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Financing ships: A risk management perspective

Qurius Informationstag f端r die Schifffahrt 15. November 2011, Hanse Lounge

Financing ships: A risk management perspective

Prof. Dr. Wolfgang Drobetz Chair for Corporate and Ship Finance, University of Hamburg


Financing ships: A risk management perspective

Agenda 1. Introduction 2. Operating cash flows, asset values and the risks in the shipping industry 3. Risk management techniques and instruments in the shipping industry 4. Capital structure and financing choices of shipping companies 5. A capital market perspective of risk management

Universit채t Hamburg

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Financing ships: A risk management perspective Financing ships and shipping operations

Shipping Company Operating Cash Flows and Risks from Changes in Operating Cash Flows Risk Management with Derivatives

Risk Management in Cash Market

Asset Values and Risks from Changes in Market Value of Assets Risk Management in Cash Market

Risk Management with Insurance

Risk Management with Derivatives

Risk Management with Insurance

Assets: Net Exposure to Changes in Operating Cash Flows and Market Values Corporate Perspective: Optimizing Operations Corporate Perspective: Optimizing Capital Structure and Financing Financing: Financing Alternatives with Bank Loans, Bonds and Equity Bank Loans Interest Rate

Bonds Cost of Debt (Rating)

Equity Cost of Capital

Capital Market Perspective Securitization of Bank Loans Universit채t Hamburg

Diversification Opportunities of Default Risk

Diversification Opportunities of Unsystematic Risk 3


Financing ships: A risk management perspective

Agenda 1. Introduction 2. Operating cash flows, asset values and the risks in the shipping industry 3. Risk management techniques and instruments in the shipping industry 4. Capital structure and financing choices of shipping companies 5. A capital market perspective of risk management

Universit채t Hamburg

4


Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in operating cash flows (1)  Variability in earnings due to changes in freight rates represent the most important operating exposure of a shipping company.  The textbook demand-supply model assumes inelastic demand for freight services. The supply of freight services is highly elastic at low freight-rate levels but becomes inelastic at high-freight rate levels due to limited stock of fleet.  This model helps to explain statistical properties of freight rates… 

compared to other asset classes, freight rate volatility is very high;

volatility depends on vessel size and charter contract maturity;

volatility is time-varying (seasonalities and volatility clustering);

freight rates strongly deviate from normality (fat tails, negative skewness);

freight rates show autocorrelation (limited opportunities for substitution over time).

Universität Hamburg

5


Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in operating cash flows (2) 700 600 500 400 300 200 100 0 1990

1992

1994

Clarksea Index

Universit채t Hamburg

1996

1998

Baltic Dry Index

2000

2002

MSCI World Stock

2004

2006

2008

2010

J.P. Morgan Global Bond

6


Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in operating cash flows (3) 1990.01-2011.04, monthly data

Volatility

Skewness

Kurtosis

Normality (JB-test)

# Obs.

Mean

(S.D.)

(S)

(K)

Clarksea Index

256

-1.19

34.68

-0.48

5.39

70.1 ***

Baltic Dry Index (BDI)

256

-0.83

53.09

-1.16

14.38

1483.3 ***

Baltic Dirty Tanker Index (BDTI)

152

-0.46

62.00

0.13

4.41

13.0 ***

Baltic Clean Tanker Index (BCTI)

152

2.08

59.33

0.18

3.69

3.8

Bulker Second Hand Price Index

256

4.35

31.98

-1.90

19.87

3188.6 ***

Tanker Second Hand Price Index

256

1.87

13.20

0.26

16.05

1819.5 ***

Container Second Hand Price Index

174

0.15

17.39

-1.13

9.65

358.1 ***

BOFA High Yield Shipping Bond Index

179

8.37

10.19

-1.74

16.98

1547.9 ***

MSCI World Stock Market Index

256

6.37

15.73

-0.88

4.97

74.1 ***

J.P. Morgan Global Government Bond Index

256

7.02

6.59

0.00

3.34

1.2

Data sources: Clarksonsand Thomson Financial Universit채t Hamburg

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Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in the market value of assets (1)  Vessel price volatility affects the balance sheets of listed shipping companies by generating accounting exposure.  There are again several stylized facts about vessel price volatility: 

Prices of larger ships are more volatile than prices of smaller ships.

Prices of second-hand ships are more volatile than prices of new-buildings.

Vessel price volatility is time-varying and affected by macroeconomic variables.

 Fair value accounting standards have made changes in the market value of vessels visible. Shipping companies were forced to deal with impairment issues.  The “fair value” is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (hence not a forced liquidation or sold under duress).

