Is the Chinese eldorado that fuels shipping investments coming to an end?

This year has seen considerable new investment in large block speculative shipping deals. Peter Georgiopoulos did a US$ 886 mio deal in May to buyout the Metrostar fleet, and now a US$ 545 mio deal for 16 bulkers from Bourbon. Metrostar paid a record price of US$ 180 mio for five container vessels. The driver is anticipated economic recovery driven by Chinese export growth. Good times again as if the 2008 meltdown never happened. Yet already there are signs of a slowdown. Will China save the day?

Global growth since the 1980's has depended increasingly on monetary easing to induce asset inflation for stimulus, each dose of monetary stimulus resulting gradually in weaker recoveries with increasing joblessness. Wages in Western countries have remained fairly static and the government authorities have encouraged consumer lending to prime consumer spending with households becoming increasingly indebted. As an example, much of the growth in the US since the Dot.com meltdown of 2000 was due to easy money that fueled a real estate bubble and led to the subprime mortgage crisis and massive foreclosures. The housing market in the US remains moribund.

The Asian emerging market countries since their financial crisis in the late 1990's moved to a neo-mercantilism whereby they kept their currencies undervalued to generate large trade surpluses through aggressive export policies. They recycle the money into developed western countries keeping down their exchange rates and financing their trade partners' deficits. One of Ben Bernanke's major speeches a few years before he become FED chairman was characteristically entitled "The Global Saving Glut and the U.S. Current Account Deficit" as a sign the times.

Eerily reminiscent of the defunct Dot.com investment craze, China has become the rage with investors as an eldorado of unlimited growth potential. This optimism fueled interest for shipping issues on Wall Street, especially for dry cargo vessels to transport iron ore and coal for the steel production with the increased demand created by the real estate boom in coastal areas. Likewise investors went wild over the container sector where the only concerns of Seaspan (SSW) CEO Jerry Wang were whether Los Angeles could expand its port facilities to cope with the insatiable demand for Chinese goods.

Since the 2008 meltdown, there has been a modest recovery in both the US and EU but there remains a huge sovereign, corporate and household debt overhang in a balance sheet style recession. The most robust growth has been in emerging markets where there are much lower sovereign debt levels. The Chinese could finance their stimulus out of their trade surpluses, but there is growing evidence that the stimulus money has resulted in commodities inventory stocking as well as an over-heated housing market that is causing a serious real estate bubble.

Growth in the US seems to be slowing now that we are moving to the second half of the year. The EU has been confronted with serious sovereign debt problems in their weaker members of which Greece is now under a joint IMF-EU workout. Bad management of the Greek crisis and serious structural deficiencies in the Euro system resulted in contagion in other member countries, which led to a massive emergency EU bailout facility funded by member states and IMF participation. The ECB balance sheet is filled with toxic EU government securities.  It even suspended minimal ratings standards for Greece. The weaker PIIGS members are all under strict austerity programs. The UK, whilst in a somewhat better position free of the Euro albatross, has also voluntarily started an austerity program to address its fiscal and debt problems.

In this environment, Chinese capital surpluses are becoming harder to export. The weaker EU members were the second largest importer of these surpluses, but now austerity programs make this unsustainable. There is is already evidence of falling trade volume on western bound container trade lanes from the Far East. Meanwhile dry cargo freights as represented by the BDI have plummeted to levels not seen since the fall of 2008. The dry cargo pundits feel that the drop in dry bulk rates is only temporary due to Chinese contract renewal negotiations with producers. Likewise, container operators like Maersk, euphoric over recent transpacific rate increases, are projecting a surge in profits that match 2008 levels. External signs, however, are troubling.

What we see is that China has an increasingly volatile economy with large swings. The real estate is showing signs of decline. Non-performing loans are on the rise. Dependence on the US to export trade surpluses has risen since EU sovereign debt problems and austerity programs. The next tension is likely to be between the US and China on trade surpluses, especially if US unemployment remains at present levels. The last thing that China wants is to import the surpluses domestically because this would lead to currency appreciation and risk bankrupting the exporting companies.

All hopes at present are on another Chinese stimulus program to shore up the output gap. There appears a growing internal debate on how to manage their housing bubble and overheated economy, but the other major issue is the sustainability of the export model and how to deal with the shock from the EU and US taking measures to address defensively their large unemployment problems in a time span that is out of their control.

As FT's Walter Munchau put it:

The pessimists believe that a strong global recovery is unlikely given the persistence of financial stress, and the deleveraging of the private and public sectors across the industrialized world.

