“Municipal Credit: A Changing Landscape” Credit A Changing Landscape 2008.pdfPortland -6.6 13.1 0.6 New York -7.4 13.4 0.2 National average -13.1 14.3 1 Bottom 5 Las Vegas -29.9

Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.Copyright (c) 2006 Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.

LAMP Annual MeetingNew Orleans, LA

Oct. 24, 2008

“Municipal Credit: A Changing Landscape”Gabe Petek, CFA

DirectorStandard & Poor’s

2.Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s.

S&P Municipal Bond Ratings: History and Key Criteria

• S&P was founded in 1860• Has provided bond rating information for about 80 years• Ratings outstanding on thousands of municipal entities in the U.S.

Main Rating Criteria (U.S. Public Finance/GO or Issuer Credit Ratings):– Economy

Tax baseEmployment baseLocation in/near major metropolitan area

– Financial conditionHistorical results, current condition, likely future projections

– DebtCurrent debt burdenIdentified capital requirements over the medium- and long-term

– Management


Municipal Credit Trends and Risks

I. Key Rating Factors Experiencing Some StressA. Economy: A key factor enduring period of stress;

B. Revenues are much flatter—but governments have higher reserves than just prior to previous recession(s);

II. U.S. Public Finance rating characteristics at S&PA. Rating distribution;

B. Recent credit rating actions;

III. S&P Financial Management Assessment (FMA)A. Analytic underpinnings;

B. What drives changes in credit quality?

C. FMA: What is it? How does it contribute to ratings analysis?

IV. Final Thoughts: LGIP and Retirement Benefit Liabilities


I. Key Rating Factors Experiencing Some Stress


Economic Context: The U.S. Is In Recession

In our view:• The economy has moved into recession.• Housing has been in recession for two years, subtracting over a percentage point

from GDP growth in 2007.• But that was offset by strength in nonresidential construction and the closing of

the trade gap, each of which added back over a half point.• Nonresidential construction is beginning to decline• Fiscal stimulus package(s) plus rescue plan(s) are causing the fiscal 2008 deficit

to more than double, and could beat the 2004 record. But it could help the credit markets and ultimately the economy.

• The recession could be mild because of the fiscal and monetary stimulus• But probably long.• Increasingly, a deeper recession appears possible if the financial markets remain

locked up or anaemic, bailout fails, and home prices continue to drop.• Along with all of this, the fed has cut rates sharply.


The Housing Bubble

In our view:• Low mortgage rates encouraged buyers to purchase homes they

otherwise could not afford• But what happened when rates went up?• Ratio of home price to income hit a record high in 2006,• Higher interest rates resulted in significant stress• Builders built too many houses at too high prices• Starts and sales have dropped sharply• Defaults and foreclosures have soared, cutting back on willingness to

lend• Prices are down 15% or more from their peak• We expect to hit bottom on starts this summer or fall• But prices probably won’t hit bottom until early 2009.


The Housing Market Cycle

0

500

1,000

1,500

2,000

2,500

1990 1993 1996 1999 2002 2005 2008-20

-10

0

10

20

30

Starts Home prices (%chya)

(Housing starts (1000) and 12-month % change in home prices (S&P/Case-Shiller))

Source: S&P and Census Bureau


Weakness And The Bubble Cities

Source: Standard & Poor’s, RealtyTrac

(S&P/Case-Shiller Home Price Indexes)

Jul-082002-2005

averageForeclosure rate

Top 5Charlotte -1.8 4.1 1.4Dallas -2.4 2.7 1.7Boston -5.4 8.6 0.5Portland -6.6 13.1 0.6New York -7.4 13.4 0.2

National average -13.1 14.3 1

Bottom 5Las Vegas -29.9 17.5 4.2Phoenix -29.3 20.6 1.9Miami -28.3 19.9 2.7Los Angeles -26.2 15.8 1.4San Diego -25.0 17.2 1.8

(12-month percent change)


Home Price Declines

0% to -3%0% to +3%

-3% or worse

(1-year change in home prices, First quarter)

+3% or more

Source: OFHEO


Default Rates Highest In Midwest And South

2.95% to 4%Over 4%

(Seriously delinquent rate, Q4)

Under 2.95%

Source: Mortgage Bankers Association


Commercial Real Estate Remains Firm

Source: Standard & Poor’s

(S&P/GRA Commercial Price Indexes, March)

Last 3 months (annual rate)

Last 12 months 2004-2006

Apartments -2.6 7.7 2.2Office -7.8 2.3 18.4Retail 4.5 3.8 13.9

Warehouse 8.2 6.1 5.4Desert Mountain West -6.2 -0.2 13.0

Mid Atlantic South 2.8 3.8 7.1Midwest 1.0 3.9 10.2

Northeast -9.6 2.6 12.5Pacific West 4.4 10.3 5.8

National -2.2 5.1 9.4


Can the Consumer Keep Spending?

