Increasing Dry Bulk Shipping Market Efficiency
by Securitization of New Build Capacity
Erasmus University
Erasmus school of Economics
Bachelor Thesis
By David Pollack
278925
Theodorus Majofskistraat 43HS
1065SV
Amsterdam
D.M.Pollack@gmail.com
Supervisor:
Martijn van der Horst
David Pollack
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Summery
The objective of this thesis is to introduce a method of securitizing dry bulk shipping companies or
vessels. The general structure and nature of securitization has been based on the mortgage-backed
securities. This method uses segmented tranches based on future charter incomes.
The thesis analyzes the market dynamics of the dry bulk shipping market and identifies problems
therein. This is done by using the four shipping markets as determined by Stopford. Each of these
markets will be summarized and its market dynamics explained. The dry bulk shipping market is
highly cyclical in nature and freight rates are volatile. This volatility along with the market dynamics
and cyclicality are shown to be due to a number of factors. One of the factors is that the investment in
new build vessels tends to follow the freight rates in a pro-cyclical manner. This is partly due to the
overinvestment in new capacity when times are good that lead to long periods of overcapacity. The
market specific dynamic is theoretically addressed by the introduction of securitization.
The thesis then enumerates the financial methods used by ship owners to manage their finances. The
issues of costs and cash flow are discussed as are the basic methods of financing used by ship owners.
Problems in addressing the specific needs and wants of the various investors simultaneously are then
identified.
The basic structure of the securitized dry bulk shipping company is next discussed. Firstly the
distinctions between the mortgage-backed securities and the intended shipping securities are discussed
in order to show why the recent failures of the mortgage-backed securities would not apply to these
securitized shipping companies. Then the players and instruments of the shipping security structure are
listed and explained. A concerted effort is made to cover the establishing of market value and default
process of the securitized dry bulk shipping companies as to complete the picture of the securitized
shipping companies and its tranches. To give clarity to the practical workings of a securitized vessel or
company a hypothetical case study is given.
With a clear picture of the workings of the securitized dry bulk shipping company a discussion is then
begun on the effects of securitization and the possibility of its addressing the problem of financing in
dry bulk shipping companies. It is proposed that the segmentation of investment opportunities would
have a dampening effect on the volatility in supply of capacity. It is also estimated that the tranches
would offer other beneficial effects as hedging opportunities to shippers and others who are adversely
affected by high freight rates. The segmentation of investment opportunities could also open up dry
bulk shipping to many different types of investors, from conservative pension funds to hyper active
derivative traders.
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Table of contents
Summery
2
1
Introduction
4
1.1
Research Questions
5
1.2
Methodology
5
1.3
Structure
5
2
The Market Dynamics of Dry Bulk Shipping Market
6
2.1
Business Cycles of the Dry Bulk Shipping Market
6
2.2
The Four Dry Bulk Shipping Markets
8
2.2.1
The Freight Market
9
2.2.2
The Charter Market
10
2.2.3
The Sale and Purchase Market
11
2.2.4
The New Building Market
12
2.3
3
4
5
Conclusion
14
Financial Management of the Dry Bulk Shipping Companies
15
3.1
Costs of a Dry Bulk Shipping Company
15
3.2
Cash Requirements of Dry Bulk Shipping Companies
16
3.3
Methods of Acquiring Financing
17
3.4
Conclusion
18
Securitization of New Build Dry Bulk Carrying Vessels
19
4.1
Structure of Securitization of New Build Capacity
20
4.1.1
Basic Structure
20
4.1.2
Market Value
22
4.1.3
Cash Flow
23
4.1.4
Default Procedure and Risk
23
4.1.5
Case Study
24
4.2
Discussion on the Effects of Securitization
25
4.3
Conclusion
27
Conclusion
28
References
30
Appendix
31
David Pollack
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1 Introduction
When Barbagio, a Venetian trader in the late Middle Ages, was trading on the Mediterranean, he had a
fleet of wooden ships. Even though the world was very different then, he faced many problems similar
to ship owners today. He could have been left with excess capacity, i.e. trading vessels, when
geopolitical shifts drastically altered the capacity demand of the market. He had to choose among
owning his vessels outright, borrowing money at fixed rates (bonds), or sharing ownership with other
investors (stock offering). His father had lost everything when his ships sank in a storm in the
Adriatic, so Barbagio was keenly aware of the dangers of owning 100% stake in the vessels. He knew
that if he took a loan, he could risk losing his possessions if he ever had a bad trading season. But he
also had experience with his interests conflicting with that of his investors whose expectancy of return
and risk taking varied with his own.
Today supply of capacity tends to be pro-cyclical in relationship to freight rates (Lung, Quaddus,
2009). Investors in shipping capacity still are faced with fundamentally the same three basic financial
tools that Barbagio had of private equity, debt, and foreign equity (Stopford 2009). Even though the
addition of ship funds and shipping stocks on the NASDAQ have offered some variation in investment
opportunity, still the un-segmented investment opportunity means that short-term return on investment
(ROI) strategies are closely interrelated to long-term ROI strategies. This means that when freight
rates are on the rise, speculators tend to directly or indirectly add capacity to the market. But since
freight rate peaks are relatively short and erratic in nature (Stopford 2009) and that added vessels have
lifetimes of around 20 years (Stopford 2009), some investors inevitably lose out. This market
anomaly is a reason for the high market cyclicality in dry-bulk shipping (Zannetos 1966).
Securitization is a new method of financing which involves the pooling and re-packaging of assets and
receivables in such a way that a relatively homogeneous asset package can support multi-tranche
issues of liquid securities (Pallis, 2007). This thesis will try to apply the basic concept of
securitization to fit the market specifics of the dry-bulk shipping market. The tranches (see 4.2.1) will
be based on the asset of future charter incomes instead of on the interest on mortgages of loans. The
application of segmentation in the tranches by level of charter income, from $0-$1000 then from
$1001-$2000 and then $2001-3000 etc., is intended to offer investors tranches with various level of
risk exposure and therefore various returns on investment (ROI). This segmentation of risk would
offer investors with different preferences and strategies, an investment product which could better
match their goals. This would ease pressure on the short-term shipbuilding market and dampen the
pro-cyclical investment in vessel capacity. In addition, the tranche sell off could transfer short-term
freight rate risk away from ship owners to investors in tranches, thus reducing the risk of the long-term
ship owners. These are the issues and questions that this thesis will try to address.
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1.1 Research Questions
The problems and topics mentioned in the introduction have led to the formulation of the following
questions. The thesis is meant to address and if possible answer these questions.
Primary question:
How can dry-bulk shipping supply and investment become more market efficient by securitization of
new build vessel capacity?
Sub questions:

How does the dry bulk shipping market operate?

How do dry bulk shipping companies manage their finances?