The optimists divide into two groups. There are those who have difficulties counting to zero, who cannot add up the global private, public, and foreign balances, which must equal zero by definition.

And then there are the rational optimists, whose expectations of resurgence in private sector demand must surely rest on the assumption of a return to even greater global imbalances than before the crisis, to which the eurozone will this time contribute actively. But this is surely not a sustainable position.

The pessimists would argue that global demand growth will not be sufficiently strong to support a selfsustained recovery in the eurozone. Even the rational optimists, who believe that this is possible, would probably conclude that these imbalances are not sustainable, and may trigger another financial crisis down the road. And if that is what you expect, you are not really an optimist.

What we know is that some of our societies are deeply over-leveraged, and that de-leveraging them means running trade surpluses, not deficits. That is not good for China nor the 'smart money' in shipping!

A prolonged, sluggish global recovery with high levels of unemployment in Western consumer economies and possibly a series of sovereign defaults of which the restructuring of the Greek public debt is high on the agenda would lead to renewed stress on the banking system, particularly in Europe. Overleveraged companies having already negotiated covenant extensions with their banks may be forced to sell assets at distressed prices that everyone has been trying to avoid the last few years.

We see a lot of 'smart money' in shipping assets. The new IPO's earlier this year like Baltic (BALT), Crude Carriers (CRU) and Scorpio (STNG) are all trading at discounts.  Albeit these companies have bought marked down assets and have low leverage, it is unlikely there will be appetite for further issues unless the discount is closed. It will be interesting to see what levels, Genco (GNK) obtains in raising equity and debt funding to close the 16-vessel Bourbon deal. Generally, Wall Street remains soft and shipping issues have generally never recovered to pre-2008 levels. Many of them are trading below US$ 10.

Is the container sector really out of the woods yet?

Investors have been euphoric over the rate increases in transpacific annual contracts. The container sector attracts keen investor interest due the long term employment with large liner companies like Maersk (OMX: MAERSKB) considered too big to fail. As a result, the sector has been plagued by huge order book overcapacity. The demand driver is the proverbial Chinese export machine. Yet container earnings may be peaking, given slowing US consumption, high retail inventory and Europe’s financial woes.

The global financial crisis hit Maersk and other liner operators very hard. They had aggressively ordered new tonnage as well as chartered in vessels from non-operating owners like Seaspan and Danaos , who had order books as large as their existing fleets. 

Maersk sank to a loss of US $1.02 bn in the historically low rate environment of 2009, overturning a profit of US $3.46 bn a year earlier. The liner operation fell to a $2.09 bn loss for the full-year as income from its containerships collapsed by nearly 30%. Aside from the container losses, Maersk also made a dreadful timing mistake in acquiring the Broström tanker fleet at top of the market prices shortly before the 2008 meltdown.

In this difficult environment, the liner companies fought back earlier this year by slow-steaming to try artificially to reinflate demand and reduce their losses from the dramatic drop in cargo volume. Industry consultants AXS Alphaliner estimate 78% and 53% the Asia-Europe and Transpacific routes strings are still running in slow steaming mode currently. Maersk also became a leader in cost cutting.

During 2010, the container shipping market was been positively affected by growing demand, primarily due to inventory restocking in the US and Europe and, to a lesser extent, growing consumer demand. Growth was seen mainly on the head haul routes and Intra Asia, which increased by 18% and 70%, respectively. Average rates in the first quarter were $2,863 per FFE, up by 18% compared to the same period of 2009 as a result of improved market conditions and higher bunker surcharges.

Maersk banked US $639 mio in the first quarter, overturning last year’s US $ 372 mio loss and smashing the US$ 225 mio consensus among analysts.

Citigroup analyst Ally Ma feels that the return to profitability for many lines may mark the beginning of renewed capacity woes as they begin taking delivery of deferred new building orders placed prior to the global financial crisis, against a backdrop of weakening demand. She reckons that the 3rd quarter rate hikes may indicate that container earnings are peaking, given slowing US consumption, high retail inventory and Europe’s financial woes.

Most new building deliveries to date are directly being employed in strings running on slow steaming effectively dampening the supply growth. The German KG market has for the past decade been a major asset provider to the container operators, owning the vessels and chartering out to the liner companies. KG participants are still facing insolvency issues and despite the recent market surge in charter rates, payments are insufficient to cover the payment of interest and principal in 2010 and 2011.

Non-Operating owners to continue facing financing issues as bank credit remains tight. Danaos Shipping (DAC) announced cancellation of three new buildings of 6,500 TEU which were ordered at Hanjin Heavy Industries and initially expected to be delivered in the first half of 2012. Seaspan (SSW) in a filing to the stock exchange stated funding shortfall for its remaining capex commitments and hinted at further cancellations on the cards.

