Fallout from the credit crunch FEI Breakfast Seminar 3 December 2008

Fallout from the credit crunch

FEI Breakfast Seminar

3 December 2008

Current state of the capital marketsFEI: Managing funding requirements

Stephen Lewis, CA , MBASenior Vice-PresidentErnst & Young Orenda Corporate Finance [email protected]

3 December 2008 When the taps run dry: getting things done during a credit crunchPage 3

Table of contents

► Current Market Conditions – Subprime Impact► Market Stabilization – Money Market Indicators► Canadian Perspective► Availability of Financing► Treasury – Focus on Short Term Liquidity► Financing Today – Conclusion


Current market conditions – subprime impact


► Despite repeated efforts by Congress and the Federal Reserve, including the passing of the $700 billion bailout and the takeover of Fannie Mae and Freddie Mac and the reduction in the benchmark rate, the U.S. economy continues to slide towards recession ► Consumers face pressure to cut spending due to an uncertain

housing market and weak job market► Of the 75.5 million U.S. households that own their homes, 16%

owe more than their homes are worth1

► The International Monetary Fund states that the global economy is headed for a recession in 2009 and estimates losses from the financial crisis to be $1.4 trillion

Where we are today

1Moody’s Economy.com


Subprime related losses

► To date, financial institutions have incurred $966 billion of asset write-downs and credit losses - $708 billion are from over 100 of the world’s largest banks and securities firms

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

► The impact of the increasing defaults in the subprime market began to trickle into the financial services sector in late 2006 and early 2007► In July 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 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 CIBC and RBC have also had write-downs


Subprime’s impact on financial services (cont’d)

► As a result of these write-downs, lenders further tightened borrowing terms to preserve their remaining capital► Covenant lite loans disappeared while the use of PIKs became

heavily restricted

► The subprime crisis came to a dramatic head when the Federal Reserve facilitated the purchase of Bear Stearns by JP Morgan in the spring of 2008

► And credit markets, which began seizing up after BNP Paribas SA halted withdrawals on three funds in August 2007, froze after Lehman Brothers Holdings Inc. collapsed on September 15, 2008, negatively impacting lenders’ confidence of repayment


Funding scarcity

► The fallout of the credit crisis has been a scarcity of capital as the lender base continues to shrink and remaining banks look to governments for help in repairing their balance sheets

► U.S. loan issuance, particularly leveraged and investment grade loans, have significantly declined since the credit crunch took hold in the summer of 2007


Funding scarcity

U.S. Loan Issuance

$0

$100

$200

$300

$400

$500

$600

1Q

00

2Q

00

3Q

00

4Q

00

1Q

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3Q

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4Q

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1Q

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3Q

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4Q

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1Q

07

2Q

07

3Q

07

4Q

07

1Q

08

2Q

08

3Q

08

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 with loans available for purchase at just over 75 cents on the dollar

► As of October 2008, it appeared that the bailout had not stopped the downhill trend in bid prices

Historic Average Bid Prices

75

80

85

90

95

100

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

Avg

. bid

(% o

f par

)


Funding scarcity (cont’d)

► 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

U.S. and European Bid/Ask Spreads

0

50

100

150

200

250

300

Jan

-07

Feb

-07

Mar

-07

Apr

-07

May

-07

Jun

-07

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Nov

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Jun

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Jul

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-08

Bid

/ask

spr

ead

(bps

)

U.S. liquid loansEuropean liquid loans


Defaults in the global bond markets

► Moody’s is forecasting default rates to climb to 6.3% globally and 7.2% in the U.S.► The U.S. speculative grade default rate has also increased from

2.5% in Q208 to 3.4% in Q308 (it was 1.2% in Q307)

Number of U.S. Speculative Grade Defaults

0

1

2

3

4

5

6

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8

9

10

Jan

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Feb-

07

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Aug

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Sep

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Oct

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Nov

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Jan

-08

Feb-

08

Mar

-08

Apr

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May

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Jun

-08

Jul

-08

Aug

-08

Sep

-08


Market stabilization – money market indicators


Market stabilization

► Markets have not yet stabilized; credit markets are still tight

► According to Standard & Poor’s, the credit crunch will come to an end once four key economic and market variables are satisfied:

1. Real estate values stabilize or increase

2. Rebound in home sales

3. Easing of credit

4. Decline in crude oil prices


Market stabilization (cont’d)

► The October 2008 bankruptcy of Lehman Bros. had a major impact on credit and financial markets by escalating the severity of the crisis

► The significant steps taken by the U.S. government and governments worldwide will hopefully help restore confidence in the coming months


