fallout from the credit crunch

Fallout from the credit crunch

FEI Breakfast Seminar

25 November 2008

Current state of the capital marketsManaging funding requirementsJoe HealeySenior Vice-PresidentErnst & Young Orenda Corporate Finance Inc.204 [email protected]

25 November 2008 When the taps run dry: getting things done during a credit crunch

Current market conditions – subprime impact


► The U.S. economy continues to slide towards recession ► Consumers continue to face enormous pressure to cut spending

due to an uncertain housing market and weak job market► 12 million, or 16% of US homeowners owe more than their homes

are worth► The IMF states that the global economy is headed for a

recession in 2009 and estimates losses from the financial crisis to be $1.4 trillion

► The Fed, ECB, BoC and 3 other central banks cut benchmark rates on October 8, 2008 – further cuts predicted

Where we are today


Subprime related losses

► Financial institutions have experienced $966 billion of asset write-downs and credit losses - $708 billion are from over 100 of the world’s largest banks and securities firms

► Approximately $828 billion has been raised to meet these losses

Worldwide Subprime-Related Losses to Date

$0

$200

$400

$600

$800

$1,000

$1,200

Losses Capital Raised Losses Capital Raised

Banks All Financial Institutions

U.S. Europe Asia


Subprime’s impact on financial services

► Increasing defaults in the subprime market trickled into the financial services sector in late 2006 and early 2007► Credit rating agencies began to downgrade certain mortgage

backed securities resulting in the evaporation of the subprime market

► Financial institutions were forced to write-down the book value of the securities held as assets on their books► Some of the highest losses have been incurred by U.S. banks such as

Citigroup ($68B), Merrill Lynch ($56B), UBS ($44B) and Wachovia ($97B)

► Canadian banks have also had writedowns


Funding scarcity

► The fallout of the credit crisis has been a scarcity of capital

U.S. Loan Issuance

$0

$100

$200

$300

$400

$500

$600

1Q00

2Q00

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4Q00

1Q01

2Q01

3Q01

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Leverage Investment Grade Other


Funding scarcity (cont’d)

► In the secondary market, the average bid for multi-quote term loans is at its lowest point ever at 75.44

► The bid/ask spreads for both U.S. and European loans also indicates lower levels of liquidity

► As of October 2008, spreads were 219 basis points in the U.S. and 266 basis points in Europe

Historic Average Bid Prices

75

80

85

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100

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Avg.

bid

(% o

f par

)

U.S. and European Bid/Ask Spreads

0

50

100

150

200

250

300

Jan-

07Fe

b-07

Mar

-07

Apr-0

7M

ay-0

7Ju

n-07

Jul-0

7Au

g-07

Sep-

07Oc

t-07

Nov-

07De

c-07

Jan-

08Fe

b-08

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-08

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ay-0

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08Oc

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Bid/

ask

spre

ad (b

ps)

U.S. liquid loansEuropean liquid loans


Market stabilization – money market indicators


Market stabilization

► Markets have not yet stabilized and the credit markets are still tight

► Standard & Poor’s predicts the credit crunch will end once four key economic and market variables are satisfied:1. Real estate values stabilize or increase2. Rebound in home sales3. Easing of credit4. Decline in crude oil prices


Market indicators

► Although LIBOR has come down significantly, credit conditions remain tight► 3-month U.S. LIBOR is currently at levels not seen since October 2004

3-Month U.S. LIBOR

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

September 1, 2008 October 1, 2008 November 1, 20083-Month U.S. LIBOR


Market indicators (cont’d)

► Prior to the credit crunch, the average spread between the 3-month U.S. LIBOR rate and the effective Federal funds rate was approximately 12 basis points

► On October 10th, 3-month U.S. LIBOR peaked at 4.82% representing a spread over the effective FFR of over 4.00%

LIBOR vs U.S. Federal Funds Rate

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-04 J an-05 J an-06 J an-07 J an-08Federal Funds Rate 3-Month LIBOR



Federal Funds Effective Rate

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

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7.00%

J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-04 J an-05 J an-06 J an-07 J an-08

