A Matter of Shipping Interest

Interest rates are on the rise. The Fed recently increased the so-called Fed Funds Rate by 0.25% and two more increases are boringly expected within 2018. There had been two increases in 2017 for a total of 0.50%, thus, in two calendar years, interest rates moved up by 1.25%. The Fed Funds Rate stands at 1.50% at the time of this writing, which is materially below the historic average. The 2yr Treasure Bill yields appr. 2.27% while 10yr Treasuries yield 2.80%, at the time of this writing.

In the short term, the US economy seems to be approaching full employment, and the risk of inflation (and higher interest rates) cannot be ignored. Of course, there are still many events, emanating both from the US and the international stage, that can affect economic growth, trade, employment, and the course of interest rates. Excluding a major shock to the system, it can be taken as a given that interest rates are on the rise for the foreseeable future.

Higher interest rates and higher interest cost can be good for regulated banks, but it can be detrimental to industries that depend on cheap financing to thrive. The shipping industry, we can all agree, is a capital intensive industry as it requires big investments upfront for the acquisition of shipping assets, and the cost of financing is crucial for the success of a shipowner.

Higher interest rates logically should be a negative development for the shipping industry: for higher cost of necessary leverage (ship mortgages) directly affects the bottom line – and, there are few shipowners who can do without leverage.

There have been few headlines in the shipping / maritime trade press about the higher interest rates. Not sure whether the news has been underestimated, or whether the shipping finance industry is so dislocated at present that rising interest rates are of little concern to the industry, but the subject has almost gone un-noticed.

Traditionally, debt financing in the shipping industry has been obtained from shipping banks in the form of first preferred ship mortgages, at LIBOR (the short-term interbank rate) plus the so-called spread, the lender’s profit margin. Interest rates obtained from shipping banks have varied over time depending on market conditions (interest rates, etc) and also the banks’ own appetite to expand their shipping lending business which has varied through business cycles. Although the loan from a shipping bank was “floating”, as the total interest rate varied with the changing-over-time LIBOR, the hedge desk from the same shipping bank would arrange – at the request of the client, of course – for an interest rate hedge / swap, so that the borrower could hedge, at the time of the loan inception, the interest rate risk. One has to note that the absolute interest rate was depending on two main factors, overall lending market conditions (LIBOR) and the banks’ appetite for shipping risk (spread), and these two variables were not necessarily in sync at all times. The other noteworthy observation is that a shipping bank was offering full service solution to the client, both the shipping loan and the hedge for the interest rate risk.

In the last several years, it’s widely known that shipping banks have been withdrawing from the shipping industry (anyone remembers the Royal Bank of Scotland (RBS) or even Lloyd’s TSB?), and credit funds have been moving into the shipping lending market. Given that institutional investors are behind such funds with higher return hurdles, the cost of borrowing from credit funds is much higher than that of the shipping banks. Still, credit funds express their interest rate offers in terms of LIBOR plus their spread over LIBOR, with usually the spread ranging in the 6-10% band. As a matter of comparison, traditionally shipping banks were (and, to the extent still active today, are) lending at 1-4% spread.

Reflecting… Image credit: Karatzas Images

No-one can blame the credit funds for being so expensive as their capital base is much different than that of a bank. [And, many would argue that shipping banks were mispricing risk and offering too cheap loans in the first place, but that’s a topic beyond the scope of this article, valid point nevertheless, in our opinion.] Also, no-one can blame credit funds that are not full service financial providers as they do not offer interest rate hedging, and shipowners / borrowers have to source it independently from banks, not an easy undertaking in today’s market when banks are disinterred in the shipping industry or in ad hoc clients and projects. The bottom line is that all ship mortgages and other debt financing instruments and transactions taken place via institutional investors are not hedged and most are fully floating and exposed to the rising interest rate environment. The cost is not inconsequential as 1% increase in interest rates reflects $27 per diem higher interest cost per each million borrowed; for a typical panamax bulker with a $10 mil mortgage from a credit fund, the 1.25% Fed rate bump in two years (included the expected twice in 2018) reflect $320 per diem additional daily financing cost, all being equal. For reference, the Baltic Exchange’s most recent report has BPI time-charter equivalent at $12,011 per diem (which incidentally is much higher than last year). $320 per diem incremental financing cost when the ship earns $12,011 per diem is not negligible, and this is still under an environment of well-behaving financial (and stock) markets presuming very rosy outcomes and being “priced to perfection”.

