Containing financial contagion

by Peter Hatges
Illustration: Gérard DuBois

In the past year financial ills have swept the global markets and Canadian businesses are not immune. Here are solutions on how to get ahead of the curve

These days the conversation in many business meetings invariably ends up focusing on the economy, the crisis in the financial markets and, of course, the debt derivatives capital markets. While those who make their living — or, more appropriately, made their living — in those specific markets might have a clearer view of what happened, for the average Canadian, the picture is as opaque as some of the financial instruments that were the catalyst behind this financial crisis. However, what is clear to all is that the problems spread with unbelievable speed through the world’s banking system and in a matter of months, a significant portion of the financial services industry in the US was reshaped in a classic case of financial contagion.

Financial contagion, when one country’s economy is negatively affected because of changes in the asset prices of another country’s financial market, is not a new phenomenon (take for example the Asian crisis in the late ’90s), but Canadians have never experienced it to the extent that it is being felt today. The global impact from the US subprime mortgage crisis will likely be remembered as one of the most unique periods in the modern history of finance, given the prevalence of securitization vehicles and conduits that have had a significant impact on bank liquidity over the past 10 years.

In the past 12 months, global financial markets experienced a significant contraction in debt markets and a precipitous decline in equity markets. Practically every major economy has been impacted and Canada has not been immune. Unfortunately, the difficulties in the financial markets come at a time when the global economy is slowing down. Industries such as auto, pulp and paper, manufacturing generally and retail are facing extremely difficult market conditions, and a decline in consumer spending will have worldwide implications. It would be misguided optimism to assume that this economic cycle will have a modest impact on business. Robert Zoellick, president of the World Bank, recently warned that “all countries are moving into a danger zone.” He is right, but as history shows, financial cycles will eventually reverse themselves. Unfortunately, for some companies, the current economic crisis will have a permanent and irreversible negative impact because of their lack of preparedness and failure to respond to the problems quickly. But for companies that plan ahead, this period can mean some unique opportunities.

BEHIND THE CURRENT PROBLEM

Banking and credit lending have gone through significant changes over the past 20 years. One of the most notable changes is that a growing proportion of bank-originated loans are sold off into securitization vehicles to investors. If securitization vehicles stop functioning properly, debt availability is effectively reduced.

A wide variety of investment vehicles have been developed to accomplish loan securitizations, including asset-backed commercial paper, mortgage-backed securities, collateralized loan obligations, collateralized debt obligations, and a myriad of other variations. Trillions of dollars in loans have been securitized into these vehicles, allowing banks to reduce their regulatory capital requirements and manage their exposure to any given borrower. This market of loan securitization is often referred to as the secondary market and in many ways it’s a system behind the primary market, or the bank lending system as we know it. The secondary market is very big; so much so that when it is disrupted, the primary market feels it, as it does now.

Over time, the complexity of loan securitizations increased, making the investment vehicles more difficult to understand. One of the most complex investment vehicles is collateralized debt obligation (CDO) conduit, first issued in 1987 by Drexel Burnham Lambert Inc., one of the originators of the 1970s junk bond market. A CDO is a structured, unregulated investment that packages loans largely originated by banks. Once packaged, the CDO is split into pieces, or tranches, based on the credit rating of each piece, giving investors the opportunity to obtain better than market interest rates offered by traditional securities, depending on the tranche they invest in. Investors in CDOs include a variety of financial institutions ranging from hedge funds and mutual funds to insurance companies and for some tranches of CDOs, even wealthy individuals. CDOs typically contain a variety of loans, including tranches of residential mortgage securitizations, commercial mortgages, project loans, commercial loans, pieces of collateralized loan obligations and sometimes whole residential mortgages.

There are also CDOs squared and CDOs cubed (CDOs made from CDOs), and synthetic CDOs, which are constructed from the cash flows of credit default swaps written as credit enhancement, or insurance, for portfolios of fixed income assets. Structures can vary significantly because the mix of assets is specific to each conduit and assets are not necessarily homogeneous. Despite the evolving complexity, up until the second quarter of 2007, the global CDO market seemed to be functioning at a record pace.

