The new sub-prime market - another slow-motion disaster

During the 2003-07 go-go years that corresponded with the debt bubble, ship financing briefly lost its reputation as a risky business, but the reality of commodity volatility has come back to haunt the market. As the article suggests, earnings have gone negative by 35-40% in the first half of this fiscal year (April to September for many). But the prices of many shipping company shares are down by twice that amount since last year.

But the situation is much more dire than that figure suggests, awful though it is. Charter rates quintupled in the six months from December 2008, when they hit a ten-year low. But half of that bounce has disappeared in the last quarter, as the Chinese hoarding surge stop on command in July. Rates continue to fall under the pressure of new ship supply and very little month-on-month demand growth from China now. Even if rates were to fall no further (we think they have much further to go), current yields would accelerate the scrappage rate for another year.

China is probably the chief villain in this story, although ambitious bankers and shipping chiefs bear equal blame. As it has tried to shift more of its export mix toward heavy manufacturing, while simultaneously trying to build a major automotive industry in less than two decades, it has strained shipping resources. Its sprint to boost its growth to double-digit levels since 2004 has exacerbated the problem and justified incredible building programs in Chinese, Taiwanese and especially in Korean shipyards.

Now, the risk of overheating and other stress has temporarily given the upper hand to the monetary hawks within the People's Bank of China and the spigot is off. Central planners are talking about scrapping old capacity and promoting "green" new factories. Between the lines one can observe that construction demand, especially for steel inputs and cement will stay fairly high after this pause. Car and road building plans remain enormous in China - perhaps unrealistic for the short term. Nonetheless, some Chinese demand will trickle back into the market and maintain volumes at about 2/3 the average of 2007 levels.

The problem is that new supply is targeted at 1/3 above that level. Thus, shipyards and their financiers will bear some of this pain too. Some yards are quoting 40% discounts off the original contract price for capesize bulk carriers, the most sensitive segment. But many bankers and funds will end up owning new ships, regardless of whether they come from shipyards or lines.

The ships older than 10 years will go almost directly to the scrapyard mudflats of Bangladesh, along with some younger single-hulls. From there, they will go back into China as scrap steel. But a big beneficiary will be exporters and consumers who will enjoy moderate freight rates for another three years. But the losers will be the banks and other creditors to these assets, who will get back about 15% of what they put in.

Like US commercial property, ship construction got a lot of non-bank money, so now some funds will suffer - but so will the CDOs the bankers stuffed with ship credits. This means that shipping-related writedowns will trigger accelerations on a number of such CDOs, driving down the value of more stable debt that was bundled together with the ship finance.

As the Baltic Dry Index plot suggests, a "death spiral" has begun in this asset class and a lot of balance sheets will suffer horribly. The need to sell off "good" assets to liquidate commingled funds could well hit the government-debt yields and the repo market again, just the way the sub-prime property collapse did in 2007-08.

In the past, this was a small risk that hit specialist banks in the maritime trade, but contagion through the CDO (and some through the CDS hedges) could cause another hiccup in the much touted global recovery story. The shipping market has grown enormously since its last catastrophe in the mid-80s. So will the ripples from this little market correction. One can expect a lot more of the kind of State intervention we have seen in the last six months. Maybe Korean and Chinese taxpayers will become bigger shipowners than banks by the end of next year!