default or a view thateconomic decline and/or default are inevitable. The

basic conclusion we start with is: The economic anddemographic trends are sufficiently adverse over the long-run that it is not obvious to us what steps could be takenby the Commonwealth to fully resolve the economic anddemographic vice grip and arrive at a favorable long-runeconomic and fiscal trend.

Here are our most likely scenarios for Puerto Rico issu-ers (using the GOs as the relevant base):

October 2013


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The Deus ex Machina Solution

The federal government comes to the rescue with di-rect financing, loan guaranties, or cash infusions. Anidea that we have not seen discussed is the reimple-mentation of Section 936 which we know to work andwhich would spread the cost to the federal govern-ment over a long time horizon. While we think thatSection 936 approach has significant merit, it is a verylow probability solution.

This scenario is unlikely because there is no good po-litical argument for bailing out Puerto Rico, but notDetroit. The related theory that perhaps the federalgovernment would bail out both is equally unlikelydue to the enormous sums required, the precedentsthat neither political party wants to establish, and thecurrent contentiousness in Washington which would

cause an Administration from either party to rule outa bailout to avoid the political drubbing the other par-ty would provide.

The Management Miracle

In this scenario, the government of Puerto Rico con-tinues to whittle away at expenses, finds sources ofadditional revenue, boosts tax collections, and skill-fully manages its way to stability.

While the current leadership of the government doesappear to have significant market savvyconsiderably

beyond the average state governmentand are mak-ing effective, timely responses to market relatedevents, our long-run outlook suggests that the prob-lems facing Puerto Rico are beyond the capacity ofany management to solve, regardless of how capable.Germany, Japan, the US and other countries havebeen unable to arrest demographic changes thatthreaten their fiscal stability, which are of no lesserrelative magnitude than Puerto Ricos. The steps thatcould be taken to reduce and reverse population de-cline are unclear. Tax incentives may provide somehelp, but there is generally a short-term cost andmany years before results appear, if at all. The easewith which Puerto Ricans can legally locate to the US,

and the vastly greater opportunities almost guarantythat younger, more educated people will leave forgreater opportunity in the US. What steps could man-agement take to reduce budget deficits of $1 billionwithout increasing poverty and promoting increasedmigration? The structural imbalance of $1 billion (agenerous figure), requires an annual hit to GDPgrowth of about 1.5%, virtually guarantying thatalong with declining population, Puerto Rico will also

face even more rapidly declining GNP. One vision ofthe future of Puerto Rico is Greece but without theECB bailout.

Long-term Decline with Uncertain Prospects

It is very difficult to construct a positive scenario forthe island that offsets the certainty of the negativepopulation and demographic effects. Can the islandincrease its share of tourism in the Caribbean? Isthere a bank haven opportunity as in the Grand Cay-man Islands? Can rum production be increased? Eco-nomic steps to reverse the economic plight of the is-land take time and investment dollars. Can PuertoRico hang on to see positive results even if they areable to find the government resources to promoteeconomic development?

Managements Best Strategy

Despite the dire prospects for Puerto Rico, no situa-tion is a fait accompli. The island could benefit frompolitical instability in other Caribbean nations whichcould boost tourism or increase migration from othercountries to Puerto Rico. Puerto Ricos location couldbecome more valuable to the US from a change in thegeographical location of threats from terrorism ordrug trafficking, boosting federal employment on theisland. However, these are events that cannot be an-ticipated. The best strategy currently available to

management is to buy time, grow the base of bondbuyers, find new financing structures to ensure con-tinued access to capital and seek to limit the growthof total net bonded debt and pension debt to the rateof growth in the economy or below (very difficultsince the trend rate could be flat to negative). If theisland can tread water for a number of years, changesin the political environment in Washington maybring the opportunity for some measure of federal

October 2013

0%

20%

40%

60%

80%

100%

120%

140%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

State/U.S. Personal Income per Capita

Massachusetts Missi ssippi Puerto Rico


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support. Maybe some variant of Section 936 couldcome back. The lack of federal assistance cannot beany worse than it is at present, so time would likelybring improvement in the USPuerto Rico relation-ship.

What Puerto Rico needs is changes that provide im-mediate impact. Some alternatives include a sub-minimum wage to boost incentives for businesses tohire, immediate waver from the Jones Act to restorecompetitiveness in shipping with Kingston, Jamaicaand other competitors, and a way to reduce energycosts through tax incentives or some other measure.