How would securitization be structured in the dry bulk shipping market?
1.2 Methodology
To introduce the idea of securitization of new build dry bulk vessel capacity, the research will have to
go through a number of phases. To establish the framework of the real-world shipping and financial
markets, research literature must be found and studied in order to gain a theoretical insight into these
markets. The market dynamics that securitization would be intended to address will have to be based
on empirical data and results from studied literature, so presumed effects of securitization would be
more than just wild estimations. Then the theoretically designed dry bulk shipping market’s specific
form of securitization can be introduced and used to discuss possible positive effects of securitization
on the real world and financial markets.
1.3 Structure
To analyze the implementation of securitization in the dry bulk shipping market first a framework of
the environment wherein securitization is to take place must be created. This will be done by using the
structural approach of Stopford’s four shipping markets. Certain market anomalies that securitization
could address will be highlighted. Since securitization is a financial tool, the current financing
methodology will be analyzed in order to formulate how and where securitization could have added
value. This will have then described the environment wherein the securitized dry bulk shipping
company can be introduced. After describing the environment wherein the securitized dry bulk
shipping company could be introduced, there will be a discussion on the possible effects that
securitization could have on the dry bulk shipping industry.
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2 The Market Dynamics of the Dry Bulk Shipping Market
In this chapter I will elaborate on the general working of the dry bulk shipping market. This market
covers many types of bulk cargo, from bauxite to grain. But, as the market is primarily dominated by
Iron ore, grain, coking and thermal coal (Stopford 2009), I will concentrate this study exclusively on
these cargo types. Furthermore the dry bulk freight market is highly homogenous with few vessels
that, in theory at least, could not be used for all types of dry bulk cargo. I chose the dry bulk shipping
industry in specific as the test group for the introduction of a new form of securitization because of the
simplicity and standardization of the vessel, and because of the market’s openness to many players.
The goal of the chapter is to establish clearly a framework of the market in which the securitization of
the dry bulk shipping would take place. In chapter 2.1, the cyclicality of the market will be addressed
and analyzed. The cyclicality is relevant as it must be incorporated into the process of securitization
and hopefully securitization will address some of the harmful effects of the volatility. In section 2.2,
the four markets of shipping as stated by Stopford will be described. These four markets together with
the cyclicality will describe the market dynamics and market factors securitization would have to take
into consideration in order to take effect. Also an understanding of certain aspects of the markets is
essential to engineering the method of financing to address effectually inherent problems in the dry
bulk shipping industry
2.1 Business Cycles of the Dry Bulk Shipping Market
The dry bulk shipping industry is highly cyclical. It regularly goes through periods of high ordering of
capacity and high freight rates, as well as through periods of surplus of shipping capacity and low
freight rates. As defined by Stopford, the shipping industry goes through four distinct stages of
shipping (figure 2.1). The four shipping markets he describes are a mechanism for coordinating supply
and demand in the dry bulk shipping market. The four
stages of the short-term shipping cycle are (Scarsi 2007):
Figure 2.1 The typical course of a
shipping cycle
Trough: A surplus of shipping capacity pulls down
freight rates near operating costs. Ship owners
Peak
Recovery
Collapse
are forced to sell ships, decommissions and
sales increase while the shipbuilding order
books decline.
Recovery: Supply and demand move towards balance,
Trough
hh
The typical course of a shipping cycle
Source: (Scarsi 2007)
while freight rates increase above operating costs.
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Peak: Freight rates are high, several times operating costs, owners become very liquid and
shipbuilding order books expand.
Collapse: Supply overtakes demand and freight rates fall again.
The freight market for dry bulk is relatively open. Cargo can be obtained through brokers and can be
offered on consignment or contract. Vessels can be bought secondhand as they are numerous and
fairly homogenous. The main barrier to entry into the market is the cash requirements in buying or
chartering vessels. The vessels cost millions of dollars and the prices fluctuate highly in a pro-cyclical
manner. The values of the second-hand vessels fluctuate pro-cyclically with the freight rates. This
means that when prices offered to transport cargo, i.e. freight rates, increase, so too do the prices of
dry bulk vessels as seen in Table 2.1 below.
Table 2.1 Correlations of new building vessel price, second-hand vessel price, scrap vessel price,
and freight rate
New building
Second-hand
Scrapping vessel
vessel price
vessel price
price
New building vessel price
1
Second-hand vessel price
0.821(**)
1
Scrapping vessel price
0.711(**)
0.915(**)
1
Freight rate
0.493(†)
0.847(**)
0.848(**)
Freight rate
1
Notes: ** significant at the 0.01 level (2-tailed)
† significant at the 0.10 level (2-tailed).
Source: (Lung, Quaddus 2009)
The synergistic effect of the owner’s income from operating the vessel in the form of charter rates, and
simultaneously the asset ballooning because of the increase in vessel value, can make the balance
sheet of the ship owner look rosier than it is actuality is. To outsiders the shipping industry will look
like a hugely profitable business. The general feeling of excitement means that investors will be
looking for companies to invest in or to start new companies themselves. At this moment, as there are
only low entry barriers except for lots of cash, new entrants will come into the market with lots of cash
just at the time that their competitors are enjoying a period of positive cash flow. The new entries and
some existing ship owners will try to leverage their income flows by increasing their capacity.
Eventually the market will be saturated or market conditions will change and freight rates will
plummet together with the balance sheets of the players in the market. Some will have sufficient cash
or charter agreements to weather the storm, but others will not be able to stay afloat and will go under.
This rollercoaster ride is not new. We can read about ancient mariners who risked all to make their
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fortune on the high seas. But just as some made their fortunes, others entered at the high watermark
and lost all. For a long time this has been a recurring experience in the shipping market. Players keep
getting caught because the shipping cycles are erratic in nature and length. The general trend now is
declining lengths of the shipping cycles, suggesting that players are quicker to respond to variations in
market conditions. The dry bulk shipping has increasingly become a regimented industry where
investors seek stable returns on investment. However, as of yet the dry bulk shipping industry still is
an arena for spectacular successes and dramatic sinking of fortunes.
2.2 The Four Dry Bulk Shipping Markets
Stopford described the working of the shipping market by subdividing it up into four quadrants:
freight; charter; sale and purchase; and new building markets (table 2.2). These quadrants are all
interdependent. This structural schematic will be used as a tool to describe the dynamics of the dry
bulk shipping market.
Table 2.2
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The Four Markets that Control Shipping
Page 8
Source: (Stopford 1997)
2.2.1 The Freight Market
The freight market refers to the process of filling capacity with cargo. In this quadrant, ship owners or
charter holders vie for freight earnings. This quadrant is a source of cash flow to the dry bulk shipping
industry. As coal gets loaded onto the vessel, the vessels are finally fulfilling their goal, to deliver
transport services for all the coal and ore that the industrialized and computerized world requires. The
price the shipper has to pay for this service can vary enormously. Figure 2.2 shows that from 20022008 the freight rates according to the Baltic Dry Index (BDI), increased from 850 in November 2001
to 11.750 in June 2008 and then plummeted down to 700 in December 2008.
Figure 2.2
Baltic Dry Index
BDI index
14,000
12,000
10,000
8,000
6,000
4,000
BDI index
2,000
0
Source, www.euroinvestor.com
Clearly, if the ship owner individually operates his fleet at spot prices, the sheer volatility of the
market makes it hard for ship owners to stay afloat. Their problem is that they need lots of cash to buy
the vessel as only the very rich could possibly buy a dry bulk carrier outright. The combination of the
high gearing ratio and volatility makes the ship owners prone to default on their loans (Goulielmus,
Psifia 2006).
The shipping market, and in particular the bulk shipping market, is extremely volatile. It is a global
business, subject to geopolitical and global economic changes (McConville1999). The players keep
getting caught because the shipping cycles are erratic in nature and length (Stopford 2009). This is
because the shipping cycles are dependant not only on internal cycles, but external ones as well. An
example of an internal one is when excess capacity in the market is lower, the relatively higher
pressure of demand on supply will drive freight rates higher. Carriers have their fingers on the pulse of
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the market and try to order more capacity when they notice that demand may overtake supply. The
newly ordered capacity takes around two years to be delivered after the moment of signing of the
contract. Many different investors and types of investors do this ordering without any general
coordination. So for a least a year, various investors see that shipping has great prospects of ROI and
invest heavily in it, but of course this enthusiasm like in the stock markets, leads to bubbles. And like
all bubbles they eventually burst. Freight rates plummet since ships cannot be taken out of the market
easily, their operational lives normally exceeding twenty years. All those investors who were so eager
to enter the shipping market are now stuck in the market with assets that have plummeted in value
from their peak value. Furthermore their cash flow from the investments is no longer very rosy.
External factors that determine capacity are the demand for bulk shipping transportation of raw
materials for heavy industry and electricity production. This demand is determined by external factors
like world consumption of bulk commodities and changes in the geographical shipment patterns.
Demand for shipping capacity by external factors is therefore taken to be independent of the effects by
internal factors (Howdon 1978). When the world economy grows, the demand for raw materials rises,
and as a result so does the demand for transportation. During economic downturns, the demand for
raw materials decreases and so does the transportation demand. While this is a fair assumption under
normal freight market conditions, researchers have argued that the demand becomes more elastic with
respect to the freight rate when freight rates are very high relative to the value of the cargo (Koopmans
1939), until the demand becomes perfectly elastic at some unknown but extremely high freight rate
level (Tvedt 2003).
Apart from volatility, ship owners have to watch out for fundamental changes in market conditions.
These changes do not reflect market fit of supply and demand or liquidity issues. Rather these changes
reflect more fundamental changes in the structure of the market or the industry itself. Examples of
these types of changes are the changes due to the Suez crisis, the industrialization of China and the
supplementation of oil with coal to supply the world of its energy needs. The Suez crisis closed a vital
canal through which the main flow of goods from Europe to the near and far-east flows. The closing of
the canal spurred the building of new classes of oil tankers and thereby changed the make-up of the
world fleet. The industrialization of China brought China beyond its ability to supply itself with
energy and, through its coal, coking and thermal, and iron ore demands, caused an explosion in global
shipping demand. The reemergence of thermal coal as an energy source also brought the dry bulk
shipping industry out of the shadow of the oil tanker industry.
2.2.2 The Charter Market
The second quadrant, the charter market, refers to the contracting process between ship owners with
vessels for hire, and vessel operators, i.e. charterers. Vessels are chartered because either a vessel
owner has bought his vessel solely as a financial investment tool, an asset play, or because the fleet at
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his disposal exceeds his need for capacity (Stopford 2009). Conversely the charter agreement taker
views the vessel as an operational benefit. He intends to use the vessel to transport cargo and so collect
on the available freight rates. The charter market in general exists to bridge the imperfections in the
intentions between the cargo shipper and the ship owner. The agreements reached and the cooperation
required are essential to the fluid workings of the shipping industry. They allocate the usage right of
the vessel efficiently throughout the market affecting freight rates so that the freight and the various
routes are not structurally out of sync.
The employment agreements and charter contracts cover certain agreements on the length of the
charter, method of payment, and if applicable the terms for carrying the cargo. These clauses can vary
greatly among different agreements, but in general the basic types of charter agreement cover voyage,
time, bare-boat charter and a contract of affreightment. A general description of the basic forms of
charter agreements is summed up below. The differences among these types of charter agreements
may seem slight to non-interested parties, but the variations in contractual specifics can have
significant strategic effects.

