Shipping's Moral Hazard

Low freight rates have been a concern for a great number of reasons and a wide range of market participants. Shipowners faced with weak cash flows cannot perform on their loans, causing problems for lenders. Investors faced with poor returns turn to asset sales, driving values even lower. Shipbuilders faced with a great deal of slippage and defaults on existing orders have seen demand for additional newbuilds vaporize.

All the concerns mentioned above – and they are only a sampling – emanate from a single cause: a depressed freight market that radiates and affects every aspect of shipping. And despite the recent bounce in the dry bulk market, freight rates are still very low and at barely operating breakeven levels. Markets have been too low for too long, and those shipowners still in business have had to dig deeply into their cash reserves or seen their equity overly diluted. There is little left in terms of available cash, funding from investors or, for that matter, patience.

Now another concern has to be added to the long list of consequences springing from a weak freight market: moral hazard. Moral hazard in this case can be defined as the behavior of an owner who is so disengaged from reality as to act carelessly in reference to an asset and the parties with an interest in the asset. The most obvious example is when the owner’s economic interest in the asset is so miniscule that there is little reason to care about it. That leads to all kinds of disrespectful and harmful behavior.

Moral Hazard in Financing

When the principal amount of the ship mortgage is materially higher than the present value of the vessel (and any hope of market recovery thereof), owners have little incentive to make any effort to fulfill their loan obligations. There is very little hope that they will ever see their money again and thus little incentive to behave.

Several owners we know had been making good, more or less, on their loans for the last couple of years in the hope of a market recovery. Two years later, having thrown good money after bad and reaching the bottom of their cash reserve piles, they are barely inclined to keep performing.

There have been cases of shipowners who have stopped paying interest and principal on their loans despite having the financial capacity to do so, believing they are better off with shipping loans in default than with performing loans. First, they preserve capital, which they can deploy to new, clean-slate shipping investments and let the legacy transactions sink. Second, for loans in default, banks seem inclined to grant concessions to shipowners with nonperforming loans while holding “good” shipowners to a much higher standard. Thus, it pays to be bad. Third, there had traditionally been an unspoken law in shipping that for a borrower defaulting to a shipping bank, effectively they were ostracized for life by the ship banking community. This was a very high incentive to behave, not to borrow more than one could afford and, even when things turned sour, to make every effort to see that the lender recovered as much as possible of the outstanding principal.

Now with several executives at shipping banks being corporate officers with little knowledge of or affection for shipping, and with a great number of shipping banks actively exiting the business, there is no longer the self-watching ship banking community to ensure proper borrower behavior and thus plenty of room for moral hazard. “You don’t have to be nice to the bank anymore” is the attitude. “What can they do to me?”

Moral Hazard in Vessel Maintenance

There has been moral hazard in reference to the maintenance of vessels as well. When the freight market is low, economizing by cutting down on expenses is required to make do with less and ensure survival in a challenging market. First goes the “fat.” Next comes “discretionary spending” (spare parts onboard the vessel is the classic case), followed by laying off people ashore, and then keeping vessel maintenance only to the extent that the classification society requires in order to renew the certificates.

Talking to inspectors boarding vessels on behalf of charterers, the technical quality of the vessels has become a concern, and this concern is highly troubling for tankers and oil companies given the level of liability in the event of an accident involving pollution. Talking to inspectors boarding vessels on behalf of port state control (such as the U.S. Coast Guard), there is real concern about vessels that have been under-maintained. Talking to inspectors boarding vessels on behalf of buyers of ships in the secondary market, there is lots of concern about vessels that have been neglected for too long.

With the freight market too low for too long and with many vessels afloat effectively “depending on the kindness of strangers,” there is little incentive to do anything beyond the absolute minimum required in terms of maintenance.

Moral Hazard in Personnel and the Environment

There has been moral hazard in reference to seafarers and the environment as well. There have been several stories recently in the trade press about seafarers being abandoned, unpaid for months and malnourished, and even stories of vessels arrested due to outstanding crew wages. Unfortunately, in a market where owners do not care much about the asset or the lender or the crew, it’s hard to envision how or why they would care much about anything else, such as the environment or adhering to sound navigational practices. Such is the risk of moral hazard.

There is no doubt we are living through unique times in shipping. The present crisis has been much more monstrous than others in the past. Examples of moral hazard are a known consequence of rapidly shifting economic structures and defaults (think of moral hazard in the subprime real estate market in the U.S. a few years ago).

However, given low expectations of a market recovery in the near future, issues arising from moral hazard will only get more complicated and perilous. After all, moral hazard in shipping can affect trade, human lives and the environment. When contemplating actions in shipping at present, one has to be cognizant of addressing alignment of interests and dissipation of moral hazard.

There is an anecdote of Shipowner A confiding to his friend, Shipowner B, that Shipping Bank X arrested four of his vessels. “Oh dear,” replies Shipowner B, “I am so sorry to hear that. And now who is your best banking relationship?” To which Shipowner A dryly replies: “I think I already told you. Bank X!”

As funny as the joke may be, a market cannot function on such a basis. – MarEx