The focus on ocean shipping vis-a-vis COVID-19 has been on what the outbreak means to the economy and what the economy means to vessel demand and freight rates.
There’s a different way to look at it: by focusing instead on what ocean shipping has to say about the COVID-19-era economy.
The global financial crisis in 2008-2009 differs in many ways from the current crisis, but even so, what befell shipowners in the decade after the Great Recession offers telling parallels to what U.S. businesses will likely face in the years ahead.
Income streams plunge
Shipowners rode a China-fueled super-cycle in the half-decade before the financial crisis. Record-high spot rates and time-charter rates supported historically steep vessel valuations. Bank debt was abundant, at times covering 90% of asset values. Lenders were relatively indiscriminate in whom they lent to.
When the global financial crisis struck, spot rates plummeted. Owners with long-term charter coverage at high precrisis rates thought they had protection, but they didn’t.
Many charterers either walked away outright or told vessel owners they would honor contracts only if rates were substantially reduced.
A massive wave of charter defaults ensued. When the dust settled, the income stream earned by ships — whether in the spot market, renegotiated time charters with existing counterparties, or time charters with new counterparties — was sharply reduced.
What this means today: A shipowner with long-term cover is analogous to a commercial or residential real estate owner, or the lessor of anything from cars to equipment. A ship owner with spot exposure is analogous to any business depending upon a daily flow of sales.
Because of the coronavirus, there is a heightened probability that lessees (renters) will default, or that lessees will only pay a substantially reduced rate — because they will not be able to afford to do otherwise. As with shipowners in the aftermath of the financial crisis, lessors (landlords) have contracts, but it may effectively be too costly to collect on those contracts, and lessees can ultimately fall back on bankruptcy protection.
The stakes are staggeringly high. According to one estimate, U.S. commercial real estate tenants pay $16 trillion in rent per year.
Asset values plunge
The value of any asset or business is derived from its income stream, whether it’s a crude tanker or a shopping mall, a commodity trading house or a laundromat. Slash the income stream and the resale value of an asset or business plummets.
Following the collapse in charter income in the wake of the Great Recession, the assessed value of oceangoing ships collapsed. Fleets at that time were highly leveraged. Banks require a certain level of collateral coverage for the loans, and the fall in asset values put the majority of shipowners in violation of their loan agreements’ loan-to-asset-value covenant.
Tripping those covenants and others required lenders to agree to not accelerate the loan and foreclose on the assets. The parties entered a so-called “forbearance” period as a restructuring plan was negotiated.
Long-term debt was reclassified as a current liability, dividends were halted, and language on “substantial doubt on the ability to continue as a going concern” became commonplace.
To help bridge the collateral gap left by the plunge in asset values, ships were sold (at below book values, requiring impairment charges), and if the shipowner was public, shares were sold at a discount to net asset value to raise cash.
Shipping stock prices sank in response to dilutive follow-on offerings, dividend restrictions and loss-making results. Many public owners had no choice but to conduct multiple reverse splits to keep their share price above $1, the minimum to remain listed. The pool of potential investors evaporated as share pricing and market caps fell below the floors required by various funds. It has been over a decade since the financial crisis and shipping stocks have yet to recover.
What this means today: The broader implication for U.S. business is that debt covenants are likely to be breached, if they haven’t already. According to Fitch Ratings, borrowers representing 17% of U.S. commercial mortgage-backed securities had already asked for forbearance as of April.
Investors who buy stocks for the dividends should watch this closely, because dividends are one of the first casualties of loan renegotiations.
Debt-covenant issues also raise a crucial question: Will U.S. creditors move aggressively to enforce their rights, or will they wait? International shipping creditors faced the same question a decade ago.
Changes of control ahead
Shipping banks did not foreclose on ships in the immediate aftermath of the Great Recession. The last thing banks wanted was to be stuck owning ships and paying managers to run them when rates were unprofitable.
Another reason shipping banks did not call their loans in the early years was that if they did so, they would have to write down the value of their loan portfolio and “crystallize” losses.
Instead of foreclosing, banks pursued a strategy known as “amend and extend” or “amend and pretend,” in which amortization (progress) payments were reduced and maturities were pushed back. The hope was that the shipping cycle would turn positive, asset values would recover, and covenant breaches would cure themselves.
