Securitization of Shipping Loans

Securitization- the process of bundling underlying financial instruments and repackaging them for sale to new investors, will be a growing feature of shipping finance. Receivables from container lessors such as Textainer and GE Seaco have already been packaged, enabling lessors to gain liquidity; now, structures borrowed from airlines and property sectors are being applied to obligations under shipping loans- rather than leases.

As noted in JTF (1 Dec 2005), three synthetic shipping loan securitizations (two by HSH Nordbank, following the groundbreaking effort by NIBCapital) have now been undertaken. In a world where the absolute sizes of shipping portfolios are growing, and where banks are increasingly focused on levels of risk based reserve capital, the ability to create liquidity and transfer risk (that otherwise would stay with mainstay industry funding sources) is a useful addition to the bankers’ toolkits. When Basel II comes into effect on Jan. 1, 2007, securiti zation will be critical to both risk exposure management and capital management. Shipping company’s debt is often not rated. Though shipping has become increasingly corporatized, in those atypical cases where the debt is rated (by an external agency) or evaluated through an internal assessment- it might fall into the 100% risk capital category (tied to credits rated at BBB+ to BB-) or quite possibly into the high risk category (below BB-, requiring 150% capital). In the securitization transactions, the bank creates a “reference portfolio” (a part of the bank’s overall shipping loan portfolio)- which is then rated. Under, the Basel II Accord, banks can get “economic capital relief” when loans are placed into a qualifying securitization structure, meaning that banks may exclude risk exposure from calculations of economic capital, if a portfolio has been securitized. Mr. Martin Halblaub, HSH Nordbank’s Head of Portfolio Management and Investments and Manager of its London branch, talked in terms of rough numbers on the securitization process, telling JTF, “we want to reduce our risk exposure in areas where we have concentrated our lending”. JTF spoke to several banks that have been involved in shipping securitizations, or soon will be. In the words of Mr. Peter Kappel, a seasoned banker with a real estate/ property background who recently joined Frankfurt based DVB Bank, he was brought in “to start the ball rolling as we look broadly at securitization, generally” . HSH Norbank’s Mr. Halblaub described his bank’s role as “Managing risk exposure and selling our asset management abilities including cross selling to our clients from the property and corporate sectors”.

The breakthrough enabler for the shipping deals is the ability to create “synthetics” – where the actual loans remain in the banks’ portfolios, with no change vis a vis the shipping client. In fact, the client need not know that its loan has been referenced. In a synthetic transaction, a Special Purpose Company (SPC) is created which issues credit linked notes to investors (in effect, the SPC is buying protection) ; the proceeds of this funded portion of the note issue is then invested in medium term note instruments (for example Pfandbriefe ) which act as collateral. The SPC then enters into a Mezzanine Credit Default Swap, effectively selling protection to the bank, against the reference portfolio of shipping loans (with the loans staying on the books of the shipping bank). The “bank can buy a credit default swap as insurance against the loans,” in Mr. Kappel’s words. When all is going well, the cash flows move through the SPC, under the watchful eye of a Trustee looking out for the investors’ interest. Periodic interest payments on the notes (“insurance premia”) move through the SPC, to the investors holding the credit linked notes. The rating agencies, S & P, Moodys and Fitch, play an important role in the transaction- in particularly in their review of the underlying loans. A comment in the pre-sale report (October 2005) from Moody’s offers the following caveats, and describes the conservatism built into the ratings process: “The underlying assets exhibit a highly volatile nature, with extreme cyclical shifts in both the earnings capability of the vessels (spot and charter rates), and the vessel values. The shipping market continues to operate at cyclical highs. Moody’s has taken this additional uncertainty into account by analysing the transaction using increased volatilities compared to those that have been historically observed.” The credit linked notes issued by the SPC consist of various debt tranches across the rating spectrum, each embedded with a credit default swap. If a credit event occurs within the portfolio, the investors have to suffer the loss (ie the difference between market value netted with the ship value). In the words of Michael Fuhrman, a New York based specialist in credit based derivatives at GFI Group, "there can be a real economic loss that must be marked to market; values on defaulted loans may be $0.60 - $0.70 on the dollar." Losses are allocated first to holders of notes with the lowest rating; usually the sponsoring bank will hold the "first loss" portion. Further losses, if any, will be absorbed by holders of the B rated notes, then BB, and further up the credit chain. Conversely, repayments flow from the top down, holders of the highest rated notes will get paid out first. GFI's Fuhrman likened the process to New York traffic- "with lower rated notes, it's as if you're riding on the bumper of car; with the higher rated notes, you are riding in the back seat in a better protected position." In contrast with container lease receivables (on a broad pool of standard assets), securitizations where the actual vessel loans are sold, would be difficult, if not impossible to package. Ship finance involves bespoke debt structures built