The future of the container industry hinges on the quality of the economic recovery ahead. The US recovery seems to be slowing down and the EU is facing a serious sovereign debt crisis where austerity measures in Southern European countries are likely to dampen severely demand.

The temptation to buy speculatively container tonnage today has led to a rise in asset prices as each new deal brings new highs. Indicatively, Metrostar is said to have shelled out some US $180 mio to buy five 10-year-old 3,500-teu ships from German owner Claus-Peter Offen. This is double what the vessels might have fetched at the start of the year.

This is driven by the expectation that container rates will soon regain historic norms and present rates are closer to 50% of this level leaving room for improvement. Yet this counter-cyclical investment could prove self defeating in dealing with the overcapacity should the recover stall and we face a longer period of sluggish growth as opposed to the forecasts of politicians and pundits.

Peter G's big gamble

Peter Georgiopoulos has been aggressively scaling up his 3 publicly listed companies: Baltic (BALT), Genmar (GMR) and Genco (GNK) with massive block vessel acquisition deals. Whilst asset prices are down from boom year levels, bulk carrier prices have risen considerably off the meltdown lows. Bulk carrier freight rates have fallen sharply. Economists like Nouriel Roubini predict a weaker 2H 2010 and a sluggish recovery ahead, with potential public debt defaults ahead. Does Peter G's timing make sense?

Baltic was conceived in late 2009 as a pure dry cargo play based on opportunistic vessel purchases, spot employment and low leverage with a high dividend payout. Baltic's IPO was successful, but at a larger discount than anticipated. It was priced between US$ 13-14 but it is currently trading at US$ 9-10. It is a captive company of Genco (GNK) who manages the vessels and earns commissions on its fixtures and S+P transactions.

Genco (GNK) crashed in 2008 to US$ 6,50-7, but then made a modest recovery in 2009. Lately it has been under pressure, trading around US$ 14-15.

Genmar (GMR), the oldest Georgiopoulos company concentrating on tankers, is trading around US$ 5,40, which represent new lows for the year. In 2009, it underwent debt restructuring with its senior lenders, which it partially refinanced by a bond issue that cost more than originally anticipated. The successful US$ 200 mio equity raise for the Metrostar 7-vessel block deal was priced at US$ 6,75, only a modest discount. Investors are presently under water, but the increased equity strengthened the company balance sheet by lowering the leverage to 70% down from 75%.

The latest Platou market reports makes subdued projections for the drybulk sector that would indicate that Peter G's timing may not prove to be the best in making his bulker acquisitions. The tanker market is looking better, but Genmar remains with fairly high bank leverage. This would generate exceptional returns if the tanker markets continues to improve, but it also means further covenant violations with senior lenders in a poor market.

The investment thesis depends on China and emerging market growth. China slowdown in construction has sent dry bulk rates southwards lately. Supply-demand conditions and cyclicals are more favorable for the tanker sector but projected demand growth in crude oil transport is low in coming years.

Time will tell whether Peter G's was overly aggressive in his massive block deals of 2010. I think that analysts may have been overly optimistic on the timing. At least, the market has been pricing the shares differently from the analysts.  The next test will be the forthcoming equity raise for Genco to support the 16-vessel Bourbon block dry bulk acquisition deal.

Kabuki theater reigns in Brussels and Athens before the deluge

No one in Brussels or Athens really seems to know what they are doing outside of Kabuki theater. Plans are made hastily and revised on a daily basis. Like the Titanic, they continue to insist that their ship is unsinkable (and there will not be any financial losses) but there are clearly not enough lifeboats for all the passengers to escape alive.

Today’s European Union does not seem very far from Thomas Mann’s masterpiece "Magic Mountain" depicting pre-WW1 Europe in an allegory of self-denial prophetically in Davos, Switzerland where there is now an annual world economic forum.

Kabuki ritual inhibits EU members from engaging in any frank and substantive discussion over the dysfunctionality of their Euro currency union. Despite their LSE credentials, George Papandreou and George Papaconstantinou give the impression of showmen rather than economic literates in terms of their performance over the past few months in the handling of this crisis, first promising expanded entitlements by soaking the rich to win the October elections, then temporizing over the debt refinancing problems until Davos and finally capitulating to the EU demands whilst feigning that they were not asking for any help. Mind you that whenever economics is laced with politics, the results are nearly always toxic no matter who are the actors involved.