TECH BUBBLE LOW INTEREST RATES HOUSING BUBBLE SUBPRIME CRISIS



► Widening LIBOR-OIS spread

LIBOR - OIS Spread

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

September1, 2008

October 1,2008

November1, 2008

Rate

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Spread

OIS Rate 3-Month LIBOR LIBOR spread over OIS


Canadian perspective


Canadian perspective

Source: Bank of Canada

3-Month BAs over 3-Month Canadian Treasuries

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

J ul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 J an-08 Feb-08 Mar-08 Apr-08 May-08 J un-08 J ul-08 Aug-08 Sep-08 Oct-08 Nov-08

Rate

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Spread

3-Month Treasury Bills 3-Month BAs Spread


Canadian perspective (cont’d)

► On September 5th, Canadian banking executives met for roundtable discussions ► The overall view is that the subprime mortgage crisis and credit crunch

will significantly impact global banking► Gord Nixon - “The days of cheap money are over, and credit spreads

across the board have, and will continue to significantly increase the cost of financing.”

► Rick Waugh - it needs to be determined which regulators will oversee financial companies in the U.S. and that process could last a year or more


Availability of financing


Availability of financing

► Credit markets in Canada are changing daily► Many international and U.S. institutions have pulled away from the

Canadian market or are in a state of uncertainty:► Remaining institutions may be “open for business” but there is

effectively no secondary market to syndicate or sell down exposure► Lending institutions are focused on optimizing the allocation of

scarce capital


Availability of financing (cont’d)

► Capital that may be made available for new funding has changed dramatically

Rate Rate EBITDAPre-Credit Crunch Post-Credit Crunch (Multiple)

Senior DebtTraditional / Asset Based Loans

Second LienLoans

Subordinated / MezzanineDebt

Equity < 20% > 25%

12% - 14% 3.0x - 4.0x

BA + 150bps 2.5x - 3.0x

BA + 500bps 3.0x - 4.0x

BA + 300bps

BA + 1,000bps

15% - 20%


Availability of financing (cont’d)

► Debt/EBITDA multiples have decreased significantly in the large corporate market (EBITDA > $50MM)

► Second lien loans have virtually disappeared

5.4x5.0x

4.6x4.2x 4.0x 4.0x 4.1x

4.3x 4.3x 4.4x4.9x

3.8x 3.7x

0x

4x

8x

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

1Q-3

Q083Q

08

FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA

Source: Standard & Poor’s, LPC

4.8x 4.6x4.1x 4.0x

3.8x 3.9x4.1x 4.3x 4.4x

4.8x4.3x

4.6x

3.6x

0x

4x

8x

FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA

Average Debt Multiples of Large Corporate Loans (EBITDA > $50M)

Average Debt Multiples of Middle Market Loans (EBITDA < $50M)


What can get done?

► Asset based loans are increasingly attractive► Loans > $30MM pose a syndication risk► Market flex risk on terms, structure, pricing, etc.► Spreads in the range of 300 bps

► Cashflow loans to borrowers of “strategic relevance” to lenders► Leverage < 3.0x► Industry specific► Sponsor makes deal “easier”► Spreads in the range of 400 bps


Treasury – focus on short term liquidity


Treasury – focus on short term liquidity

► A portfolio approach to manage risk► Understand the liquidity needs of the company► Measurement/forecasting on a timely basis► Actively manage investments or borrowings

► Manage portfolio to:1. Understand degree of counterparty risk

► Review investment policy2. Align maturities with requirements

► Limit exposure to any single point in time► Ladder portfolio to reduce exposure to short term market

dislocations


Treasury – focus on short term liquidity (cont’d)

► Manage counterparty risk► Traditional approach needs review► Additional due diligence required

► Clearly define goal of investment policy: income generation, or secure and efficient store of liquidity► Increase requirement for lower yielding but more secure

investments► Governments► BAs from Canadian chartered banks► Careful review of money market funds


Financing today – conclusion


Financing today – conclusion

► Be aware of the supply and demand constraints► Increased scrutiny and aggressive due diligence

requirements► The terms under which different lending institutions are

willing to lend may vary significantly► To succeed in this market, businesses must recognize

that the path to funding starts significantly ahead of the formal financing process