The shipping finance market is materially dislocated at present and the step-wise increases of interest rates by the Fed are a small problem to have in a much more challenging market. The concern however is that rising interest rates is a headache the market is ill prepared to deal with at present, and given that many borrowers (and lenders) are already stretched, there is minimal room for error. Anecdotally, we are aware of a couple of cases where shipowners trying to replace their 8% spread from credit funds with new financing, and not because they have expectations for lower interest rates.

It’s been a while since the shipping industry has been moving from one ring to a lower ring in what in business is called “vicious cycle”, when strategic errors keep compounding, further driving companies and the industry deeper into Dante’s Inferno.

Higher interest rates, in all likelihood, would push institutional investors and credit funds to increase their spreads as well, as now, in a new interest rate environment, their expected returns have to increase as well. Credit funds may theoretically opt to compete with each other on price (spread) in order to gain market share, or possibly decide to curtail their lending activities in shipping, neither option being a great outcome for the shipping industry.

Rising interest rates is not a laughing matter for the shipping industry, especially for the shipowners who went on the limb to borrow expensively in the hopes of out-running the business cycle. We would expect more news (and honestly more advisory work) from these developments.

Calm seas but not calm shipping… Image credit: Karatzas Images


© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

 

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Boats of the Highly Levered Seas

There used to be a time when the financing options for a shipowner where simple: seed capital was levered with a ship mortgage from a bank, and the loan was paid off based on an agreed-upon principal repayment profile from the operating profit. The terms of the shipping loans from banks were very similar and often the only differentiating factors for shipping loans were a few quantitative factors, principal among them the so-called spread, the difference over Libor for the cost of the debt.

Obviously, for any rational borrower, the lender with the lowest cost (interest rate) would get the business. When all things were equal, it was easy to note the sole differentiating factor, and push for the lowest number. Borrowers (shipowners) did not really have to create an “indifference curve”, their optimal set of choices. The leverage was in the 60-70% of FMV, the terms and covenants comparable, and thus the choices were limited. The “product” was one-dimensional and business was earned on the lowest spread.

Now that we live in times where by necessity there have been more types of capital than seed capital and traditional debt, such as alternative capital, mezz, senior and junior debt, etc, there is a greater opportunity to see the choices of preference for the shipowners.

There are funds that provide senior lending at only 500 basis points (5%) over Libor, but they do so at rather conservative terms, such as by lending in the 50-60% range of the FMV in today’s depressed asset pricing market environment. We would think that such financing is both cost competitive (in absolute terms) and also acts as prudent financial gearing for an owner to maximize returns and stay flexible when market conditions turn bad.

On the other hand, there are funds that provide close to 80% leverage, or even more, but at much higher cost, typically in the 8-12% range plus expectations of profit sharing, etc. The financial gearing is almost as sizeable as in the go-go days of the stratospheric market of a decade ago, but such levels of financial gearing add a lot to the costs of running profitably a vessel, and also multiplies the risk that when markets turn bad, the whole financial structure will not stand for more after the first few waves of the crisis reach the beach.

The options outlined above are as distinct as they can get, and although there are a few shades of gray between these two opposites, borrowers (shipowners) seem to gravitate to either of these polar opposites in terms of debt financing. And, watching shipowners make choices in the present market offers some insights on he direction of the market, the utility curves of the shipowners, their willingness to pay at various ranges of the curve, their risk appetite or risk aversion, and the inflection points thereof.

Even after the debacle of the last decade and the massive decade and rather fair prospects looking forward for shipping, there is a clear trend whereby shipowners prefer the high leverage, high cost (and high risk) option set over the low leverage, low cost (and low risk) alternative. There are many more shipowners who would rather borrow 80% of the value of a ship at 8% (spread) interest than shipowners who would borrow 55% at 5% (spread) interest. Credit funds and lenders in the former category are much more active than lenders in the latter camp.

Stephen, the Roaring Lion. Image credit: Karatzas Images

Apparently, shipowners (borrowers) seem to think that this is a time for “risk on” investments and thus higher financial gearing (at higher cost) makes sense. Asset prices, in the dry bulk market especially, are up by 30-50% on average in the last eighteen months, and thus, allegedly a high stakes strategy has paid off. Improving world economies and trade, and a historically low newbuilding orderbook add more fuel to the argument. But, playing the proverbial devil’s advocate, adjusted for risk, is a 50% asset appreciation investment justified on an 8% cost of debt?

