Shipping debt – Valuation in the eye of the beholder?
Tony Foster, CEO, and Gihan Ismail (pictured), Business Development Director at Marine Capital Ltd., comment on the problems of shipping valuation in Germany.
Just as an understanding of shipping in general requires an appreciation of what process goes into making up the valuation of ships, the same can be said of shipping debt. Unfortunately, different valuation methodologies may be at work, confusing the picture for the inexperienced observer. Hopefully we can remove this feeling of confusion. In some ways, shipping debt (i.e. primarily, mortgage-backed loans) was, and remains, the most ‘obvious’ route for external investors, particularly PE investors with designated credit funds and/or distress funds, or hedge funds, to participate in shipping.
In a novel entitled ‘The Shipping Man’ published in 2011, the tale of an American hedge fund manager who changes his life and becomes a shipowner, the story begins with a description of a trail of U.S. fund managers travelling to Hamburg to look for discounted shipping debt from German banks. The German shipping market, where the ingénue in the book began his quest, was dominated by limited partnership equity investment funds (known as K/Gs) which were sold as retail products, originally with large tax breaks, and eventually with few or no tax advantages. The non-recourse or partial-recourse nature of these structures added to the German lending banks’ huge headache when the shipping markets collapsed in 2008, a headache they are still feeling.
For those unaware of the story, here is a brief summary: in the years leading up to 2008/2009, the container ship market in particular enjoyed a large amount of capital pouring in from K/Gs. These vehicles were set up to encourage investment by individuals and sold aggressively by Independent Financial Advisers. The K/G funds provided the equity financing for a significant number of new ships that were then chartered on medium to long term contracts. A number of reputable German banks provided the debt funding. So far so good, but one of the problems was that the banks provided loans based not on the value of the underlying assets but on the value of the asset plus the (not insignificant) fees paid to the IFAs, the manager of the K/G and to themselves.
While those assets were rising in value together with strong charter rates, the situation was win-win for all, but following the peak of the market in 2004, the system started to fall apart, particularly after the slump in the shipping market in 2008 when ship prices plummeted just as many of the ships’ initial charter contracts came to an end. The banks were left with loans significantly greater than the value of the underlying assets with little or no further ability to call for additional equity, and the K/Gs having much weaker ability to service existing loans out of lower charter rates. Those K/G companies able to service interest only payments on their bank loans have been largely able to survive, whereas other investors saw the value of their equity wiped out and the asset transferred to the control of the banks where, in many cases, they still reside.
The so-called Zombie companies are those which are still alive, courtesy only of their lenders. The nub of the issue, from almost all aspects, is if, how, why, and perhaps for how long, this courtesy can be extended. It was natural for (particularly U.S.) credit funds to assume that the German banks would be sellers of these loans, and at genuinely distressed price levels, after all, it was all over the press that the big German banks, HSH-Nordbank, Commerzbank and probably NordLB were in difficulty over their shipping books (although not only shipping): wrong assumption. German banks have not marked to market these loans which might have enabled them to sell very much more than they have (either of the loans, or the ships themselves), depending on the losses involved.
Look out! Here comes the ECB
Various rumours have circulated about the attitude of the European Central Bank to potential losses in the German banks, including leaked remarks from Brussels about ‘particular concern over shipping loans’, but the result of such concern will only be seen after the ECB publishes its Asset Quality Review which includes shipping debt and which is due in a few weeks’ time.
There is no doubt that prior to 2008, the shipping market, like many others, was awash with cheap money. Banks were happy to provide financing on terms that were often generous, and in some cases lax. The most obvious examples of such policies were probably to be found among large German banks, who lent to K/G investment partnerships on easy terms. These included, in some cases, putting up instalment payments to shipyards for newbuildings against a letter of undertaking from a K/G manager that the equity would be forthcoming. A number of ships became the immediate property of lenders after the Global Financial Crisis when those undertakings proved worthless.
Despite the fact that the face value of so many loans is now significantly higher than the value of the underlying assets, surprisingly, to many of the PE and hedge fund managers, particularly those from the U.S. who are perhaps more accustomed to quick responses from investment banks to such situations, but unsurprisingly to all shipping professionals, there has been relatively little activity in terms of loan sales (or the associated underlying ships), for numerous reasons, including the following key ones:
Value of Loans
Most fundamentally, loans have not been marked to market. Commercial banks in general, and European commercial banks are no exception, keep loans at par unless they are deemed to be impaired. Importantly what is ‘deemed impaired’ is a matter for some subjective interpretation by the bank in question. Following the 2008 crash, at a time when, for example, Clarksons, the largest shipbroker, key provider of industry data and the valuer of reference, briefly suspended its ship valuation service, German banks persuaded their auditors to accept a DCF model, with assumed future cash-flows rising to historical averages, which in turn raised the value of the underlying collateral and allowed loans not to be impaired. This was called the Hamburg Valuation Model. These valuations are based on future earnings assumptions rather than known cash-flows.
As long as banks are not pressed to mark-to-market, then their willingness or ability to realise losses will depend on numerous other factors, such as the belief of any chance of recovery, overall profitability at the bank level, the effect on solvency ratios of taking upfront losses, and so on. Only in specific circumstances, and for specific asset classes, has a mark-to-market model been enforced (e.g. Spanish banks’ property loans in exchange for the Brussels- directed bail-out of Spanish banks. HSH Nordbank’s two biggest negative exposures, for example, were U.S. subprime mortgages and shipping loans, so the effect there would clearly have been disastrous.