Voyage Charter: This is a charter agreement for a single voyage of a vessel. For example the
ship owner agrees to ship X amount of cargo from port A to port B for a fixed price. It can be
presumed that the vessel will be chartered at spot price.

Contract of Affreightment (COA): The COA agreement is an agreement that covers a number
of voyages at a preset, fixed price. It could for example mean that a ship owner agrees to ship
10 cargos of coal of 25,000 tons each from Columbia to Rotterdam at intervals of 2 months.

Time Charter: A type of charter agreement where the ship owner cedes the operational control
of the vessel for a preset period of time to someone else. The voyage costs are then not paid by
the ship owner, but by the charter taker.

Bare-Boat Charter: Bare-boat contracts only include the bare boat, i.e. the basic vessel. A
reason to choose this form of agreement could be that the shipping company has its own
network to supply itself efficiently for all operating services and so would control costs.
2.2.3 The Sale and Purchase Market
The market for sale and purchase and the charter market have been called auxiliary markets (Wijnolst,
Wergeland 1996). This is because both the charter market and the market for secondhand vessels
fulfill the function of distributing existing capacity efficiently among all players in the market. The
sale and purchase market also diminishes exit costs for market players because at the end of a sales
agreement of a secondhand vessel, one player has sold his vessel.
These negotiating players can be competitors or even new entrants into the market. A buyer would opt
for a second hand vessel over a new build because secondhand vessels may require less initial capital
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and can be available relative immediately compared to new builds which can take several years from
contracting until completion. So if a player is looking for short-term operational benefits and can’t find
adequate capacity on the charter, he would opt for a secondhand vessel. Secondhand vessel pricing can
be seen as dependant on the availability of capacity, acceptability of built or chartered rates, and on
freight rates (Adland, Haiying, Strandenes 2006). The freight market provides the main cash inflow
into the shipping market. Therefore, high freight rates will cause cash inflow into the shipping market
and as a result, drive the prices of secondhand vessels up too. But if there’s overcapacity in the market
because of a downturn and delivery of new build capacity, the market price can tumble as price reach
marginal costs far under the level of recovery of capital costs. Thus the prices of secondhand vessels
are very volatile as they absorb the fluctuations in demand in the short-term, before the long term
market capacity adjustments of the shipbuilding industry can come into play.
Another aspect of this quadrant, though not strictly a part of this quadrant, is the demolition market,
also called the market for scrapping. This is the market sector where capacity is taken out of the
market in exchange for cash (see Table 2.3). A ship owner would opt for this exit strategy only if the
price he can get on the charter or secondhand markets is to low or even non-existent (Stopford 2009).
The second-hand vessel sale market and that for scrapping of vessels are both highly cyclical and
competitive. While shipbuilding prices form an upper constraint to the pricing of second-hand vessels,
scrapping prices form the lower constraint to the pricing of the second-hand vessels (McConville
1999), even though the upper and theoretically even the lower constraints on the pricing of
secondhand vessels can be broken in the short run. This happens when immediate demand for capacity
outstrips the capability of the shipyards to catch up since all current shipbuilding capacity would be
filled. This would then mean that extra demand in the freight market could only be satisfied with the
existing capacity. And as supply could then no longer grow with demand, prices could grow
substantially.
At any given moment in the market, the capacity is made up of many types of vessels of various ages.
This means that the ship owners may be carrying fairly homogenous products yet their industry is not
so homogenous. This is because the vessels on offer have distinctive costs structures and a fixed
capacity. Therefore, in a market of overcapacity, some players can be systematically outcompeted.
The ship owners might decide to scrap their older vessel and replace them with newer ones. A newer
vessel would offer better operational economy and be able to offer better Dwt/$ efficiency.
2.2.4 The New Building Market
The shipbuilding market is the genesis of the shipping industry. It is in this segment that all new
capacity is added. Every commissioned new build vessel has basically two parties, the buyer and the
builder. Each party is subjected to distinctive market constraints and short and long-term objectives.
The main reason for a buyer to want to order a new vessel to be built can be summed up as follows:
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
To replace aged and outdated capacity
This could be because the existing vessels are worn out by age. Older vessels have higher
bunker costs and lower capital costs because they run less efficiently than new builds, but
have lower mortgage payments.

To obtain a specific vessel of a certain size not obtainable on the secondhand market
Often this course of action is taken by companies that require vessels with specific features
such as icebreaking hulls.

To obtain a vessel at lower cost than the secondhand market
If the goal of the buyer is a longer term investment, buying a ship that can be delivered
immediately could be unprofitable. Large increases in short term shipping demand can inflate
secondhand prices to a level that would make them less profitable in the long run than a new
build.