Universität Hamburg

8


Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in the market value of assets (2)  Hedging the risks that emanate from mark-to-market accounting is inconsistent with the notion that investors are able to focus on a shipping company’s true cash-flow-generating ability.  Impairment losses increase a shipping bank’s risks by reducing collateral values, and they require an increase in the regulatory equity capital.  Recent theoretical models predict that market prices and fundamental values can diverge; liquidation becomes costly when an accumulation of assets is liquidated at the same time: 

The maximum amount of collateralized borrowing that can be supported by an asset can fall and even be equal the minimum possible future value of the asset.

Even if the arrival of bad news signals only a small change in the fundamental value, lenders may reduce the maturity of debt they are willing to hold, and the decline in the amount of collateralized borrowing can be substantial (liquidity freeze).

Universität Hamburg

9


Financing ships: A risk management perspective Operating cash flows, asset values and the risks in the shipping industry

Risks from changes in the market value of assets (3)  Vessel price risk not only affects a single shipping company and its lending institution, but it can magnify shocks to the economy through a collateral channel.  High vessel price volatility has a negative impact on collateral values, potentially leading to financial distress (or even bankruptcy) and “fire-sale” externalities… 

a shipping company’s bankruptcy increases the likelihood of vessel sales, and the increasing supply puts downward pressure on the value of similar vessels;

shipping banks were reluctant to liquidate collaterals from non-performing loans although loan-to value covenants were broken;

banks were forced to allocate additional equity capital, limiting banks’ lending capacity and raising the cost of debt capital industry-wide.

Universität Hamburg

10


Financing ships: A risk management perspective

Agenda 1. Introduction 2. Operating cash flows, asset values and the risks in the shipping industry 3. Risk management techniques and instruments in the shipping industry 4. Capital structure and financing choices of shipping companies 5. A capital market perspective of risk management

Universit채t Hamburg

11


Financing ships: A risk management perspective Risk management techniques in the shipping industry

Managing cash flow risks through operations (1)  Investments in different size vessels offer portfolio diversifying effects similar to different financial assets in an investor’s portfolio.  Strategic risk management decisions also involve the choice of the appropriate type of employment for the vessels (spot vs. time-charter).  Another possibility to smooth freight earnings is to take tactical decisions by exploit temporal seasonalities in freight rates.  To some extent, these operational strategies are useful in reducing risk, but… 

it is costly and takes time to buy/sell vessels and to go into/out of freight contracts;

long-term contracts are hard to find when the market declines (charter-party risk);

putting a large portion of the fleet on long-term charter rather than employing the vessels on the spot market may imply losing knowledge and customer relationship;

owners specialize into segments with largest benefits from operational expertise.

Universität Hamburg

12


Financing ships: A risk management perspective Risk management techniques in the shipping industry

Managing cash flow risks through operations (2) BCI

BPI

BHI

BDTI

BCTI

MSCI

JPM

Wheat

Corn

BPI

0,74

BHI

0,42

0,58

BDTI

0,35

0,52

0,30

BCTI

-0,26

-0,01

0,09

0,72

MSCI World Stock

-0,36

-0,23

-0,02

-0,32

-0,08

JPM Global Bond

0,00

-0,16

-0,19

-0,29

-0,15

0,33

-0,07

-0,22

-0,38

-0,12

0,04

0,18

0,30

Corn

0,12

-0,16

-0,03

-0,11

-0,11

0,04

0,24

0,68

Iron ore

0,09

0,26

0,12

-0,06

-0,22

0,33

-0,31

-0,10

-0,33

Brent oil

0,28

0,09

0,01

0,15

-0,13

0,41

0,17

0,18

0,13

Wheat

Iron ore

0,20

Data sources: Clarkson and Thomson Financial Universit채t Hamburg

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Financing ships: A risk management perspective Risk management techniques in the shipping industry

Managing cash flow risks using freight rate derivatives  There are two generic types of Forward Freight Agreement (FFA) trades… 

shipowners and ship operators want to transfer the risk of an unexpected decline in freight rates, and hence they hedge their freight in-come by selling FFAs (short FFA);

the charterer of a vessel wants to protect against unexpected increases in freight rates, and buying FFAs limits the charter payments to be made (long FFA).

 Freight options are more flexible… 

shipowners who and ship operators want to protect freight income against declines in freight rates will buy put options;

the charterer of a vessel who attempts to protect against an increase in the cost of transportation will buy call options.

 Vessel price derivative and scrap derivatives are still in infancy.

Universität Hamburg

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Financing ships: A risk management perspective Risk management techniques in the shipping industry

Risk management and capital structure (1)  A company’s net risk exposure must be covered by sufficient equity capital. 

Shipping companies need to trade-off the risks from changes in operating cash flows and asset values with the scope of their risk management activities through changes in their operations and using financial derivatives.