Since the 2008 meltdown, it was always difficult to fathom how the remedy of socializing private losses on public balance sheets made any sense. This strategy always seemed like pushing the problem around rather than addressing the issues of overleveraging and cleaning up balance sheets in the financial industry. It was built on a wall of hope that financial engineering would lead to a robust recovery and in time, the losses would disappear like a bad dream without any pain or consequence.

Europe, overtaxed and overleveraged, is one of the most exposed regions with the slimmest means to hold out until better days. The Euro system was badly constructed on inflexible rules that Milton Friedman once called the equivalent of “locking yourself in a room and throwing the keys out the window….” It is not surprising that Eurozone is becoming a leader in sovereign debt crises and this is putting the currency union to test.

Greece was an accident waiting to happen. The last time there was productive investment was back in the 1960’s when there was a policy of balanced budgets, strict control over entitlements and major projects in refineries, shipyards and aluminum production. The Military Junta, black-listed by Western governments for loans, openly solicited private investment, with a vision to develop Greece as an offshore center for the Middle East. Greek construction companies expanded abroad in Middle East infrastructure projects. Piraeus was filled with new shipping companies. Major corporations established marketing offices in Greece and foreign banks queued to open branch offices. Greek per capita income increased three fold over a short period of time. Greece seemed a fledging emerging market economy with a GDP larger than Turkey at the time.

When the politicians returned in 1974; seething with resentment and bitterness after years out of power, they started to settle accounts with the business community who had prospered in this period. Socialism and transfer of wealth become the predominate development model and the private sector was to service the state. Onassis was driven out of Olympic Airways, the Andreadis businesses were confiscated. They created a web of laws and regulations that forced many businesses into debt and bankruptcy. This unfortunate climate was escalated by the Socialist triumph of 1981. The Socialists massively expanded entitlements, extending them to many who had never paid any contributions. They moved to socialize failing businesses, transforming them into loss-making state owned enterprises staffing them with party cronies. Public deficits soared and public debt rose rapidly. By 1986, Greece was forced to devalue the drachmae and declare the first of a serious of austerity programs. Interest expense soaked up public budgets and it was in part monetized by double digit inflation.

It was in this climate that the Socialist Party back in power after a brief hiatus in the early 1990’s decided to make entry into the Eurozone a national priority. They were enticed by the benefits of low interest rates to relieve their financial woes from their mounting debts and stagnating economy without a stable tax base. Their concept of development was use of EU transfer money for large public infrastructure projects. They used the privatization allegedly to enrich themselves on the Athens stock exchange by rampant insider trading, playing musical chairs taking positions through state-controlled corporations. They shunned arms-length professional management preferring control through union-affiliated pension funds.   Brussels welcomed them in open arms because they wanted as many countries to participate as possible in the new currency union and this was a means for them to expand their markets into southern Europe. Indeed the relations between Brussels and Athens seemed almost symbiotic at the time. This EU culture of corruption is partially borne out by the Siemens trials in Germany where Siemens top management allegedly bribed Greek officials of the two major parties to obtain contracts for security equipment required for the Athens Olympics - indicative of the times.

As Simon Johnson elegantly points out in his recent WSJ piece “The Greek Tragedy That Changed Europe”:

If Greece (and the other troubled countries) still had their own currencies, it would all be a lot easier. Just as in the U.K. since 2008, their exchange rates would depreciate sharply. This would lower the cost of labor, making them competitive again (remember Asia after 1997-'98) while also inflating asset prices and helping to refloat borrowers who are underwater on their mortgages and other debts. It would undoubtedly hurt the Germans and the French, who would suffer from less competitiveness—but when you are in deep trouble, who cares?

Indeed prior 2002 when Greece abandoned the Drachma, the Bank of Greece had a policy of slow depreciation against the US dollar. Inflation was higher than hard money countries but prices were lower. People sheltered themselves by investing in real estate and holding foreign currency. Interest rates were as high as 20% at times on Greek government obligations so savings was rewarded. Consumer credit was limited. Euro entry created enormous distortions. Local prices started to rise to EU levels but salary levels lagged, putting considerable pressure on the middle and lower classes. Interest paid on savings became negligible. People turned to consumer credit to cover their diminished purchasing power. Banks prospered with enormous spreads. The Greek state was able to borrow with hard money credit ratings so the public balance sheet grew. The commercial deficits soared. Greek domestic production was replaced by EU imports. This credit expansion fueled the price increases. The Greek government was lax to take restrictive measures fearing a popular revolt since the population was under increasing economic pressure, unemployment remained high (especially youth unemployment was at disastrous levels) and they feared the bursting of the domestic credit bubble.

