Tuesday, March 12, 2013

Why not a derivatives market in vessel asset values?

Shipping investment projects have always been mostly asset plays rather than new business models to serve customers more efficiently in the transport of cargo. The Greek shipping industry craves for investment in physical assets as opposed to the Norwegian asset-light cargo operator model with chartered-in tonnage often on purchase options. Profits are generated from moving in and out of assets in the shipping cycle. Cargo transport operations remains secondary in the process mainly to keep holding costs down. Lately investment firms have also gotten into the game, teaming up with operating companies to acquire shipping assets.

Would not it be easier and more efficient to develop a derivatives market for this process rather than taking on all the headaches of physical asset ownership?

The latest version of this asset play concept is the Oceanbulk Carriers partnership between Petros Pappas and Oaktree Capital with the purpose of picking up distressed dry cargo shipping assets and eventually making profits on market recovery. Petros Pappas has an excellent record as one of the most successful asset players in the Greek shipping community, having sold off most of his dry cargo fleet in the heady boom years of the late 2000’s to the point of even moving out of basic ship management and operations.

There is no doubt that the dry cargo business is currently under severe stress. The sector has been plagued for years with a historically high vessel order book on expectations of infinite Chinese growth with their insatiable appetite for commodities imports and incessant speculation in commodities resources. The Chinese themselves have become major shipbuilders with huge expansion of yard capacity, mainly for dry cargo vessels. It did not take much of a drop in Chinese growth rates in 2012 and some inventory destocking to send dry cargo freight rates tumbling.

As this point, several high profile listed dry cargo companies like Genco (GNK) and Excel Maritime (EXM) are on the verge of bankruptcy, plagued by asset prices falling below loan outstandings and cash flow problems to service the debt payments. Unlike Asian competitors like Pacific Basin with large cargo books, these companies themselves started as asset speculations. They leveraged up with debt to expand their fleets in large block purchase deals, playing the market cycle.

Excel Maritime went to the extreme of merging very unwisely with another asset play, Quintana (QMAR) shortly before the 2008 global financial crisis and reportedly taking on US$ 1 billion additional debt to finance this transaction. The motive to merge for the Quintana stakeholders backed in part by First Reserve private equity was to realize their asset position for profit because their operating profits were restricted by long term time charters and this kept their stock price from appreciating as much as they would have liked to see. Just the announcement that they were planning this move caused a bounce in their share price.

Contrary to their mission statement to focus on distressed assets, the Oceanbulk-Oaktree venture recently decided to place new orders rather than to wait for opportunities in existing tonnage. At the same time, their new business development director and former investment banker, Hamish Norton, recently gave a dry bulk presentation at an industry forum in Athens where he sagely noted that the continued drybulk order book risks putting off any market recovery for another year yet in the sector. So ordering additional dry cargo vessels would at least appear to be contributing to more industry distress and counter-productive in hastening any market upturn in rates.

Perhaps a vessel asset futures market – if feasible – would be a more efficient tool for these cyclical asset plays. The ship derivatives could be based on standard type bulk commodities vessels, just as the Baltic Freight index is based on standard voyage routes. Banks could use the derivatives in order to hedge their loan exposure, reducing their credit risks to shipping companies. Shipping companies could hedge their asset purchases against fall in value and impairment charges. Hedge funds and institutional investors could take speculative positions on rising and even falling asset prices.

The beauty of a derivatives market for ship values is that it would not entail any ship ordering. Shipping companies could go back to the fundamental business of transporting cargoes for their customers. Because the derivatives market would allow for both long and short positions on vessel values, it might even assist in providing a reduction of vessel asset price volatility. Positions could be taken and unwound very quickly.

All this would relieve investors from the trouble for these cumbersome partnerships to buy physical assets, the need for bank finance, the travails of ship management and needs to charter the vessels with risks of charterer default, etc., only to lead to a game of musical chairs on market recovery to sell the assets or the shares in the company to the next guy with a mark-up.

Of course, the last guy in the chain like Excel Maritime in the Quintana merger or Berlian Laju (acquiring Chembulk from AMA at a sizeable mark-up), is invariably left holding the candle, facing bankruptcy as the market sours.

The shipping industry would become more of a logistics business, but is it not what it was supposed to be in the first place?

