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A PIMCO Advisory Presentation to NAIC:

If Ratings Agencies Didn’t Exist, Would We Invent Them?

September 24, 2009

Advisory_NAIC(09-23-09)

This communication is not a public offer and should not be deemed to be a contractual commitment or undertaking between the intended recipient of this communication and PIMCO but an indication of what services may be offered subject to a legally binding contract between the parties and therefore no reliance should be placed on this document or its content.

Opinions, estimates and recommendations offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This communication and its content represent confidential information.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal adviser regarding such matters.

Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 949-720-6000

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AAA Through the Crisis – 05-07 Vintage RMBS Ratings Downgrades

Only 25% of subprime bonds remain AAA, while 46% are below investment grade

Only 4% of Alt-A remain AAA, while 76% are below investment grade

Only 6% of prime RMBS remain AAA, while 47% are below investment grade

SOURCE: PIMCO, Moody’s and Intex (as of August 09).

Has AAA Lived Up to Expectations? 05-07 Vintage AAA Ratings Transitions

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

AAA A- AA BBB B- BB C- CCC

Current Rating Category

% R

ati

ngs

Dis

trib

uti

on

Subprime

Alt- A

Prime

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What Do We Do Today?

Problem:

– Very high percentage of originally AAA ratings are clustered in below investment grade ratings category

– These ratings generate very high capital charges despite the fact that they are in senior positions and would likely enjoy a high recovery. Further there is great variation in expected recoveries within a rating category

Potential solutions:

– Reremic: elevates a large proportion of bond to AAA

– Ignore ratings and use purely expected loss approach based on 3rd party generated model forecasts

– Notch ratings higher for below investment grade ratings where the recovery is expected to be high

– Treat like whole loans: given that most senior securities are expected to take a loss, the treatment for capital purposes should be no worse than that for a comparable whole loan pool

– Important to consider carrying value of the bonds as it may vary by institution. Capital % held against a bond carried at 50 for Institution A, should be less than capital against the same bond carried at 70 by Institution B

Refer to Appendix for additional outlook information.

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What Do We Do Today?

Additional Issues – forecasting the future:

– Forecasting methodology: Roll rates vs. econometric model? Can the two be combined?

– Model Validation: How do we know a model is accurate? What are the methods for validation? Judgment based validation or statistical based validation?

– Macro assumptions: A well specified model can be undermined by poorly specified macro forecasts (home prices and unemployment)

– Base case losses vs. tail: The tail risk of the bond may be underestimated relative to a base case only (e.g. a mezz bond may be protected in base case, but wiped out in stress case)

– Judgment overlay:

- Can models produce good results purely by the magic of statistical gymnastics?

- Or do real world practitioners need to tune the model?

- How can models incorporate government policy impact?

- How do users inject judgment into a statistical model?

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How Stable Are the Expected Bond Losses? – A Framework for Capital Allocation

Bond Losses in Base Case

Range

Bond Losses in Pessimistic Case Range               

0-5 5-15 15-25 25-35 35-45 45-55 55-65 65-75 75-85 85-95 95-100 Total

0-5 79% 13% 4% 1% 1%       1%     100%

5-15   23% 46% 21% 3% 5% 2% 100%

15-25   3% 40% 27% 23% 3% 3% 100%

25-35   43% 43% 6% 6% 3% 100%

35-45   8% 25% 58% 8% 100%

45-55   43% 29% 14% 14% 100%

55-65   10% 60% 10% 20% 100%

65-75   29% 29% 43% 100%

75-85   67% 33% 100%

85-95   100% 100%

95-100   100% 100%

Total 51% 11% 8% 6% 6% 6% 3% 2% 2% 2% 3% 100%

Table shows the distribution of expected bond losses in base case vs. pessimistic case using PIMCO’s RMBS model. This is a representative sample of bonds

Table illustrates how levered bond is with respect to losses. Green means the bond isn’t so sensitive to losses, while Red means the bond is more highly levered

Example: 46% of bonds that take a 5-15% loss range in the base case take a 15-25% loss in pessimistic case while 5% take a loss in the 45-55% range in the pessimistic scenario

As of June 2009SOURCE: PIMCOHypothetical Example for illustrative purposes only.Refer to Appendix for additional hypothetical example information.

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How RMBS Ratings Process Failed

Lack of due diligence: Ratings agencies don’t do due diligence and they relied on 3 rd party due diligence that was severely flawed and conflicted.

Overreliance on models, with flawed assumptions: While models should be an important part of ratings process, failure to reality check the models resulted in dramatically inflated ratings; particularly for CDOs where correlation assumptions were wildly optimistic.

Failure to understand the business: Structured finance analysts tended to be too far removed from the actual business underlying the loans. They failed to fully understand the changes in business practices, failed to properly understand the role of due diligence firms and they missed the extent of the fraud that was occurring. The blowups in Franchise and Manufactured Housing revealed that prior lessons weren’t learned.

Fraud and Misrepresentations: A significant percentage of the loans had features that were dramatically different than those represented to ratings agencies and investors. Occupancy and income fraud were particularly pronounced.

Competitive landscape: Limited incentives of ratings agencies to be more conservative. Incentives were distorted up and down the securitization food chain.

CDOs: Collateralized Debt Obligations

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Future Role of Ratings Agencies: What are the Issues?

