Increasing Dry Bulk Shipping Market Efficiency by Securitization of New Build Capacity

Increasing Dry Bulk Shipping Market Efficiency by Securitization of New Build Capacity

Erasmus University

Erasmus school of Economics

Bachelor Thesis

By David Pollack

278925

Theodorus Majofskistraat 43HS

1065SV Amsterdam

Supervisor:

Martijn van der Horst

Summery

The objective of this thesis is to introduce a method of securitizing dry bulk shipping companies or vessels. The general structure and nature of securitization has been based on the mortgage-backed securities. This method uses segmented tranches based on future charter incomes.

The thesis analyzes the market dynamics of the dry bulk shipping market and identifies problems therein. This is done by using the four shipping markets as determined by Stopford. Each of these markets will be summarized and its market dynamics explained. The dry bulk shipping market is highly cyclical in nature and freight rates are volatile. This volatility along with the market dynamics and cyclicality are shown to be due to a number of factors. One of the factors is that the investment in new build vessels tends to follow the freight rates in a pro-cyclical manner. This is partly due to the overinvestment in new capacity when times are good that lead to long periods of overcapacity. The market specific dynamic is theoretically addressed by the introduction of securitization.

The thesis then enumerates the financial methods used by ship owners to manage their finances. The issues of costs and cash flow are discussed as are the basic methods of financing used by ship owners. Problems in addressing the specific needs and wants of the various investors simultaneously are then identified.

The basic structure of the securitized dry bulk shipping company is next discussed. Firstly the distinctions between the mortgage-backed securities and the intended shipping securities are discussed in order to show why the recent failures of the mortgage-backed securities would not apply to these securitized shipping companies. Then the players and instruments of the shipping security structure are listed and explained. A concerted effort is made to cover the establishing of market value and default process of the securitized dry bulk shipping companies as to complete the picture of the securitized shipping companies and its tranches. To give clarity to the practical workings of a securitized vessel or company a hypothetical case study is given.

With a clear picture of the workings of the securitized dry bulk shipping company a discussion is then begun on the effects of securitization and the possibility of its addressing the problem of financing in dry bulk shipping companies. It is proposed that the segmentation of investment opportunities would have a dampening effect on the volatility in supply of capacity. It is also estimated that the tranches would offer other beneficial effects as hedging opportunities to shippers and others who are adversely affected by high freight rates. The segmentation of investment opportunities could also open up dry bulk shipping to many different types of investors, from conservative pension funds to hyper active derivative traders.

Table of contents

Summery 2

1 Introduction 4

1.1 Research Questions 5

1.2 Methodology 5

1.3 Structure 5

2 The Market Dynamics of Dry Bulk Shipping Market 6

2.1 Business Cycles of the Dry Bulk Shipping Market 6

2.2 The Four Dry Bulk Shipping Markets 8

2.2.1 The Freight Market 9

2.2.2 The Charter Market 10

2.2.3 The Sale and Purchase Market 11

2.2.4 The New Building Market 12

2.3 Conclusion 14

3 Financial Management of the Dry Bulk Shipping Companies 15

3.1 Costs of a Dry Bulk Shipping Company 15

3.2 Cash Requirements of Dry Bulk Shipping Companies 16

3.3 Methods of Acquiring Financing 17

3.4 Conclusion 18

4 Securitization of New Build Dry Bulk Carrying Vessels 19

4.1 Structure of Securitization of New Build Capacity 20

4.1.1 Basic Structure 20

4.1.2 Market Value 22

4.1.3 Cash Flow 23

4.1.4 Default Procedure and Risk 23

4.1.5 Case Study 24

4.2 Discussion on the Effects of Securitization 25

4.3 Conclusion 27

5 Conclusion 28

References 30

Appendix 31

1 Introduction

When Barbagio, a Venetian trader in the late Middle Ages, was trading on the Mediterranean, he had a fleet of wooden ships. Even though the world was very different then, he faced many problems similar to ship owners today. He could have been left with excess capacity, i.e. trading vessels, when geopolitical shifts drastically altered the capacity demand of the market. He had to choose among owning his vessels outright, borrowing money at fixed rates (bonds), or sharing ownership with other investors (stock offering). His father had lost everything when his ships sank in a storm in the Adriatic, so Barbagio was keenly aware of the dangers of owning 100% stake in the vessels. He knew that if he took a loan, he could risk losing his possessions if he ever had a bad trading season. But he also had experience with his interests conflicting with that of his investors whose expectancy of return and risk taking varied with his own.