To make a speculative bet on low prices offered by shipbuilders and/or on freight rates in the
future.
Buyers could be trying to buy and sell high on value. In this case they would be trying an asset
play in the market.
Builders of vessels are in a very different situation from buyers. Whereas buyers can often be small
shipping companies with few employees and even less infrastructure since all they need is an office,
shipbuilders on the other hand, require a large technically skilled workforce, a shipyard and many
dedicated machines. This means that shipyards are not in the position to withdraw from the market
when market conditions make it difficult to cover costs. Moreover the social effects of shutting down
shipyards often push governing bodies to intervene and subsidize the shipyards. This along with other
capital and labor costs, especially labor costs since they amount to 40-50% of total costs (Stopford
2009), cause shipyards to have varying cost structures as labor costs in China are substantially lower
than in Europe or Japan.
A buyer of a new dry bulk vessel would analyze and evaluate the development of the future market
cycle. He would then order vessels to fit his specific demands. But building a new vessel isn’t
instantaneous. It takes two to three years after completion of a contractual agreement for the vessel to
be delivered. Since freight rates can vary so much and are erratic in nature and length, there isn’t any
guarantee that when the vessel is delivered there will be sufficient market demand for it to operate
profitably. In fact, as evident in figure 2.4, the volume of the ordering of vessels follows the flow of
freight rates. Figure 2.4 is based on data of the BDI from 1990-2006 and the data of the volume of
shipbuilding demand during the same years. The change in percentage of the BDI and shipbuilding
demand each year was compared and the results are shown in figure 2.4 below. A simple correlative
calculation of the two data columns gives a result of +0.338. Clearly they are positively correlated to
some degree showing that the level of shipbuilding demand tends to increase and decrease in tandem
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with the BDI index, i.e. the freight rates. This is partly due the fact that banks lend money to shipping
companies almost exclusively during boom periods, thus spurring on overcapacity. The overcapacity
that this creates dampens the freight market and thus ironically saddles the banks with losses
(Goulielmos, Psifia 2006).
Figure 2.4 Level of demand and index rate as a percentage of the previous year.
300%
250%
200%
vessel demand
150%
feight rate index
100%
50%
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0%
Source: (Stopford 2009)
2.3 Conclusion
For securitization to have effectual benefits, the market conditions of the dry bulk shipping market will
have to be considered. The volatility and cyclicality of the market are factors that highly influence if
not drive the present day dry bulk shipping market. In addition, the tendency to order vessels in a procyclical manner shows that market players do not optimally coordinate their investment actions. The
intention of the securitization is to create a market tool for players to coordinate their investment
strategies, long-term or short-term, and thus affect a more steady fluctuation of market vessel capacity.
But in order to accomplish this goal, the financial tool of securitization will have to be designed in a
way to incorporate the interactions of the four shipping markets of Stopford. Only if all four markets
are considered and enough play room is allowed can all interested investment parties be coordinated in
a securitized shipping financial system.
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3: Financial Management of the Dry Bulk shipping Companies
Dry bulk shipping companies operate in a capital intensive industry. The vessels are more often than
not mortgaged and the fuel consumption is closely tied to the energy market in which they operate.
Therefore the companies are vulnerable to market swings in the economies around the world. The
applicability of the vessels to various markets means that they are flexible concerning the market in
which they wish to operate. Yet market conditions change even more than freight rates. Thus the dry
bulk vessel operators and owners have to stay on top of market conditions to maintain a steady source
of income. The consistency of a source of income and therefore the need constantly to operate their
fleet is essential since the vessels continually need maintenance, are always aging, and have mortgages
to be paid. To maintain control of their vessels and not lose them to the bank, dry bulk shipping
companies need liquidity, i.e. cash flow. In order to keep their balance sheet bottom lines in the black
ship owners need long term profits. Furthermore shipping companies have to deal with both inter and
extra cyclical factors. Considering the volatility in the market as mentioned earlier, these are
challenges that at times can be daunting. It is these financial challenges and the methods used by a
shipping company to address them that will be discussed in the following chapter. 3.1 will give an
overview of the costs that the shipping companies have to cover. In 3.2 the issue of the cash flow
needs of the shipping companies will be discussed. These sections will complete a picture of the
necessary financial issues of a dry bulk shipping company. 3.3 will elaborate on a number of methods
in use by companies to address their financial needs effectively. Some of the methods have had
periods of higher popularity than now, but all are viable to some degree and so must be addressed in
order to give a thorough financial overview of the methods used to address the problems of procyclical investment in new builds. This will set out the groundwork of the financial environment in
which the securitization will have to be applied.
3.1 Costs of a Dry Bulk Shipping Company
The costs a shipping company has to deal with are Capital, Operational and Voyage costs (Stopford
2009). Each of these costs is specific to a certain part of the shipping process. Once a company lends
money to buy a vessel, it has regular capital payments that have to be met. This could be in the form of
interest payments to bondholders or as mortgage payments. Even if the vessel is paid ‘out of pocket’
the investor has to deal with opportunity costs and should therefore view his return on investment
(ROI) as a relative financial option to be analytically decided on. Operational costs refer to the other
costs that must be considered by shipping companies. The operational costs are made up of the costs
specific to maintaining a vessel in operational status, like maintenance costs or insurance. Unlike
capital costs, these costs can be chartered out. If a vessel is chartered ‘bare-boat,’ the operational costs
and voyage costs are to be met by the charterer. The voyage costs refer to the costs made by using the
ship, i.e. shipping cargo from port to port. The costs that fall under voyage costs are port costs like
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port and stevedoring charges, and bunker costs, like fuel and canal charges. If a ship owner charters
his vessel out on a time-charter basis, the voyage costs would not be included in costs that he has to
cover.
3.2 Cash Requirements of Dry Bulk Shipping Companies
Cash is of high importance in the dry bulk shipping industry. Each of the costs mentioned above
requires timely outflows of cash to operate efficiently and seamlessly without unnecessary delays.
Companies therefore require a positive cash reserve. Thus income from shipping services of charter
arrangements must be producing cash on a regular basis and not once in a few years. To achieve this,
it is imperative to have a well managed operational income system in place with the long-term goals.
Even if the company is in theory purely trying to perform an asset play, i.e. make money on the
increase in value of the asset, it needs to implement a successful cash flow producing strategy in order
to avoid a seizure of its assets or a forced sale.
To acquire financing, dry bulk shipping companies can either issue debt or sell off equity. Examples
of debt financing are the acquiring of a mortgage or the issuance of bonds (Pallis 2007). The issuance
of debt increases the debt to equity ratio and therefore the leverage of the company. The amount of
leverage a company takes on depends on how much risk it is willing to take or how important a vessel
acquiring program is to the management of the company. Debt could also just be acquired to cover
expenditures, which doesn’t have to mean that the company is going bankrupt. It could also just be
seen as a necessary bridge loan. Equity inflows are for example the investment of private money or the
cash inflow derived from the sale of stock through an initial public offering, (IPO). An IPO refers to
the first time a company sells stock publicly through an index such as the NASDAQ. After the initial
public offering of stock, cash could be raised by the issuing of more stock publicly.
Private money increases the value per share whereas the taking on of additional debt increases the
gearing ratio (debt to equity ratio) of the company and therefore the potential risks and rewards. Dry
bulk shipping companies need vessels in order to trade and cash flow to cover constant costs.
Therefore if players intend to buy shares for short speculative stints, the price of the share would
fluctuate very heavily. This is why many publicly offered shipping companies offer dividend payouts
to shareholders. Another reason for the prevalence of dividends in the dry bulk shipping market is that
many companies are privately owned and operated. A family could maintain control over its company
and at the same time satisfy its personal financial needs through the payments of dividends. This way
the family does not have to sell shares to acquire cash income from its company.
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3.3 Methods of Acquiring Financing
The capital needs of investors in the dry-bulk industry vary greatly. Whereas centuries ago there was
only the possibility to own a vessel, a piece of a vessel or lend money to a ship owner, nowadays the
methods of financing available to be employed are more extensive. As seen in attachment 1,
depending on the balance sheet of the investor, different methods can be employed. If the investor has
equity in the form of future charter income, vessels, or other types of assets, he has the option to
encumber them to gain liquidity. This injection of new liquidity effectively increases the amount of
leverage he is using. The increase in leverage inherently means that he is taking on more risk (Chen,
Wang 2004) unless the liquidity is used to hedge his existing investments. However banks are not
always so keen on granting the investors their wishes. The charter-backed financing had its heyday in
the 1950s and 60s. The Japanese became especially adept at this method (Stopford, 2009), but
stagnation in market growth and sudden shift in market conditions because of the aftermath of the
Yom Kippur War caused the charter incomes to fall short (Stopford, 2009). In the 1970s the banks