Market indicators

► Although LIBOR has come down significantly from its high of 4.81% on October 10, 2008, credit conditions remain tight► 3-month U.S. LIBOR is currently at levels not seen since October

2004► The cause for the decline is primarily due to the provision of

virtually unlimited funding from central banks as well as government offered bailouts and guarantees to financial institutions


Market indicators (cont’d)

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, 2008



► 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%

► The spread is currently just over 160 basis points► A narrowing of this spread to 25 basis points would be

positive, however forward markets indicate that this will not happen until the middle of 2010



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-08

Effective Federal Funds Rate

3-Month U.S. LIBOR



► The daily effective federal funds rate is a volume-weighted average of rates on trades arranged by major brokers and is calculated by the Federal Reserve Bank of New York

Federal Funds Effective 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-08

TECH BUBBLE LOW INTEREST RATES HOUSING BUBBLE SUBPRIME



► A key indicator of credit conditions is the LIBOR-OIS spread which compares the 3-month U.S. LIBOR rate and the overnight index swap (OIS) rate► A widening spread indicates that banks believe other banks to

which they are lending have a higher risk of default so they charge a higher interest rate to offset this risk

► The spread, currently around 170 bps, compares with 87 bps on the last trading day before Lehman declared bankruptcy, and an average of 11 bps in the five years prior to the financial crisis



LIBOR - OIS Spread

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

September

1, 2008

October 1,

2008

November

1, 2008

Rat

e

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

► The Canadian market has also been impacted by the U.S. financial crisis as evidenced by the widened spread between the 3-month Canadian T-bills and 3-month BAs in Q2 and Q3 of 2008

3-Month BAs over 3-Month Canadian Treasuries

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Jul

-07

Aug

-07

Sep

-07

Oct

-07

Nov

-07

Dec

-07

Jan

-08

Feb

-08

Mar

-08

Apr

-08

May

-08

Jun

-08

Jul

-08

Aug

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Sep

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Oct

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Nov

-08

Rat

e

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Spread

3-Month Treasuries

3-Month BAs

Spread


Canadian perspective (cont’d)

► On September 5th, Canadian banking executives met for roundtable discussions and the overall view is that the subprime mortgage crisis and credit crunch will significantly impact global banking► “The days of cheap money are over, and credit spreads across

the board have, and will continue to significantly increase the cost of financing.” – Gord Nixon, CEO, of Royal Bank of Canada

► “It needs to be determined which regulators will oversee financial companies in the U.S….that process could last a year or more” – Rick Waugh, CEO, Bank of Nova Scotia

► Overall, the banking industry is facing more transparency and scrutiny of their balance sheets and the expectation is that regulatory capital requirements will be increased


Canadian perspective (cont’d)

“Three major interrelated developments are having a profound impact on the Canadian economy. First, the intensification of the global financial crisis has led to severe strains in financial markets. The associated need for the global banking sector to continue to reduce leverage will restrain growth for some time. Second, the global economy appears to be heading into a mild recession, led by a U.S. economy already in recession. Third, there have been sharp declines in many commodity prices. The outlook for growth and inflation in Canada is now more uncertain than usual.”

- Bank of Canada press release dated October 21, 2008


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:► CIT► GMAC► Wachovia

► 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

► GE Capital► Deutsche Bank► ABN Amro / LaSalle


Availability of financing (cont’d)

► Capital that may be made available for new funding has changed dramatically, as illustrated below:

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%



► Lending is being governed by greater discipline as underwriting standards have become more stringent resulting in lower multiples, higher pricing and tighter covenants► The impact of the credit crunch to senior cash flow lending has

resulted in lower debt to EBITDA multiples which are currently in the 2.5 – 3.0x range with up to 1.5x incrementally available from mezzanine lenders

► Moreover, subjective “addbacks,” “adjustments” or “normalizing entries” to earnings are also coming under greater scrutiny



► Borrowers are being faced with increased due diligence from an ever shrinking base of lenders resulting in elongated deal timetables

► “Fully underwritten” transactions are history► Borrowers are being forced to piece together club deals to meet

capital needs


What can get done?