Financing today – conclusion (cont’d)

► Plan early to deal with debt maturities► Expect increased pricing and tighter covenants► Expect a reduction in unutilized credit availability/carve back of

acquisition and expenditure accommodations► In large syndicates, plan for fall-out of fringe participants

► Review short to mid-term capital needs and strive to preserve capital► Review working capital cycle► Capital expenditures► Sale of non-core/redundant assets

Financial reporting implications of current market conditionsMark SingleErnst & Young LLP204 [email protected]


Fair value in financial reporting - the debate

► Debate about merits of fair value in financial reporting ► Fair value measures necessarily reflect conditions at the balance

sheet date, they are not forecasts of future market prices► Investors want current fair value information and that transparency

about fair values is important ► Implications going forward


Recent market events: accounting and reporting considerations

Valuation of investments► Measuring fair values► Evidence supporting fair value may not come from trading► Valuation models should reflect assumptions that market

participants would use in pricing an asset in a current transaction► Inputs should be restricted to information available to market

participants at the reporting date► IAS 39 Amendments – Reclassifications of financial assets

► Effective date is July 1, 2008, entities can make transfers as of that date provided this aligns with intent as of that date

► Extensive disclosure requirements when reclassifications are made



► Valuation of Investments (cont’d)► CICA Amendments

► To be effective for reclassifications made on or after July 1, 2008 provided statements have not previously been issued

► Amendments implemented on emergency basis without public comment period

► Amendments posted to the CICA AcSB website



► Internal controls over financial reporting► Current market conditions have changed the nature and extent of

risks and the related internal and disclosure controls & procedures necessary

► Credit risk and derivatives► Non-performance risk (including credit risk) of both parties impacts

fair value► Recent events may have effected the credit worthiness of both

parties to a derivative instrument► Deterioration of a derivative counterparty’s credit worthiness or

company’s own creditworthiness can cause hedge ineffectiveness



► Impairment of depreciable long-lived assets► Impairment indicators are more likely to be prevalent, requiring

assets to be evaluated for impairment► Long-lived assets to be held and used are reviewed for

impairment and tested for impairment whenever impairment indicators are present► Due to the current economic environment, it may be more likely

that impairment indicators exists► Impairment must be considered at both interim and annual

reporting dates► When a long-lived asset is tested for recoverability, it may also be

necessary to review depreciation and amortization estimates and methods



► Impairment of goodwill and indefinite life intangible assets► Impairment test for goodwill and indefinite life intangible assets

may be required to be performed on more than an annual basis► Tests for impairment of goodwill are required between annual

tests if circumstances suggest it is more likely than not that the fair value is less than its carrying value

► Tests for impairment of indefinite life intangible assets are required between annual tests if circumstances indicate the asset might be impaired

► Current economic and market conditions increase the risk that impairment indicators exist



Income taxes► Losses in recent years must be considered in evaluating deferred

tax assets for realization► Cumulative losses or expectations of cumulative losses generally

indicate the need for valuation allowance► Appropriate disclosures should be made to support either the

absence or existence of the valuation allowance► Liquidity concerns may cause companies to consider repatriation

of earnings from foreign operations► Consider accounting impact vs. cash flow impact



Inventory► Excess or obsolete inventories and lower of cost or market

adjustments may be necessary► Valuation issues associated with returns from merchants and

leftover merchandise from the retail season► Companies should disclose the manner in which lower of cost or

market is determined► Assess impact of idle plant capacity on overhead allocations



Post retirement benefits► Current market conditions suggest that benefit plan accounting

expense and funding requirements will increase► Increased credit risk and reduced liquidity in the marketplace have

likely affected the fair value of plan assets used in determining funded status and resulted in experience losses

► These factors will also make it challenging to choose an appropriate discount rate

► Assumed returns on plan assets should reflect current expectations about long term rates of return



Debt► Compliance with provisions in covenants► Ability to refinance maturing debt► Classification of debt as long-term vs. current – impact of going

concern assessment

Share-based payments► Accounting impacts of modifying, cancelling or replacing a share-

based payment award► Impacts of equity restructuring on share-based payment awards



