Freight market hits credit rocks

New Angles

The fast-growing market in derivativeslinked to maritime freight capacityis attracting an increasingnumber of players. But a default by aGreek shipping company and the resulting$8.5 million lawsuit by the NorwegianFutures & Options Clearinghouse (NOS)is fuelling concerns about credit risk inthis often opaque market.

Known as forward freight agreements(FFAs), freight derivatives have becomepopular in the past 12 months as the spotmarket cost of shipping cargo worldwidehas risen sharply. There are both supplyand demand reasons behind the increase.Booming economic conditions in Asia createdemand, while high prices of steel(needed for building new ships) along withnew EU regulations for the construction oftankers have squeezed supply.

Ship owners or charter companies thatexpect to provide cargo capacity in thefuture (perhaps after a new ship has beenbuilt) can lock in today’s price (quoted indollars per tonne) using an FFA. Standardisedcontracts have evolved to meetthis demand, both for ‘wet freight’ (suchas oil) and ‘dry freight’ (such as steel, coaland soft commodities), with additionalspecifications for the route and size of vessel.Largely intermediated by freight andship brokers, but now attracting banks aswell, the market is estimated to be at least$30 billion in size.

The FFA market is split between anover-the-counter market, where brokersbring counterparties together individually,and an online exchange, Imarex, wherecounterparty risk is transferred to the NOSvia a clearing member of the exchange.The NOS calculates variation margins thatare required as credit loss reserves againstdaily mark-to-market swings in FFA prices.

It is these swings in price that havecaused problems. For example, betweenSeptember 2003 and September 2004, thePanamax 2005 FFA, one of the most heavilytraded dry cargo contracts, exhibitedprice swings of 100%, with a volatility of30%. When the contract price fell from itspeak in early 2004, the winners and losersbegan to emerge. One shipping company,Hong Kong-based Jinhui, reportedFFA losses of $67 million, while MonteCarlo-based Coeclerici reported gains of$92 million.

The default came in July, after the NOSrevised its dry cargo margins upwards forthe second time this year (they were increaseda third time in September). NavitransMaritime, a privately owned Greekshipping company that had become aclearing member of the NOS in April, wasunable to pay a margin call, according tothe NOS, and under the exchange rules,had its positions closed out as a result. TheNOS then used its own reserves to settleopposing positions with exchange counterparties,and began legal proceedings torecover the money, estimated to be $8.5million. Navitrans declined to comment.

Concern grew in October, when theNOS announced it was raising $9 millionfrom its shareholders to cover the shortfallin its capital caused by the default.This led to complaints from brokers thatthe clearing house was badly managedand poorly capitalised. Philip Van denAbeele, managing director of brokerClarkson Securities, says: “My suggestionto the NOS is that maybe it wasn’t a verygood idea to accept Navitrans as a client,because maybe they were not the sort ofclient you should be having if you startclearing freight derivatives.”

Inaccurate

Morten Erichsen, managing director of theNOS, responds: “Like all members, Navitranshad to provide information to us, andtheir information fulfilled our criteria. Wehave now re-examined this informationand have found it to be inaccurate.”

Van den Abeele remains sceptical, animpression reinforced by the recent NOScash call. “It is not a very good sign. Iknew that one day NOS would have problemswith a counterparty because theywere insufficiently capitalised.” Erichsendismisses the suggestion that the NOSposes a credit risk to counterparties,pointing out that in addition to its cashreserves that were depleted by the Navitransdefault, it also has a bank guaranteeof $35 million. But he concedes thatthis is small compared with the $1 billionpluscapital cushions enjoyed by big clearinghouses such as LCH Clearnet, and says that the NOS is looking at ways of increasingits capital.

The OTC market (which accounts for85% of volumes) is less transparent, andin the absence of FFA netting agreements,there is no way of knowing the total exposureof a given counterparty. As Erichsenis quick to point out, this highlightsthe advantages of a centralised clearinghouse system, where cross-margining canbe used to reduce risk. According to theLondon-based brokers who spoke to Risk,there have been no defaults in the OTCmarket. These same brokers strongly defendtheir ability to evaluate the creditrisks of counterparties they bring together,and they note that they are subject toFinancial Services Authority rules.

However, the banks building up theirpresence in the freight market are sceptical.Eric Verha, head of European powerand gas trading at Deutsche Bank, whichrecently became a clearing member of theNOS, says: “For the long-term freight players,in the light of the enormous volatilitywe’ve seen, they should aggressivelyscreen their counterparties in terms ofcredit risk, and if they don’t like the numbersbehind their companies, they shouldn’tdeal with them.”

The problem, the bankers say, is thatshipping and charter companies are oftenfamily owned, and divide their assetsamong different companies for tax reasons.While the industry as a whole is veryprofitable, and most such companies arewell run, this kind of corporate structuremakes it difficult for banks to deal withship owners.

Verha comments: “Operators are splittingup their fleet into 15 different companies,one for each vessel. It’s a veryfragmented industry. And if I was a majorplayer exposed to these freight rates, Iwould not hedge with somebody who hasstructured their company in such a way.I would hedge with somebody who wasbetter structured, because default is nolonger theoretical.”

One possible solution has come fromRoyal Bank of Scotland (RBS), which hasa large ship financing business. RBS allowsits ship finance customers to access the FFAmarket using RBS as a counterparty. Theidea behind this is that swings in FFA pricesare usually accompanied by similar movesin the spot market. Thus, negative exposureto RBS due to a rise in FFA prices wouldbe compensated by an increase in the valueof the borrower’s collateral. RBS was notavailable for comment.