During the fourth quarter of 2008, the outlook for the dry bulk sector was looking bleak when the plummeting Baltic Exchange Dry Index (BDI) made the headlines.
In tandem with the BDI, steel production, the main driver of dry bulk shipments (Figure 1: Steel consumers and producers in 2009 (world market share in percentages)), fell sharply in 2009 (by 8.0 per cent). This brought total output down to 1,219.7 million tons (compared to 1,326.5 million tons in 2008). At the same time, world demand for steel contracted by 6.7 per cent in 2009, with the total volume standing at 1,124.3 million tons.29 Surprisingly, however, the dry bulk market, driven mainly by strong demand from China, did not perform as badly as expected, with volumes of iron ore, the key raw input material used for the production of steel performing particularly well20.
Figure 1: Steel consumers and producers in 2009 (world market share in percentages)
Tankers Market
Although the tanker shipping sector was hit by the economic crisis, owners and charterers did not smart under problems like other shipping sectors.
Demand for tankers is influenced by world oil demand and supply, which in turn is affected by factors such as international economic stability, geographic changes in oil production and consumption, price levels of oil, inventory policies of major oil trading companies and strategic policies of countries.
"The unprecedented global economic recession lead to a second consecutive year of decreased world oil demand (Figure 2: World Oil Demand in Million Barrels per day) which, coupled with considerable OPEC production cuts and large newbuilding inflows, created an air of uncertainty that pushed spot rates to levels near or below vessels' operating expenses."
In 2010, freight rates recovered on the back of stronger demand due to the global economic recovery, lower oil stocks, and inclement weather, but they are still below their historic averages. The spot market is the most volatile particularly for the larger vessels. In May 2010, the one-year time charter daily rate rose to $43,000 for VLCCs, $25,000 for Suezmaxes and $18,500 for Aframaxes. The average rates for 2009 were $39,600, $30,600 and $20,100 respectively and for 2008, $73,400, $47,200 and $35,800. The inflation adjusted 10-year average rates for these vessels are $52,500, $39,300 and $29,900 respectively. With daily vessel operating expenses at around $9,500 for a modern VLCC and $8,500 for modern Suezmaxes and $7,500 for modern Aframaxes, even at current freight levels, this leaves a healthy EBITDA margin 14.
Figure 2: World Oil Demand in Million Barrels per day
Containers Market
The global financial crisis and subsequent economic recession dented demand for consumer and manufactured goods, as well as for durables. As these goods are mainly carried by container, and as major importers, namely the United States and Europe, were badly hit by the recession, container trade received a major blow. Container traffic along the three major east-west container trade routes, namely the trans-Pacific, Asia-Europe, and the trans-Atlantic, was the most significantly affected, with volumes recording double-digit declines on some of the major legs (Figure 3: Estimated cargo flows on major East-West container trade routes, 2008-2009 and Figure 4: Global container trade, 1990-2010 (TEUs and annual percentage change)) In 2009, aggregate Asia-Europe volumes declined by 9.5 per cent, with the head haul segment from Asia to Europe contracting by 14.8 per cent. This contrasts significantly with the impressive annual growth rate of about 20.0 per cent recorded previously. Trade on the trans-Pacific route fell by 9.3 per cent, with peak leg volumes declining by 14.2 per cent. Trade between the United States and Europe slumped by 20.1 per cent, with volumes from the United States to Europe falling by 25.1 per cent. The transatlantic trade was badly hit by the combined effect of declining volumes, unsustainably low freight rates, and rising bunker costs. The difficulties faced by the container sector were also reflected in dramatically lower container freight rates and containership charter rates, which collapsed earnings for shipowners and caused a gap between the pre-2009 and post-2009 value of container ships 20..
