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Fallout from the credit crunch

Fallout from the credit crunch. FEI Breakfast Seminar 3 December 2008. Current state of the capital markets FEI: Managing funding requirements. Stephen Lewis , CA , MBA Senior Vice-President Ernst & Young Orenda Corporate Finance Inc. 416-943-2659 Stephen.E.Lewis@ca.ey.com.

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Fallout from the credit crunch

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  1. Fallout from the credit crunch FEI Breakfast Seminar 3 December 2008

  2. Current state of the capital marketsFEI: Managing funding requirements Stephen Lewis, CA , MBA Senior Vice-PresidentErnst & Young Orenda Corporate Finance Inc. 416-943-2659Stephen.E.Lewis@ca.ey.com

  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

  4. Current market conditions – subprime impact

  5. Where we are today • 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 1Moody’s Economy.com

  6. 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

  7. 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

  8. 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

  9. 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

  10. Funding scarcity

  11. 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 Funding scarcity (cont’d)

  12. 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 Funding scarcity (cont’d)

  13. 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)

  14. Market stabilization – money market indicators

  15. 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: • Real estate values stabilize or increase • Rebound in home sales • Easing of credit • Decline in crude oil prices

  16. 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

  17. 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

  18. Market indicators (cont’d)

  19. 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% • 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

  20. Market indicators (cont’d)

  21. Market indicators (cont’d) • 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

  22. Market indicators (cont’d) • 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

  23. Market indicators (cont’d)

  24. Canadian perspective

  25. 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

  26. 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

  27. 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

  28. Availability of financing

  29. 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

  30. Availability of financing (cont’d) • Capital that may be made available for new funding has changed dramatically, as illustrated below:

  31. Availability of financing (cont’d) • 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

  32. Availability of financing (cont’d) • 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

  33. 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

  34. Treasury – focus onshort term liquidity

  35. 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

  36. 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: • Understand degree of counterparty risk • Review investment policy • Align maturities with requirements • Limit exposure to any single point in time • Ladder portfolio to reduce exposure to short term market dislocations

  37. 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

  38. Financing today –conclusion

  39. 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

  40. 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

  41. Taxes: Creating value andminimizing risk in turbulent times Grant Smith, Senior Manger Transaction Advisory Services Transaction Tax Ernst & Young LLP 613-598-4348 Grant.Smith@ca.ey.com Steve Landau, Partner Transaction Advisory Services Transaction Tax Ernst & Young LLP 416-943-2067 Steve.Landau@ca.ey.com

  42. Agenda • Tax perspective of the current economic conditions • Issues to consider • Tax strategies to preserve cash

  43. 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

  44. What is the impact to your business? Acquisitions Cash Divestments Tax function Current Market Conditions Accounting for tax Closures Structures Refinancing or Recaps

  45. 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

  46. 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

  47. 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

  48. 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

  49. 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

  50. 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

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