Despite the banks’ leniency, many shipowners were forced to seek U.S. bankruptcy protection (whether Chapter 7 or 11 if the primary proceeding was in the U.S., or Chapter 15 if the primary proceeding was outside the U.S.), ultimately transforming defaulted debt into equity and/or paying back debt through asset sales. Bankruptcy filers in the first half-decade after the financial crisis included Eastwind, Excel Maritime, General Maritime, OSG, TBS, Trailer Bridge, Korea Line, Samsung Logix, Sahmo, Sanko, U.S. Shipping Partners, B&H, and Omega Navigation, among others.
The Chapter 11 filings of Genco Shipping & Trading (NYE: GNK) and Eagle Bulk Shipping (NASDAQ: EGLE) in 2014 highlighted a new trend.
As the years passed, banks became more willing to crystallize loan losses and write down portfolios — in part because regulators in Europe were forcing them to. Consequently, banks started to ask lower prices for distressed debt, which attracted more bids from private-equity (PE) buyers, and eventually the bid-ask spread narrowed. Bank debt of both Eagle Bulk and Genco was sold to PE buyers.
PE groups bought the debt to pursue a strategy called “loan to own.” Once they controlled the debt, they compelled the companies to restructure via Chapter 11 bankruptcies, with the PE debt converted to equity in the restructured companies.
Meanwhile, a different post-crisis pattern emerged in the container sector than in bulk shipping. Numerous container lines would have collapsed but governments bailed them out. One major carrier did finally go down in 2016: Hanjin Shipping. South Korea’s government stepped in to save Hyundai Merchant Marine but let Hanjin go under.
What this means today: The takeaway for U.S. businesses is that creditors may not move immediately to take over debtors’ properties even if they can legally do so, because they may not want to own and operate such properties in the middle of an economic crisis.
However, distress investors eventually move in. There will be changes of control ahead to the extent governments do not intervene. The COVID-19 crisis will curtail income streams, which will reduce property and business values, which will breach debt covenants, which will give creditors the right to accelerate loans, which will provide distress investors the opportunity to obtain ownership at highly discounted prices.
Funds are already in position to do so. A New York Times article published Wednesday reported that real-estate funds have around $300 billion ready and available to deploy on distress opportunities.
There is an important difference between today’s distress-investment scenario and what happened to shipping in the past decade.
PE investors pursuing loan-to-own strategies bought distressed shipping debt for 80-90 cents on the dollar in 2013-14, on the belief that asset values would revert to the mean. That turned out to be far too small a discount. Shipping asset values didn’t revert to the mean and many PE funds suffered heavy losses.
Distress investors will look at land-based properties and businesses differently in the wake of COVID-19 than in the case of a purely financial crisis. Behavioral changes will likely mean that values of some businesses and properties will not revert to previrus levels for many years, if ever. Consequently, buyers may insist upon much higher discounts, which would lock in the new normal for business valuations at even lower levels.
The new normal
Shipowners suffered through an incredibly tumultuous decade after the global financial crisis. A vast amount of value and wealth was lost and never recovered.
Ironically, shipowners’ travails put them in a better position to weather COVID-19. Because asset values are still low, they don’t have too far to fall this time around, so loan-to-value debt covenants are not being breached.
Bulk shipowners also have much lower leverage, with debt covering 50%-60% of asset value, not 90%. While the same is not true for container lines — which have very high leverage due to consolidation deals — governments are once again intervening to bail them out.
The challenge for many segments of the U.S. business community, particularly commercial real estate, is that values do indeed have a long way to fall. One need only look to the skyline of Manhattan to grasp the enormity of the problem.
It will be a long road ahead, more akin to the experience of ocean shipping post-2008 than to a regional recovery from a hurricane.
Businesses that can’t placate their creditors in the face of lower income streams will either go insolvent or see ownership change hands. The new normal for valuations for certain types of businesses and properties will dramatically decline. And for all the uncertainty that lies ahead, one thing is guaranteed: The lawyers will be extremely busy. Click for more FreightWaves/American Shipper articles by Greg Miller