• Consumer spending has led the expansion

• But wealth is down because home prices declined and stock prices are weak

• Incomes have not grown

• Borrowing is more difficult, and home equity loans much less available

• Confidence has dropped to record lows

• Consumers are likely to save more

• Rebates provided some quick cash most of which we observed were spent and provided temporary economic boost


Municipal Credit Implications

In our opinion:

• Reduced home prices and equity values depress wealth causing reduced taxable spending

• Real estate fallout to local government is particularly acute inreal estate transfer tax revenues

• Tax limitation laws provide value and/or revenue stability

• Sales tax trends are generally resilient to downturns…from an historical or empirical standpoint

• State and Local Governments are generally well poised to weather a period of sluggish revenues


Do Fund Balance Reserves Provide Cushion?

Local Government Credits' Fund Balances

23.00

24.00

25.00

26.00

27.00

28.00

29.00

30.00

31.00

2008Unaudited

2007 2006 2005 2004

Unreserved Fund Balances as % of Exp


II. U.S. Public Finance Ratings & Developments at S&P


Recent Credit Trends

• In 2001, Standard & Poor's completed its first US Public Finance (USPF) default and transition study.

• At that time, we reiterated our commitment to a global scale, highlighted the differences in credit characteristics and performance between and among different sectors, and undertook a criteria review that continues through today.

• Since that time USPF criteria have been reviewed several times and we have made changes to promote comparability in our ratings…

CONFIDENTIAL AND PROPRIETARY.Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’sCopyright © 2006 Standard & Poor’s a subsidiary of The McGraw-hill Companies, Inc. All rights reserved.


Credit Trends

• As a result of the criteria revisions and combined with what we believe is strong economic performance experienced by many governments in the United States, the ratio of upgrades to downgrades in the period since 2001 has been approximately 3:1.

• From 2000-2007, 5,300 ratings have been upgraded in US Public Finance.

• In the tax secured universe, upgrades have been, and we expect will continue to be, more likely than downgrades within the 'BBB' and 'A' rating categories. Nearly 40% of tax secured entity ratings are already in the 'AA' or 'AAA' categories.



U.S. Public Finance Rating Migration

0.010.020.030.040.050.060.070.0

AAA/AA A

BBBSpe

culat

ive gr

ade

%

1986

2008



Standard and Poor’s Rating Distributions - 2007

Rating Count %AAA 5 0.27%AA 23 1.26%A 202 11.05%

BBB 386 21.12%BB 387 21.17%B 764 41.79%

CCC 52 2.84%CC 4 0.22%D 5 0.27%

Grand Total 1828 100.00%

US Corporate FinanceRating Count %AAA 376 3.07%AA 3818 31.15%A 5998 48.93%

BBB 1920 15.66%BB 112 0.91%B 24 0.20%

CCC 4 0.03%CC 1 0.01%C 4 0.03%D 1 0.01%

Total 12258 100.00%

US Public Finance Rating Count %AAA 1377 58.17%AA 684 28.90%A 222 9.38%

BBB 35 1.48%BB 20 0.84%B 15 0.63%

CCC 7 0.30%CC 3 0.13%C 1 0.04%D 3 0.13%

Grand Total 2367 100.00%

US Public Finance Housing



Rating Distribution U.S. PF vs. U.S. Corporates

0

0.1

0.2

0.3

0.4

0.5

0.6

AAA AA A BBB BB B CCC

Rating Category

US PF

US Corporates



III. S&P Financial Management (FMA)


General Obligation (G.O.) Credit Ratings

• Full faith and credit pledge

• Most often, secured by an unlimited ad valorem property tax

• Most ratings, over time, have had a general tendency to stay the same or go up

• Low default ratio


Rating Transitions After One Year (%) *

75.0715.510.550.000.00BB

0.2187.963.640.060.00BBB

0.010.6089.242.430.01A

0.000.031.1992.210.61AA

0.000.000.152.2496.06AAA

BBBBBAAAAAARating Category

*All U.S. Public Finance issuers, 1986 to 2007. Source: Standard & Poor’s data, as of July 2008


Cumulative Default Rates, U.S. Public Finance*

Default Rate (%)

1.01

0.08

0.02

0.00

0.00

Y11

1.011.011.01Speculative grade

0.080.080.02BBB

0.020.020.01A

0.000.000.00AA

0.000.000.00AAA

Y20Y15Y3Rating Category

*Tax-secured issuers, 1986 to 2007. Source: Standard & Poor’s data, as of July 2008


Financial Factors Play a Role in Most Downgrades

Year TotalFinance related

Sustained Financial Deterioration

Extreme Financial Deterioration

Economic and Financial Deterioration

Economic Detrioration Only

Management Related

Debt Related

2000 9 8 4 3 1 0 1 02001 8 6 3 0 1 0 1 02002 15 15 6 5 6 0 0 02003 23 21 7 3 8 1 3 02004 36 30 13 9 3 2 2 02005 49 35 22 10 5 7 1 4

Total 140 115 55 30 24 10 8 4

U.S. Public Finance G.O. Downgrades from 2000 to 2005


Where Are the Downgrades Occurring?