started to revise their strategies and denied ship owners the kind of leverage they were used to with the
charter-backed financing. Asset backed financing became the new method of choice. This meant that
ship owners had to offer not only operational income, but also assets as collateral for loans. To enter
into and invest in shipping, they needed a sizable amount of capital. This barrier of high capital needs
led to the next step in financing of vessels, the introduction of the stock and bond market into shipping
(Stopford 2009). Shipping companies approached the financial markets with bond issues. Ship funds
were created to take advantage of the fluctuation in the asset value of the vessels in order to buy low
and sell high (Stopford, 2009). ‘Bulk Transport’ was the first of this method of investing in shipping
and was setup in 1984. In the early 90s the shipping industry started to get more involved in IPOs and
issuances of ‘high yield’ bonds. The bonds are a method of securitizing debt. These issuances were
intended to syndicate naturally the loans to shipping companies. Because the buyers would be more
numerous this way than directly through the banks, it would theoretically bring down the cost of
borrowing. During the period of 1992-2005 there were 61 issuances by shipping companies of ‘high
yield’ or ‘junk bonds.’ (Pallis, 2007) However, because the trading volume of these bonds stayed low,
the potential savings were not met. Moreover the dramatic shifts in freight rates led to a higher level of
defaults by shipping companies on their bonds as opposed to the average of the market as a whole. In
1999 ten shipping companies defaulted which made up 38% of the total defaults. The corresponding
default rate of the market as a whole was 1.28% (Grammenos, Nomikos, Papapostolou 2006).
Cyclicality, volatility and high-leveraging jeopardize shipping companies’ cash flow especially during
recession periods. This led to the high level of defaults and the shipping bond issuances compared to
other players in the market of equal rating (Pallis 2007). Obviously this meant that shipping bond
issuances popularity had declined.
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Since shipping companies still needed access to capital, a new frontier was entered, the equity markets
through the use of IPOs. To enter the stock market, the shipping companies had to transform
structurally and culturally (Pallis, 2007). The changes were necessary as the expectations of investors
required shipping companies to be professionally managed and investor interests to be protected.
Equity finance, IPO, can be an attractive form of finance since the issuance of new stock to attract
capital can be cheaper than other methods. This is partly due to the fact that shipping companies
traditionally pay lower dividends to investors because they need to retain earnings for fleet
replacement or expansion. The downside is that investors typically expect returns of 15-20% (Pallis,
2007), because of the level of volatility in the freight market and their risk exposure. The attraction of
equity instead of debt does have a stabilizing effect on the shipping industry. This is because
devaluation of asset value due to downturns can be absorbed by investors who suffer the financial loss
as opposed to bond holders who confiscate vessels. The main problem for equity funded dry bulk
shipping companies during downturns is producing enough cash inflow to cover the necessary cash
outflows. But even if cash is needed in the short term in order to cover immediate cash outflows,
speculators might be willing to accept the issuance of new stock, hoping on returns based on asset
appreciation. This step by various dry bulk shipping companies to go public has added a possibility of
anti-cyclical investment to the dry bulk shipping industry. Yet the problem remains that when a
financial crisis and economic shock occurs, the resulting upheaval in trade affects a downturn in
freight rates. So the problem remains that investment capital is scarce when economic opportunities
arise.
3.4 Conclusion
Fitting a preferred method of financing to a management strategy is not always possible. High yield
investment opportunities are abundantly available when asset value is low or when short-term capacity
availability is scarce. The volatility of the sector makes the traditional methods of financing through
bonds and mortgages relative to other sectors too risky to become generally viable. IPOs have met
with some success. The countercyclical effect of bargain-shopping stock buyers and the diversification
of risk to stockholders, both help guarantee the continuity of the shipping company. Unfortunately
plain stocks in shipping companies do not leave much room for diversification of risk preferences of
investors. This leaves the cyclical effect of bloated balance sheets and investment levels during boom
times that lead to oversupply of vessel capacity. It is precisely this diversification of investment
opportunity and risk that securitization of dry bulk shipping companies is intended to address.
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4 Securitization of New Build Dry Bulk Carrying Vessels
Securitization is an elaborate financial structure in which an income or interest producing asset is
made to fit many different types of investors. It is precisely the effect of flexibility in the types of
investment opportunities created that could help diminish volatility in the market. To make the idea of
securitization applicable to the dry-bulk shipping market, the basic structural ideas of tranche creation
(see below) and general structure has been copied from the mortgage backed securities and
commoditized mortgage obligations. So the idea of selling tranches on future income isn’t new, it is
the method of applying this to dry bulk shipping with the tranche value being based on segmented
charter income which is innovative. The present day preferred methods of financing is through IPOs,
corporate bonds, bank loans and private equity as discussed in the previous chapter.
But by financing through the selling off of tranches of different value ranges on possible future charter
income, the dry-bulk shipping industry could get a more flexible, extra-cyclical, tool to help finance its
vessel purchases. It is this idea that will be introduced in this chapter.
But before the concept can be introduced the issue of the recent financial crisis must be discussed. It is
essential that this happens first as securitization has played a significant role in causing it (Diamand,
Rajan, 2009). In specific the mortgage backed security can be marked as a root cause of the recent
financial crisis (Jaffe, Lynch, Richardson, Van Nieuwerburgh, 2009). It was these securitized products
that had been used as an investment product and as a source of reserves. The problem with this was
that the mortgages had to be packed into groups to be large enough to be traded off effectively. As a
result, after the packaging and selling off of some essential mortgages, specific data was lost
(Diamand, Rajan, 2009). A buyer of a tranche packet would not know which mortgages he was
investing in and who the occupants were. Therefore prices of the packages could not effectively be
determined (Diamand, Rajan, 2009). In addition, the mortgages on housing have the fundamental
problem that in a downturn the assets are fixed in one location and have no alternative source of
producing income.
Dry bulk shipping would not be affected by these fundamental flaws because the vessels can be
relocated to other geographical areas and deployed there. If the ship operator thinks that the downturn
will only be temporary he can choose to anchor the vessel for the time being and reduce his operating
costs. If the downturn lasts too long for the ship owner’s financial situation, he can sell the vessel for
scrap and thereby obtain a measure of liquidity from the asset (Stopford 2009). Finally, the
securitization of dry bulk vessel would not cause the assets to be impersonalized as the individual
value of the vessel is large enough to warrant individual securitization or at most through the bundling
of a few vessels. This would mean that the sold off tranches could easily be traceable back to the
vessels on which their value is based on.
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In 4.1 the basic structure of securitization will be laid out. This will be done by first enumerating the
players and instruments that are necessary and placing them in a complete picture. Then an analysis of
the development of market value determination, cash flow generation and default procedures will give
a general estimation of the manner in which the securitized shipping companies would fit in the
shipping market. In 4.1.5 a case study will give an example of the way in which the securitized drybulk shipping company would function and so clarify the process of securitization. In 4.2 a discussion
will be opened on the effects of securitization. Herein will be stated some theoretically estimated
consequences of this concept of securitization. The goal of the chapter is to introduce the concept of
the securitization of dry bulk shipping and to clarify it in order to encourage further contemplation and
research.
4.1 Structure of Securitization of New Build Capacity
4.1.1 Basic Structure
Securitization requires the creation of a homogenous pool of assets (Pallis, 2007). These assets have
been houses in other situations, but in dry bulk shipping the assets are vessels. These vessels, taken
separately or in a group, are then placed under the auspices of a custodian (attachment 3). The job of
the custodian is to maintain the integrity of the dry bulk shipping company and identify and portion off
tranches (see below) of future charter income. This could be done to fit many different preferences of
risk managers’ investment portfolios with for example, pension funds. The risk could also be spread
out temporally to protect the investor from short-term shocks in freight rate levels. This would mean in
practice that the investor would be investing on the long term stability or even just the existence of
trade flows and the shipping industry’s capabilities to match them in the long-term. But short-term
speculative investors who want to make a large profit on the expected volatility in freight rates could
make a bet on high grade tranches near maturity as the factor of time until maturity would no longer
be calculated into price (Natenberg, 1994). The introduction of securitization would thus mean that
long term and speculative investments into shipping could be segmented. The various investor
preferences could be met with different tranche mixtures sold separately or as packages in SPVs. This
would hopefully dampen the pro-cyclical investment effect in shipping. To better clarify and define
the aspects of securitization of the shipping companies, it is necessary to list the definitions of the
instruments of and players in the securitization of new builds in dry bulk shipping below. All figures
used are hypothetical and purely meant to illustrate the conceptual idea.
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The definitions of instruments in securitization of dry bulk shipping:

Tranche and tranche ranges and rating
Tranche refers to a predefined segment of possible future income from the chartering out of
the vessels during a predefined period of time. For example, a tranche would be the portion of
the charter income over 6 months averaged out per day with a value from $3000 to $4000
during the period of 4 1/2 years to 5 years in the future.
If the average day charter rate take of a vessel were $4312, the holder of the tranche would
receive $1000 per day over 6 months, to be paid at the end of the 6 months. But if the charter
income take were only $3549 per day, the tranche holder would receive $549 per day during
those 6 months.
The tranches would be subdivided into layers of income. Each layer would have a different
risk of return and therefore a different price and potential payout. The lowest tranche, average
of $0-$1000 a day, would be the most secure with nearly no historical record of charter rates
on these types of vessels dipping below this level, and if so only for very short periods of time.
Each subsequent higher level tranche would have a higher risk of not paying out full value. A
tranche of 6 months with a right to charter income from $2000 to $3000 during a period when
the average freight rate and charter income was only $2500 would collect only $500. The
lowest tranche would thus have the lowest risk of not paying out full value. This would mean
that the tranches could be rated by the S&P rating as a mixture of types of assets and thus
could be rated in the range from AAA to D (Attachment 4).

SPV special purpose vehicle (attachment 3):
An SPV is a single purpose corporation created to house the underlying assets, vessel(s) or
tranches. An SPV would be created by the originator, see below, to house the underlying asset
of the vessel. And separate SPVs could or would be created to house a mixture of tranches to
spread the risk of rate fluctuations. But for clarity purposes we will only refer to vessel SPVs
as SPVs.

Spreading on tranche investment package
The collection of a myriad of tranches to assemble the overall wanted long-term risk would
mean in practice that a tranche SPV would consist of a mixture of maturity durations. Thus a
conservative pension fund could buy the lowest tranche of, for example $250-$1000, not for
just one period but for a mixture of periods ranging over the next 5 years or more depending
on the wants of the pension fund. The sale of tranches nearing maturity date or at maturity
date to fund the purchase of future tranches or to generate cash would keep this position of
long term charter income assets in place. And as mentioned before, investors could try to
spread risk in various tranches from various vessels sailing various routes with various
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maturities. This would mean that the individual shocks would affect them only partially and
not sink their portfolios.
The players that would be involved in a securitized shipping enterprise would be:

The shipyard
The shipyard provides the capacity to build new vessels. It would build them at the request of
the SPV originator or manager.

Bank, Financer
The role of the bank is to make available the necessary funds to finance the commissioning of
the vessel.

Bank, Pension fund, hedger etc.
Pension fund, wealth managers, etc., means those investors that want to purchase the charter
tranches to add to their portfolios. The tranches could act as a possible hedge against
significant increases in charter rates or as a safe form of holding the needed reserves.

Charter and vessel brokers
These brokers will have the task of selling the available charter income tranches to investors.
Other brokers would be charged with finding charterers to fill up the capacity of the vessels.

