San Bernardino County Treasury

1. San Bernardino County Treasury Credit process Overview

2. Preliminary Analysis • Does the potential issuer issue securities that fit the IPS as well as meet California code? • 3(a)3 programs: San Bernardino County not a Qualified Institutional Buyer (QIB) according to SEC – Cannot purchase 144(a) or 4(2) programs (private placement) • Credit Ratings- Minimum of A-/A3/A- on LT ratings and A-1/P-1/F1 on ST ratings of programs required. Needs to be rated by at least 2 of the rating agencies • Asset Type: Commercial Paper (CP), Certificate of Deposit (CDs), medium term notes (MTNs) • Issuance Levels: Is there market breadth and volume in their debt securities? EX: Google

3. Fundamental Analysis • Credit Ratings- Not fully relied on given that they usually lag fundamental deterioration. A full review and due diligence of company fundamentals are done on a potential issuer. • Mixture of both top-down and bottom-up approach used • Looking through at least the last 5 years of historical financial data for trends or one-time events • Material events that took place longer than 5 years ago are taken into consideration and stated in the initial report. • EX: Microsoft- In FY05 Microsoft paid a special one-time dividend worth $37B that took retained earnings from $18.4B to a retained deficit of $12.3B. The balance didn’t return positive until FY13. Microsoft didn’t access the bond market until 2009. Historically management has shown shareholder friendly activity; but this is expected given most of their capital structure is composed of equity capital. Debt balances have increased but have been well managed since accessing bond market in 2009. • Economic Outlook • Monetary/Fiscal Policy • Industry Analysis • Peer Comparison • Market pricing/trends on credit default swaps (CDS) on the debt of potential issuer • Multinational business- What is the main country of business and what other countries does the issuer operate in? • Accounting Standards- US GAAP, IFRS, JP GAAP

4. Fundamental Analysis (cont.) • Company Filings: • SEC Filings- 10Q, 10K, 6K, 8K • Press Releases • Earnings Call • Company Presentations • Supplementary Documents • Annual Reports • Secondary sources: • CreditSights • Rating agency commentary • Analyst opinions

5. Fundamental Analysis (cont.) • Metrics looked at depend on the industry: • Financial Institutions/Banks: • Regulatory capital levels- Basel regulations as well as regulations specific to each country • Liquidity- Cash levels, liquidity coverage ratio (LCR), High quality liquid assets (HQLA) • Leverage- Leverage ratio, amount of bail-in debt securities before capital is hit • Asset quality- Impaired loans, delinquencies, provisions, loan loss reserve, underwriting standards • Funding- Deposits, wholesale funding, laddering of debt that has been issued • Revenue- Is composition of revenue stream consist of stable sources such as net interest income or fee income, or is it largely from volatile sources such as trading revenue? • Level and composition of marked to market assets on balance sheet-Can the issuer handle a stress event in financial markets if they hold a large amount of marked to market securities?

6. Fundamental Analysis (cont.) • Non-bank corporation: • Revenue stream stability, accounting recognition of revenue • Cash flow- Has operating and free cash flow shown similar trends and stability/growth? • Capital Structure- What is the allocation of debt and equity in the capital structure? • Management- Has management historically done financial engineering or favored equity holders at the expense of creditors? • Adjusted non-GAAP metrics- Does management try to get investors more focused non-GAAP metrics when GAAP metrics show opposite trends? • Leverage- How have debt levels historically been managed? How is outstanding debt laddered? • Cash balances and liquidity • Level of intangible assets on balance sheet • Aggressive or conservative accounting changes

7. Fundamental Analysis (cont.) • If issuer is unique, more in depth analysis needed: • EX: Dexia • State-owned financial institution that is currently in run-down • Government of Belgium, France, and Luxembourg own stake in Dexia and have a pledge in place to guarantee debt that matures within 10 years • On top of looking at Dexia’s fundamentals, report looked at the fiscal situation as well as economies of Belgium, France, and Luxembourg as well as the intricacies of the guarantee • Guarantee can be amended at anytime, however securities that were issued before the amendment are grandfathered • Guarantee currently set to expire at the end of 2021 • Belgium represents 51.41% of guarantee, France 45.49%, and Luxembourg, 3%. Total guarantee consists of EUR 85B. • Dexia’s main focus is the orderly resolution of its operations, no new loans have been issued and the balance sheet size has been declining over the last few years