CA14%

LA7%

TX9%

PA6%

IL6%

All Others58%

In Tennessee:3 downgrades (2%)

U.S. Public Finance G.O. Downgrades from 2000 to 2005


The Financial Management Assessment

An analytical methodology that evaluates established and ongoing management practices and policies in the seven areas we believe most likely to affect credit quality.

1. Revenue and expenditure assumptions

2. Budget amendments and updates

3. Long term financial planning

4. Long term capital planning

5. Investment management policies

6. Debt management policies

7. Reserve and liquidity policies

Currently applicable only to general government tax- and appropriation-backed issues, excluding special districts.



Why the Financial Management Assessment?

In our opinion, this leads to:

• Better transparency to long-standing aspects of the analysis

• Better communication about the environment in which financial decisions are made

• Highlights in a consistent manner the most transparent aspects of management that are common to most governments



What The FMA Is and What The FMA Isn’t

IS

• One component of the entire rating process

• An enhancement to the existing process

• An evaluation of the guiding assumptions and policies regarding financial decision-making

• A statement of best practices you’ve probably already heard before from S&P, GFOA, ICMA, etc.

ISN’T

• A separate rating

• An evaluation of the competency or aptitude of individual finance professionals or elected and appointed representatives

• An assessment of actual financial performance



Revenue and Expenditure Assumptions

An important question we look at is whether we find the organization’s financial assumptions and projections realistic and well grounded from both long-term and recent trend perspectives?

Strong We find formal historic trend analysis performed and updated annually for both revenue and spending; regular effort is made to determine whether revenues or expenditures will deviate from their long-term historic trends over the next year; evidence of independent revenue forecasting exists (when possible).

Standard Optimistic assumptions exist that, while we believe may be supportable, also add risk; assumptions are based on recent performance, but we find little evidence of questioning or validating assumptions. Budget accuracy is mixed and sometimes may reflect optimistic assumptions.

Vulnerable We believeassumptions neglect likely shortfalls, expenditure pressures or other pending issues; assumptions exist which we don’t believe enjoy prudent validation.



Budget Amendments and Updates

Another important question we analyze is whether we believe there are procedures for reviewing and amending the budget based on updated information and actual performance?

StrongAt least quarterly budget surveillance is maintained to identify problem areas and enable timely budget adjustments; we believe management exhibits ability and willingness to address necessary intra-year revenue and expenditure changes to meet fiscal targets.

Standard Semiannual budget reviews exist; management identifies variances between budget and actual performance.

VulnerableWe find no formal process exists for regular review and timely updating of budget during the year.



Long-Term Financial Planning

We also ask whether we believe management has a long-term financial plan that allows them to identify future revenues and expenditures as well as address upcoming issues that might affect these?

Strong A multi-year financial plan exists where future issues are identified and possible solutions are identified, if not implemented; revenue and expenditure decisions are made primarily from a long-term perspective. Structural balance is a clear goal.

Standard Multi-year projections are done informally; multi-year projections are done, but without discussion of pending issues, so that issues are not addressed; some one-shot actions exist, but the long-term consequences of these actions are acknowledged and communicated.

Vulnerable We find no long-term financial planning exists; operational planning is done on a year-to-year (or budget-to-budget) basis; one-shot budget fixes are used with little attention to long-term consequences.



Long-Term Capital Planning

Has the organization created a capital improvement plan?

StrongWe find, generally speaking, that a five-year rolling CIP with funding identified for all years exists and is linked to the operating budget and long-term revenue and financing strategies.

Standard A five-year CIP is done, but is generally limited to projects to be funded from the current budget plus a four-year wish list; some funding for out-year projects is identified, but not all.

Vulnerable No five-year CIP exists; capital planning is done in our view as needs arise.



Investment Management Policies

We also look at whether the organization established policies pertaining to investments and how often does the organization monitor compliance with its policy?

Strong Investment policies exist and, in our opinion, are well defined; we find that strong reporting and monitoring mechanisms exist and are functioning.

Standard Informal or non-published policies exist; policies are widely communicated and followed.

Vulnerable Absence of informal or non-published policies.