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Rating Agency Reform – 4 Themes

Skin in the Game: Rating agencies need to have more skin in the game. One way is for them to assume more liability

Enhanced Disclosure: Methodology and changes need to be disclosed regularly

Increased Regulatory Oversight: Stronger regulatory oversight is needed and it’s likely that some variation of government approved rating agencies will be needed

What is the basic framework for RA oversight?: limited number of approved ratings agencies, with continuation of issuer pay model, but with buy side input into rating agency selection

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Should Government Bless RAs? Let’s Call the RAs Independent Risk Evaluators or IRE

Two ends of the spectrum: 1) Free unregulated market vs. 2) limited set of government regulated and blessed RAs – which is the best model?

What if we had no ratings agencies?:

– Would all investors have to do their own analysis?

– What about smaller investors who don’t have the capacity to evaluate investments?

– Assuming most investors can’t evaluate securities on their own, isn’t a 3rd party still needed?

– How would smaller investors compare independent 3rd parties?

– For large investors, even if capable of performing their own analysis (e.g. internal risk/ratings based approached), who would evaluate their results? How would I compare my corporate bond portfolio to brand X?

– How do third party users of financial statements evaluate financial statements and investment risk absent 3rd party evaluation (e.g. ratings)?

Plenty of examples where ratings aren’t directly used:

– Bank balance sheet loans, unrated private placements, equity, etc.

– If it works for these assets why not structured finance bonds?

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Skin in the Game: RAs Publishing Companies or Fiduciary?

Ratings agencies traditionally have viewed their ratings as an opinion generally protected under First Amendment

Is the free press argument consistent with the critical role ratings agencies play in the global capital markets?

Is there a middle way? More liability than today, but less than what other fiduciaries are exposed to?

We note a recent court ruling may call into question ability of rating agencies to use First Amendment rights

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How to Quantify Ratings: Or the Meaning of AAA

In order to assess the role of ratings in risk management, it’s important to translate the letter rating to something that is comparable across all IREs/RAs

AAAs represent the lion’s share of a securitization and it’s therefore important to get the meaning of AAA right

– Quantitative definition of AAA Example (rating agency): .006bps expected annual losses over a 10 year period

– Qualitative definition – eg should withstand a severe economic stress comparable to the Great Depression

A related question is: how sensitive do we want the ratings to be?

– When asked if we want timely ratings updates, most would say yes

– When asked whether ratings should be relatively stable and not frequently change, we would also say yes

We want ratings to be stable but updated on a timely basis. How should we balance the competing needs?

Regardless of the answers to the above, we need to ask what we want of ratings in order to properly chart the course forward

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How Many IREs or RAs?

The greater the number of IREs, the more difficult it is for the investment community to manage and the more challenging it becomes to avoid rating shopping

If there were 10 ratings agencies offering structured finance ratings and issuers followed the typical path of selecting the 2-3 IREs with lower credit support, it’s likely the structured finance ratings debacle would have been far worse

Having a limited number of IREs or RAs may be unappealing from a free market standpoint, but having an unlimited number would render ratings shopping difficult to control and would make it harder to compare ratings across deals

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Who Pays?

Issuer pay vs. Investor pay is a red herring issue

There are conflicts in any of the alternative approaches and the key is to manage the conflicts

Investor/subscriber based model:

– Can investors influence ratings?

– I.e. Can investor shop for favorable ratings by terminating subscription with vendor who provides unacceptable ratings

– Do investors have incentives to have inflated ratings or deflated ratings (i.e. a hedge fund shorting a bank)

Conflicts can’t be eliminated, only managed

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Disclosure

Ratings agencies should be required to disclose detailed rating methodology, and the methodology should be updated annually

Further, updates to methodology or credit enhancement levels should be subject to immediate disclosure prior to being used on actual ratings

By requiring IREs to publicly disclose changes in methodology, it will be harder for them to win market share by lowering credit enhancement levels

When IREs can lower credit enhancement levels under cover of the night, under pressure from investment banks, ratings shopping and conflicts of interest can more easily corrupt the ratings process

If IREs had to disclose the rationale for ratings changes prior to them taking effect, it would reduce temptation to lower credit enhancement in order to win business

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Ratings Shopping

Ratings shopping was a major issue during the crisis

The ability of bankers/issuers to put ratings agencies “in comp”, resulted in undue pressure for ratings agencies to lower credit enhancement levels

Ratings shopping risk increases proportionately with the number of “approved” ratings agencies

Unless issuers are required to hire all agencies, ratings shopping needs to be controlled

Ratings shopping could be controlled by:

– Using all ratings agencies:

– Random selection of ratings agencies:

– Issuer paid/investor selects: Allow investors to select via consortium one of the ratings agencies on a deal. So perhaps issuer selects one, investor selects another, but issuer pays for both

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Regulatory Oversight

The framework for overseeing the role of RAs or IREs needs to be significantly strengthened

The approval process and oversight of RAs is enormously complicated and requires sufficient resources including data modelers, industry experts, etc.

Non- NRSRO entities can be leveraged to provide input to the regulatory bodies, but the regulator needs to sufficient expertise as well

Given the global nature of capital flows, it’s important for international regulatory bodies to reach consensus on the role of RAs in the global capital markets

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Appendix

Past performance is not a guarantee or a reliable indicator of future results.

Hypothetical ExampleHypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

OutlookStatements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, ©2009, PIMCO.

Advisory_NAIC(09-23-09)Appendix