Figure 3: Estimated cargo flows on major East-West container trade routes, 2008-2009
(millions of TEUs and annual percentage change)
Figure 4: Global container trade, 1990-2010 (TEUs and annual percentage change)
Figure 5: Indices for global container, tanker and major dry bulks volumes, 1990-2010
Therefore we can conclude that seaborne trade volumes were significantly impacted by the falling global demand that followed 2009's historical contractions in world GDP and merchandise trade (Figure 5: Indices for global container, tanker and major dry bulks volumes, 1990-2010). All shipping segments have been negatively affected, with the exception of the major dry bulks which showed more resilience due to China's robust demand for coal and iron ore.
In sum, the factors affect freight rates are the following:
Demand and Supply
Global economic situation
Vessels efficiency and capacity
Environmental (i.e weather)
Stock levels
Transportation routes and distance
Oil prices
Geographical changes of oil production
Vessels operating costs
Developing economies
Financing Vessels' Acquisitions
The factors that influence financing of ship acquisition are the following:
Shipping Market dynamics: When market is on the peak stage ordering ships is a bad business as the ship prices are very high.
Freight rate dynamics: When freight rate rise or fall the changing sentiment ripples through into the sale and purchase market and from there into the new building market.
Supply & Demand: When demand exceeds supply there is a need of more vessels to be purchased.
Furthermore the following factors affect ship financing evaluation and selection 19:
Net present value (NPV): To compare financing schemes, the shipowner performs NPV calculations for each alternative, discounting the cash outflow required to pay interest and debt amortization at a rate that reflects the cost of capital or opportunity costs (the rate of return available through other investments). The shipowner will usually consider the alternative with the lowest NPV to be the most favorable. Typically, the lowest NPV is associated with financing that allows the shipowner to borrow the greatest percentage of the price, to be repaid over the longest period of time, at the lowest available interest rate and origination cost. While at first glance the alternative with the lowest NPV is the best, there are other considerations. Beyond price and delivery, they include interest during construction, owner's supervision and plan review, attendant legal and underwriting costs, and other expenses included in the owner's total acquisition cost (capitalized cost).
Cash flow: Cash flow considerations can lead a shipowner to select a financing scheme that does not have the lowest NPV. For example, if all debt repayments are delayed for three years, the shipowner may prefer this alternative (particularly if buying in a "down market"), even though total payments will be greater over time. The owner will consider manner of debt amortization, whether in equal annual principal amounts; "level debt" payments (like a typical home mortgage); or low amortization in the early years with a "balloon" payment at the end of the financing term.
There are many factors that influence the prospect of cash flows in ship operations, among which the following are considered most important 18:
(a) Level of freight rate and quantity of cargo lifted;
(b) Ship acquisition price;
(c) Terms and conditions of ship finance:
(i) Interest rate
(ii) Loan repayment period
(iii) Maximum loan coverage
(iv) Grace period of loan
Collateral requirements: The collateral required of the shipowner by the lender will also be a major consideration in evaluating financing alternatives. One lender might require detailed financial information on all the owners of a vessel and personal as well as extensive corporate assurances or guarantees. Assignment of revenue streams from charters or other vessel-employment arrangements might also be required. Another lender may be satisfied simply with the ship as collateral for the loan, with few additional requirements. The potential variations and permutations are endless and play an important part in the shipowner's evaluation process.
Shipping Market Influences on Shipping Finance
Shipping market is divided into many different sectors and is characterized by cyclicality. Cycles play a central part in the finance of the shipping industry by managing the risk of shipping investment in a business where there is a great uncertainty about the future. The most important feature of the Shipping market characteristics is that for much of the time it is far too unpredictable to provide bankers or anyone else with much guidance on the future earnings or the collateral value of the vessels they finance. The unpredictability of shipping revenues resulting in falling asset values impacts on the creditworthiness of the industry in general. The shipping cycles have the following characteristics 15 & 17:
Stage 1: Trough - characterized by shipping capacity surplus, freight rates fall to operating costs, lack of liquidity, sell vessels at distress prices, old vessels price fall to scrap prices, demolition increased, low freights and tight credits create negative net cash flow.
Stage 2: Recovery - characterized by increase of supply and demand, freight rates increase above operating costs, liquidity improves and second hand prices increase.
