SEPTEMBER 4,2008 DATE: DEBT MANAGEMENT DIVISION FROM: RESERVE FUNDS SUMMARY:

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1 DATE: SEPTEMBER 4,2008 Executive Director's Report to the Board of Harbor Commissioners FROM: DEBT MANAGEMENT DIVISION SUMMARY: As a result of recent downgrades of bond insurance companies, the Harbor Department seeks to cash fund its reserve funds in order to comply with its bond covenants. Therefore the Department staff is recommending that $61,519,938 be transferred from the Harbor Emergency Fund (Fund 751) to the Department's bond trustee. The current aggregate reserve requirement of $61,519,938 represents the total mitigation required. This amount must be deposited with the trustee prior to December 2008, which is within six months from the date of the insurance company downgrade. RECOMMENDATION: It is recommended that the Board of Harbor Commissioners: 1. Approve the transfer of $61,519,938 from the Harbor Emergency Fund (Fund 751) to the trustee, US Bank Trust N.A., for deposit in the reserve funds. 2. Adopt Resolution No. DISCUSSION: 1. The Department has $744,040,000 of outstanding parity bonds as of August 1, Each Indenture for the Department's outstanding bonds requires the Department to establish a reserve fund, and authorizes the Department to obtain one or more reserve sureties in lieu of fully funding the reserve fund with cash. Three bond insurers (Ambac, and MBIA) provide the reserve sureties for the Department's outstanding bonds. The current aggregate reserve requirement for the reserve funds for all of the Department's outstanding bonds is $61,519, The table below details each bond series by insurance provider:

2 DATE: SEPTEMBER 4,2008 Page 2 of 6 Outstanding Maturities Insurance Issue Balance(8/1/08) (August 1) Provider 2001 Series A Bonds $ 36,180, Ambac 2001 Series B Bonds $ 64,925, Ambac 2002 Series A Bonds $ 40,995, Am bac Total Ambac $142,100, Series C Bonds $ 875, Series A Bonds $ 71,235, Series B Bonds $201,395, Series C Bonds $ 16,310,000 FGIC $289,815, Series A Bonds $ 29,930, Series B Bonds $ 29,985, Series C Bonds $ 33,665, Series A Bonds $1 10,620, Series D Bonds $107,925,000 Total $312,125,000 TOTAL $744,040, Until December 2007, these three bond insurers maintained "AAA ratings from the three rating agencies: Fitch, Moody's, and Standard & Poor's. Starting in January 2008, the rating agencies began downgrading the bond insurers. The Department filed material event notices as part of its continuing disclosure undertakings subsequent to each of the related downgrades or placements on negative outlook. Currently Standard & Poor's rates Ambac "AA" with a status of "Negative Credit Watch" and Moody's rates Ambac "Aa3" with a "Negative Outlookn. Standard & Poor's rates "BB" with a status of "Negative Credit Watch" and Moody's rates "BI" with a "Negative Outlook.

3 DATE: SEPTEMBER 4,2008 Page 3 of 6 Standard & Poor's rates "AA with a status of "Negative Credit Watch" while Moody's rates "A2" with a "Negative Outlook". The Department's underlying credit of "AA remains in effect by all three rating agencies. 4. The downgrade of has triggered certain specific requirements in the lndenture with respect to the reserve surety. Pursuant to Section 12.02(d)(vii) of Indenture, if the rating of the claims paying ability of falls below a S&P "AAA" or a Moody's "Aaa", the Department shall either (1) deposit into the reserve fund under the lndenture an amount sufficient to cause the cash on deposit in such reserve fund to equal the reserve requirement on all outstanding bonds, such amount to be paid over the ensuing five years in equal installments deposited at least semi-annually or (2) replace reserve surety with a surety bond or insurance policy of a municipal bond insurer rated "AAA" or a surety bond or insurance policy of a non-municipal bond insurer acceptable to FGIC, or an "AA" rated letter of credit with a term of at least three years, within six months of such occurrence. If the rating of the claims-paying ability of falls below "A, the Department shall either (a) deposit into the reserve fund under the lndenture an amount sufficient to cause the cash on deposit in such reserve fund to equal to reserve requirement on all outstanding bonds, such amount to be paid over the ensuing year in equal installments on at least a monthly basis (rather than semi-annually over the five-year period required by the previous sentence) or (b) replace such instrument with a surety bond or insurance policy of a municipal bond insurer rated "AAA" or a surety bond or insurance policy, or an "AA rated letter of credit within six months of such occurrence. Such language providing for the deposit of cash (both over the five-year period and the one-year period) does not appear to take into account the value of the reserve surety also on deposit in the reserve fund under the lndenture and arguably requires replacing both the reserve surety and the reserve surety. 5. Each lndenture separately requires that the reserve surety used to meet the reserve requirement shall have ratings in the highest rating category by two of the rating agencies, but the language is ambiguous as to whether such ratings are required only at the time of deposit or are required at all times. The lndenture and the 2006D lndenture do not contain the requirements for replacement of reserve sureties set forth in Section 12.02(d)(vii) of the lndenture described above since such language was specifically required by for the Indenture. If