8. Issuer Monitoring • Following the approval of an issuer, the credit team continues to monitor performance and news items: • News is followed on a daily basis, both at the issuer level and macroeconomic level • Rating actions/commentary are also monitored daily to ensure issuers remain complaint with IPS and State code. • Depending on reporting frequency, reports (tear sheets) are done periodically on the issuers most recent financials, addressing any changes in fundamentals and performance over the reporting period. The majority of issuers report on a quarterly basis, however certain issuers only report semi-annually. • Credit team holds periodic credit meetings on issuers in a respective peer set (Canadian Banks, US Banks, French Banks, etc). During the meetings items discussed include recent income statement performance, changes in the balance sheet, accounting changes, regulatory changes that may affect operations, pending litigation items, macroeconomic and industry trends that may affect the issuer in the future, new items in regards to the issuer(s), rating agency commentary or actions, as well as any follow-up questions asked from upper management. • Credit team may also hold a meeting on a specific issuer or macroeconomic issue that has come up in the news if deemed material enough • Quarterly calls are conducted with PFM in which PFM discusses changes in issuer fundamentals as well as market related information

9. ISSUER REPORTING FREQUENCY

10. Issuer Monitoring (cont.) • If any significant deterioration in company fundamentals is seen in an issuer over a period time, action is taken: • EX: GE • Recently GE was placed on hold from 735 days as fundamental deterioration has been seen over the last few years. Cash flow has deteriorated significantly while management focuses on adjusted non-GAAP cash flow metrics in quarterly performance results. GE’s CFOA (an adjusted cash flow metric) is presented as growing between 2014-2016; whereas looking at the actual GAAP statement of cash flows between 2014-2016 it shows a significant deterioration. No reconciliation between the two is provided by management • GE’s pension plan remains underfunded. As of their FY16 10-K, GE reported a net pension liability of $36.8B. This will eat into future cash flows and liquidity as well if they start setting aside more cash to fund future benefits • Debt levels on an absolute basis have dropped due to significantly downsizing GE Capital and other restructuring activities over the last few years. Total debt was reported at $136.4B as of Q317; vs. $300-$320B during 2013-2014. However, on a ratio level, financial leverage (assets to equity) has only fallen to 4.88 from its peak of 5.6 in 2015 (see tear sheet for peer group comparison). Not that much of a drop considering how much restructuring has occurred. Liquidity balances have also declined, with cash balance as of Q317 reported at $39.9B. This compares to $130-$140B during 2013-2014. • GE’s tangible equity (Book value of equity less intangible assets) is underwater. Tangible equity was $-11.01B as of Q317. Tangible equity first went negative in Q316. • Earnings quality at GE are poor; numerous adjustments are constantly made making overall results and financial health unclear and convoluted. Numerous articles with analyst statements have also made note of GE’s poor earnings quality. • Since GE removed the SIFI label from their name after downsizing GECC, they have stopped reporting certain ratios for GECC such as CET1, leverage ratio etc. • GE’s management seems to be struggling in terms of what businesses to get into as well as divest. GE acquired a majority stake in oil-field equipment servicer, Baker Hughes that was announced on 10/31/16 and completed on 7/3/17. In their recent investor day on November 13, 2017 they announced they may consider getting out of Baker Hughes; a little over 4 months after completing the acquisition.