Brussels offered them no solace because as Simon Johnson puts it: ECB policies have been overly contractionary—resulting in a strong euro and very low inflation—and not appropriate for member countries in the midst of a financial collapse. Milton Friedman said that putting your money in the hands of others was bound to lead to conflicts.

Indeed it was the ECB according to Simon Johnson – not “speculators” - who initiated the crisis in Greek spreads when on German prodding they decided to cut off the special credit windows that they had opened to support the weaker members like Greece by buying their government bonds. This lead to higher spreads on Greek bonds, albeit 6-7% pa pricing can hardly be considered usury when credit card interest rates in Greece have been 18-20% pa on consumers. The ECB was suddenly confronted with the specter of a possible Greek sovereign debt default that was leading to massive shorting of the Euro. Fearing contagion to other weaker EU members, Brussels went into panic. Immediately all fingers were pointed to Greece to extract a ‘pound of flesh’ by the concept of an ‘internal’ devaluation whereby all salaries are cut and taxes are raised. In other words, the EU is asking Greece to massively curtail demand, lower wages and reduce the public sector workforce. It interesting to note that the last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed directly to the onset of the Great Depression in the 1930s.

Unfortunately, it is almost taboo to open substantive issues on the imbalances in Euro system, which is considered virtually a ‘sacred cow’ ; much less question the wisdom of the proposed EU remedies on their weaker members. The Russian dissident Vladimir Bukovsky has said that political system in the EU resembles in many ways the former Soviet Union. Whilst the normal path for a country like Greece would be to go to the IMF for assistance, Brussels appears to see this negatively. They do not seem to want to see Greece to take an IMF credit facility and Greek politicians are too beholden to take any actions of their own. Brussels is concocting their own aid package but no one is permitted to discuss the details. Greece is obliged to say that are not asking any aid and they do not need it. Simon Johnson points out some of the reasons for this Kabuki theater:

• Many in Europe view the fund as an American-influenced institution—located three blocks from the White House for a reason—that would be invading Europe's territory. My personal experience is that Eurocrats become livid whenever any critical discussions on the Euro system by outsiders and tend to lose any sense of reason.

• French President Nicolas Sarkozy has serious personal reasons to push the IMF away. Mr. Strauss-Kahn is a serious potential challenger in France's upcoming elections; Mr. Sarkozy would hate to see the IMF play a statesman-like role on his home turf.

• Chancellor Angela Merkel, currently maneuvering to ensure a German is the next head at the ECB, is also concerned. The IMF might ask for a revision of ECB policies and request structural reforms. This would challenge the prevailing ideology among Frankfurt-dominated policy makers and reduce their power over weaker EU members.

I believe that the Greek debt crisis is really two crises: a crisis of a failed economic and political system in Greece and a failed Euro system. Indeed Greece sought refuge in the Euro because their system was a failure. I do not think that the Greek government’s stability plan has any connection with reality and I do not see it as feasible. Of course, the Greek government is hoping that Brussels will give them an ‘E’ for effort along with substantial discounts as has always been the case in the past. This will not do anything to resolve their ‘Ponzi’ public deficit pyramid. No one in Brussels seems to want to revise the Euro system albeit there is considerable academic ink being currently spent on possible alternatives such as the recent piece: “The Option of Last Resort: A Two-Currency EMU” by two Greek economists Michael G. Arghyrou and John Tsoukalas, proposing some relief for the European south.

Nouriel Roubini feels (and I concur) that things could get considerably worse:

In the end, if Greece is politically unable to do enough fiscal adjustment to forestall unsustainable debt dynamics – i.e., if it turns out to be insolvent and not just illiquid in spite of a partial financial support from the IMF and/or or the EU/ECB – one solution that is one step short of default (that occurred in Russia, Argentina and Ecuador) may be a coercive restructuring of its public debt – under threat of default – along the lines of what was done in Pakistan, Ukraine, Uruguay and the Dominican Republic. In effect, this would entail a coercive lengthening of the maturity of the debt without face value reduction of the debt (no formal haircut) together with a coercive reduction of the interest rate on the new debt at below markets levels. Such surgical solution would imply some losses for creditors on a NPV basis but much smaller losses and less systemic disruption than an outright default. As the experience of past emerging market crises suggests such coercive restructuring can be designed – even in the absence of collective action clauses – via exchange offers that bypass the need for unanimity in changes in the terms of such public debt.

Still, such a coercive restructuring of the debt would resolve – or push to the longer future – the issue of public debt sustainability. But it would not resolve – in the absence of structural reforms or outright exit from the monetary union – the problem of the loss of competitiveness and the unsustainable external balance. That is why default (or coercive debt restructuring) without devaluation may not be possible and devaluation (exit from EMU) without default may not be possible either.