In general, over the last decade, cost of capital (mostly debt) is going up in shipping. Interest rates have gone up, especially when they are expressed in terms of spreads. And, leverage overall has come down in shipping in the last decade. Likely, when shipowners (borrowers) are slowly adjusting their financing cost expectations, they seem to focus more on (and prefer) higher gearing at the trade of cost. In a theoretical binary choice of “give me more leverage or give me lower cost”, they are for the former, hands down. It may be that it takes a lot of time for habits to die?

High leverage at high cost has its risk, as mentioned. Already there are several transactions in the market where borrowers have already run into trouble and they desperately look to refinance high-priced transactions based on this structure. There are ships that have been arrested or are very close to arrest, ships financed with high leverage at high cost. And this is at a time when 2017 and 2018 freight rates are dreamboats of the 2015 and 2016 monster freight markets. Thus, in a relatively decent freight market, these high leverage preferences do not seem to always work out very well. We are afraid that after the debacle of private equity investments in 2011/2014 going sour in a major way and resulting in massive write-downs, the industry is setting itself up for another round of misguided investments powered by institutional money.

Shipping is a unique industry with its high volatility and risk at an operational level as this can be counted by the spot freight market (in the last eighteen months, BDI has been up by a factor of 5 but down 40% in the last month or so). Financial gearing over operational gearing can easily get out of hand.

But again, how fortunes have been made… or…

Stitt, the Quiescent Lion. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

For the Shipping Industry, a Matter of Interest and Indebtedness

Ever since shipping banks (and banks in other industries) have been curtailing their lending to shipowners (and for other banks outside shipping to small and middle-market companies), there has been a big funding gap, a market need, that has to be filled for the economy to grow. Many credit funds or alternative capital funds have popped in shipping that lend money for those who look for financing to buy or refinance ships. On a broader scale, many brand-name private equity funds have been setting up credit funds in order to serve the market need of lack of debt financing in numerous industries; with more regulation for banks (among other things), un-regulated lenders step in to serve the market.

There are substantial differences in the way a bank evaluates a loan in shipping than a credit funds approaches the market; although effectively they both look to undertake credit risk (they both lend money), there are always more types of risk entangled around credit: asset risk, operational risk, counterparty risk, etc No doubt that credit funds, as non-regulated lenders typically, have much more flexibility of the structures and the terms of the loans they can underwrite. For starters, credit funds can also take a little or a lot of residual asset risk (balloon payments, etc), market risk (profit sharing, etc), asset risk (finance older vessels, etc), that is, they can think outside the “credit risk” box and provide commercially more flexible structures (of course, at a higher cost of capital.) Also, since credit funds are not regulated, when there is a default of a loan, there is no reporting to a regulatory body which would have consequences on ratios and strategy; a credit fund would have the precious luxury to convert late payments to equity or accept payment-in-kind (PIK) or impose a higher profit sharing scheme and eventually take over the asset, if things really go bad. To be sure, a default for a loan is a painful experience for all those involved, for the shipowner / borrower of course, and also for the financier / creditor, whether the creditor is a regulated bank or a credit fund as practically no-one wishes for such an outcome of default (unless the lender is really a niche vulture fund specializing on feeding on carcasses and liquidation, but honestly, this is the exception than the rule.)

The typical credit fund these days would charge approximately 8% interest for a first preferred ship mortgage; for some, this is expressed as annual interest in absolute terms, but for others, it’s the spread over Libor (L+800 bps), meaning that the borrower also undertakes interest rate risk (at a time when the Fed and other central banks shifting to a tightening mode.) The amount of leverage is dependable, but most likely it populates in the 60-70% range, inlying that still a respectable percentage of equity is required; of course, more equity means that the shipowner has to be selective with their projects and also that the credit risk for the creditor goes down as the percentage of equity goes up. Although some credit funds can accept a bullet payment of the principal (under certain circumstances), a certain level of amortization is required for most cases. And, there are the usual assignment of earnings, minimum value clause, minimum liquidity clause, negative covenant clauses, and also pledge of shares, undated signed director resignations, and, more frequently these days, demands for a personal or corporate guarantee. All in all, the loan terms these days seem to be the extreme opposite of the easy credit days of a decade ago of name lending and loans agreed on a handshake.

