Credit Analysis

1. Credit Analysis Area Five CACTTC Conference April 23, 2009 John Johnson, Investment Officer

2. Organizational Chart

3. Investment Process Investment Policy Strategic Management Credit Analysis Portfolio Management Implementation Execution and Documentation The County Investment Policy sets restrictions for the securities allowed as Pool investments. The County’s restrictions are in many cases stricter than State law. Annually, The Investment Policy is reviewed by the County’s Outside Advisor and the Treasury Oversight Committee prior to its submission to the Board of Supervisors for review and adoption. • The County Treasurer, County investment team and its advisors develop an overall investment strategy. • Cash Flows • Target Duration • Laddered Maturities • The Outside Advisor verifies that the trades included in their overall strategy would be in compliance with the Investment Policy. • The County investment team prepares a bi-weekly strategy report and sets trade recommendations based on the following factors: • Credit Quality • Duration • Sectors • Swaps • Yield Curve • The Treasurer approves the trade recommendations and gives the investment team approval to complete the transactions. Based on the report’s recommendations, the County investment team completes transactions of purchases and sales. The transactions are limited to authorized broker/dealers, and only the Treasurer, Assistant Treasurer, Investment Officer or Assistant Investment Officer are authorized to make investments. A copy of each day’s transactions is filed with the County Auditor / Controller, who audits the investments six times per year, and with the Investment Advisor, who completes a daily compliance report. A credit analyst researches and monitors issuers on the County’s pre-approved list. The County Treasurer approves all changes to the pre-approved list. The investment team can only purchase securities issued by entities on the pre-approved issuer list. The Bloomberg system includes “filters” so that only these issuers are displayed on the inventory screen. Separate staff perform accounting and auditing functions, and coordinate with the County’s custodial bank for delivery. The County investment team prepares trade documentation sheets of all comps. The Assistant Treasurer and Treasurer review and approve the documentation. The transactions are also detailed in the Investment Advisor’s monthly report, which is delivered to the Treasury Oversight Committee and the Board of Supervisors. The Treasury Oversight Committee causes an annual audit to be conducted, and the investments are also audited in conjunction with the CAFR.

4. Credit Analysis Process Government Code Investment Policy Formal Approved Issuer List Issuer Monitoring and Ongoing Analysis Reporting to Management

5. Credit Risk Philosophy Safety, Liquidity, and then Yield We don’t trust the ratings agencies We do our own credit analysis We perform credit analysis primarily to protect our Pool assets----not to justify earning higher yields We don’t make assumptions----if we don’t understand it, we don’t buy it We have a very disciplined credit process We have open, ongoing discussions about credits with our advisor We have a sell discipline if a credit deteriorates We invest in technology, services, and research

6. Credit Analysis Tools In-house full time Investment Analyst Outside Advisor---PFM Asset Management Bloomberg resources Credit Sights Fitch Research Egan-Jones Broker provided research and analysis Periodicals

8. Results No exposures to Bear Stearns, Lehman, AIG, Merrill Lynch, or Washington Mutual No losses occurred due to credit defaults Maintained a higher letter credit quality of issuers held by the Investment Pool Maintained highest possible Investment Pool credit ratings from Moody’s, S&P, and Fitch Investment Pool participants reassured Positive for County debt issuance and maintenance Good public relations---Good Press!

9. Conclusion Effective credit analysis integrated with tactical and strategic investment management can yield positive results for your investment pool. QUESTIONS ?????? Contact Us: (909)-387-6319

10. Navigating the Credit Markets CACTTC Area Five Conference Presented by: Robert Cheddar, CFA Portfolio Manager, PFM

11. Table of Contents • Current State of Credit Markets • Will the Markets Return to Normal? • Managing Credit Risk

12. Current State of the Credit Markets Out of Business Under New Management Government Supported

13. The Credit Crisis has Entered its Third Year • Some credit markets are still frozen • Many financial companies are still not able to issue unguaranteed debt • Unprecedented levels of support have been provided to help stabilize markets • Credit continues to underperform • Credit spreads are quite attractive, but the outlook is uncertain • Liquidity in some sectors is difficult to find • Sentiment remains negative, particularly in the financial sector