The best long-term solution may be the same one nec-essary to resuscitate Detroit: to shrink the cost of liv-ing and working in Puerto Rico in order to createcompelling reasons for people to want to stay or moveto the island. This is the economic version of

devaluing the currency. In Detroit, consolidatingtracks of mostly abandoned residential areas, clearingthem, and making the parcels available for develop-ment at very low cost (to give companies free land inexchange for unabated property tax payments, forexample) could be the basis for reversing that cityslong-term decline. Can the government of Puerto Ricotake actions like those contemplated in Detroit? Ulti-mately, economies stabilize when prices adjustenough to make opportunities to live and work in thestagnant area compelling. Lowering labor costs inPuerto Rico, finding ways to reduce costs that are im-posed upon the island by the US, and attracting in-

vestment through innovative strategies are what areneeded. In the meantime will there be enough cashto service $87 billion in overall debt?

It is very difficult to do a cash flow analysis to esti-mate when the Commonwealth might be most vul-nerable to a debt payment problem. The informationthat the Commonwealth is required to provide is dat-ed, as is typical of the municipal market. The islandssystem of government finance is a Byzantine laby-rinth of agencies, debt issuers, and governmental enti-ties with active movement of financial resources.From our cursory analysis, the magnitude of the debtservicing issue is of lower immediate concern than the

scale of the structural budget imbalance. With skillfulcreation of bond structures with coverage sufficient toproduce investment grade ratings, the island can con-tinue to finance its structural imbalance for years.Asset sales and leasebacks can provide short-term cashinfusions, but with diminishing productivity. Thecrown jewelthe airporthas already been privat-ized.

What if Puerto Rico Breaks Bad?

If things go badly, the collateral damage could be ex-tensive. The rating agencies have maintained invest-ment grade ratings for a long period of time whileeconomic and fiscal conditions unambiguously dete-riorated. This allowed the island to accumulate $70billion in outstanding bonded debt. Did the ratingagencies maintain these investment grade ratings fartoo long in the face of clear trends that would nor-mally indicate a below investment grade rating?Were the ratings political in some sense? The regu-latory scrutiny of the rating agencies can only be in-flamed by a major Puerto Rico problem. Litigation isalso not out of the question.

Mutual fund companies, broker-dealers, UITs, andother retail-oriented investment providers will facehard questions if they are found to be leaning too far

over their skis in Puerto Rico paper in order to boostyields on single state funds because of the triple ex-emption. Justifying a reasonable exposure will not bea problem. Pity the mutual fund that is caught with25% exposure to Puerto Rican issuers in a state fundthat does not even exempt their own debt.

The worst case scenario from the industry perspectivecould be developments that would encourage Con-gress and the Treasury Department to call into ques-tion (again) the value of tax-exemption. A majorblow-up, no matter when or how it occurs, wouldprovide much more fuel to the fire and reverse the

progress lobbying groups in favor of maintenance oftax-exemption have made.

The Future: From Ashes to Ashes

While we hope that solutions are found that keep allPuerto Rico issuers in good credit standing for thelong-run, the possibility that a dark future awaitsgives us a sense of irony about Puerto Rico. Section936 and other tax breaks and inducements made theisland an effective tool of US State Department policy,helping to demonstrate that capitalism offered morepromise to other Caribbean nations than Cubas com-munist vision. Unfortunately, with all the incentives

gone since 2006, we may be seeing the gradual returnof Puerto Rico to its former natural state before US taxpolicy boosted its prospects.

October 2013


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October 2013

This chart shows tax revenue for each state (no federaltransfers or user fees) divided by personal income foreach state (tax yield). It is a measure of how mucheach state is already using its income resources tofund its government. Puerto Rico taxes personal in-come at the second highest rate behind Alaska, whichwe know is always a huge exception because of itssmall population and vast natural resources whichallow it to fund a government not limited by the scaleof its personal income. The average for all twelve AAArated Moodys states is 6.88% and the median is 5.8%(splitting the difference between the values closest tothe median, since we have 12 states). There are fifteenstates rated Aa2 and below by Moodys. The averageis 6.4% and the median is 5.4%. While there is noapparent correlation within a reasonable range of val-ues with respect to tax yield and Moodys rating,

Puerto Rico is more than double the median value of6.00% for the entire population of 50 states and Puer-to Rico.

At the minimum, this means that Puerto Rico has al-

ready encumbered its personal income by a factor of2X the 50 state median, while having a substantiallylower per capita personal income than even the poor-

est of the 50 states.

