Low freight rates have been a concern for a great number of reasons and to a wide range of market participants: low freight rates entail weak cash flows for the shipowners who cannot perform on their loans and causing problems for the shipping lenders; investors in shipping having experienced poor returns on their investments contemplating asset sales and leading even lower asset prices; shipbuilders facing a great deal of slippage and defaults on existing newbuilding orders while demand for additional orders has vaporized; charterers and cargo owners have to be very careful that vessels chartered even in the spot market not only are seaworthy and commercially competitive, but also the shipowner is current with their financial obligations and there is no risk of seeing the vessel delayed or arrested and the cargo onboard not delivered on time; likewise, vendors to the shipping industry have to be experts with managing credit risk and keep their clients on a short leash (further curtailing market activity and their own business).
All the concerns mentioned above emanate from a single cause, a low freight market that radiates and affects every dimension of the shipping market. Despite the recent bounce in the dry bulk market, freight rates are still very low and at barely operating break-even levels. The freight markets have been too low and for too long, and shipowners, still in business, have had to dip deeply into their cash reserves or seen their equity overly diluted. There is little more aside in terms of cash reserves, funding from investors and financiers outside the industry, or for that matter, of patience.
Based on recent transactions and experience, now another concern has to be added to the long list springing from a weak freight market: moral hazard. Moral hazard in this case can be defined as the behavior where an owner is so much disengaged from reality as to act carelessly in reference to the asset and the parties with an interest in the asset. The most obvious example is when the owner’ economic interest in the asset is so minuscule that there is precious little to care about the asset.
There has been moral hazard in reference to financing and outstanding shipping loans. When the principal amount of the ship mortgage is materially higher than the present value of the vessel (and any hope of market recovery thereof), the shipowner has little incentive to make any effort to fulfill their obligations according to the loan agreement. There is very little hope that they will ever see their money back and thus little incentive to behave. Several owners we know had been making good, more or less, on their loans for the last couple of years in the hope of a market recovery. Two years later, having thrown good money after bad money, and reaching the bottom of their cash reserve piles, now they are barely inclined to keep performing. There have been cases of shipowners who have stopped paying interest and principal of their loans despite having the financial capacity to do so. They are better off with shipping loans in default than with performing loans. First, they reserve capital, which they can deploy to new clean-slate shipping investments and let the legacy transactions sink. Second, for loans in default, shipping banks seem keener to grand concessions to shipowners with non-performing loans while they seem to uphold ‘good’ shipowners at a much higher standard. Thus, it pays to be bad. Thirdly, there had been traditionally an unspoken law in shipping that for a borrower defaulting to a shipping bank, effectively they were ostracized for life by the ship banking community, thus a very high incentive to behave: not to borrow more than one could afford, and, even when things turned sour, to make every effort to see the lender to recover as much as possible of the principal outstanding. Now with several executives at shipping banks being corporate officers with little knowledge of or affection for shipping or with a great deal of shipping banks actively exiting shipping, there is no longer the self-watching ship banking community to ensure proper borrower behavior and thus, plenty of room for moral hazard. Sort of, ‘what they can do to me?’
There has been moral hazard in reference to the maintenance of the vessels as well. When the freight market is low, economizing by cutting on expenses is required to make do with less and ensure survival in a challenging market. First goes the ‘fat’ and then ‘discretionary spending’ (spare parts onboard the vessel is the classic case) and then laying off people ashore, and then keeping vessel maintenance only to the extent that the classification society requires in order to renew the certificates. Talking to inspectors boarding vessels on behalf of charterers, the technical quality of the vessels has become a concern; and, this concern is highly troubling for tankers and for oil companies given the level of liability in the event of an accident involving pollution. Talking to inspectors boarding vessels on behalf of the port state control (such as the US Coast Guard), there is real concern about vessels that have been under-maintained. Talking to inspectors boarding vessels on behalf of buyers of ships in the secondary market, there is lots of concern about vessels that have been neglected for too long. With the freight market too weak for too long and with many vessels afloat ‘depending on the kindness of strangers’, there is little incentive to do anything above the absolutely minimum required in terms of maintenance.
There has been moral hazard in reference to seafarers and the environment as well. There have been several stories recently in the trade press about seafarers getting abandoned, gone unpaid for months and malnourished, and even stories of vessels arrested due to outstanding crew wages. And, in a market place where the shipowner does not care much about the asset or the lender or the crew, it’s hard to envision how or why they would care much about anything else, such as the environment or adhering to sound navigational practices. Such is the risk of moral hazard.
There is no doubt that we are living through unique times in shipping; the present shipping crisis has been much more monstrous than others in the past. Examples of moral hazard is a known consequence of rapidly shifting economic structures and defaults (think of moral hazard in the subprime real estate in the US a few years ago). However, given that there is low expectation of a market recovery in the near future, issues arising from moral hazard will only get more complicated and perilous. After all, moral hazard in shipping can affect trade, human lives and the environment. When contemplating actions in shipping at present, one has to be cognizant of addressing alignment of interests and dissipation of moral hazard.
There is an anecdote of Shipowner A confiding to their friend, Shipowner B, that Shipping Bank X arrested four of their vessels. ‘Oh dear,’ replies Shipowner B, ‘I am so sorry to hear. And now, who is your best banking relationship?’ he asks, to which, Shipowner A dryly replies with relief: ‘I think I already told you, Bank X’!
As funny as the joke is, a market cannot function on such a basis.
The above article was originally published on The Maritime Executive website on August 30th, 2016, under the title: “Shipping’s Moral Hazard”. We are thankful to the Editors of The Maritime Executive for hosting our article.
An abbreviated version of the article suitable for the weekly market report was published on September 2, 2016 by BMTI in Germany, under the title: “Concerns About Moral Hazard in the Shipping Industry”. We are thankful to our friends at BMTI (a well respected dry bulk market data provider, with special focus on smaller tonnages and MPP vessels, and the short sea market) for hosting our article. For more info on BMTI and their services please click on the image of their homepage to the right!
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