14. Unguaranteed Financial Issuance has been Minimal Source: Barclays Capital

15. Access to the Credit Markets has been Company Specific 2009 Top Issuers 2008 Top Issuers Citigroup Bank of America JP Morgan GECC Deutsch Bank Wachovia Merrill Lynch Verizon Wells Fargo Morgan Stanley • Pfizer • Roche • ConocoPhillips • AT&T • Chevron • InBev • Novartis • Verizon • Altria • Cisco Source: Merrill Lynch

16. Commercial Paper Yields Reflect Credit Freeze Source: Bloomberg

17. Commercial Paper Outstanding Contracted as the Economy Deleveraged

18. Returns in Credit Sectors have Lagged 2008 was worst year ever 1990 to 2007 *1-5 Year Benchmarks - Excess return over U.S. Treasuries Source: Bloomberg - Merrill Lynch Indices Years of Outperformance Years of Underperformance Worst Year of Performance

19. Credit Markets are Likely to Deteriorate Further • Continued economic deterioration may spread credit concerns to sectors other than financials • Investors have been offered alternatives to Treasuries that have earned un-guaranteed like returns • A “have” and “have not” environment has been created, investors are choosing those with government support • S&P announced they are considering lowering the rating of 936 companies • Liquidity concerns are still hampering demand for credit.

20. How Long Will Rating Downgrades Accelerate? • Credit Lags the Business Cycle S&P, Moody’s and Fitch Up/Downgrades of North American Companies 3,500 200% Recession 180% 3,000 160% 2,500 140% 120% 2,000 100% 1,500 80% 60% 1,000 40% 500 20% 0 0% Jun 99 Dec 99 Dec 00 Dec 01 Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 00 Jun 01 Jun 02 Downgrade Upgrade Up/Downgrade Ratio (Right Axis)

21. Investors have Lost Confidence • Credit rating agencies failed to quantify the true risks of some investments • In many cases management has not been able to reassure investors • Government actions have at times been bold, but in others have been unclear and confusing • Difficult to predict the unintended consequences of some government actions

22. Governments Around the World have Worked to Contain the Crisis • Credit markets would have shut down completely without government intervention • Support has been given in the form of loans, guarantees and liquidity • How will support be withdrawn? • When will markets be able to operate without support? • Some sectors of the credit market, i.e. asset-backed, may never return to pre-crisis activity • The perception of all markets is not the same • Investors are becoming concerned about the cost of the support

23. Sovereign Risk has Risen as the Cost of Bailouts and Stimulus have Ballooned Source: Bloomberg

24. Perception of The United States’ Credit Worthiness has Fallen 1.Switzerland 2. Norway 3. Luxembourg 4. Germany 5. Netherlands 6. Finland 7. Denmark 8. Canada 9. France 10.Sweden 15.United States The perception of the United States’ credit worthiness has fallen to 15th from 13th in a recent survey by Institutional Investor. The ranking is the United States' lowest in the survey’s history. Concern over the cost of economic stimulus and market stabilization efforts are weighing on investors. Institutional Investor

25. CDS of US Banks are Generally Wider than Other International Banks Source: Bloomberg

26. General Obligation State Municipal CDS have Widened Source: Barclays Capital

27. Will Credit Markets Return to Normal? Credit Losses Panic Selling/ Flight to Quality Other Assets Lose Value Deleveraging MoreMark-to-Market Losses Less Liquidity / Less Trading More Panic Wider Spreads Stock Values Plummet Raising Capital Becomes Impossible Eventually the Least Liquid Players are Forced Out of Business

28. Corporate Yield Spreads have been Volatile Corporate spreads are still well above historic averages Source: Merrill Lynch U.S. Treasury and AAA-A Corporate Master Indices

29. Federal Agency Yield Spreads Peaked Last Year • Spreads between 2-year Federal Agency and 2-year U.S. Treasury securities reached a record high of 2.06% at the end of November, but have fallen precipitously since Bailout 10 Year Average Spread 0.35%

30. Will Government Support Continue to Drive the Credit Markets? • TLGP to support financial institutions • Many banks quasi-nationalized • Fed and Treasury supporting money market funds • Consumer and homeowner lending facilities likely to be expanded • Longer term, withdrawal of support will be an issue, but markets cannot currently perform without support

