Credit Risk MATURITY OF CREDIT RISK EXPOSURE DECEMBER 31, 2003 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS P N M R E S O U R C E S • 2 0 0 3 A n n u a l R e p o r t t o S h a r e h o l d e r s Interest Rate Risk Natural Gas Supply Contracts Equity Market Risk 40 SCHEDULE OF WHOLESALE OPERATIONS  CREDIT RISK EXPOSURE DECEMBER 31, 2003 PNM is exposed to credit losses in the event of non-performance or non-payment by counterparties. The Company uses a credit management process to assess and monitor the financial conditions of counterparties. Credit exposure is also regularly monitored by the RMC. The Company provides for losses due to market and credit risk. PNM’s credit risk with its largest counterparty as of December 31, 2003 was $23.5 million.  The following table provides information related to PNM’s credit exposure as of December 31, 2003. The Company does not hold any credit collateral as of December 31, 2003. The table further delineates that exposure by the credit worthiness (credit rating) of the counterparties and provides guidance as to the concentration of credit risk to individual counterparties PNM may have. Also provided is an indication of the maturity of a company’s credit risk by credit ratings of the counterparties. (a) Rating – Included in “Investment Grade” are counterparties with a minimum S&P rating of BBB- or Moody's rating of Baa3. If the counterparty has provided a guarantee by a higher rated entity (e.g., its parent), determination is based on the rating of its guarantor. The “Internal Ratings - Investment Grade” includes those counterparties that are internally rated as investment grade in accordance with the guidelines established in the Company’s credit policy. (b) The Net Credit Risk Exposure is the net credit exposure to PNM from its Wholesale Operations. This includes long-term contracts, forward sales and short-term sales. The exposure captures the net amounts due to PNM from receivables/payables for realized transactions, delivered and unbilled revenues, and mark-to-market gains/losses (pursuant to contract terms). Exposures are offset according to legally binding netting arrangements and reduced by credit collateral. Credit collateral includes cash deposits, letters of credit and performance bonds received from counterparties. Amounts are presented before those reserves that are determined on a portfolio basis. LESS THAN TOTAL NET RATING 2 YEARS 2-5 YEARS EXPOSURE (In thousands) (In thousands) (In thousands) Investment grade $ 34,795)% $ 12,004)% $ 46,799)% Non-investment grade 162)% –)% 162)% Split rating 43)% –)% 43)% Internal ratings Investment grade 71)% –)% 71)% Non-investment grade 18,678)% 18,678)% TOTAL $ 53,749 )% $ 12,004)% $ 65,753)% NET CREDIT NUMBER OF NET EXPOSURE OF RATING (A) RISK EXPOSURE (B) COUNTER-PARTIES >10% COUNTER-PARTIES >10% (Dollars in thousands) (Dollars in thousands) Investment grade $ 46,799)% 2)% $23,536)% Non-investment grade 162)% –)% –)% Split rating 43)% –)% –)% Internal ratings Investment grade 71)% –)% –)% Non-investment grade 18,678)% 1)% 7,055)% TOTAL $ 65,753 )% $30,591)% PNM hedges certain portions of natural gas supply contracts in order to protect its retail customers from adverse price fluctuations in the natural gas market. The financial impact of all hedge gains and losses, including the related costs of the program, is recoverable through the purchased gas adjustment clause. As a result, earnings are not affected by gains and losses generated by these instruments. As of December 31, 2003 the Company had liquidated its investment portfolio of fixed-rate government obligations and corporate securities.  PNM has long-term debt which subjects it to the risk of loss associated with movements in market interest rates. The majority of the Company’s long-term debt is fixed-rate debt, and therefore, does not expose the Company’s earnings to a major risk of loss due to adverse changes in market interest rates. However, the fair value of all long-term debt instruments would increase by approximately 3.25% or $33.2 million if interest rates were to decline by 50 basis points from their levels at December 31, 2003. As of December 31, 2003, the fair value of PNM’s long-term debt was $1,029 million as compared to a book-value of $987 million. In general, an increase in fair value would impact earnings and cash flows if PNM were to re-acquire all or a portion of its debt instruments in the open market prior to their maturity. During the twelve months ended December 31, 2003, PNM contributed cash of $20.0 million and approximately $28.9 million in Holding Company common shares for plan year 2002 and 2003 to the trust for the Company’s pension plan. In addition, the Company contributed cash of approximately $6.2 million to other post retirement benefits for plan year 2003. The securities held by the trusts had an estimated fair value of $563.7 million as of December 31, 2003, of which approximately 29% were fixed-rate debt securities that subject the Company to risk of loss of fair value with movements in market interest rates. If rates were to increase by 50 basis points from their levels at December 31, 2003, the decrease in the fair value of the securities would be 2.8% or $4.6 million. PNM does not currently recover or return through rates any losses or gains on these securities. The Company, therefore, is at risk for shortfalls in its funding of its obligations due to investment losses. The Company does not believe that long-term market returns over the period of funding will be less than required for the Company to meet its obligations. However, this belief is based on assumptions about future returns that are inherently uncertain. PNM contributes to trusts established to fund its share of the decommissioning costs of PVNGS and pension and other post-retirement benefits. The trusts hold certain equity securities as of December 31, 2003. These equity securities also expose the Company to losses in fair value. Approximately 63% of the securities held by the various trusts were equity securities as of December 31, 2003. The Company is currently implementing a change in the asset allocation in the pension portfolio, which will reduce the domestic equity exposure from 55% to 47.5%. Similar to the debt securities held for funding decommissioning and certain pension and other post-retirement costs, PNM does not recover or earn a return through rates on any losses or gains on these equity securities.  In 2001, the Company implemented an enhanced cash management strategy using derivative instruments based on the S&P 100, S&P 500, and Nasdaq composite indices. The strategy is designed to capitalize on high market volatility or benefit from market direction. An investment manager is utilized to execute the program. The risk related to the program is carefully managed by the RMC and has VAR and stop-loss limits established. Trades are typically closed-out before the end of a reporting period and within the same day of execution. In January 2004, the Company terminated the use of this derivative trading strategy for the enhanced cash management program. 41