Shipping has been hit hard in recent months, with the liquidity crisis and global recession affecting all sectors.
Record low dry and wet bulk rates and a sharp decline in vessel values are causing covenant breaches and going-concern considerations. More and more ship owners are attempting to get out of their order commitments. And impairment and fleet values are of increasing concern to those with stakes in the shipping business.
Owners, after the shipping boom of the last few years, are now finding themselves with ships bought at peak prices against high lending. Many of those owners, who have set aside cash in the good years, will be able to ride out the storm, at least for the foreseeable future. But with the enormous decrease in freight rates – and a corresponding decrease of second-hand prices for ships – numerous owners can no longer payback principal and interest to their lenders.
This looming threat of default is causing very real anxiety for those banks holding large shipping portfolios.
So what can lenders do to safeguard their position and mitigate losses? With the unique challenges presented by a shipping default – either potential or actual –bankers need to be prepared and consider all options.
An industry in transition
With economies worldwide downsizing in terms of both demand and production, the global shipping industry is looking at a harsh new economic reality. A lack of
consumer demand in such key sectors as construction and auto has led to much-publicized reductions in output from producers of large transport goods, such as steel makers, with a corresponding impact on the overall appetite for raw materials. According to recent economic briefings from the International Monetary Fund (IMF) and the Organization for Cooperation and Economic Development (OCED), world growth is expected to fall to its lowest level since World War II, with both trade and global output forecast to plummet. And the Economist Intelligence Unit estimates global trade growth to be only 1.3 percent in 2010.1
This global economic slowdown has already had a devastating impact on the shipping industry, which transports 9 percent of globally traded goods andcommodities.2 In December 2008, the Baltic Dry Index was down to 672 points from its high of 11,793 in May 2008, levels not seen since mid-1986. In addition, both the Capesize and Panamax indices have reached their lowest recorded levels in the history of the Baltic Exchange, with the average time charter rate for a Capsize vessel falling to less than 1 percent of the record high of US$233,988 in June 2008. From the lows of late 2008, charter rates have only just now begun a slow recovery
The crisis faced by the dry bulk market has now extended to the wet sector, with the oil tanker market showing signs of distress. The steep falls in industrial production and consumption of raw materials has led to a decrease in short-term demand for oil: according to the International Energy Agency (IEA), for the first time in 28 years, the global demand for oil is expected to fall by 3 percent in 2009.3 Decreasing demand has caused a precipitous drop in the price of crude oil –from a peak of $147 per barrel in July 2008 to $32.40at the close of the year – causing significant margin erosion for large oil tankers. In response, many vessels are either idle or under utilized, with delivery of new vessels ordered during peak demand placing further downward pressure on freight rates.
Shipping companies have already begun to cut back their capital expenditure on acquiring new vessels and many are expected to scrap cargoes and delay or evencancel new build to effect some order of stability on freight rates.
For example, the Nordic American Tanker Shipping, in the wake of a reduction in revenue, vowed to cut its capital expenditure by US$5000 a day per vessel across its fleet of 13 vessels. Other specialized oil tankers are mitigating oversupply through "contango" – that is, buying and hoarding oil to sell it at a future delivery date when the price is higher. It is now estimated that close to 130 million barrels of crude oil, along with at least 30 million barrels of petroleum products, are currently being stored at sea in more than 50vessels – reducing supply tanker tonnage and offering some stability to freight rates in the short term. Overall, the price of transporting liquid commodities is expected to either stabilise at current levels or continue to decrease slightly in 2009.4
The shipping challenge for banks
Given increasingly gloomy growth forecasts, the ability of shipping companies to generate revenues sufficient to service debt obligations must come into question –presenting very real risks to banks that provide financing to shipping companies. On paper, these financial institutions may have sufficient security against shipping defaults in the form of mortgages, assignments, and pledges, and possibly guarantees from group companies or directors. But with the falling prices of certain types of ships, mortgages on assets may not cover the loans. Even more important, it takes time, effort, and money to sell collateral. As such, banks are encountering a challenging set of circumstances when it comes to securing their shipping portfolios
Debt financing
Some shipping enterprises with sufficient reserves maybe able to agree with their lenders on adjustment of ratios (such as loan to value) and/or restructuring of debt. To meet obligations, these companies also have the option of laying up part of their fleets until demand returns. This could allow for decreased operational costs – especially as prices of bunkers have decreased considerably along with charter rates.
Asset sales
Ship owners who have not built up reserves may not be able to survive, forcing the sale of assets to repay the lender. But in any sale of a ship, there will be the issue of competing claims. That is, when ship owners cannot meet debt obligations, they typically are not able to pay other creditors either, such as the crew, bunkers, spares, agents, and insurers. As such, the ship cannot simply be sold to another party, as many of the claims against the defaulting owner may still be enforced against the ship after it has been sold. The ship will most likely have to be sold in a judicial sale or auction – where the chances of lenders losing money can escalate significantly.