According to data summarized by the Securities Industry and Financial Markets Association, in 2007, approximately US$503 billion in CDOs were issued globally. Between 2004 and 2007, there was almost US$1.5 trillion in global CDO market issuance alone.

As problems started to surface in the US subprime mortgages that formed part of CDOs, coupled with other problems in asset-backed commercial paper, investors in CDOs and other securitization vehicles lost confidence and many stopped investing. As a result, new CDO issuance slowed to a trickle in 2008. GlobalCDO issuance is set forth in the chart above.

IMPACT OF SECONDARY MARKET DISRUPTION

When the amount of available debt capital is reduced, the weighted average cost of capital for corporate borrowers goes up. This condition tends to curtail growth and spending and has a predictable impact on merger and acquisition activity. Set forth in the chart on page 31 is a summary of loan volume used by financial sponsors, such as private equity firms, in financing transactions. The trend in sponsored loan volumes follows a pattern very similar to that of CDO volumes.

Currently, the secondary debt market has provided cash-rich institutions with some outstanding buying opportunities as hedge funds and other investors try to cope with redemptions and a general lack of available capital. As the investors in the existing CDOs and other conduits get pressed for cash, they redeem their investment units in their various conduits. The managers of the conduits generally have no other choice but to sell the underlying debt instruments and flood the market. In some cases, even interest rate spreads on debt obligations that were highly rated have widened to phenomenal levels. Buyers are able to snap up quality debt issues at discounts on par value ranging from 10% to 40%, resulting in double digit effective rates of interest. On the face of it, those are good deals. But that spells trouble for the current primary debt markets, the lending market as most Canadian business knows it. The fact is, there are better deals in the secondary market and that chokes off available capital to the primary market.

Predictably, credit spreads have begun to widen in step with increases in the banks’ cost of capital for many corporate borrowers. Currently, credit spreads on Canadian senior bank debt are approximately 400 basis points over the London interbank offer rates (the interest rate the banks charge each other for loans). US senior bank debt spreads are as high as 600 basis points or more. Loans that experience events of default, regardless of how minor, are likely to be repriced upward at the earliest opportunity.

Pricing is not the only change afoot in the debt markets. Bank covenants and lending ratios are becoming more conservative, resulting in potentially far-reaching implications for the capital structure of many companies. This could have a significant impact on balance sheets and it is reasonable to assume that the result will be seen in a sharp up-tick in restructurings and balance sheet reorganizations required to facilitate new or replacement debt capital.

To cope with the problems and opportunities that arise from tight credit markets and a slowing global economy, Canadian businesses will need to think differently.

Previous recessions were, in part, responses to bouts of inflation curtailed by high interest rates and expensive credit. This time the problems in the debt capital markets are different.

Getting ahead of the curve will require creative thinking. Credit markets are not closed, but a certain amount of deleveraging has been imposed on the market and, ultimately, that translates into less available debt capital for companies. Because of that, lower base interest rates will not necessarily turn into a lower weighted average cost of capital.

There are a number of key initiatives that corporate borrowers need to undertake in such credit markets and periods of declining economic activity to ensure they are prepared for the changes that are going to impact their borrowing capacity and business.

