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

Organizational Chart
Dick Larsen
Treasurer
Annette Kerber
Assistant Treasurer
John Johnson
Cash Manager/ Investment Officer
John Byerly
Assistant Investment
Officer
Robin Derdowski
Investment Analyst
David Carnes
Investment Analyst Assistant
Wendy Sieruga
Treasury Manager
Lupe Perez
Accounting Technician
Isabel Morales
Fiscal Assistant
2

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
A credit analyst researches and investment team and its advisors monitors issuers on the County’s develop an overall investment pre-approved list.
The County strategy.
Treasurer approves all
•Cash Flows changes to the
•Target Duration
The Outside pre-approved list.
• Laddered
Maturities
The investment team can only purchase securities issued
Advisor verifies by entities on the that the trades pre-approved included in their overall strategy issuer list. The would be in
Bloomberg compliance with the Investment system includes
“filters” so that
Policy. only these issuers are displayed on the inventory screen.
The County investment team prepares a biweekly 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.
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.
3

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

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
5

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
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1853
INTEROFFICE MEMO
DATE September 26, 2008 PHONE 7-6379
FROM Robin Derdowski,
Investment Analyst
TO John Johnson,
Cash Manager/Investment Officer
Annette Kerber,
Assistant Treasurer-Tax Collector
Dick Larsen,
Treasurer-Tax Collector
SUBJECT RECOMMENDATION TO REMOVE ISSUER FROM PRE-APPROVED ISSUER LIST
County of San Bernardino
ISSUER: Wachovia Corporation (Wachovia)
RECOMMENDATION:
CURRENT RATINGS:
Remove issuer from pre-approved issuer list
S&P/Moody’s/Fitch
S/T A-1/P-1/F1+
L/T A+/A1, Neg O/L/A+, Neg O/L
Remove Wachovia from the pre-approved issuer list for the following reasons:
 Wachovia has been on Do Not Buy since 4/3/08 due to the bank’s concentrated exposure to mortgage loans and merger integration costs during a market stressed period.
 Moody’s and Fitch have a Neg O/L on the bank with rating agencies downgrading Wachovia’s L/T ratings during July 2008.
 Market conditions in the credit and equity markets have led to the bank’s struggle to build additional capital.

Wac hovia’s future earnings prospects and continued credit quality deterioration warrant removal from the pre-approved issuer list.
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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!
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Effective credit analysis integrated with tactical and strategic investment management can yield positive results for your investment pool.
Contact Us:
(909)-387-6319
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CACTTC Area Five Conference
Presented by:
Robert Cheddar, CFA
Portfolio Manager, PFM
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Table of Contents
I.
Current State of Credit Markets
II.
Will the Markets Return to Normal?
III.
Managing Credit Risk
11

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

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
13

Unguaranteed Financial Issuance has been
Minimal
US Financial, Non Government Guaranteed Investment Grade Issuance
60
50
40
30
20
10
0
Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09
Source: Barclays Capital 14

Access to the Credit Markets has been
Company Specific
2009 Top Issuers
1) Pfizer
2) Roche
3) ConocoPhillips
4) AT&T
5) Chevron
6) InBev
7) Novartis
8) Verizon
9) Altria
10) Cisco
Source: Merrill Lynch
2008 Top Issuers
1) Citigroup
2) Bank of America
3) JP Morgan
4) GECC
5) Deutsch Bank
6) Wachovia
7) Merrill Lynch
8) Verizon
9) Wells Fargo
10) Morgan Stanley
15

Commercial Paper Yields Reflect Credit Freeze
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
30 - day money market yields
December 2007 to December 2008
U.S. Treasury Bill
Agency Discount Note
Direct Issue A-1+/P-1 Commercial
Paper
1.00%
0.00%
Dec 07 Feb 08 Apr 08 Jun 08 Aug 08 Oct 08 Dec 08
Source: Bloomberg
16

Commercial Paper Outstanding Contracted as the Economy Deleveraged
2,500.00
Commercial Paper Outstanding
January 1, 2003 to January 7, 2009
2,000.00
1,500.00
1,000.00
500.00
0.00
Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09
Commercial Paper Asset Backed Commercial Paper
17

Returns in Credit Sectors have Lagged
2008 was worst year ever
1990 to 2007
Sector 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
40 -11 -10 15 27 -43 59 -5 -58 42 44 50 22 24 41 19 73 -89 -107
--------133 142 164 95 -135 124 112 -63 121 98 271 113 115 -97 -128
-18 41 68 39 96 56 61 43 23 -46 94 118 172 192 59 26 66 -86 -432
-25 111 51 107 81 99 58 70 31 -19 104 227 206 173 76 14 75 -176 -767
-73 90 120 174 63 140 59 15 18 27 32 156 218 293 91 34 92 -249 -1556
*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
18

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.
19

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

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
21

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
22

Sovereign Risk has Risen as the Cost of
Bailouts and Stimulus have Ballooned
Sovereign Debt Credit Default Spreads
180
160
C
D
S
140
120 e a d
S p r
100
80
60
40
20
0
Sovereign Issuer
Source: Bloomberg
23

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
Institutional Investor
The perception of the United
States’ credit worthiness has fallen to 15 th from 13 th 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.
24

CDS of US Banks are Generally Wider than
Other International Banks
CDS Spreads in Bank Issuers
600
500
C
D
S
400 e a d
S p r
300
200
100
0
Bank Issuer
Source: Bloomberg
25

General Obligation State Municipal CDS have
Widened
GO Municipal CDS Spreads
400
350
C
D
S
300
250 r e
S p a d
200
150
100
50
0
CA CT DE FL IL
State
MD MI NY VA
Source: Barclays Capital
26

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

Corporate Yield Spreads have been Volatile
Corporate spreads are still well above historic averages
Basis Points
800
700
Yield Spread: U.S. Treasuries Vs. AAA-A Rated Corporates
March 2003 to March 2009
600
500
400
300
200
100
0
Mar 03 Dec 03 Sep 04 Jun 05 Mar 06
Source: Merrill Lynch U.S. Treasury and AAA-A Corporate Master Indices
Dec 06 Sep 07 Jun 08 Mar 09
28

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
Yield Spread - 2-year U.S. Treasury versus 2-year Federal Agency
January 1, 2008 - December 31, 2008
2.00%
Bailout
10 Year Average Spread 0.35%
1.00%
0.00%
Jan 08 Mar 08 May 08 Jul 08 Sep 08 Nov 08
29

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
30

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
31

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.
32

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

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
34

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
35

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
36

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
37

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
38

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
39

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
40

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
41

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
42

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"
43