On the revenue side, their opportunities for generat-ing additional tax revenue are low because the is-lands aggregate income is already heavily taxeddouble the national median for statesand is appliedon an extremely low per capita personal income basecompared to the 50 states.

To get the $1.5 to $2.5 billion they need annually toclose the budget gap, they would have to tax personalincome by an additional 3%, which would take themfrom taxing personal income by 13% to 16%, an in-crease in the burden on personal income of about23%.

The expense side is equally daunting with cuts of 10%to 14% required for structural balance based upon thelast four years of results. (This may not include allsteps already taken by the government, but not fullyin effect.)

To put the magnitude of the problem in perspective,the roughly $110 billion annualized cut required un-der sequestration represents about 3% of the entirefederal budget of $3.7 trillion. What Puerto Riconeeds to do (using the back of the envelope) is to un-

dertake a cut of 3 to 4 times that scale, and maybemore.

Were the government to actually undertake thesesteps, how much civil unrest would ensue?

If you exclude debtserviceas if thebondholders forgaveall outstanding princi-

pal and interestPuerto Rico would stillrun a budget deficit!

(This data is fromMoodyswe do notguaranty accuracy.)

Addendum: Examining Required Revenue Increases or Expenditure Cuts

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0 10 20 30 40 50 60

TaxYield States

Tax

Yield

StatesLinear(TaxYield States)

PuertoRico

(2.00)

(1.80)

(1.60)

(1.40)

(1.20)

(1.00)

(0.80)

(0.60)

(0.40)

(0.20)

0.00

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Budget Deficit Excluding Debt Repayment

Source: US Census


9/14


9

Health Insurance Exchange Enrollment Update and Impact to Providers

Overview

On October 1, 2013, the health insurance exchanges

created by the Affordable Care Act (ACA) opened forbusiness. Many individuals and families across thecountry are accessing the State-Run insurance ex-change websites and many have created accounts (seetable below). Though the enrollment success of stateinsurance exchanges cannot be determined, manyhave said that the exchange market is projected to bethe single largest expansion of health coverage in theU.S. since the creation of Medicare in 19651.

States had the option to form their own distinct mar-ketplaces or collaborate with the federal governmentto operate an exchange. Seventeen states and the Dis-trict of Columbia have set up their own exchange,while 33 will rely on the federal government to do so.The new exchange population will be a combinationof newly insured, no longer covered by an employeror those who would have purchased insurance ontheir own in the individual market.

Hospitals and other providers can be significantly af-fected by health insurance exchanges depending onthe role the exchange market has on best practices,quality improvement and incentives around a morevalue-based delivery system.

Health Insurance Exchange Impact on ProviderSummary

Providers will face clear challenges in serving anew customer base with a demographic profile

and health needs that differ from privately in-sured population2:

- More likely to be minorities- Higher potential for lower health status- More likely to speak a language other thanEnglish

- Less likely to have a college degree

Providers will face an uncertain payment land-scape and new payer mix.

For an insurer to sell in the Exchange it must firstbecome a Qualified Health Plan (QHP). It isthrough the QHP certification that state Exchang-es can impact quality improvement, patient safe-ty and encourage a more value-based delivery

system.

- For providers to be considered within theQHPs network, they must comply withthe clinical data and quality improvementinitiatives

Exchanges could advertise information on theprices charged by different hospitals, physiciansand other providers to help consumers makemore informed choices.

Exchanges will be in a position to encourage theadoption of certain innovations like bundled pay-

ments and/or accountable care organizations,should they be successful.

Price sensitive newly insured individuals may optfor low cost, high deductible plans and not beable to afford deductible/copay which in turnimpacts a hospitals bad debt expense.

Reimbursements for care from the insurance carri-ers participating in the exchange may be dis-counted when compared to the rates that privateinsurers currently pay for various procedures.