Today supply of capacity tends to be pro-cyclical in relationship to freight rates (Lung, Quaddus, 2009). Investors in shipping capacity still are faced with fundamentally the same three basic financial tools that Barbagio had of private equity, debt, and foreign equity (Stopford 2009). Even though the addition of ship funds and shipping stocks on the NASDAQ have offered some variation in investment opportunity, still the un-segmented investment opportunity means that short-term return on investment (ROI) strategies are closely interrelated to long-term ROI strategies. This means that when freight rates are on the rise, speculators tend to directly or indirectly add capacity to the market. But since freight rate peaks are relatively short and erratic in nature (Stopford 2009) and that added vessels have lifetimes of around 20 years (Stopford 2009), some investors inevitably lose out. This market anomaly is a reason for the high market cyclicality in dry-bulk shipping (Zannetos 1966).

Securitization is a new method of financing which involves the pooling and re-packaging of assets and receivables in such a way that a relatively homogeneous asset package can support multi-tranche issues of liquid securities (Pallis, 2007). This thesis will try to apply the basic concept of securitization to fit the market specifics of the dry-bulk shipping market. The tranches (see 4.2.1) will be based on the asset of future charter incomes instead of on the interest on mortgages of loans. The application of segmentation in the tranches by level of charter income, from $0-$1000 then from $1001-$2000 and then $2001-3000 etc., is intended to offer investors tranches with various level of risk exposure and therefore various returns on investment (ROI). This segmentation of risk would offer investors with different preferences and strategies, an investment product which could better match their goals. This would ease pressure on the short-term shipbuilding market and dampen the pro-cyclical investment in vessel capacity. In addition, the tranche sell off could transfer short-term freight rate risk away from ship owners to investors in tranches, thus reducing the risk of the long-term ship owners. These are the issues and questions that this thesis will try to address.

1.1 Research Questions

The problems and topics mentioned in the introduction have led to the formulation of the following questions. The thesis is meant to address and if possible answer these questions.

Primary question:

How can dry-bulk shipping supply and investment become more market efficient by securitization of new build vessel capacity?

Sub questions:

·  How does the dry bulk shipping market operate?

·  How do dry bulk shipping companies manage their finances?

·  How would securitization be structured in the dry bulk shipping market?

1.2 Methodology

To introduce the idea of securitization of new build dry bulk vessel capacity, the research will have to go through a number of phases. To establish the framework of the real-world shipping and financial markets, research literature must be found and studied in order to gain a theoretical insight into these markets. The market dynamics that securitization would be intended to address will have to be based on empirical data and results from studied literature, so presumed effects of securitization would be more than just wild estimations. Then the theoretically designed dry bulk shipping market’s specific form of securitization can be introduced and used to discuss possible positive effects of securitization on the real world and financial markets.

1.3 Structure

To analyze the implementation of securitization in the dry bulk shipping market first a framework of the environment wherein securitization is to take place must be created. This will be done by using the structural approach of Stopford’s four shipping markets. Certain market anomalies that securitization could address will be highlighted. Since securitization is a financial tool, the current financing methodology will be analyzed in order to formulate how and where securitization could have added value. This will have then described the environment wherein the securitized dry bulk shipping company can be introduced. After describing the environment wherein the securitized dry bulk shipping company could be introduced, there will be a discussion on the possible effects that securitization could have on the dry bulk shipping industry.