The question of what is ‘non-performing’ remains subject to interpretation. A U.S.-based, Greek managed shipping business, Navios, completed a much-trumpeted deal with HSH in April 2013, which involved the transfer of a group of ships to a new, Navios-controlled entity from a defaulted borrower. The structure of the deal was claimed to be a template for many such future deals which Navios and its investors would do with the bank. In principle it would have enabled the bank not to mark to market its loan(s) on those assets, by ascribing to them a ‘performing’ tag by placing them in a new vehicle.
To our knowledge, it remains tellingly, the only such deal reported. The underlying reason is again one of valuation. Was the excess (over-the-market) piece of new debt ‘performing’ because it had been transferred into a new structure? Such issues are at the heart of the fierce debate now going on in Germany between the banks, their auditors, the German regulator (BaFin), the Bundesbank and the ECB. Until a bank knows which structures might be reclassified as performing, it isn’t going to try and push that kind of deal through. At the time of that reported transaction, HSH had transferred 9 bn. Euros worth of shipping loans, representing 1100 underlying ships, to its restructuring unit alone.
Kicking the can down the road was likely to be the only ‘option’. Ship lending banks are familiar with having to hold or warehouse assets from defaulted borrowers, and the German banks were always going to make the argument that the market would save them. The idea, then, that they were going to sell loans widely, in a manner that would enable buyers to profit when the market rose, by taking prompt enforcement measures and waiting for the market to rise ( so called loan-to-own deals) makes no sense.
Much of the exposure held by German banks to K/G shipping structures was to containerships. Unfortunately, far from improving since 2009, the containership market has worsened, and asset values for existing, particularly older containerships remain under huge pressure. Banks who ‘decided’ to wait and see are still waiting. The ‘Hamburg valuation model’ has garnered plenty of sniggers from the international shipping community outside Germany because real shipowners just wouldn’t make those earnings assumptions in order to derive a price, if they were acquiring those underlying assets. The community also took the Hamburg Model as offering further clear evidence that nothing was going to be done with problem loans as long as the trouble was managed in a domestic environment and the auditors continued to sign-off the banks’ books on that basis.
Of course there have been some disposals from Germany, but these have been very much piecemeal, and relating to loans where either the bank could afford to take the haircut, or to situations where the owning entity was indisputably insolvent, forcing the bank then to mark to market, the (usually German) manager had lost the confidence of the lender, and enforcement had become a necessity. Commerzbank very recently confirmed that it had entered into a transaction to sell a bloc of 9 containerships at $160m (realising a loss of $56m) and that this was only the second such transaction executed by this unit within a 12 month period: hardly rapid disposal pace. Despite the fact that such transactions receive plenty of publicity in the shipping market, they are clearly small in the grand scheme of things. Moreover the investor play is nothing complex. The manager of this newly acquired fleet was quoted as saying ‘we can’t do anything different (from the previous owners) except they come with a healthier balance sheet that will allow these vessels time to get into a better market.’
It is unlikely that this situation can continue indefinitely without some change, however, particularly with the ECB due to opine formally on risk weighting, provisions, capital ratios etc. within the coming weeks. The Germans will have a hard time seeking exceptional treatment on valuation methodology for ships when they were at the heart of the pan-European argument on aggressive loan write-downs elsewhere, in real estate for example, in the Eurozone.
Ultimately, politics will play a significant role. We hear that, ’Everyone is shouting at everyone else’ on this subject. In the case of HSH, its solvency is guaranteed by two regional states, but undoubtedly they don’t want that guarantee to be called. Auditors are in the firing line because of the pressure to change all their existing/previous conclusions. BaFin is under pressure from the ECB on one side, and its banks on the other. There is probably a residual negative attitude in Brussels to German banking and domestic treatment of the Landesbanks in general. All in all, this is still a mess. Even legal action by the banks isn’t ruled out by some observers. That may be another way of playing for time, until a quiet, domestic burial can be engineered.
Even if loans are discounted, you still have to know the market values of the underlying asset. Outside of Germany, there have been relatively few major or complete sales of shipping loan books, but the most notable was undoubtedly that of Lloyds TSB in the UK, which has now all but completed a $9bn disposal. This was done in numerous tranches, typically of $500-750m. It is debatable whether, apart from the early deals done, there have been many winners amongst the (mostly PE and hedge fund) buyers. Too much money in credit funds chasing too few deals, perhaps?
Many of these financial investors undoubtedly took the view that they could replicate their expertise in corporate financial restructuring within the shipping sphere only to find out that the same rules don’t apply. Purchasing loans at a discount is all very good but this means nothing if the quality of the underlying ships is poor, or more importantly the real value of the underlying asset is misunderstood. Inability to understand the asset and its true worth in the market is a significant weakness for non-specialist credit investors. On top of this, shipping loans are far from homogeneous in structure, making it necessary to examine each one minutely. The unique nature of these loans also explains the absence of securitisations in the sector.
Although the situation in Germany has resulted in some banks there stopping new business, most notably Commerzbank and effectively HSH, others are still active. The issue for European banks as a whole is the risk weighting that the ECB will ascribe to shipping loans and the resultant capital requirements for such lending in the future. Ready access to U.S. dollars (in a market where nearly all transactions are in dollars) is also a factor.
Other banks that have been heavily involved in shipping lending for many years, and for whom it remains core business, such as the Scandinavian lenders DNB and Nordea, have suffered very low levels of default on their shipping loan books. Shipping, however, is not particularly well understood by those not directly involved in the market and the large credit agencies such as S&P and Moody’s are still trying to come to terms with the workings (and most probably valuation techniques) of the industry, as well as foreclosure costs, potential volatility in operating expenses, sets of unique individual loan documentation and so on. No wonder then that many of the European banks have been considering their options in this area and many have either scaled back or are effectively in run-off.
In conclusion, from whichever angle a potential buyer approaches shipping, there will be no substitute for homework on the real value of the assets (ships) involved, and expert help should be sought.