References

(1) Kaiser Family Foundation, Medicare: A Timelineof Key Developments, Available at: http://www.kff.org/medicare/medicaretimeline.cfm

(1) Price Waterhouse Coopers, Health InsuranceExchanges: Long on options, short on time, Availa-ble at: http://www.pwc.com/us/en/health-industries/publications/health-insurance-exchanges-and-medicaid-expansion.jhtml

October 2013

Health Insurance Exchange (State-Run)

State Number of Accounts Enrolled As of Date

California 16,311 -- 10/8/2013

Colorado 6,900 -- 10/2/2013

Connecticut 1,175 -- 10/8/2013

Idaho -- -- --

Kentucky 6,900 3,000 10/2/2013

Maryland 13,532 326 10/7/2013

Massachusetts 1,134 -- 10/7/2013

Minnesota 6,800 -- 10/4/2013

Nevada 19,931 -- 10/4/2013

New Mexico -- -- --

New York 40,000 -- 10/8/2013

Oregon 1,300 -- 10/7/2013

Rhode Island 2,929 580 10/4/2013

Vermont 3,600 -- 10/4/2013

Washington 39,000 9,500 10/4/2013

Sources: various news outlets


10/14

10


1.00%

0.50%

0.00%

0.50%

1.00%

1.50%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Mean StDev

AAA MMD Callable Scale Average Bond Price Changes (October)

To assist municipal bond portfolio managers andanalysts, we have calculated historical bond price

changes for each point on the AAA MMD callablecurve during the month of October for the last 12years.

October has historically been a negative month formunicipal bonds, with bond prices falling about0.50%, on average, across the curve.

Price volatility rose in the wake of financial crisis.15 year bond was the most volatile, with standard

deviation of monthly bond price changes of1.42%

Average decline in bond prices across the curve inOctober was 0.57% over the last 12 years, with thelargest average loss of 0.95% for 11 year maturity.

AAA MMD Callable Scale Historical Monthly Bond Price Changes

Maturity 5 10 15 20 25 30

Oct01 0.40% 1.26% 1.17% 1.00% 0.93% 1.00%

Oct02 1.06% 2.57% 2.23% 2.37% 2.14% 2.21%

Oct03 1.11% 1.66% 1.49% 0.86% 0.78% 0.70%

Oct04 0.22% 0.56% 0.80% 0.87% 0.63% 0.63%

Oct05 0.79% 1.50% 1.34% 1.25% 1.17% 1.17%

Oct06 0.09% 0.32% 0.40% 0.48% 0.71% 0.79%

Oct

07 0.13% 0.00% 0.24% 0.24% 0.39% 0.32%

Oct08 0.40% 0.86% 1.10% 0.62% 0.16% 0.85%

Oct09 1.25% 3.65% 3.23% 2.75% 2.74% 2.81%

Oct10 0.14% 1.05% 1.68% 1.51% 1.27% 1.26%

Oct11 1.08% 1.37% 1.04% 0.88% 1.42% 1.58%

Oct12 0.23% 0.16% 0.24% 0.16% 0.08% 0.24%

Mean 0.43% 0.89% 0.63% 0.55% 0.58% 0.63%

StDev 0.60% 1.39% 1.42% 1.26% 1.19% 1.24%

October 2013


11/14

11


Market Review The Yield Curve

1-Year Forward Roll-downAAA MMD Curve (AAA MMD October 7, 2013)

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Yield&T

otalReturn

Maturity (Yr)Ideal YC Ideal YC Rolldown

Actual YC Actual YC Rolldown

Sources: MMD, LCM

* Callable AAA rated G.O. bonds

Cheap: Buy Here

10%

15%

20%

25%

30%

35%

40%

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Maturity (Yr)09/09/13 10/03/13

* 10-year callSources: MMD, Loop Capital Markets

As yields decvolatilities rose

the curve over th4 weeks.

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Maturity (Yr)Sources: MMD, LCM* Price change only

Implied Municipal Volatilities

Monthly Price Change AAA GO Bonds* (9/6/13 10/7/13)

Bond prices across the curvemonth.

October 2013

Expected munbond returns aretively close to thical values.


12/14

12


0.00

1.00

2.00

3.00

4.00

5.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Maturity (Yr)10/7/11 10/5/12 10/7/13

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Average Yields (7/8/13-9/9/13) Current Yields (10/7/13) MaturitySource: MMD

Current vs. Historical Municipal Yield Curves (%)

3-Month Average AAA MMD Yield

Muni and Treasury Yield Curves

Yields have across much ofcurve recently.

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

40%

60%

80%

100%

120%

140%

160%

180%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Yield

Ratio

MMD Curve Treasury Curve Ratio

Ratio = 100% Ratio = 110%

Source: Bloomberg, MMD

Ratios

Yields

Yields on the

end of the curvhigher than theyat this time in and 2012.