Shipping companies with higher business risks should be more likely to practice risk management, and vice versa.

 In addition to risk management activities on the asset side of the balance sheet, the capital structure constitutes another layer of risk management. 

Risk management and equity capital are to some extent substitutes.

By reducing leverage a shipping company reduces shareholders’ total risk exposure; equity is a residual claim and offers an all-purpose risk cushion against losses.

Equity provides protection against all risks that are difficult to anticipate or measure, or for which no suitable derivative instruments are available.

Universität Hamburg

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Financing ships: A risk management perspective Risk management techniques in the shipping industry

Risk management and capital structure (2) 60% 50% 40% 30% 20% 10% 0%

Sample: 108 listed shipping companies; 1992-2010. Book leverage is defined as total (interest bearing) debt divided by total assets , market values use book levels of debt.

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Universit채t Hamburg

Shipping Companies (Book)

G7 Benchmark (Book)

Shipping Companies (Market)

G7 Benchmark (Market)

16


Financing ships: A risk management perspective Risk management techniques in the shipping industry

Risk management and capital structure (3)  Integrated risk management involves simultaneous decisions about shipping operations, the use of financial derivatives and capital structure choices… 

the more a shipping company hedges its business risk exposures, the less equity it requires to support its business and minimize the risk of bankruptcy;

given that risk management and equity capital are to some extent substitutes, companies with little debt financing may gain less from hedging the overall risk position.

 Compared to the mean book leverage of all companies from the G7 countries in Compustat Global, shipping companies carry high financial leverage.  Given their high financial leverage, shipping companies would be natural candidates to engage in risk management activities.

Universität Hamburg

17


Financing ships: A risk management perspective

Agenda 1. Introduction 2. Operating cash flows, asset values and the risks in the shipping industry 3. Risk management techniques and instruments in the shipping industry 4. Capital structure and financing choices of shipping companies 5. A capital market perspective of risk management

Universit채t Hamburg

18


Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Determinants of shipping firms’ capital structure  Liquid assets are less costly to monitor and liquidate for debtholders, and hence higher asset liquidity increases the optimal amount of leverage.  Asset liquidity decreases the expected costs of financial distress (reducing the discount when forced to sell in “normal” times) and allows more debt.  High tangibility makes vessels good collaterals for a loan, and therefore a higher fraction of tangible assets increases a company’s debt capacity.  Many shipping companies are founder-dominated… 

more leverage allows for higher concentration of equity ownership and better control opportunities for (founder) blockholders;

supporting the notion that debt is a non-control-diluting security, family-dominated firms have a preference for debt financing and are reluctant to raise public equity.

Universität Hamburg

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Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Traditional sources of ship finance

Source: ABN AMRO, 2011 Universit채t Hamburg

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Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Syndicated shipping loans 100 90

Source: Marine Money, 2011 Annual issuance,in $bn

80 70 60 50 40 30 20 10 0 2000

Universit채t Hamburg

2001

2002

2003

2004

2005

2006

2007

2008

2009

21


Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Shipping bond issuances 12 Quelle: Marine Money, 2011 Annual numbers in $bn

10

8

6

4

2

0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Universit채t Hamburg

22


Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Shipping equity issuances 18 16

Source: Marine Money, 2011 Annual numbers in $bn (IPOs and seasoned equity issuances)

14 12 10 8 6 4 2 0 2000

Universit채t Hamburg

2001

2002

2003

2004

2005

2006

2007

2008

2009

23


Financing ships: A risk management perspective

Agenda 1. Introduction 2. Operating cash flows, asset values and the risks in the shipping industry 3. Risk management techniques and instruments in the shipping industry 4. Capital structure and financing choices of shipping companies 5. A capital market perspective of risk management

Universit채t Hamburg

24


Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Shifting from indirect finance to direct finance (1)  The regulatory environment makes it difficult for banks to bear the risks involved in lending to the shipping industry.  The Basel III rules supervise liquidity risks and limit maturity transformation… 

a net stable funding ratio for structural liquidity on the balance sheet weighs available funds with regard to stability and compares it to refinancing needs of assets;

this requires banks to refinance loans on a long-term basis through capital markets, albeit the market for funds with maturities of 5-10 year has become illiquid;

a new (non-risk based) leverage ratio compares Tier 1 capital to unweighted total assets and off balance sheet items; the minimum (unweighted) leverage ratio is 3%;

for riskier loans this ratio is automatically fulfilled through the “normal” capital adequacy standards; however, for ship mortgage bonds with lower risks (and lower risk weights) this ratio will be binding.

Universität Hamburg

25


Financing ships: A risk management perspective Capital structure and financing choices of shipping companies

Shifting from indirect finance to direct finance (2)  Banks are unable to keep the risks from shipping loans on their balance sheets, and bank facilities for ship financing are likely to decrease. 