► Revenue recognition► Impact of any enhanced rights of return will require more attention

on estimating returns► Customer requests for extended payment terms could change the

timing of revenue recognition

► Disclosure requirements- Re-evaluate financial statement and MD&A disclosure around

interest, FX, credit and liquidity risks- Re-evaluate financial statement and MD&A disclosure around

capital management- Re-evaluate critical accounting estimates disclosures- Assess going concern based on current market conditions

Taxes: Creating Value and Minimizing Risk in Turbulent Times

Craig RoskosPartner, Tax Advisory ServicesErnst & Young LLP204 [email protected]


Agenda

► Tax perspective of the current economic conditions

► Issues to consider

► Tax strategies to preserve cash


Tax perspective of the current economic conditions

► The current economic climate is a crucial time to leverage tax opportunities to create and preserve value

► Tax strategies may need to shift in focus to:►Releasing cash►Reducing costs ►Efficient refinancing/restructuring


What is the impact to your business?

Accounting for tax

Structures

Cash

Tax functionDivestments

Acquisitions

Closures

Current market

conditions

Refinancing or Recaps


Cash [

► Converting tax assets to cash► Review capital and current expenditures► Utilization of losses ► Tax instalments, payments and refunds

► Realizing or securing tax benefits► SR&ED tax credits► Carry back of losses► Clearing out Capital Dividend Account before losses► Crystallize CGE while eligible


Cash [

► Deferral of Tax► Timing of recognition of profits► Capitalize new business ► Intellectual property planning

► Repatriation and Cross Border► Tax efficient repatriation of cash► Review existing transfer pricing and financing

structures


Cash

► Factoring receivables► Sale and lease back► Loss planning

► Crystallizing losses when required and preserving losses and adjusted cost base

► Accuracy of forecasts► Ensure tax assumptions reflect business

expectations in a downturn – can tax payments be deferred, are instalments correct


Cash

► Commodity taxes - Apply a variety of strategies to improve commodity taxes cash flow:

► Offsetting payroll remittances against GST/HST/QST refunds

► Accelerating GST/HST/QST input tax credit

► Have early billing date on transactions for GST/QST purposes

► For significant purchases with GST/HST/QST payable, use a legal entity that is in a net GST/QST payable position for the purchase (and re-supply)


Review of current structure

► Is the current group / tax structure optimal for the current downturn?

► Matching profits and losses► Reviewing tax structures for revised profit or loss forecast► Taxable reorganization of corporate group ► Revisit management compensation planning

► Transfer pricing► Determine if intercompany transactions are being created to deal with cash

shortages and to crystallize losses in certain jurisdictions► Review current practice to ensure compliance with transfer pricing rules

► International Assignment Policy► Review international assignment policies to introduce cost efficiencies► Social security tax agreements should be reviewed for employer tax

savings► Are there outstanding tax equalizations for assignees that should be

completed


Refinancing or recaps

► Refinancing► Debt/equity swaps – ensuring debt is not inadvertently

extinguished and taxed under debt forgiveness rules► Thin capitalization – determine how the position will change

subsequent to refinancing and changes in the balance sheet

► Acquisition of debt at a discount► Ensure undertaken in most tax efficient manner


Closures

► Closure costs► Maximize tax relief for costs e.g., which entity should incur the costs,

when costs are incurred

► Losses► Efficient utilization of losses and potential creation of losses as a result of

closures► Timing for merging of entities to optimize use of tax attributes

► Pensions► Maximize tax relief for contributions


Divestitures

► Preparation for exit► Tax efficient restructuring to package assets/companies for sale, including

elimination of intercompany debts► Maximizing value when selling companies with losses by preserving tax

attributes► Tax efficient exercise of incentive compensation plans

► Using an insolvency process to effect the sale of assets

► Tax planning to ensure divestitures are tax efficient► Creation of losses to offset gains on disposal► Any unrealized losses in the group that can be accessed?► Consider deferral mechanisms on sale such as capital gains reserves and

timing of sale


Q & A

fallout from the credit crunch

Documents