2 The Market Dynamics of the Dry Bulk Shipping Market

In this chapter I will elaborate on the general working of the dry bulk shipping market. This market covers many types of bulk cargo, from bauxite to grain. But, as the market is primarily dominated by Iron ore, grain, coking and thermal coal (Stopford 2009), I will concentrate this study exclusively on these cargo types. Furthermore the dry bulk freight market is highly homogenous with few vessels that, in theory at least, could not be used for all types of dry bulk cargo. I chose the dry bulk shipping industry in specific as the test group for the introduction of a new form of securitization because of the simplicity and standardization of the vessel, and because of the market’s openness to many players. The goal of the chapter is to establish clearly a framework of the market in which the securitization of the dry bulk shipping would take place. In chapter 2.1, the cyclicality of the market will be addressed and analyzed. The cyclicality is relevant as it must be incorporated into the process of securitization and hopefully securitization will address some of the harmful effects of the volatility. In section 2.2, the four markets of shipping as stated by Stopford will be described. These four markets together with the cyclicality will describe the market dynamics and market factors securitization would have to take into consideration in order to take effect. Also an understanding of certain aspects of the markets is essential to engineering the method of financing to address effectually inherent problems in the dry bulk shipping industry

2.1 Business Cycles of the Dry Bulk Shipping Market

The dry bulk shipping industry is highly cyclical. It regularly goes through periods of high ordering of capacity and high freight rates, as well as through periods of surplus of shipping capacity and low freight rates. As defined by Stopford, the shipping industry goes through four distinct stages of shipping (figure 2.1). The four shipping markets he describes are a mechanism for coordinating supply and demand in the dry bulk shipping market. The four stages of the short-term shipping cycle are (Scarsi 2007):

Trough: A surplus of shipping capacity pulls down

freight rates near operating costs. Ship owners

are forced to sell ships, decommissions and

sales increase while the shipbuilding order

books decline.

Recovery: Supply and demand move towards balance,

while freight rates increase above operating costs.

Peak: Freight rates are high, several times operating costs, owners become very liquid and shipbuilding order books expand.

Collapse: Supply overtakes demand and freight rates fall again.

The freight market for dry bulk is relatively open. Cargo can be obtained through brokers and can be offered on consignment or contract. Vessels can be bought secondhand as they are numerous and fairly homogenous. The main barrier to entry into the market is the cash requirements in buying or chartering vessels. The vessels cost millions of dollars and the prices fluctuate highly in a pro-cyclical manner. The values of the second-hand vessels fluctuate pro-cyclically with the freight rates. This means that when prices offered to transport cargo, i.e. freight rates, increase, so too do the prices of dry bulk vessels as seen in Table 2.1 below.

Table 2.1 Correlations of new building vessel price, second-hand vessel price, scrap vessel price, and freight rate
New building vessel price / Second-hand vessel price / Scrapping vessel price / Freight rate
New building vessel price / 1
Second-hand vessel price / 0.821(**) / 1
Scrapping vessel price / 0.711(**) / 0.915(**) / 1
Freight rate / 0.493(†) / 0.847(**) / 0.848(**) / 1
Notes: ** significant at the 0.01 level (2-tailed)
† significant at the 0.10 level (2-tailed).

Source: (Lung, Quaddus 2009)

The synergistic effect of the owner’s income from operating the vessel in the form of charter rates, and simultaneously the asset ballooning because of the increase in vessel value, can make the balance sheet of the ship owner look rosier than it is actuality is. To outsiders the shipping industry will look like a hugely profitable business. The general feeling of excitement means that investors will be looking for companies to invest in or to start new companies themselves. At this moment, as there are only low entry barriers except for lots of cash, new entrants will come into the market with lots of cash just at the time that their competitors are enjoying a period of positive cash flow. The new entries and some existing ship owners will try to leverage their income flows by increasing their capacity. Eventually the market will be saturated or market conditions will change and freight rates will plummet together with the balance sheets of the players in the market. Some will have sufficient cash or charter agreements to weather the storm, but others will not be able to stay afloat and will go under. This rollercoaster ride is not new. We can read about ancient mariners who risked all to make their fortune on the high seas. But just as some made their fortunes, others entered at the high watermark and lost all. For a long time this has been a recurring experience in the shipping market. Players keep getting caught because the shipping cycles are erratic in nature and length. The general trend now is declining lengths of the shipping cycles, suggesting that players are quicker to respond to variations in market conditions. The dry bulk shipping has increasingly become a regimented industry where investors seek stable returns on investment. However, as of yet the dry bulk shipping industry still is an arena for spectacular successes and dramatic sinking of fortunes.