Having lived though this problem in Greece, I believe that coercive restructuring of Greek public debt is the only realistic solution for Greece. Given that much of this debt is held by other EU countries, this would inflict considerable pain, especially on Germany and this is probably one of the major reasons why they appear to be so reluctant for IMF involvement.  I do not see Germany, however, without responsibilities for the failed policies in the EU.

Many economists like Nouriel Roubini and Simon Johnson are making constructive suggestions to the EU on the management of this crisis. Simon Johnson even goes to far as to call for intervention of the US government to press Brussels to bring in the IMF and to cooperate assertively to help reduce the risk of further collapse in Europe.

I think that that is a fair view of the stakes involved in this matter. Neither Brussels nor Greece is really capable of resolving this complex matter on their own and the stakes are too high for failure.

Greek financial crisis: Panic, bad policies and conflicts of interest

In one of Prime Minister George Papandreou's recent brainstorming session, Joseph Stiglitz apparently told him that the IMF is the only way out for Greece. He does not think that the EU will do the job properly.

In the meantime, the Papandreou government seems to be in a panic to raise money and Finance Minister Papaconstantinou is preparing a new draconian tax code. The result is that there is already a sizeable flight of capital leaving Greece.

I fear that these measures will result in killing what little exists in the private sector. Years of socialist government in Greece have resulted an oversized government that has systematically crowded out the private sector and driven large parts of it underground. The Greek government expanded entitlements, which they financed by deficits and public debt. Privatization always met considerable resistance, of which the recent wild cat Piraeus Port Authority strikes encouraged by the pre-election rhetoric of the now ruling Socialist party, is a vivid example.

The Socialists denounced the COSCO port privatization for a container transshipment facility as neo-colonialism and called renegotiation and rescission of the agreement. As soon as elected to office, they faced a nasty strike by Communist party-controlled unions in an attempt to frustrate the government privatization agreement. The strike created considerable consequential damages in the Greek private sector as well as revenue losses to the Greek state in port dues. Despite empty public coffers, the socialist government ended the strike by conceding to the Communist party-controlled unions with generous pay terms that have no relation to market reality. Whilst nearly defaulting on the terms with COSCO for the use of the port facilities in Piraeus, the Greek government turned unsuccessfully to the Chinese government for public loans.....

The government is now targeting those who declare low incomes. Whilst a few in this category are hiding larger incomes, most of them are self employed and small businesses as well as black market labor who are living very marginally. Forcing them to pay taxes when they are just surviving in a recessionary environment will result in putting them in abject poverty. Many more shops and small businesses will be forced to close. They are also preparing a new onslaught of heavy property taxes. The construction industry will largely fold. Already property values are falling. The Athens area is vastly overbuilt in both commercial and private residential construction. The Conservative party told them that they are spreading panic in the market place and this risks provoking general economic collapse.

The Greek banks are in trouble because of 1.) flight of capital from Greece to safer havens and 2.) the potentially toxic debt that they hold in the way of Greek government obligations and 3.) risks of non-performing loans from consumer finance and housing as the economy collapses.

Within the EU, there is considerable politics over Greece. The Greek government seems to be hoping for new loans from France and Germany as a bailout, albeit they are worried about the tough conditions. The EU does not want Greece to go to the IMF. Partly they fear the contagion to the Euro system and pressure on the Euro with the bad money (Greece) in the system driving out the good money (France, Germany). No currency union without fiscal and political union has ever survived and EU system was badly flawed from inception as many economists like Milton Friedman and lately even his adversary Robert Mundell have pointed out. Already some are discussing a two-currency system in the EU.

The heart of the matter is the potentially toxic Greek debt. Whilst the Italians and Spanish have public debt problems, too; a lot of their debt is held domestically. It appears that in the case of Greece, the largest share of their debt is held in other EU countries. A Greek default will result in sizeable losses in unexpected places such as German pension funds. For this reason, the EU commission prefers the ‘pound of flesh’ method forcing Greece into high taxes and permanent recession rather than an IMF workout that would result in partial default and losses on Greek debt holders.

Greece never really met conditions for EU participation but the EU authorities winked for political reasons, wanting as many countries to participate as possible. Ironically a few of the sounder countries like the UK, Sweden and Denmark passed but the weak countries such as the PIIGS all jumped for it.

Greece has had public debt problems for years due the socialist politics of entitlements and consumption as opposed to productivity and investment. Greek politicians latched on to the Euro as a means of credit enhancement, obtaining a defacto subsidized interest rate to lower their public debt interest costs. This allowed them to borrow even more.