Stage 3: Peak/Plateau - characterized by tight balance of supply and demand, freight rates are high two or three times above operating costs, owners become very liquid, banks are keen to lend, second hand prices increase and shipbuilding order book expands.
Stage 4: Collapse - characterized by collapse of the market as supply overtake demand, spot ships build up in key ports, freight rates fall, liquidity remains high, sentiment is confused changing with each rally in rates.
The above characteristics are a financial switchbox that regulates investment. Therefore as banks have to secure its investment they have to consider the following risks coming from the characteristics of the Shipping market cycles mentioned above 3:
Market risk: Shipping markets cycles vary unpredictable in length and severity which affects company's ability to meet obligations and the value of collateral.
Operating risk: Failure to comply with regulations as well as technical problems may be lead the ship off hire or port detention creating problems with the classification society and insurance.
Counterparty risk: Charterers creditworthiness must be considered.
Competitive risk: Competition environment may be affect company's financial performance.
Diversification risk: Diversification reduces risks if the sector cycles are not correlated and specialization increases it.
Ship size and age risk: New ships carry a high capital costs and are vulnerable to changes in capital costs. In contrast old ships face lower capital costs and are vulnerable to operating, repair and regulatory costs.
Financial Structure: Debt must be services according to market circumstances.
BANKING PRODUCTS FOR SHIP ACQUISITION (Part 2)
1The main methods of raising ship finance include private funds, bank loans, the capital markets and special purpose companies SPCs. However bank loans are a major source of finance for ship-owners and shipping companies, offering the following four main products:
Mortgage loans secured against the ship: Mortgage loans may be lower priced than other forms of borrowing because the value of the ship reduces risk for the lender. The flexibility of interest rates also adds to the benefits of mortgage loans. Here, the interest rates may be fixed for the life of the loan or can be changed at certain predefined periods. The amount paid per period and the frequency of payments, in some cases, the amount paid per period may change or the borrower may have the option to increase or decrease the amount paid.
The repayments may depend on locality, tax laws and prevailing culture. Another important thing is that during our interest only period, our entire monthly payment is tax deductible. However for large shipping companies, borrowing against individual ships is inconvenient because any change in the fleet creates a time consuming loan transaction. For this reason I believe that mortgage loans are not addressed to large companies with well established financial structure that often prefer to borrow using their corporate balance sheet as collateral. In other word they prefer a corporate loan.
Corporate loans secured against the company balance sheet in order to eliminate repayment stability risks. This kind of loans has three limitations.Fistly Banks advance limited amounts so large loans must be syndicated amongst a group of Banks. Managing large syndications is difficult when shipping market is poor. Furthermore loans are usually restricted to 5-7 years and an advance rate of 70-80% both of which are limiting. 2
Shipyard credit is another way of raising capital through debt, which is provided direct by the shipyards or governments by offering guarantees or even interest rate subsidies. Obtaining government guarantees gives the ship-owner the ability to raise capital through a commercial bank, which will use the guarantee for securitization. From the shipyard perpective this kind of guarantees with favorable terms comparing to market standards is a big advantage for the shipyard as it can attract more market segments. Furthermore the subsidization of interest rate has been used to recoup for the difference between the fixed agreed rate on the law and the current market rate. However such financial schemes have been under dispute and will be abandoned in case of agreement upon the terms of OECD (Organization for Economic Co-operation and Development) on Export Credit of Ships.12
Mezzanine finance can close the gap between debt and equity and describes the level of capital between senior debt and equity. However mezzanine finance provides an expansive layer of subordinated debt, operating cash flow from vessels may often be insuffecient to provide adequate coverage of both senior and subordinated charges, thus endangering the whole project. Therefore i believe that Mezzanine financing does not have the potential of seriously taking a big crunch out of the mortgage-based loan share, since it is seen as an expensive option for the ship-owner and a high risk one for the banks.12
Private placement is funding acquired by selling securities directly to a small number of private investors, usually institutional investors such as banks, insurance companies and pension funds. Private placements are the most widely used and diverse means of raising capital. They are used by all types and sizes of entities ranging from small startups to large international companies in need of business funding sources. In today's economic climate there are fewer business funding sources through the shipping market. Using a big bank to fund our project may leave us mid-project and out of funds. Private placement allows borrowers to forgo the shipping market all together by tapping into the private investors market. Private placement is regulated, no-fuss, and low key. In a time where funding seems to be drying up, private placement on a variety of financial instruments keeps commercial funding alive and moving ahead.11
The Institutions offer the above mentioned products are the following:
Commercial Banks offer mortgage loans and corporate loans. Commercial Banks' loan policies contain a uniformity regarding their strategic approach. Commercial Banks secure their investment by securing the ship or the company's balance sheet. In case the borrower does not have any money for the repayment of the loan then Commercial bank follow the relative jurisdiction for the arrestment of the ship or any property belongs to the borrower. Eliminating potential risks the bank has to secure its investment as well as its clients liquidity and trustworthiness.