High cash flow volatility, lower collateral values due to fair value accounting and lower ratings of shipping companies require banks to increase their regulatory capital.

 Banks can transfer these risks by securitizing shipping loans.  Larger shipping companies with higher debt capacity and access to capital markets are able to arrange an additional risk transformation on their own balance sheet by directly issuing bonds and stocks.  The role of shipping banks will change from a lending institution (commercial banking) to an arranger (investment banking) of a variety of financing structures in the capital markets.

Universität Hamburg

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Financing ships: A risk management perspective A capital market perspective of risk management

Corporate risk management and equity exposure  If risk management should not minimize cash flow volatility, there is no unique answer whether a company should hedge all risks, deal only with certain kinds of risk or leave all exposures unhedged.  A question is whether management of the equity risk exposure should happen at the firm-level or at the market-level… 

diversification offers a powerful and inexpensive risk management tool. Many risks a shipping company faces will not increase the risk of a diversified investor portfolio;

according to this irrelevance hypothesis, firm-level risk management activities only reduce the cash flow variance, but not the cost of capital;

if investors and creditors find it difficult and costly to monitor the firm’s changing risk exposures, less volatile cash flows can reduce monitoring costs, facilitate performance evaluation and eventually reduce the cost of capital (e.g., by communicating what freight exposure will remain after a firm-level risk management program).

Universität Hamburg

27


Financing ships: A risk management perspective A capital market perspective of risk management

Capital market frictions, cost of capital and valuation (1)  Risk reduction through hedging can only add value if the cash flow volatility arising from such risks has potential “real” costs on a shipping company… 

risk management with the goal to limit the probability and the costs of financial distress may effectively reduce distress costs;

volatile freight rates and limited access to debt capital provide an incentive to protect cash flows against a spike in freight rates to achieve a certain bond rating;

loans usually have cash covenants that require to hedge a part of total revenues.

 Hedging can help to ensure that a company is able to fund all profitable investment projects internally and avoid an underinvestment situation… 

the value of hedging depends on the correlation between a company’s investment opportunities and the cash-flow effects associated with hedgeable risks;

a higher correlation reduces the probability for an underinvestment situation.

Universität Hamburg

28


Financing ships: A risk management perspective A capital market perspective of risk management

Capital market frictions, cost of capital and valuation (2) 0,9

(Clarksea, Capex/at)  0.32

0,7 0,5 0,3 0,1 -0,1

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-0,3 Clarksea

-0,5

CAPEX/AT

-0,7

Investment opportunities and actual spending are greater during periods with low or decreasing freight rates… 

the value added of hedging is to preserve a company’s ability to exploit investment opportunities when freight rates are low and cash flows/vessel values are down;

hedging freight rates may enable asset players to acquire vessels at fire-sale prices during periods of weak cash flows.

Universität Hamburg

29


Financing ships: A risk management perspective A capital market perspective of risk management

Implications for the shipping financial risk manager (1)  Another real cost of unhedged risk exposures relates to the required returns to owners of closely held shipping firms… 

blockholders and family-owners have most of their wealth tied up in the company, and they are under-diversified in the sense that their required rate of return reflects both systematic and non-systematic (or diversifiable) sources of risk;

given a concentrated ownership structure, risk management may not only serve riskaverse managers who fear personal consequences from volatility, but it could rather help to increase firm value by decreasing the owners’ required rate of return.

 A shipping company needs to understand its comparative advantages… 

it seems unlikely that in the case of exchange rates, interest rates or bunker prices, a shipping company has access to superior information;

as long as these risks do not endanger a shipping company’s operations and its financial flexibility, there is little reason to devote resources to hedge them.

Universität Hamburg

30


Financing ships: A risk management perspective A capital market perspective of risk management

Implications for the shipping financial risk manager (2)  If they have a comparative advantage in taking freight rate risks, shipping companies may choose the hedge selectively (i.e. time the market based on subjective views)… 

this requires a capability of “self-insuring” over a full business cycle and large potential trading losses do not endanger the continuation of operating activities;

an asset player makes active bets on changing vessel prices, and hence he may have a superior opinion about shipping markets;

if the focus is on the mere transport of goods, a shipping company may refrain from hedging due to the lack of comparative advantages or, if freight rate risk endangers the normal operations, simply hedge a fixed fraction of expected annual freight;

selective hedging requires having some informational advantage over other market participants. If the FFA rate is an unbiased predictor of the future spot rate, the concepts of selective hedging and speculation are hard to disentangle.

Universität Hamburg

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Vortrag Schiffsfinanzierung aus Sicht des Risikomanagements_Qurius Schifffahrstag 15._November 2011