A lot of the EU transfer money was used for political show projects of which the Olympic Games was an example, but the now empty athletic halls did not prove sustainable, productive investments to build a sound economy. The socialist mentality in Greece always favored state-sponsored capitalism rather than private investment, which they saw as an affront to their dignity and a threat to their strategy of captive voters totally dependent on the state bureaucracy. The EU tolerated this (looking the other way with the false accounting and dubious statistics and now feigning false indignation) because the transfer money opened infrastructure projects for European firms and Greece became a vast dumping ground for EU and other exporting countries like Germany and China, with an ever widening commercial deficit now 14% GDP - reputedly the largest in the EU. The global financial crisis ended the party!

The result of these policies today is the present financial nightmare. The Greek government has to turnover debt and borrow even more every money to cover ever-widening deficits. The deficits are exploding because of a rapidly shrinking tax base as the economy implodes and ever rising interest costs due the increasing default risk. In these circumstances, more EU money even on soft terms, is really only making the longer term situation worse.

Without productive private investment, Greece will never be able to repay its debts or survive in the future. No one will invest in Greece under the present circumstances. The public sector needs to be downsized. Entitlements must be reformed. Public debt needs to be renegotiated and partially written down. Good to have the stigma on the political system that created the mess in hope of future credibility. Prolonging the agony will only increase the losses. Better to take the losses now and focus on changing the rules for a sound economy for tomorrow.

I believe that the EU Commission approach is tantamount to permanent loss of Greek sovereignty and will result in years of recession and economic stagnation, whereas the IMF approach will allow Greece more leverage with the EU in view of these conflicts of interest and a speedier turnaround.

Dryships turns to the bond market

After repeated ATM share offerings with massive dilution, Dryships (DRYS) has now turned to the bond market for additional capital with a new US$ 400 mio offering (initially US$ 300 mio). The deal also includes a US$ 150 mio loan in notes to Deutsche Bank, the sole bookrunning manager of the deal. As a feature, the deal appears to offer investors a convertible arbitrage where they can take a short position against the company common share value so they can hedge their investment.

Dryships was badly hit by the financial crisis and precipitous drop in the dry bulk market last year. The company had been outperforming its peers with a more speculative policy of older vessels, shorter term employment, building up the fleet by riding the market up and selling older tonnage to finance and expand into new tonnage. Bank leverage rose accordingly.

George Economou's decision to use Dryships to support his foray into off-shore drilling purchasing OceanRig changed the nature of the company. He privately booked several additional oil rigs and in his usual practice shifted them to Dryships, where there was broader access to capital markets to support the transaction.

An oil rig is a substantially higher capital intensive investment than a ship. The oil rig assets on the company balance sheet quickly overshadowed the shipping operation. Capital needs increased geometrically.

Economou was constrained to posture his fleet with longer term employment to support the burden of ever increasing debt on the company balance sheet under the strain of this new scaling up in another sector. The longer employment profile for the bulk carriers proved a timely move in view of the subsequent financial meltdown in the fall of 2008.

The crash in freight rates and asset values put Dryships into default with its senior lenders that has taken months to renegotiate this year. At the same time, Economou had to restructure the aggressive company capital expenditure program that included both dry cargo vessels and oil rigs. The company was obliged to cancel a large number of new building orders and forfeit deposit money as well as to take substantial asset impairment charges.

To cover the financial hemorrhaging, Dryships embarked upon a series of ATM (at the market) share offerings to increase its capital by massive share dilution. As things have stabilized in the dry cargo market and the oil rigs on order are coming up for delivery, presumably Economou wants to avoid further share dilution by turning to the bond market, hoping to lock in good terms in the face of future increase in interest costs.

The short hedge feature is likely a sweetener for potential hedge fund investors, who are a mainstay investor market for the shipping sector. Most hedge funds have considerable experience in commodities . There is close relation between shipping freight markets and commodities markets. Spot rates are driven by inventory levels and the pricing structure between the derivatives and physical markets.

The higher than expected interest cost of the recent Genmar bond issue, however, would appear to create some clouds on the probable pricing for the Dryships bond issue. With Dryships there is always an ongoing debate on how much new capital is being used to refinance and manage existing debt as opposed to going into fresh investments.

DryShips's two semi-submersible units and four drillships on order for 2011 delivery have recently been valued by analysts at US$ 3.7 bio against the value of its bulker fleet and above-market charters, which is barely half that at US$ 1.9 bio. Most analysts are in agreement that Dryships will have no problems in securing contracts and employment for its oil rigs, but divergence on rate forecasts drives the stock recommendations for the company. Nordea tends to be cautious whilst Lazard is showing some optimism for DRYS.  Both are placing their emphasis on the offshore drilling market and assuming firmer oil prices in 2010.