Investment Banks do not provide capital themselves. They arrange loan syndications, public offerings of equity, bond issues in the capital market, and the prívate placement of debt or equity with financial institutions or prívate investors.
Governments, Shipyards and State-owned agencies offer shipbuilding credit through guarantees, public offering or interest rates subsidies that help the borrower to raise his capital with a debt offering good terms and a fixed rate from a third party financial institution or a bank.
OTHER SOURCES FOR SHIPPING FINANCE (Part 3)
Ships' Leasing Business
Leasing is another method of ship financing. It is a 100% financing method, which is strong relief to the ship-owner, especially on high ship-price time. Leasing ships by financing is the internationally adopted mode of ship financing. It is a financing behavior of shipping enterprises to lease ships by financing from leasing companies, credit companies and other professional institutions, pay rents regularly and financially occupy the ownership of ships. It can significantly promote the development of shipping enterprises and the ship industry, and improve the situation where the ship industry, especially the ship export, depends severely on the national policy credit capital. However, the operation of the ship financial leasing business needs professional institutions and the support of relevant policies. 6 A straightforward leasing structure would be set up as follows: The ship is sold by the shipping company to a bank and leased back from the bank under a long-term agreement which gives the former owner control over the operation of the asset. Title to the vessel is vested in the bank or may be in a separate special purpose vehicle. The bank benefits by taking tax advantages in its home jurisdiction. 2
Leasing structures vary depending on the complexity of the deal and are primarily tax driven.
Tax allowances is the most important aspect in a lease scheme. A ship-owner repaying a loan is taxed on the premium and allowed for in the interest charged by bank. Conversely, the lease payments are normally allowable in full for tax purposes. Even more, the asset does not appear in the balance sheet of the ship-owner. The lessor likewise enjoys tax allowance merits from depreciating expensive assets such a ship.4
However, as ship leasing benefits are related and depended from the leasing transactions law of each country different opportunities for tax evasive financing schemes have been developed in countries where tax regulations have allowed it. The key jurisdictions around the globe on that matter are United Kingdom, Japan, Germany, Norway and the United States. In all cases, the fundamental driving force behind these investment schemes is the sheltering of the personal tax liabilities for individual investors. 4
Such alternative investment vehicles are generally creatures of stronger markets, where the charterers feel comfortable locking in levels that are compensatory to owners, covering debt service, operating costs and providing a return on equity. For example Global Ship Lease (GSL) leased away its fleet of ships in 2007 and 2008 over long-term periods, locking in future revenue rates. As a result, despite the fact that the shipping industry has been hit hard and shipping rates have fallen industry-wide, GSL continues to turn in profits. This should continue, as no leases are set to expire until December of 2012, and even then only 2 of the company's 16 ships will need new contracts. The following chart (Figure 6: Number Of Lease Contracts Expiring By Year) illustrates how long the company's ships have been leased out for at guaranteed rates: 8
Figure 6: Number Of Lease Contracts Expiring By Year
Offset Leasing Running Costs
Leases are in essence paying rent for asset. But even though the asset is rented, the lessor will charge interest on outstanding balances. Lease interest is usually calculated by a simple interest formula and will not compound over the lease term. The lease payment (monthly, bimonthly or possibly quarterly) have to include the necessary interest. Also, since lease amounts have simple interest, there is rarely an advantage to paying off the lease amount early.