Although a few short years ago shipowners would never had conceded to a first preferred ship mortgage with an interest rate above 4-5% or other funky terms, these days there are few options, and thus the reason that 8% has become the prevailing cost of the debt for ship mortgages. Different types, different norms, as said before.

For a theoretical example of a five-year modern panamax bulker valued at $22 mil and 65% leverage and five year term, at 8% annual interest, the daily interest payment alone is appr. $3,000 per diem; presuming that there is a requirement for the principal to be amortized by 50% over the term of the facility, then another $4,000 pd had to be added to the financing payments. Based on a back-of-the-envelope assumption of $6,500 pd vessel daily operating expenses, the cash expenses for operating such a ship range from $9,500 – $13,500 pd; just as a reminder, only in the last eight months panamax freight rates sustainably moved above $10,000 pd, meaning that many borrowers, at best, they were breaking even in the last eighteen months. Of course, there is the hope for higher asset prices and higher freight rates, but, as they say, hope does not make for a good business plan. This model of 8% cost of debt financing would never work with modern, expensive ships (as the interest payment would become exorbitant in today’s freight market), while older tonnage (to the extent that a credit fund can be enticed enough to consider it) has more favorable economics.

There are a few corollaries to the prevailing market practices that need come elaboration:

  1. the cost of debt financing has moved to such high levels that it’s barely economically feasible to undertake new projects or buy ships for the smaller, independent shipowner
  2. borrowers undertake severe interest rate risk at a time when interest rates are moving higher (unlike a shipping bank with its interest rate swap desk that offered a full package, credit funds do not offer such service, and the borrower has to search a dis-incentivized market for this product for effectively project finance and small amounts)
  3. there is a lot of risk for both the borrower and the creditor under such scenario of high interest rates, and it will not take much for many of these financing projects to be underwater, so to speak
  4. as several more tight covenants have been added to these types of loans, in the event of defaults, it can be really ugly; if the overall market turns south (an unlikely scenario for now, but as we have learned, in shipping even unlikely scenarios are probable), there will be a massive cascading problem (credit funds will not be as cavalier as shipping banks with arresting ships, but then how they would be operating them or sell them in a declining market?)
  5. with so many credit funds having been set up for shipping, potentially there could be the possibility of them having to compete and lowering their standards in order to gain business; we are well aware of at least one credit fund that between April and October 2016 made a complete U-turn on their credit underwriting as they could not get one deal done.
  6. as cost of debt financing is too high, many financial sources keep looking entering the market which likely would undermine the credit fund market; we are working with a Chinese-originating fund providing first preferred ship mortgages at 5% interest for 50-60% leverage and very normalized covenants.
  7. disappointedly, for credit funds being private equity funds and well versed in structured finance, their proposed structures are extremely monolithic and inflexible, which will cost them a lot over the long term; being unregulated and flexible, only imagination could limit structures where they could make big returns if they were willing to be flexible and exchange some credit risk for some market risk and some asset risk and some residual risk and some counterparty risk and some… All credit funds have been pigeon-holed into credit, they compete heads-one with every other credit fund, and the only reason they do business now is that shipping is desperate for capital; this market could easily move away. But again, most of these credit funds have been run by former shipping bankers with some trying to exonerate themselves for the shipping bank mistakes of the last decade…

For now for sure, shipping debt is an interest-ing market to watch…

For some, a foggy market… One World Trade Center in Downtown Manhattan. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

Sailing the Seas Depends on the Helmsman

Once upon a time, there was an independent shipowner with, let’s say, ten modern product tankers. Three of their tankers were mortgaged with a major European bank, a very well-known name and with proven past commitment to the shipping industry. And, the shipowner themselves, have been in the shipping business for more than a couple of decades and enjoying a solid reputation in the shipping community and with charterers. These, being legacy shipping loans, their terms were highly competitive in this market despite some success of the bank to tighten the loan terms since the market collapse a few years ago. Actually, the terms of these loans were exceptional, by today’s standards, as the spread was just 300 basis points. And, of course, the shipowner had watched these loans like the apple of their eye, and they were current with interest payments and principal repayments and the loans were comfortably meeting the loan-to-value (LTV) covenants.