Debt Management Policies

Has the organization established policies pertaining to the issuance of debt?

StrongDebt policies exist and we find them to be well defined; we believe strong reporting and monitoring mechanisms exist and are functioning. If swaps are allowed, a formal swap management plan has been adopted.

Standard Basic policies exist; policies are widely communicated and followed. If swaps are allowed there is a swap management plan in place, but it does not conform to S&P’s criteria.

VulnerableWe find an absence of basic policies or clear evidence that basic policies are followed. Swaps are allowed but there is no swap management plan in place, and/or there is no local (non-FA) knowledge about the swap.



Reserve and Liquidity Policies

Has the organization established a formalized operating reserve policy, which takes into account the government's cash flow/operating requirements and the historic volatility of revenues and expenditures through economic cycles?

StrongWe believe a formal operating reserve policy is well defined. Reserve levels are clearly linked to the government’s cash flow needs and the historic volatility of revenues and expenditures throughout economic cycles. Management has historically adhered to it.

StandardA less defined policy exists, which may not have an actual basis but has been historically adhered to it.

VulnerableWe find an absence of basic policies or, if they exist, are not followed.



Assessment Methodology

• Qualitative score assigned to each of the seven areas

• Revenue and expenditure assumptions, budget amendments and updates are given their relatively higher importance in our analysis;

• Long-term financial planning and reserve and liquidity are given relatively average importance; and

• Capital planning, debt policies, and investment policies are given relatively less weight.

The difference in degrees of importance is limited so that each

factor’s contribution to the assessment is meaningful.



Overall FMA Scores

Applying our criteria:

StrongA Financial Management Assessment of ‘strong’ indicates that practices are strong, well embedded, and likely sustainable. The government maintains most of what we consider to be best practices deemed critical to supporting credit quality and these are well embedded in the government’s daily operations and practices. Formal policies support many of these activities, adding to the likelihood that these practices will be continued into the future and transcend changes in the operating environment or personnel.

Good*A Financial Management Assessment of ‘good’ indicates our opinion that practices exist in most areas, although not all may be formalized or regularly monitored by governance officials. The government maintains many of what we consider to be best practices deemed as critical to supporting credit quality, particularly within the finance department. These practices, however, may not be institutionalized or formalized in policy, may lack detail or long term elements, or may have little recognition by decision makers outside of the finance department.

*The term ‘good’, in addition to the terms ‘strong’, standard, and ‘vulnerable’, is used to further differentiate governments with a mix of strong and standard practices.



Overall FMA Scores (continued)

StandardA Financial Management Assessment of ‘standard’ indicates that we believe the finance department maintains adequate policies in some but not all key areas. These policies often lack formal detail and institutionalization in our view and may not include best practices. Such policies would be more commonplace in smaller governments with limited finance department resources.

VulnerableA Financial Management Assessment of ‘vulnerable’ indicates that we believe the government lacks policies in many of the areas deemed most critical to supporting credit quality. The ‘vulnerable’ designation suggests a high degree of uncertainty in our opinion regarding a government’s ability to effectively adapt to changing conditions that could threaten its long-term financial position.



Standard & Poor’s has completed roughly 3,396 FMA’s since June 2006:

• 306 entities have scored ‘strong’

• 1,376 entities have scored ‘good’

• 1,682 entities scored ‘standard’

• 32 entities scored ‘vulnerable’

FMA Stats

Good 40.5%

Standard 49.5%

Vulnerable 0.9%

Strong 9.0%

Strong Good Standard Vulnerable


IV. Final Thoughts: LGIP and Retirement Benefit Liabilities


Money Markets Impact Local Governments

• Florida LGIP temporarily froze withdrawals

• King County, WA owned 4 ABCP assets determined to be impaired, equivalent to 4.5% of portfolio value

• S&P Survey of California County Investment Pools:

– 55 of 58 California Counties responded

– WAM is 385 (3/31/2008) versus 339 (3/31/2007) days, a 13.6% increase

– WAM is above 9/30/2007 measure of 356

– Duration is monitored by 32 of 55 responding counties; Mean = 0.80

• We believe increased WAM (and duration strategies) have appeal:

– Investment returns offset downturn in economically based revenues

– Counties compete for “hot money”

– Federal Reserve rate cuts encourage credit and duration-based alternative strategies


contact

Gabriel Petek, CFADirectorStandard & Poor’s Ratings Services1 Market St.Steuart Tower, 15th FlrSan Francisco, CA 94105

[email protected]

Documents

“Municipal Credit: A Changing Landscape” Credit A Changing Landscape 2008.pdfPortland -6.6 13.1 0.6 New York -7.4 13.4 0.2 National average -13.1 14.3 1 Bottom 5 Las Vegas -29.9