11. Issuer Monitoring (cont.) • Certain issuers may placed on hold due to headline or political risk without any deterioration in fundamentals: • EX: BNP • BNP was placed on hold in 2014 due to BNP’s fine of approximately $10B for dealings with sanctioned countries • BNP was placed back on the list in 2015 with an approval of 95 days • EX: Wells Fargo • On 9/28/16 Wells Fargo was placed on hold due to the heightened regulatory scrutiny of the unauthorized account openings of several consumers • California State Treasurer Chiang also placed sanctions on Wells Fargo in 2016, and announced on 10/16/17 that he is extending the sanctions for another year

12. Issuer Monitoring (cont.) • Certain issuers have been taken off the approved issuer list completely from significant deterioration in fundamentals, headline risk, or change in programs that the county can purchase - 3(a)3 program switched to 4(2) or 144(a): • EX: • IBM • Deutsche Bank • SocieteGenerale • Lehman Brothers • Chevron • British Petroleum (BP) • Citigroup

13. Issuer Monitoring (cont.) • If improving fundamentals are seen, extension of tenor on security purchases are considered: • EX: French Banks • French banks (BNP Paribas, Credit Agricole, and BPCE) were recently reviewed and a tenor limit extension recommendation was issued to upper management • All three French banks have materially improved earnings quality and transparency in the last few years • Operations remain stable despite domestic retail banking showing low net interest margins • Capital and funding levels have been better managed and improvement has been seen • Legal structures have been simplified • Rating agencies have also noted the improvement and recently upgraded Credit Agricole and BPCE • EX: US Bancorp and JPMorgan • JPMorgan’s pretax margins have been showing steady improvement over the last couple of years, continuing to be in the highest among peers (see tear sheet). Revenue growth has been supported by higher NII, as well as noninterest revenues related to wealth management fees as well as gains in mark to market securities. NII is expected to improve assuming a continued upward shift and steepening in the yield curve over the long-term. • US Bancorp has continued to generate strong and stable profits during the past several years. The bank has generated good margin return on stable growth. Revenue growth has been supported by NII growth from both higher average loan balances and higher NIM from higher interest rates. Pretax margins continue to be above peers (see tear sheet). • Capital levels and asset quality have improved in both banks in the last few years • Both US Bancorp and JPMorgan were recently approved for extension to 1100 days from 735 days and 545 days respectively

14. Case Study • 2008 Financial Crisis • Lehman Brothers • Record earnings were reported by the brokerage firms and profitability measures were strong leading up to the financial crisis. • 2006 -2007: First signs of credit stress from Bear Stearns hedge funds in June 2007. Due diligence of monitoring news on a daily basis captured Bear Stearns headline news and led to concern about the mortgage backed securities market. Bear Stearns has to pledge $1.3B to cover losses on hedge funds backed by residential mortgages. • During August 2007, credit default swaps (CDS) spiked on Bear Stearns and Lehman Brothers. CDS price move was noted as a concern given recent subprime loan losses reported by Bear Stearns. Bear Stearns was placed on a “Do Not Buy” restriction and Lehman Brothers was placed on “Overnight investments only” due to market losses tied to Bear Stearns’ hedge funds. Lehman Brother’s CDS price also spiked leading to restriction placed on the issuer to just overnight purchases. • Financial disclosures of the brokerage firms, Bear Stearns and Lehman Brothers revealed higher leverage ratios and retained interest in mortgage related assets. Higher leverage ratios and retained interests held in concerning mortgage assets was noted in quarterly credit write-ups for Bear Stearns and Lehman Brothers. Footnotes were important pieces within financial reports. • Lehman Brother’s long-term borrowings increased during 2006 due to higher trading balances and financing needed to accommodate mortgage backed security transactions. This was a red flag during the 2006-2007 period. • Lehman’s Level 3 assets increased in % of total assets. Level 3 assets were considered very illiquid with fair value calculated using estimates or risk-adjusted ranges. This was a concern given market losses reported by brokerage firms during Q406. • Rating agencies flip flopped between positive and negative rating actions against brokerage firms. However, rating downgrades did contribute to restrictions taken by San Bernardino County. • On March 14, 2008 our office dropped Bear Stearns as an approved issuer (restricted to “Do Not Buy” since August 6, 2007). Lehman Brothers and Merrill Lynch were restricted to “Do Not Buy” on March 14, 2008. • Lehman Brothers was removed from Approved Issuer List (AIL) on August 21, 2008 due to concerns about future writedowns on trading and mortgage related assets. • Lehman Brothers filed for bankruptcy on September 15th, 2008.