Eighteen months ago, the shipowner got a note from their mortgage bank that since they (the bank) were exiting the shipping industry, the shipowner was given notice to make arrangements to pay back the loans (there was a small discount offered) or the bank would had to take matters in their own hands. Since these were performing loans, the mortgage bank could sell the loans at close to par, likely to a credit fund or an institutional investor, or possibly even to another bank if there were still banks out there buying shipping loans – not a likely cozy prospect under any circumstances.

It took a few months for the shipowner to recover from the first shock, having a brand-name bank giving them notice on performing loans. And, it only got worse from there. The shipowner’s shock got greater as soon as they started “shopping” the market for new financing: few shipping banks had interest in new clients or business or the capacity to finance a three-vessel package. While approaching institutional investors, the strategy was modified to squeeze the mortgage bank for a hefty discount of the loans, but with the institutional investors sharing (a great deal of) the economics of the transaction and not just to provide new loans. Almost a year passed since the mortgage bank had given notice and the shipowner could not find a new “deal” good enough. But again, having to replace shipping loans priced at L+300 bps in today’s market, one feels like they have been punched in the stomach.

And, while the shipowner was taking their sweet time to find the perfect financing they thought they deserved, the product tanker freight market started deteriorating: first freight rates dipped and then halved, and, as one would expect, secondary market product tanker sales started taking place at lower price levels. While the shipowner had a few million in cash in the bank, dry-dockings and other expenses started chipping away on the balances. And, the lower asset prices triggered LTV defaults now, giving much more leeway to the bank to sell the vessels themselves, and not just the loans – an even worse prospect for the shipowner.

And, lower freight rates and lower asset prices were making financing the original loans more difficult: cash flows now would only support lower financing, and institutional investors lost appetite since any discount now had less value in a weakening market.

All being told, the shipowner managed to finance just two of the vessels at today’s prevailing conditions (lower leverage, tighter covenants and cost in excess of L+600 bps.) And, the third vessel was let go and was sold (at a small loss) since no financing could be found within the parameters of a weak freight market and limited “sweat equity” from the shipowner.

This is a real story (unfortunately) and no names or other details can be divulged; but, such details do not matter really. If there are lessons to be learned is that first, in this market, shipping finance is the “determining factor” of the shipping industry, the independent shipowners. Shipping finance is the new battlefield where shipowners will be called to fight; if they cannot sort out their shipping finance game in the new market, they will be driven out of business – as simple as that. Second, in this difficult market, it’s not only “bad shipowners” who have problems; if your bank is not committed to shipping or you or they are having higher priorities unrelated to shipping, that’s the weakest link in the business, even if the loans are good and performing. Third, it pays to be pro-active in this market and tie loose ends as soon as possible; looking for the perfect financing at the expense of time, one can lose much more than a few hundred basis points – not arguing that two hundred basis points are not worth fighting for, but again, this is not a time when banks and lenders can bend much, if at all. And, lastly, independent shipowners had become a substantial part of the industry based on their shipping and operational expertise and efficiencies and not on their financial expertise (shipping banks were lending in the past liberally and just on the basics of how to extend credit); the present market is much more sophisticated than that and hiring competent shipping advisors may very well be warranted; trying to avoid paying an advisory fee can cost one whole ships.

“Sailing the Seas Depends on the Helmsman” was a revolutionary, patriotic song for Mao Zedong’s Red Guards in the 1960’s and 1970’s exemplifying the Chairman’s leadership skills, metaphorically speaking. For an independent shipowner these days, sailing the seas depends on the helmsman navigating the new reality of the shipping finance markets.

A long shadow over one of world’s most important shipping cluster. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

Shipping Banks and Credit Funds

For anyone who approached a shipping bank in 2015 requesting a shipping loan (mortgage), the reality has been as rough as the waves of the North Atlantic in the winter season. Shipping banks have been leaving a large funding gap behind them, and a few new entrants to the market, whether banks, lessors, or more prominently credit funds, have been making waves about. In the current issue of the Cayman Financial Review, Basil M. Karatzas with Karatzas Marine Advisors & Co explores the new reality.

The article can be accessed online at the website of the Cayman Financial Review by clicking here, or a pdf article of the article can be access by clicking on the picture herebelow. The article has been reproduced courtesy of the Cayman Financial Review where the copyright belongs to. We are thankful to them for hosting us for the second time in a year, testament to the Caribbean Islands being hospitable to maritime and shipping finance insight!2015 12DEC CFR Credit funds in the wake of departing shipping banks

 


© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

2015 12DEC CFR Credit funds in the wake of departing shipping banks