Eurozone politicians face growing credibility problems from angry European voters

The European Union project is one of the biggest attempts in history to change the geopolitical status quo in Europe and eventually abolish the nation-state with rule from a supranational entity in Brussels. A principle mechanism for this unification is the Eurozone currency union, where 17 European Union (EU) member states that have adopted the euro (€) as their common currency and sole legal tender. Monetary policy of the zone is the responsibility of the European Central Bank (ECB) which is governed by a president and a board of the heads of national central banks. There is no common representation, governance or fiscal policy for the currency union. When rarely taken to plebiscite as in Sweden or Denmark, rank and file voters have rejected the concept, preferring to remain with national currencies. None of this has much broad public support or popular legitimacy in Europe beyond the European political elite.

Since 2008 an increasingly larger number of Eurozone Periphery countries have been facing national bankruptcy with high levels of public debt, trade imbalances and loss of market access to issue debt. The bailout programs have put the EU Periphery in deep recession with loss of output at levels similar or in excess of the Great Depression with very high levels of unemployment in excess of 20%. Last year the World Bank cited the Eurozone debt crisis as a major threat to the world economy that could lead to a renewed global financial crisis. We have not seen such an attempt at internationalization since the Soviet Union in the 1920’s and 1930’s at such heavy human cost with presently millions of Europeans out of the work and economically marginalized. The rise of broad-based popular discontent with the economic hardship is now challenging this new status quo in Europe.

Recent Italian elections results have reopened the Eurozone debt crisis with a majority of Italians voting for anti-Eurozone Beppe Grillo five star movement and the increasingly Eurosceptic PdL/ Legha Nord coalition. The pro-Eurozone Socialist PD and Monti parties had disappointing results. There are three basic dimensions to the Eurozone debt crisis:

• The EU political elite are locked into the concept of the Eurozone monetary union in which they have staked their careers as a new economic Utopia.

• The Eurozone area is mired in a deepening recession with a growing divergence between the Core members setting the policies and Periphery countries suffering by these policies severe loss of GDP, massive unemployment and permanent damage to their economies.

• The currency union is a powerful tool for forced political integration, but it was not founded on sound economic fundamentals nor the broad consent of European voters.

The severe economic dislocation with resulting social turmoil is discrediting the EU political elite and unleashing new political forces of renewed nationalism that may in the end result in a breakup of the currency union if the growing divergences cannot be resolved.

The purpose of the Eurozone was to enhance the single market and move the member states to political union. European policy makers frequently cite the United States as a proto-type with optimism that they will achieve the same political union under a single supra government. Of course, they overlook the fact that even today there exists considerable political tension between the US federal government and the various states. There is a continuing debate about the size and role of the US federal government – issues taboo for open discussion in Brussels. Further, it took a long and bloody civil war for the union to prevail in the US.

The challenges in Europe for union are much larger. European countries are nation-states with different languages and political cultures. European societies like Greece and Italy have no wish to become multicultural melting pots. The Greeks, for example, revolted from the Ottoman Empire with the concept of a homeland for all Greeks - both living in Greece and abroad – to be free, not terribly different from the more recent case of Israel.

The currency union was sold to the smaller EU countries as a road to prosperity because they would not have to worry about future currency devaluation vis-à-vis the other members and they would benefit by credit enhancement with lower interest rates and more credit availability.

The EU political elite discarded from the outset any trade flow criteria that would justify rational participation in a common currency zone. Instead of starting with a small and sound base of core members, they tried to get the maximum number of EU members to sign up for the project at the outset with the aim of using this currency zone as a lever for greater political union. Frequently, Eurozone entry - as in the case of Greece - was finessed by use of credit derivatives and accounting tricks with the collusion of the Brussels policy makers.

The Eurozone set-up lacked a central bank lender of the last resort. The commercial banks were to supply credit to member state governments. The ECB, moreover, operates under rules that the Germans insisted for their participation to mimic the German Bundesbank. The rigid monetary policy favored Germany and its exports over the other member states. This led over time to asset bubbles in the Periphery and created chronic import dependency in the Periphery countries, devastating local production. The growing trade imbalances left the Periphery country members with the dilemma of increased public indebtedness or deep recession and unemployment

Perhaps the most poorly understood aspect of a currency union is that by giving up national currency, basic social contracts like social security systems as well as commercial banking system were put in jeopardy.

Member countries no longer had any control over monetary policy, money creation or interest rates. They faced severe spending restraints.