Undertake a review of your capital structure and scheduled debt maturities. If you anticipate problems, be prepared to have constructive in-depth discussions with your key lenders and stakeholders. Take the initiative as soon as possible and give consideration to informal and formal restructuring alternatives.
Review the potential deferment of certain capital spending or other discretionary spending and look for ways to monetize your redundant, or nonoperating, assets.
Take a critical look at your underperforming divisions with excess capacity. Mitigating losses by closing or rendering a division idle is as significant as realizing cash on the sale of assets and it will alleviate pressure on a company’s bank covenants.
Consider your working capital requirements and the ratios that might be required in the new credit environment. Canadian business should anticipate that certain bank covenants will be more restrictive on renewals. Look for opportunities to reduce overall financing requirements by managing inventory hold levels downward.
Review your current syndicated loan facilities as new bank participants may be needed in order to maintain credit availability and pricing at manageable levels. This will be difficult without a thorough canvassing of the market.
Consider asset-based lending as a viable alternative that might free up additional collateral and alleviate covenant pressure, particularly in economic cycles where your earnings are likely to decrease. Earnings-based covenants, such as debt-to-EBITDA, are going to be tested frequently over the next 12 months and potentially breached.
Be prepared to re-evaluate the amount of equity capital and subordinated debt capital employed in the business, as the amount of available debt is limited. This is a difficult area CEOs and owner/managers will have to tackle because of the potential for the dilution of existing shareholder interests. But a dilution in ownership is far better than an extinguishment of ownership.
If you plan to take advantage of a buying opportunity, make sure you have enough financial and management capacity to withstand a prolonged downturn. Undertake enough due diligence to understand the pre- and post-merger integration risks. Understand that the quantum of debt that may have been available in the past to finance acquisitions likely will not be available. CEOs need to be prepared to complete acquisitions with a higher proportion of equity. This makes it even more important to integrate the new business and achieve the desired synergistic benefits quickly.

Bank debt capital is available, but it is scarce and companies that will be successful in obtaining new debt will have a well-supported business case for the use of debt proceeds, or loans. Just as importantly, they will be perceived to be well-enough positioned to withstand an unpredictable downturn in economic activity.

Loans of $35 million or less will be easier to get than larger ones that would typically attract bank syndication or securitization. For companies in industries facing difficulties, pending economic problems are going to pose even more challenges. When managing working capital downward and realizing on redundant assets is not enough, broader alternatives need to be considered.

As if the credit crisis wasn’t enough, North American companies are facing a year of compounding problems. The auto industry, for example, has an enormous impact on the North American economy and is facing significantly lower sales and a variety of structural challenges. Changes in that industry will have an overarching impact on a variety of auto-parts manufacturers. Auto-industry participants are considering potential mergers. In the US, airlines such as Delta and Northwest and financial institutions such as Wells Fargo and Wachovia have completed mergers as a way to deal with financial and market challenges and have positioned themselves to withstand an economic downturn.

This is where a cashless merger solution may be a viable course for many companies. Although mergers are rarely purely cashless and are not a panacea, a combination of businesses through an exchange of shares can be completed in down markets without declining equity values or scarce debt capital standing in the way of a good business decision. If anything, it may be the best available alternative in today’s environment. In some cases, because of current economic and financial pressures, a merger may result in a business combination that would have been almost impossible to negotiate in stronger markets. And it just may result in the creation of this century’s most successful companies.

One of the biggest hurdles in a merger is the exchange ratio — how share ownership looks after businesses are combined. But in these markets, the significant decline in equity values across the board and the common increases in the weighted cost of capital experienced by virtually all companies make the exchange-ratio issue easier to deal with. Acquisitions with a view to obtaining absolute control are difficult in today’s market without significant cash resources by the acquirer. But mergers that make strategic sense and have the potential to generate operating synergies and facilitate diversification are one real remaining option for firms facing challenges. And such mergers don’t require a lot of debt.

Canadian business shouldn’t count private equity out at this point either. Good businesses that have too much bank debt may find private equity groups willing to correct the problem. Of course, new equity will likely result in dilution or more expensive capital. But it will also be patient capital and may be one of the few options available in the capital markets. In some instances, private-equity capital may be more willing to fund a well-thought-out merger than a stand-alone business. Most importantly, private-equity capital will be more inclined to co-invest with companies that can understand where the buying opportunities are and are able to realize the synergies that financial buyers can’t access.

The lost opportunities will have, in some ways, as much of an impact as the restructuring and insolvencies that will arise. Canadian business is going to experience rapid-paced changes. Some companies are going to benefit from the changes and some will find themselves at a competitive disadvantage without even knowing it. If there was ever a time for Canadian business to get ahead of the curve — this is it. Acting now will pay big dividends later and will position Canadian businesses to weather the current financial contagion storm. Waiting for the cycle to inevitably reverse itself will not only be dangerous, it may be too late.

Peter Hatges is a partner, KPMG LLP, Toronto, and president and national service line leader, KPMG Corporate Finance Canada. He is also CAmagazine’s technical editor for Finance