Jurisdiction
The jurisdiction of a ship is also of concern to banks trying to recoup on a default. Depending on where the ship is currently located, the time to auction it can range from weeks to years – and it is without a doubt in the lender's best interest to auction a ship as soon as possible. As the ship lays idle, its value will most likely decrease due to a lack of maintenance and use, while at the same time unpaid interest and capital will continue to accumulate. And in some jurisdictions, the party putting a ship up for auction is liable for any costs and damages incurred from unforeseen accidents or problems related to the vessel. Another jurisdiction factor is the ranking of claims against the proceeds ofthe judicial sale, which can differ by location. Obviously, a lender wants to be in a jurisdiction where the mortgagee's rights are of highest rank
Preparing for the worst
Right now, banks need to prepare for the worst when it comes to their shipping portfolios. They need to undertake business reviews to assess the viability of their shipping clients, identifying which companies are in danger of default, and work to find solutions as soon as possible to preserve their interests and hopefully prevent further deterioration. However, in the cases where default cannot be avoided, banks must be ready to take a course of action that best protects their capital, including the following steps:
Consensual restructuring
Banks need to review a company's accounts for both solvent and insolvent restructuring options, seeking a clear analysis of the potential financial outcome and associated risks of each option. If a consensual restructuring option is agreed upon, a detailed framework for implementation needs to be developed and negotiated.
Contingency planning
If a consensual solution or restructuring cannot be achieved, banks need to have alternatives that are readily executable. Contingency planning involves the identification of key practical, commercial, legal, and operational risks of an insolvency process. Provisions for these risks should involve detailed strategies and action plans developed to ensure any insolvency process, should it be necessary, minimizes the impact on a business and maximizes returns.
Insolvency preparation
As part of contingency planning, banks must have an insolvency process in place in the event that the disposal of assets becomes necessary. This should include a review of security, capital, and group structures; a review of the balance sheet and other current financial information; an estimate of "going concern" and "forced sale" values and solvent enterprise valuations; and identification of benchmarks against which options may be compared. It will also involve legal assessment for competing claims, plans for a judicial sale or auction and associated costs, and preparation for any logistical actions that need to betaken in terms of locations, storage, liability, and upkeep of assets.
Valuation assessment
Throughout all steps of the above processes, banks must undertake reliable valuation analyses supported by logical and coherent arguments. This must include practical valuation benchmarks in the context of market realities and in line with value realization options.
The location factor
Although part of the above processes, jurisdiction isa particular challenge in shipping. Understanding its importance is critical to recouping an investment and ensuring the quick and efficient disposal of distressed assets when it involves an auction. The best jurisdictions for judicial sales are the United Kingdom, Gibraltar, and the Netherlands. In all three:
- It is possible to conclude an auction within about five weeks – a process that can be dragged out to a considerable length of time in other areas.
- A mortgage is ranked highly, with only the costs of the auction, certain crew costs, costs of securing the ship during auction, and the contribution in general average and salvage ranking higher.
- There is no liability for the ship during the auction process; however, in England and Gibraltar a percentage of the proceeds must be paid to the admiralty marshal.
In the Netherlands it is also possible to conclude a "private sale in the context of an auction." This means that within the judicial sale and with court approval, the ship can be sold to a third party of the lenders' choice and "washed clean" of all claims.
If a bank finds itself in the position of needing to auction assets, it is paramount to transfer ships to one of these jurisdictions. Banks should achieve this, if possible, without actually taking possession of the ship. Although many standard loan documents allow for this – giving lenders the right to direct a ship to a certain port – it also means that they become liable for the vessel. Other means, without creating the appearance of taking possession, should be used, such as promising payment to the crew to sail the ship to one of these jurisdictions or some other financial agreement with the owner or charterer. By directing the ship to "friendly" jurisdictions, lenders can ensure that they make the most of their collateral.
The best defense is a good offense
Although theoretically banks with shipping portfolios may not be faced with defaults, being prepared is always a good strategy. Some of the steps listed above can prove useful in assessing current client needs even if they are not in peril of default. Some may even help prevent a default. But for those lenders facing imminent repayment issues within their shipping portfolio, developing a plan of attack ahead of time can helpmitigate losses as well as save time and effort.
About Deloitte's Shipping & Ports Group
Deloitte's Shipping & Ports Group specializes in providing professional services to the water transportation industry including cruise lines, ferries, cargo shipping, ports and harbor authorities. Our main objective is to develop solutions to assist our clients resolve the issues affecting them and the complex industry environmenting which they operate. The group comprises of a multidisciplinary network of 420 industry practitioners, of which 240 are partners, in 33 major shipping centers and continues to expand. Professionals in the member firms have worked together for many years to serve the shipping industry.
Footnotes
1 "http://www.eiu.com/index.asp?layout=displayVw& article_id=1294523114&geography_id=®ion_id=1510000351"
3 http://www.bloomberg.com/apps/news?pid=20602099&sid=a2oaDrBSipy0
4 http://www.guardian.co.uk/business/feedarticle/8519251
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