Security originator and manager
The security managers will have the task of setting up and managing each new securitized
vessel. There real task will be to assess the real market demand for capacity of dry bulk
vessels in the future. As the speculative risks will be sold off, this will just leave the limited
margins to be made by keeping the supply and demand for vessels balanced. Their money will
be in maintaining good contact with the most efficient shipyards, charter tranche brokers and
movements of other players commissioning dry bulk shipping vessels.
4.1.2 Market Value
A securitized dry bulk shipping company with commoditized charter income tranches would have two
main asset types. The first is the value of the vessel and the second is the value of the tranches. The
value of the securitized shipping company is derived from the principle that the value of a vessel is the
sum of all future bare-boat charter income plus eventual value as scrap.
The balance sheet will basically vary throughout the lifetime of the vessel as follows. At the moment
of commissioning, i.e. signing of the build contract two years before completion, the balance sheet of
the SPV (securitized shipping company) will be as in attachment 2.1. If the security initiator or
manager of SPV holding needs extra liquidity to fund the building of the vessel, this could happen
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through a bridge loan, i.e. short-term loan. This would be the amount of capital needed that would be
raised through the selling of tranches during the building of the vessel. The rest of necessary funding
would come from either equity investment or mortgage/asset-backed debt, i.e. a mortgage. The vessel
is valued at salable tranches plus resale value since it is reasonable to accept that at this stage not all
tranches available until the end of the operational lifetime of the vessel will be sold immediately or
before completion of the building of the vessel. The balance sheet at this moment will look like
attachment 2.2. The change in makeup of the balance sheet of the SPV once the vessel is operational is
that the contract obligations have been replaced by the obligation of the SPV to honor the outstanding
tranches. These tranches would be valued at market price, marked to market. The balance sheet at this
moment will look like attachment 2.3.
Nearing the end of the operational lifetime of the securitized vessel the sale value of the vessel will be
only the discounted scrap sale value and the unsold tranches left. If at this time there are tranches sold
past the scrap date, they would have to be refunded at market price of vessel of equivalent dwt class.
4.1.3 Cash Flow
As stated before, dry bulk carrying vessels have capital, operational and voyage costs. Securitized dry
bulk shipping would in theory only deal with a bare-boat charter arrangement so operational and
voyage costs would not be an issue. Only capital costs would have to be covered (Stopford 2009). The
SPVs method in which this is accomplished with securitization is by the sale of tranches. These
tranches are constantly reaching salable maturity dates. This is because tranches far in the future can
be sold but at discounted value, as is done for freight forward agreements (FFA) (Koekebakker,
Adland, Sodal, 2007). This can mean that selling off tranches with ten years until maturity will not
cover much of the immediate outgoing negative cash flow. If a situation of negative cash flow arises
because interest on debt must be paid, this would best be solves by attracting more equity or the
conversion of debt into equity.
It should be noted that by selling off the tranches of future charter income, the dry bulk shipping
company’s income becomes in fact extra-cyclical. A large part of the freight rate risk is thereby
transferred to the tranche buyers from the ship owner.
4.1.4 Default Procedure and Risk
Especially in the present environment of a global financial crisis spurred on by the defaulting of
people on their mortgages it is essential to analyze the risk of default of SPVs and the appropriate
default procedure. At default, the SPV shares would be confiscated and given as equity to the creditor.
In other words, the debt would be converted into equity. The vessel wouldn’t sink and if the vessel
would be long-term unprofitable, it would be scraped or anchored until time to scrap. Defaulting by an
SPV would therefore not have an effect on the economic viability of the vessel.
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Then there is the issue of outstanding tranches which cannot be honored nor refunded at the moment
of scrapping. The issue arises of rank order of debt. Do the mortgage holders have precedence over
tranche holders? This is a legal question which must be predetermined before the securitization of
shipping can be implemented. Either way it is essential that outstanding tranches be publicly known
and certified (Douglas, Diamond, Raghuram, Rajan, 2009). Since tranches can be packaged,
repackaged and resold, there can be a question of disintegration of market information. This too must
be addressed before securitization can be implemented. The sale of tranches should probably be
approved and cleared by the Baltic Exchange or any market place that wants to sell these tranches.
4.1.5 Case Study
This hypothetical case study is meant to clarify the workings of the securitized dry bulk shipping in
practice. It will show how theory with all its players and instruments, can have clear, real world
applicability.
Suppose that in 2010 a shipping company, Long Term Vessel Management (LTVM), has analyzed
general market conditions and has determined that it expects general demand for dry bulk vessel of
25,000 Dwt to stay strong for years to come. Furthermore LTVM has analyzed the prices and supply
levels of tranches with maturities of 2-10 years and thinks that there is room in the market for more
tonnage. After looking through the market for sale of existing capacity by getting in contact with
various vessel brokers, LTVM has determined that commissioning a new build might be a more
profitable option. So LTVM gets in contact with a number of shipyards to see if any has the capacity
to produce such a vessel at a as low as possible price. China Bulk Builds (CBB) has offered the most
competitive price with the best conditions. CBB will build the vessel over an 18 month period to start
in 6 months. The price of the vessel is $20,000,000 and the payment method is ¼ at the start of
building, ¼ when one third of the work is done, ¼ when two thirds of the vessel is built and the last ¼
at christening of the vessel. $1,000,000 must be paid at the moment of reservation of building
capacity. This fee is non-refundable, but will be subtracted from the last payment if LTVM is
unwilling or unable to fulfill its requirement as stated in the vessel building contract.
LTVM now looks for investors for the new vessel. The necessary capital can come from a mortgage
(Debt) or by the selling off of shares (Equity). The bank says that it is willing to grant a 15 year
mortgage for 60% of the total cost at 7% interest. But the new SPV must have at least $10,000,000 in
equity at the start of the build. Furthermore LTVM must invest at least $2,000,000 of its own. This
would leave an operational liquidity buffer of $2,000,000. If LTVM invests $4,000,000, this would
leave $6,000,000 to be raised.
Before signing the contract, LTVM makes inquiries at the shipping securities commission and
exchange (SSCE) for approval of the sale of the prospected tranches. Once the deal is pre-approved,
LTVM will form an SPV to house the yet to be built vessel called Neptune’s Toy. The SPV managed
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by LTVM, will sign the agreement with CBB to build Neptune’s Toy and then report the vessel to the
Baltic Shipping Securities Exchange (BSSE). There LTVM will announce the public offering of the
new tranches. After five months LTVM has sold tranches with maturities 2-6 years through brokers at
the exchange to an array of steel mills, pension funds and hedge funds. The sold tranches have raised
an additional $4,000,000 in capital. Now LTVM needs to find $2,000,000 more capital quickly or
invest $2,000,000 more. To accomplish this LTVM sells a third of its shares to a Greek shipping
company named Mykonos Shipping (MS). Now the bank offers the funding to be called on when
necessary.
LTVM has already contracted a charter broker to take control of the operational running of the new
SPV. The only job left for LTVM is to manage the financials of the SPV. This entails making sure the
tranches are regularly sold in order to meet the mortgage payments, checking up on the chartering of
the vessel to make sure it is employed and paying Mykonos Shipping its share of the profits.
After 17 years of operation, LTVM concludes that the vessel will not be operationally profitable
enough in 3 years. Therefore it orders the suspension of tranche sale with maturities past the scrapping
date and repays any tranche holders, if applicable. Two years later it contracts a scrapping yard to
accept the vessel for the equivalent of $2,000,000 in 2010. Thus in 2030, Neptune’s toy is sold for
scrap and the shares holders are paid out the remainder of the asset value left in the SPV.
The profitability of Neptune’s Toy for LTVM depends on the value of the tranches throughout the
years. Sudden short-term market fluctuations would not have made Neptune’s Toy profitable for
LTVM because it presold the tranches years in advance. Rather profitability would come from longterm structural added value to the market offered by the new build shipping capacity.
4.2 Discussion on the Effects of Securitization
Securitization is only a method to improve the efficiency of the real world markets of dry bulk
shipping. Securitization of the new build dry bulk vessel would affect the dry bulk shipping industry in
all 4 shipping markets of Stopford (Table2.2) since all four markets are interconnected. Moreover this
method of using tranches of future charter income as commercial paper to be sold off, opens up dry
bulk shipping to many different types of investors. The tranches of different grades/ratings would
entice different types of investors from pension funds to high yield investors.

AAA to A rated tranches could be eligible paper for investment by pension funds and other
such conservative investors.