Muni / Treasury are currently ar110% in the year area of the c

October 2013


13/14

13


Lipper Municipal Mutual Fund Flows

Market Conditions

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

(%)

10-Yr Treasury Is Cheap

Our model comthe 10-year Tryield to other categories. Trehave cheapenedrelative basis drising yields. This currently compared to financial assets.

Retail investorspulled total of

billion out of funds over 20 cotive weeks of necash flow. The pwithdrawals surecently.

2-30 Yr AAA MMD Spread (bps)

0

50

100

150

200

250

300

350

400

450

Dec99 Dec

01 Dec

03 Dec

05 Dec

07 Dec

09 Dec

11 Dec

13

The slope of thesteepened by 16points since yields reached hlows in Nov2012.

October 2013

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

(5.00)

(4.00)

(3.00)

(2.00)

(1.00)

0.00

1.00

2.00

3.00

4.00

Oct10 Jan11 Apr11 Jul11 Oct11 Jan12 Apr12 Jul12 Oct12 Jan13 Apr13 Jul13 Oct13

10YrAAAMM

D(%)

MuniFundFlows

($Billion)

LipperFlows($Billion) 10YrAAAMMD(%)

Rich

Cheap


14/14

Loop Capital Markets LLC, an investment bank, prepared this document for informational purposes only. Loop Capital Markets LLC does not provide researchservices, therefore this product is not a research report and it should not be construed as such. Loop Capital has or may have provided investment banking servicesto issuers referenced in this document.

All materials are indicative and for discussion purposes only. Opinions expressed are our present opinions only and are subject to change without further notice.Opinions expressed herein are current opinions only as of the date indicated. Any historical price(s) or value(s) are also only as of the date indicated and as appli-cable from any source that may be noted. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sellor a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy.

Loop Capital Markets LLC shall have no liability, contingent or otherwise, to the user or to third parties, or any responsibility whatsoever, for the correctness,quality, accuracy, timeliness, pricing, reliability, performance or completeness of the data or formulae provided herein or for any other aspect of the performanceof the materials. Loop Capital Markets LLC is a Delaware limited liability company.

14


Loop Capital Markets Upcoming Negotiated Calendar

I applaud the creativity,but I dont think the

bond market is ready foran interest only Treas-

ury note as a way aroundthe debt ceiling

October 2013

Chris Mier, CFA Managing Director [email protected] 312.356.5840

Ivan Gulich, CFA Senior Vice President [email protected] 312.913.2204

Ann Kibler Vice President [email protected] 312.913.2209

Dimitra Stamatoukos Econometrician [email protected] 312.913.2236

Vania Petkova Analyst Vangel iya.Petkova@loopcapi tal.com 312.913.2229

Maggie Avila Administrative Assistant [email protected] 312.913.2258

Prakash Ramani Vice President [email protected] 312.356.5005

Loop Capital Markets Analytical Services Division

Investment Banking Division - Public Finance

DatePar

Amount($ mil)

Issue Lead Manager

10/15/13 47.2 Aldine ISD Unlimited Tax School Bldg. and Ref. Bonds (PSF Guarantee) Wells Fargo

10/16/13 33.0 VIA Metropolitan District Transportation Credit Sales Tax Bonds Loop Capital

10/17/13 955.9 DASNY Sales Tax Revenue Bonds Series 2013A P Morgan

10/22/13 2,000.0 State of California General Obligation New Money and Refunding Bonds P Morgan / Citigroup

10/23/13 600.0 State of Connecticut Special Tax Obligation Bonds Siebert

10/24/13 50.0 Massachusetts HFA Single Family Housing Revenue Bonds (Non-AMT) Morgan Stanley

10/29/13 143.3 Dallas ISD Limited Tax School Building Bonds Series 2013 Loop Capital

10/29/13 32.0 Massachusetts HFA Housing Bonds Series E TBDWeek of

10-2855.0 Louisiana Transportation Authority Citibank

Oct-2013 60.0 Allegheny County Sanitary Authority Sewer Revenue, Refunding Series Boenning & Scattergood

11/1/13 TBD Arkansas Development Finance Authority Crews

11/5/13 125.0 State of Arkansas General Obligation Bonds (Big River Steel Project) Stephens

11/5/13 300.0 Los Angeles World Airports De La Rosa

11/6/13 25.0 Virginia Resource Authority P Morgan

11/7/13 380.0 LADWP Water System Revenue Bonds, 2013 Series B Wells Fargo / De La Rosa

11/13/13 42.0 Parkland Health & Hospital System Limited Tax Bonds, Series 2013 BAML

Documents

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