Business asset depreciates rapidly. The business must account for this depreciation immediately during the first year of the lease. The depreciation is a cost associated with acquiring the asset and reflects the lost collateral available to secure the lease amount. Business are able to deduct this depreciation on taxes over time but the lost value is a very real cost to the business.
Major capital asset leases involve delivery, and set up costs to get the asset operating. These costs may not be covered by the lease total and considered an additional charge to the business. Lessees should plan on having the necessary cash available prior to acquisition to pay these costs if not covered by the lease total. It should be possible, however, to negotiate a charge account with the vendor and paying the total amount over time. 9
However these running costs can be offset as the shipping company is in an advantageous position by receiving finance over a period in which it can reasonably calculate its cash flow through charter arrangements. Interest costs are reduced as tax benefits accruing to the bank can be reflected in the lease arrangements. Equally important is the fact that the shipping company does not own the ship and therefore the financing cost does not appear on its balance sheet and so the company's debt to equity ratio is not effected, largely giving the company greater borrowing power.2
Furthermore selected activities are outsourced to quality service providers by the lessor, in order to keep overheads low and allow the business to be readily scalable. A good example is GSL (Global Shipping Lease) that continue to outsource, under close supervision, the day-to-day technical management of its fleet to well-established ship managers with considerable expertise. This approach facilitates both the tailoring of ship management to the preferences of charterers and effective cost control and risk management. GSL's initial charterer is CMA CGM, which is the third largest liner shipping company in the world. GSL intends to selectively expand its customer base over time, capitalizing on the industry expertise and extensive relationship network of its management team and Board of Directors. GSL has predictable cash flows due to its long-term contracts. In its SEC filings the company fully discloses the length of each charter contract, as well as the amount they are paid on a daily basis for chartering each ship. The company's expenses are relatively easy to gauge if not handicap, too, since GSL actually outsources "ship management" to a division of CMA CGM.13
Finally I believe that a negotiation between lessee and lessor is needed prior to a leasing agreement in order for both parties to secure their investment.
The Concept of Securitization
In a world where the absolute sizes of shipping portfolios are growing, and where banks are increasingly focused on levels of risk based reserve capital, the ability to create liquidity and transfer risk (that otherwise would stay with mainstay industry funding sources) is a useful addition to the bankers' toolkits.1
Securitization programs are innovative financing vehicles. Securitization involves the conversion of a cash flow from a portfolio of assets into a security (usually a debt instrument) which is then sold to investors secured on the underlying assets of the issuer, and is often combined with some form of credit enhancement. Some of the benefits of securitization include off-balance sheet financing, which is an inexpensive means of raising funds, access to a broader investor base, a reduction in interest rates, and securing the transaction from the potential bankruptcy of the originator.2
Securitization works best where there is a large pool of assets with similar risk/reward profiles. It is possible to structure a ship financing package whereby a portfolio of assets i.e. receivables from a long-term charter, is sold to a special purpose company owned by a special purpose trust. The issuer of the debt instruments will have the advantage of being situated in a jurisdiction known to institutional investors around the world. Law allows for 'purpose' trusts to hold assets for a commercial purpose. This takes the asset off the balance sheet of the originator, and renders it bankruptcy remote. This can make a multi-jurisdictional transaction less tax onerous and is often used in the financing of substantial capital assets. Also, a purpose trust can be used for the "securitization" of assets from other jurisdictions.2
Under, the Basel II Accord, banks can get "economic capital relief" when loans are placed into a qualifying securitization structure, meaning that banks may exclude risk exposure from calculations of economic capital, if a portfolio has been securitized. From an industry wide perspective, the liquidity aspect of the securitization process is paramount. 1
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