4 DATE: SEPTEMBER 4,2008 Page 4 of 6 such language is construed by bondholders as an ongoing requirement, the failure of the Department to replace the reserve sureties in a timely manner could be deemed to be a breach of a covenant under the Indentures and after the appropriate grace period, an event of default under the Indentures. The Department's bond counsel has advised the Department to take a consistent approach with all of the reserve funds because the Department's outstanding bonds are all parity obligations, and to apply the requirements of Section 12.02(d)(vii) of the Indenture to all of the reserve sureties and reserve funds. 6. In the current market environment, the ability to obtain either new "AAA" reserve sureties (option 1) or direct-pay letters of credit (option 2) is virtually impossible. As long as the Department's outstanding bonds have the existing insurance policies in place, no "AM" surety provider or commercial bank will be willing to take a credit position that is subordinate to the repayment obligation to the existing bond insurers. 7. With the downgrades of FGIC, Ambac and MBIA, and the recent announcement by Moody's of potential downgrades to FSA and Assured Guaranty, there remains only one insurer, Berkshire Hathaway, that will be rated "AAA" and it is not currently providing insurance to municipal issuers. 8. Rather than fund the reserve with existing cash, the Department has the option to cash fund the reserve funds from the proceeds of a revenue bond issue. However, the Department's bond counsel has advised the Department that there are limitations on using tax-exempt bond proceeds to cash fund the reserve funds and staff has concluded that these limitations preclude utilizing this option. 9. It is possible that the reserve funds could be funded with an initial deposit of cash in an amount equal to the first semiannual installment for the five-year period and the issuance of an affirmative statement to the marketplace of the Department's intent to continue making the additional semiannual deposits to fully fund the reserve funds. However, if FGIC, Ambac and MBIA's ratings are downgraded below "A/A2", additional deposits would need to be made monthly but now over a one-year period. While making an affirmative declaration to the marketplace will be helpful to the Department's reputation in the bond marketplace, it does not make as strong a statement as a one-time funding of the entire amount. Consequently, this alternative is NOT being recommended.

5 DATE: SEPTEMBER 4,2008 Page 5 of 6 10.There also remains the choice of funding with cash from either the Harbor Revenue Fund or the Emergency Fund. As of June 30, 2008, the Harbor Revenue Fund (Fund 702) held a balance of $412 million while the Emergency Fund (Fund 751) held a balance of $96.8 million. The one-time funding of the entire amount with cash will be perceived favorably by the bond marketplace and will only enhance the perception of the Department's financial viability. This action could have the potential benefits of lowering future borrowing costs. On the other hand, a one-time deposit of the entire amount to the reserve funds reduces the Department's liquidity. 11. Staff therefore recommends that money be taken from the Emergency Fund to cash fund the Department's reserve funds with a one-time deposit of the entire amount. The Emergency Fund was originally established per Resolution No adopted on July 29, 1987 as a self-insurance fund for potential losses due to catastrophic occurrences, i.e., earthquakes, and to reduce premiums for commercial earthquake insurance. The initial deposit into this fund was $12.3 million on April 6, On February 28, 1996, the name of fund was changed to "Emergency Fund" per Board Resolution No The purpose of the fund was expanded to include reimbursement of operation and maintenance expenses, debt service, capital development, or other urgent needs. An additional $20M was deposited into the fund on April 25, Disbursements from the fund were for reimbursements for repair of damages due to the "Northridge Earthquake" of Total costs paid from January 1994 through May 1995 amounted to $676,432. As of June 30, 2008 the balance in the Emergency Fund was $96.8 million. Anticipated yields from the reserve funds to be held and invested by the Department Bond Trustee in the permitted investments will likely be higher than the yields received from the City Treasurer's Special Pool providing a small benefit in opportunity gains. ENVIRONMENTAL ASSESSMENT: The proposed action is a transfer of Harbor Department funds from the Harbor Emergency Fund to the Department's Bond Trustee. Funds would be used to ensure the Port meets bond reserve requirements due to recent changes in the financial and bond markets. As an administrative action, the Director of Environmental Management has determined that the proposed action is exempt from the requirements of the California Environmental Quality Act (CEQA) in accordance with Article II Section 2(f) of the Los Angeles City CEQA guidelines.

6 DATE: SEPTEMBER 4,2008 Page 6 of 6 ECONOMIC BENEFITS: This Board action will have no employment effects. FINANCIAL IMPACT: The transfer of $61,519,938 from the Emergency Fund to the Department Bond Trustee, US Bank Trust N.A., to establish the reserve funds will reduce interest earnings in that fund. However, the anticipated yields on the reserve funds will be credited by the trustee toward payment of interest on Harbor Revenue Bonds. CITY ATTORNEY: There are no legal issues to address at this time. TRANSMITTALS: Monoline Bond Insurance Ratings (August 14, 2008) Director, Debt Management (u KARL K.Y. PW Chief Financial 'officer Deputy Executive Director r' Executive Director