31. Federal Agency Securities – Generally Represent Minimal Risk • Some have explicit government guarantee • Others have implicit government backing • They have low risk-based capital weightings • Most are permitted investments for risk-adverse investors without limit • Also known as Government Sponsored Enterprises (“GSEs”) • Government Sponsored Enterprises include: • Fannie Mae • Freddie Mac • Federal Home Loan Banks • Federal Farm Credit Banks

32. What is the Future of GSEs? • Congress passed significant GSE reform legislation in 2008. • Framework for the recent action that moved Fannie Mae and Freddie Mac into Conservatorship. • Established the Federal Housing Finance Agency (FHFA) as an independent agency to oversee Fannie Mae, Freddie Mac and Federal Home Loan Bank. • Authorized an unlimited increase in the line of credit from the Treasury to the GSEs. • Approved Treasury Secretary Paulson’s request to authorize the Treasury to make direct equity investments in the two GSEs. • Provided debt relief and other measures to aid homeowners facing foreclosure.

33. Managing Credit Risk Out of Business Under New Management Government Supported

34. Is Credit Risk Worth Taking? If the answer is yes, then the appropriate resources and processes are needed • Dedicated credit staff • Third party data providers – credit rating agencies, etc. • Assistance from an outside source • Processes and procedures to approve and monitor credit need to be developed • Formal review process and due diligence • Ongoing monitoring

35. PFM’s Credit Philosophy • Safety is the primary concern at PFM, willing to forgo return for safety • Issuer credit quality is determined on a fundamental basis • Micro or Issuer specific analysis • Macro or Industry/Country level analysis • Credit ratings are important, but secondary to our own analysis

36. PFM’s Credit Committee & Approved Credit List • PFM Credit Committee • Review approved list, current market trends and new issuers • Committee consists of Chief Investment Officer, Chief Credit Officer, Portfolio Managers and Credit Analysts • All issuers reviewed before being added to the approved list of issuers • Approved list is a living document • Rating changes updated immediately • Credit analysis beyond published credit rating • Monitoring of credit ratings is essential • Utilize proprietary credit monitoring models

37. Where Should a Review Start? A qualitative assessment of the company is usually conducted first • What type of business is the company in? • Where does the company derive its profit from? • Who are the company’s customers? • What is the company’s structure? • Where does the company operate? Sources of information include company filings, analysts’ reports, rating agencies and other available information

38. A Quantitative Review is also Necessary Although necessary, a quantitative review alone would have missed potential problems • A comparison between peers should be conducted • Profitability ratios, operating results and capital analysis is important • Dependent on management reporting, auditors and local accounting regulations • Rating agencies and analysts in the broker/dealer community regularly calculate a variety of ratios In the end, judgment has to be exercised

39. Some Characteristics of Good Credits Companies that are “good” credit risks have similar characteristics • Leader in its industry • Essential Industry • Diverse revenue and profit streams • Superior financial condition, debt levels and profitability when compared to peers • Large market capitalization • Improving or stable credit rating • Easily accessible information • Plenty of news flow

40. Approved Credit List An approved credit list is an effective management and oversight tool • Restricts the issuers that portfolio managers and traders can purchase • Staff responsible for managing the portfolio is always aware of any potential exposure • Resources can be focused on areas of exposure • Oversight bodies are always aware of potential exposure

41. Credit Monitoring is Essential Some events are effective warning signals • Changes in regulatory environment • Management indifference to bondholders • Lawsuits, subpoenas or SEC investigations • Drastic changes in business conditions • Changes in firm's strategy or management • Pending mergers or acquisitions • Changes in market valuations • Stock price • Credit default swap levels • Credit spreads

42. Mitigating Credit Losses Sometimes a sale is necessary to avoid greater loss • The most rigorous credit process may not be able to predict all future difficulties • Difficult to determine if a sale is necessary • Significant deterioration in economic environment, company or sector • Downgrades and the issuer remains on negative credit watch or negative outlook • Pricing of other securities like equity or credit default swaps deteriorate • A predetermined process may add discipline

43. Importance of Credit – Lessons Learned • Thorough review of credit is necessary • Cannot rely on brokers or rating agencies • Some structures were difficult to understand • Understand risks you are taking – what is worst case? • If you are going to take risk, it needs to be managed • "Buy and hold" does not work in times of crisis • Survive a small loss rather than absorb a catastrophic one • Avoiding losses is not about "being lucky"