► Asset based loans are becoming increasingly attractive to certain borrowers► 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 onshort term liquidity


Treasury – focus on short term liquidity

► Current market dislocations require Treasurers to more closely focus on short term liquidity

► A more disciplined approach is in order► Stronger focus on quality of investments► Better understanding of organizations liquidity

requirements


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

► A portfolio approach to manage risk makes sense:► Understand the liabilities, i.e. the liquidity needs of the company► Measurement/forecasting needs to be done on a weekly if not daily

basis► Manage investments or borrowings to meet that liability stream

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

► Review investment policy

2. 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 of heavy reliance on debt ratings 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

► To obtain financing in today’s market, businesses need to be cognisant of the supply and demand constraints with which they are faced

► Transactions are subject to more 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

Taxes: Creating value andminimizing risk in turbulent times

Steve Landau, PartnerTransaction Advisory ServicesTransaction TaxErnst & Young [email protected]

Grant Smith, Senior MangerTransaction Advisory ServicesTransaction TaxErnst & Young [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 Capital Gains Exemption 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

► Tax Audit Management


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

► 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 resupply


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

► Redundancies► Maximize tax relief for costs and consider impact on share valuations

► 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► Consider US golden parachute provisions for any US executives► 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

Financial reporting implications of current market conditionsDeanna Monaghan, FCAManaging PartnerErnst & Young [email protected]


Fair value in financial reporting - the debate

► Debate about merits of fair value in financial reporting ► Contributed to the current credit crunch conditions► Or has the credit crisis highlighted the benefits of fair value in

financial reporting while exposing some of its limitations► Fair value measures necessarily reflect conditions at the balance

sheet date; they are not forecasts of future market prices► Nonetheless investors want current fair value information and that

transparency about fair values is important ► Implications

► Fair value in financial reporting is not going away► New guidance provided for making fair value estimates► Good modelling and scenario analysis capabilities are required

when active market prices do not exist► Critical to have disclosure of assumptions and sensitivities


Recent market events: accounting and reporting considerations

Valuation of investments► Measuring the fair values of certain asset classes has been

challenging in the current environment► The number of factors affecting an investments fair value can be

extensive ► Evidence supporting the fair value may not come from trading in

active primary or secondary markets► Valuation models should reflect assumptions that market

participants would use in pricing an asset in a current transaction (fair value is a current value and not a potential future value) and therefore should reflect current credit, interest, liquidity and risk premium conditions

► Inputs should be restricted to information available to market participants at the reporting date

► No forward looking perspective



► Valuation of Investments (cont’d)► IAS 39 Amendments – Reclassifications of financial assets

► Allowed to reclassify out of HFT or AFS in certain circumstances and intended to more closely align IAS 39 with US GAAP

► Distinguishes loans and receivables from other securities► Loans and receivables may be reclassified from HFT or AFS to loans and

receivables if intentions have changed such that► not held for the purpose of trading in the near term; and ► intention and ability to hold for the foreseeable future

► Other securities (excluding derivatives and those designated at FVTPL at inception) may be reclassified out of HFT into AFS or HTM “in rare circumstances”► IASB has indicated that current financial market conditions are such a

“rare circumstance”► Also must no longer be held for the purpose of trading in the near term

► Reclassification to take place at fair value► 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 Canadian Accounting Standards

► “Trading” securities are carried at fair value and changes in fair value are included in earnings.

► Reclassifications out of trading were not permitted – abuse of hindsight► Accounting Standards Board has introduced amendments to CICA 3855 in

response to the similar recent IAS 39 amendments► Permit reclassifications of securities (excluding derivatives and securities

designated as trading at inception) out of trading (to AFS or HTM)► “in rare circumstances” and► no longer held for the purpose of trading

► 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 to address them

► Processes and controls relating to the development of inputs and assumptions for the valuation of significant assets and liabilities

► Review of assets for recoverability or impairment► The need for external specialists (e.g. valuation or actuarial expert) to assist in

the determination of the recorded amounts of certain assets and liabilities► Processes and controls for monitoring compliance with covenants► Internal auditors should reconsider their current audit plans in light of any new

or increased risks facing the company► Potential changes to disclosure controls to ensure risks are identified and

disclosure obligations are met (financial statements and MD&A disclosures including market and liquidity risk, capital resources, material events, discussion of risk factors, significant estimates)



► 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► Sufficient taxable income must exist to support 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 ► Such cash transfers could have tax implications.



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

adjustments may be necessary► Current market conditions and corresponding effects on

spending may result in excess and obsolete inventories ► Financial condition of major customers could impair the

recoverability of inventory on hand► Valuation issues associated with returns from merchants and

leftover merchandise from the retail season► SEC staff has recently issued comments asking registrants how

they have determined that inventories are stated at a lower cost or market► Companies should disclose the manner in which lower of cost

or market is determined



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

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

based payment award► Modifications of share-based payment awards may result in

the recognition of additional compensation cost► 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


Q & A

Documents

Fallout from the credit crunch FEI Breakfast Seminar 3 December 2008