BBB to B rated tranches could be enticing to a range of investors or portfolio builders as the
risk and therefore rewards ratios could be quite high.
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CCC to D rated tranches, or ‘junk’ tranches, could be seen as ‘junk’ bonds and so used for
leveraged buyouts, or they could be bought as possible hedging opportunities for shippers
against high freight rates.
The effect on the four shipping markets of Stopford could be as follows.
Freight Market
The choice of investors to speculate on high freight rates by buying high risk tranches instead of
adding capacity for short-term returns would hypothetically have an effect of dimming market
volatility. The tranches would act to market capacity much as stock options act to stocks (Natenberg
1994) and FFA act to spot freight rates (Kavussanos, Visvikis, 2004). Volatility in spot freight rates
would also decrease due to the dampening effect of greater foresight into responses to the global
supply and demand fluctuations by the tranche holders and shipping managers.
Charter Market
Precise predictions cannot be made on the effect of securitization on the contract forms of the charter
market. What can be said is that time-chartering would have a new competitor, the hedged spot market
charter. This hedged spot market charter, hedged with a packet of tranches, would form an alternative
for long-term time charter. The prices of the BDI and the tranche trading market could therefore be
seen as a new way of gauging the market price for time-charters. The improvement in distribution and
availability of market price data could help improve competition between ship owners and hopefully
stabilize and lower slightly, the charter rates.
Secondhand Sale and Purchase Market
The tranches could add an extra dimension to the pricing of existing capacity, because they could be
packaged and pre-sold through an SPV. They could then be used much as a leveraged buyout with
junk bonds. The effect of the introduction of pricing of secondhand vessels based of a number of years
of predicted future freight rates would add a measure of calm to the secondhand vessel markets
(Stopford 2009). In fact this would mean that the vessel would have a two layered bottom price, the
first layer being the scrap price and the second layer being the average freight rates over the next few
years and the availability of investment capital. Volatility in the secondhand market prices would
decrease.
Shipbuilding
Chinese shipyards can structurally out-compete European ones because the former’s labor costs and
environmental requirements are substantially lower. European shipyards only get orders for dry bulk
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vessels if demand and prices are high (Stopford, 2009). But what if the expansion of shipyard capacity
in China could be priced as well? This would mean that prospected building capacity could be presold before taking the decision to build extra shipbuilding capacity. If this could be done then the
commissioners of new builds would have the choice of going to Europe or waiting a few months and
building in China. And with the introduction of securitization into shipping, the trading of tranches
would provide a market price on expansion or generation of shipbuilding capacity. This could mean
that an approved building shipyard building project could be introduced into the market. Therefore
instead of going to Europe or other more expensive shipyards, a ship could be ordered and tranches
sold of not yet built ships of Chinese shipyards. This creation of a market for selling projected capacity
would help orientate shipyards to areas where they are most efficient and thus facilitate the
repositioning of the market to align itself faster along more efficient lines. Furthermore the greater
inter-temporal scope of vessel commissioning originators would assist them in spreading out their
vessel purchases. The introduction of tranches into securitized shipping companies could optimize the
sub-optimal (Dikos, 2004) new build prices.
4.3 Conclusion
Securitization is an innovative and highly dynamic instrument for financing shipbuilding and
managing existing capacity. The introduction thereof would bring into being a whole array of new
professions as did the introduction of the FFA (forward freight agreement). Securitization would
enable shippers to hedge risks and exposures through the buying of tranches which would act as call
options and hedge against the increase in charter rates. But more importantly the tranche trading
market prices would be an accessible source of market representative data. The better coordination of
the players in the market because of the new market gauges could improve market efficiency and
coordination.
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5 Conclusion
With a literature review, the market operation of the dry bulk shipping market was analyzed and four
separate, but interrelated markets that describe how the dry bulk shipping market operates were
identified. Capacity is added to the market through new building. Existing capacity is efficiently
allocated by sale and purchase of existing capacity. And the employment of the vessel is based on
charter agreement on the spot market or for longer term. Prices for these charter agreements are based
on the freight rates charged to shippers of cargo. These four markets however do not form an
environment of perfect competition as freight rate levels are hard to predict and shipyards are slow to
deliver capacity. When freight rates are high the market attracts investment capital, but a lack of a
global informational source on excepted future capacity hampers the coordination of the ordering of
vessels. Without this informational source it is difficult to arrange charter agreements because it is
difficult to estimate accurately the future supply of vessel capacity.
By extending the literature review it was determined that the dry bulk shipping company’s main
financial goal is to generate a positive bottom line cash flow. In order to attract long or short term
investment capital the companies need to attract financing through debt, as in a mortgage or issuance
of bonds, or equity, through an IPO or investment of private equity. Current methods of financing
exacerbate the pro-cyclicality of the investment in new build capacity. The reason is the lack of
segmentation between short-term speculative and long-term investment vehicles. Short-term
speculative investors buy the same stocks and bonds as longer-term more conservative investors.
Moreover if ship owners could have a method of transferring short-term price risk years in advance to
receptive investors, they would have an extra-cyclical financial tool to fund the shipping companies.
The ship owners, SPV originators, would have more freedom to focus on addressing the long-term
supply and demand needs of the dry bulk shipping market.
Then a method of securitization of dry bulk shipping was conceived to satisfy a perceived demand for
a more versatile financial tool. The form of securitization was loosely based on the existing formation
method of a mortgage-backed security. It was then discussed that securitization of dry bulk shipping
companies could make the dry bulk shipping industry more market efficient. The securitization of a
dry bulk shipping company with segmented tranches based on future charter incomes could offer the
industry a versatile financial tool. The segmented tranches would offer better investment products for
all investors and speculative investors would have less reason to invest in new build capacity to earn
money on short term fluctuations in freight rates. Moreover the tranches could be used as a hedging
tool for players adversely affected by high freight rates. The trading market for tranches would be a
good source for data on the expected offering of capacity in the future. This information could help
decision making for the players in the market. It would also help the shipbuilding industry supply
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capacity in a timely manner and streamline itself through the possibility of selling tranches on
prospected shipbuilding capacity. It would assist the ship building market in structurally adjusting the
supply of shipbuilding capacity along more efficient lines and in more efficient locations.
These theoretically possible advances in efficiency could only come into fruition if steps are taken to
test the real-life possibilities of implementation. The thesis has been based on literate review and a
case study and has inherent limitations as it lacks a quantative approach to the securitization. As this
thesis was hereby limited in size and scope it has not researched in detail the method of establishing
and determining pricing. Moreover the creation of a tranche trading market with the entire necessary
infrastructure in the form of financial and human networks will undoubtedly run into unforeseen
obstacles. It would be beneficial to investigate further in detail the framework which must be
established and how the players would effectively coordinate their partition in the process of
securitization. Further research would also be warranted in the detailed predictions of the real world
effects of implementation of securitization in the dry bulk shipping market. Before implementation it
is imperative to have a well researched end detailed prediction of the market effects of securitization
as the issue of balance sheet management is essential to the survival of the dry bulk shipping
companies. Dry bulk shipping companies would thus not agree to securitization if they were not
satisfied with the predictability and stability of securitization. Further research is necessary to unlock
the substantial potential benefits of securitization of dry bulk shipping.
David Pollack
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References
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David Pollack
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Appendix
Attachment 1: Overview Financing Methods
Financing
Finance
method
type
Private
Equity
investment
Mortgage
Method summary
Upside
Downside
Owner or partner
Limit to losses
Lack of leverage limits
invest personal assets
Debt
backed loan
growth opportunity
Bank offers credit
Book vessel value
Shortage in cash flow
backed by vessel
generates investment
means loss of vessel
capital
Asset backed
Debt
loan
Bank offers credit
Book asset value
Losses may be greater
backed by assets
generates investment
than vessel value alone
capital
Charter
Debt
Bank offers credit
Future charter income
Freight rates are volatile
backed by charter
generates investment
so default are prevalent
contract
capital
Investor gives capital
Gives capital without
Interest rates are stable
against future cash
encumbering assets
but market income is not
Investor gives capital
Gives capital without
Ratio capital investment
against possible future
encumbering assets
to future payout is high
New equity attracted
New working capital
Free rider, stock market
to company
without more debt
based buyout
Equity/
Raising new working
Counter-cyclical asset
Speculative investment,
Debt
capital independent of
play possible
long term investment
backed loan
High yield
Debt
Bond
flow generation
Junk Bond
Debt
asset value growth
IPO
Ship fund
Equity
shipping market
mismatch
Source: (Pallis 2007, Stopford 2009)
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Attachment 2 Balance sheets of SPVs during different periods of lifetime
Attachment 2.1:
Value SPV vessel at moment commissioning:
Assets
Liabilities
Value salable tranches
Invested equity:
(at least 2 years to maturity)
shares in SPV holding
Discounted estimated sale value after expiration
Debt:
sold tranches
bridge or mortgage loan, outstanding bonds
Liquid assets
Contract commitments:
Payment terms during building of vessel
Attachment 2.2:
Value SPV vessel after completion build:
Assets
Value salable tranches
Liabilities
Invested equity:
shares in SPV holding
Discounted estimated sale value after expiration
Debt:
sold tranches
bridge or mortgage loan, outstanding bonds
Liquid assets
Market value of sold tranches
Attachment 2.3:
Value SPV vessel at end operational lifetime:
Assets
Value salable tranches
Liabilities
Invested equity:
shares in SPV holding
Discounted scrap sale value
Debt:
bridge or mortgage loan, outstanding bonds
Liquid assets
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Market value of sold tranches
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Attachment 3:
Source: (Pallis, 2007)
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Attachment 4:
Source: (Pallis, 2007)
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