15. Credit Agency Rating Actions • Canadian Banks: • 10/27/17: Fitch revises Royal Bank of Canada’s outlook to Stable from Negative. • French Banks: • 10/20/17: S&P revised BPCE's (Natixis) outlook to 'Positive' from 'Stable' after strong improvement in S&P's measure of the BPCE’s additional loss absorbing capacity (ALAC). Ratings were also affirmed at 'A/A-1'. • 10/25/17: S&P upgraded Credit Agricole's outlook to 'Stable' from 'Positive while affirming the ratings at 'A/A-1'. • 12/18/17: Fitch revises Group BPCE (Natixis) Outlook to Positive. • Japanese Banks/Corporates: • 10/6/17: Moody's downgraded the long-term ratings of Honda Motor Co. and its respective captive finance subsidiaries (American Honda Finance) to 'A2/P-1' Stable from 'A-1*-/P-1'. • 11/29/17: S&P lowered its long-term issuer credit rating on Mitsubishi UFJ Financial Group Inc. (MUFG) to 'A-' from 'A' and its long-term issuer credit ratings on its major banking subsidiaries, which are core banking subsidiaries of the group, including Bank of Tokyo-Mitsubishi UFJ Ltd., to 'A' from 'A+'. ST ratings affirmed at ‘A-1’ and the outlook is Stable. • Nordic Banks: • 11/24/17: S&P revises Swedbank’s outlook to Stable from Negative.

16. Credit Agency Rating Actions • US Banks: • 10/3/17: Fitch downgraded the ratings of Wells Fargo & Company to ‘A+/F1’ from ‘AA-/F1+’, and revised the outlook to Stable from Negative. The rating action reflects Fitch's view of WFC's earnings profile, risk controls, and governance. • US Corporates: • 12/7/17: Moody’s revises Microsoft’s outlook to Stable from Negative. • 10/20/17: S&P placed GE on Creditwatch negative 'AA-*-/A-1+*-' from 'AA-/A-1+' Stable. • 10/30/17: Fitch revises GE’s outlook to Negative from Stable. • 11/16/17: Moody's downgrades GE's senior unsecured rating to A2, affirms short-term rating at P-1; outlook stable. The downgrades reflect the severe deterioration in the financial performance of GE's Power segment that will last through at least 2019. • 11/28/17: Fitch downgrades GE and related subsidiaries' ratings to 'A+/F1' from 'AA-/F1+'. The rating outlook remains negative. • 12/4/17: S&P downgrades GE’s ratings to ‘A/A-1’ Stable, from ‘AA-*-/A-1+*-‘.

17. RATING ACTION CHANGES - 2017

18. Internal updates to the AIL • On 10/19/17 JPM and USB were approved to have tenor limits extended to 1100 days from 735 days. • On 11/27/17 GE was approved to be placed on Hold from 735 days. • On 12/1/17 Dexia’s US commercial paper program was approved and added to the list with a 270 day tenor limit. • On 12/18/17 French bank tenors were approved to be extended to the following tenors: • BNP Paribas – 185 days from 95 days. • Credit Agricole – 95 days from 35 days. • Natixis – 35 days from 19 days.

19. Conclusion • Issuer fundamentals as well as related news is watched on a daily basis • Fundamentals are reviewed as frequently as company reports earnings results; majority are quarterly but some issuers report only semi-annually • Action is taken in the event of a material deterioration seen in company fundamentals or headline and political risks are seen in the news of an issuer. Action may also be taken if forward looking indicators such as the macro-economic horizon (consumer trends, rising unemployment, unsustainable consumer debt levels, bubbles seen in certain asset classes such as real estate, deterioration in the general business outlook, etc.) may have a material impact on future earnings results

20. Questions/Concerns?