They could no longer fund via their central banks their social security systems nor could they bail out their banking system in their local currency when under stress. Their heavy reliance on local commercial banks to finance their deficits starved their private sector from credit and ultimately led to the insolvency of their banking systems.

In financial crisis, they were totally beholden to the ECB, Brussels policy makers and the mercy of other member states for any assistance in a cumbersome, interminable and dysfunctional resolution process. In effect, Core members – namely Germany –dictate their terms on the weaker members in the workout programs with entire brunt of the adjustment process and pain falling on them. They suffer unwittingly a severe loss of their national sovereignty.

The Bank of England foreseeing these factors in their risk assessment blocked the UK from entering the Eurozone. The UK has its problems but its fate is in its own hands.

Eurozone members lack defacto the right to request IMF assistance without the consent of the other Eurozone members and then with heavy EU involvement with EU officials often at loggerheads with the IMF staff.

Normally for a sovereign nation under a bilateral IMF workout, the IMF would propose structural reforms along with a currency devaluation. The devaluation is meant to produce a boost in exports making immediately all goods and services cheaper whilst leaving wages, salaries and pensions intact. This primes the period of structural reforms making up for the lost output and unemployment in the restructuring process. The adjustment is less economically painful and socially destabilizing.

The Germans view EU periphery countries in terms of their unification experience with East Germany, where they developed their theories of ‘internal devaluation’ now used in all EU workout programs for debt-ridden EU periphery countries. Contrary to current US thinking to avoid recession and deflation, the EU/ German process purposely provokes deep recession and high unemployment to drive prices levels down through deflation in place of currency devaluation.

In the case of German reunification, it took over ten years for these structural reforms to have a serious impact. The cost for this process was a permanent population loss of 12% with chronic unemployment and low wage levels that remain today. This has been the pattern in all EU workouts, with severe GDP loss and high unemployment.

The countries under these EU/ German-style workouts are left with permanent economic damage from the severe deflation. Aging, shrinking European societies like Greece and Italy, simply cannot afford permanent population loss much less a prolonged period of lost growth. The severe loss in GDP is almost impossible to recoup. Chronically high unemployment, low wages and living standards remain for years.

The countries under these EU/ German workouts are invariably left with very high levels of debt as the relative value of debt increases in the deflationary environment whilst the capacity to pay it down diminishes with the shrinking economic output and population loss leading to an outbreak of private and public sector bankruptcies together with ensuing debt restructuring.

If bilateral IMF workouts left scars from the experience of pain and humiliation in South Asia countries, which led to their adoption of export policies to run trade surpluses for more financial independence, the severely harsher EU/ German method of ‘internal devaluation’ constitutes a highly explosive political time bomb in Europe.

The present European climate where EU periphery countries are mired in deep economic depressions with GDP compression and unemployment in excess of 20% has become surreal. EU governments promise a future nirvana of European unification with prosperity just around the corner. The Greek government, for example, is currently betting the house for economic recovery latter this year to buy time with increasingly violent protest.

The European electorate is rapidly discovering that the utopia of the Eurocurrency zone is a nightmare of economic pain and social marginalization. There is a growing sentiment that the EZ workout programs with constant creditor pressure for harsh measures for the next bailout installment and heavy-handed interference in local elections for a government of EU approval are an exhibition of tyranny and coercion. Voters increasingly feel that their political elite have not been truthful with them. Political rage is leading to the collapse of the traditional party systems and to creation of new anti-EU/ Eurozone protest parties that are growing rapidly in ranks.

This was the message of the recent Italian elections. Now the EU elite is currently searching desperately for a solution that they managed last June to achieve in Greece with the present docile, compliant pro-Euro government to continue the same highly unpopular policies. Italy as opposed to Greece is a larger country with considerably more debtor leverage. Should the EU/ Germany ultimately be obliged to consent to the growing demands in Italy to jettison austerity and higher taxes reversing the Monti government; then they risk a rebellion of the smaller Eurozone members, who are increasingly desperate.

The issue remains whether the EU elite will be able to put the genie back into the bottle and regain control as happened in the 1848 European unrest or this protest momentum will ultimately lead to their overturn and disgrace of the existing European Union status quo with the emergence of new political and social order in Europe.

Greece in the position of Oliver Twist under supervision of the EU in the role of Mr. Bumble could potentially get swept up in the Italian protest if it grows and spreads to other Eurozone member states.