A turnaround for Aries?

New CEO Michael Zolotas and CFO Allan Shaw recently gave a presentation of their plans to turn around Aries Maritime (RAMS) and use it as a platform for growth. They talked about recapitalization, fleet mix, in-house technical management, chartering strategy, steamlined GA costs and the new management team. Their new focus is on dry cargo and product trades. They have dropped in six additional units from GrandUnion and recapitalized with US$ 36 equity and US$ 182 mio additional debt. Let's evaluate.

The vessel transfer from GrandUnion consists of two 1990-vintage Capesize bulkers, two Panamax bulkers built 1990/ 2002 and two Dwt 37.000 product tankers built 2003/ 2004. The nominal purchase price is US$ 180 mio of which US$ 160 mio in debt liabilities and US$ 20 mio in shares (at a 125% premium to current price). The new management has booked the two remaining Aries container units for sale at US$ 11,4 mio .

In terms of hardware, Aries now has a fleet of 21 vessels: eleven product carriers and seven bulk carriers. Two Dwt 73.000 product tankers are on bareboat charter to Stena until 2H 2010. The two additional product carriers are time chartered until 2011. The remaining product tankers ranging from Dwt 38.000 t0 73.000 are on the spot market. All the bulk carriers are on time charters of various durations with fairly low rates mostly in the teens except the Cape unit Brazil, which has a good paying period charter with an initial rate of US$ 28.000 per day.

The large number of product carriers on the spot market presents a serious exposure problem since this sector was very hard hit this year and is suffering badly in the current market. The new management will have to determine a new employment strategy. This is a challenge but their new business director, Paul Wogan played an instrumental role in developing the Seachem pool for Livanos facilitating the Odfjell merger and is a capable person. They may have to invest to build up a chartering team. There appears to be no existing contract base from GrandUnion and they will have to create a viable customer base for Aries in the product sector.

Ironically their fleet mix is similar to Top Ships (TOPS), the other well-known Wall Street laggard of the Greek Shipping community, which seems to be doing a bit better lately. The Aries drybulk units are distinctly older than the TOPS units that were bought at the height of the market albeit with much better age profile. The Aries units are mainly Capesize units whereas TOPS focused on the Panamax size. The Capesize sector has been outperforming the market this year. Older units like the Aries vessels can be very profitable, but it is a very volatile market.  Presently they are tied up on time-charters with rate levels that are moderate compared to more modern units, excepting the Brazil charter. 

What is worrisome is the high level of debt on the six additional vessels (US$ 160 mio liabilities out of a purchase price of US$ 180 mio) and the large amount of additional debt in the recapitalization (US$ 182 mio against US$ 36 mio new equity). The 30.09.2009 pro-forma balance sheet looks ghastly with the shrunken asset values, high level of debt, free cash down to zero, US$ 124 mio loss of which a US$ 91 mio asset impairment charge and distinctly negative net worth.

It would have been helpful with all the additional changes and recapitalization that they had included in their presentation a restatement of their balance sheet after the additional changes in the fleet and capitalization. I find, however, difficult to see any major improvement in leverage in these subsequent events.  The largest share of new funds has been raised by additional debt. The new equity is small in comparison to the new debt and the drop-in units are highly leveraged. Aries still appears to be a company swimming in debt. Perhaps they preferred debt in the recapitalization to limit share dilution, assuming limited downside risk on further fall in vessel market values and looking to enhance returns. The positive hope is expectations of improved earnings from the expanded fleet and new management.

The new members of the management mark a considerable qualitative improvement from the previous management (the former CEO Jeff Parry was probably the sole credible person). It was a good move that they wrote down the assets and renegotiated the debt. Adding Newlead management was a very positive step. The previous technical management was disastrous and had a horrendous insurance record. It is now largely a matter of their commercial team and their opportunistic accreditive acquisitions to create value in their business.

They have secured additional funds for this, but they still appear to have a strained balanced sheet as a limiting factor. If there is a nice market upturn in 2010, it will provide them much necessary uplift in free cash flow and retained earnings to rebuild shareholder equity and deleverage. Rising asset prices will also help.  On the other hand, they will be at risk if market recovery is delayed and 2010 proves a poor year. In the negative scenario, they could end up with some of their new funds being cannibalized for debt service and require further financial restructuring.

Aries certainly shows significant progress, but it is still work in progress and a speculative play.