around unique company circumstances (and operational issues) in a world of volatile asset prices and charter rates. Furthermore, the typical international cross-border legal framework for big shipping deals would create nightmarish documentation challenges to packagers attempting to wrap dozens of loans into a palatable vehicle for a financial investor. Indeed, DVB’s Kappel alluded to his institution’s role subtly shifting to that of “…an origination platform, and assembler of packages…” Similarly, HSH Nordbank press materials described its transformation “from an asset financier to an asset manager.” NIBCapital, a merchant bank based in the Hague with an important franchise in ship finance, was responsible for “Latitude Synthetic”, shipping’s first securitization (a $660 Million transaction referencing 100 loans, concluded in September 2002),. HSH Nordbank, created in 2003 from the combination of two Landesbanks, is believed to have the world’s largest portfolio of shipping loans, pegged at nearly US $23 Billion (in mid 2005). HSH Nordbank was responsible for Ocean Star 2004 (closed in October 2004)- a portfolio of 80 loans worth US $1.054 Billion, and, now, for Ocean Star 2005- a bundle of 72 loans worth approximately US $570 Million. In the Ocean Star 2005 offering, which mirrors the larger 2004 offering, a major chunk of the new notes (approximately $427 Million, out of the $570 Million total) consists of a Senior Credit Default Swap between HSH Nordbank, and a large OECD bank. The remaining US $131 Million (excluding the first loss piece of US $12.6 Million) , just about 25% of the total, is funded by investors. The legal final maturity of the notes is November, 2012 (seven years), compared to the weighted average life of the portfolio loans of 6.04 years (closer to the expected term of the deal). The conservativism of the transaction is further evidenced by the average loan to value ratio of 39.7%, and the exceedingly young average age of portfolio vessels of 3.16 years. Ocean Star 2005’s threshold portion (the “first loss” piece, described by GFI’s Mr. Fuhrman). In the earlier (2002) Latitude transaction, NIBCapital- the originator, entered into a credit default swap, in respect to the reference portfolio, with Merrill Lynch International, in turn passing the risks on to investors in credit linked notes (CLNs), with margins over LIBOR varying from 0.65% to 3.00%, due in 2012. Of the $663 Million deal, the super senior portion totaled $397 Million, the mezzanine component (containing the CLNs) totaled $209 Million. A $16.5 Million junior default swap and NIBCapital’s $39.8 Million first loss piece comprised the remainder. From an industry wide perspective, the liquidity aspect of the securitization process is paramount; though new banks have joined the ranks of shipping lenders, market veterans refer to them derisively as “tourist banks” who may exit the sector as both freight rates and margins drop. However, and in contrast to some of the container leasing deals, liquidity is not the paramount concern for the issuers. HSH Nordbank’s Halblaub was emphatic, “…we don’t need the liquidity,

for us- our primary driver is economic capital relief.” Mr. Halblaub, in discussing the investor side, said that “ investment considerations, not familiarity with shipping, are driving the purchase of Ocean Star notes.” He described the investors in the Ocean Star issues as being “institutional investors, mainly Europeans and Americans split equally, in the 2004 issue, joined by Asians in the Ocean Star 2005, after they have had some time to analyze the first deal.” He added that “the traditional institutions will go for the investment grade portions of the issue, while the lower portions, rated BBB and BB, would be taken by U.S. hedge funds.” An underlying question surrounding securitizations of maritime loans concerns their impact on time tested practices of ship finance. Clearly, an important facet is the tricky balance between the maritime bankers’ skills at “working things out”, the definitions of credit events (the industry’s propensity for “rescheduling rather than defaulting”- in the words of Moody’s), and the needs of loans to conform to the structure of the securitized financing. The Moody’s pre-sale memo on Ocean Star 2005 provides hints of such accommodations: “The potential of restructuring loans which are facing financial difficulty, while typically a benefit to offset short term price and asset volatility, could delay default, and hence impact severity. However, HSH will be constrained in their capability to do this by limiting the individual loan restructuring to a maximum extension of the weighted average life of 2 years (but not beyond the original scheduled maturity of the loan), and on a pool basis, by not more than an weighted average life of 4 months (on a cumulative basis).” Replenishment of a portfolio, where transactions not in the portfolio at a deal’s inception may be brought in, are important in a business with frequent repayments and re-financings, in response to market conditions or to corporate consolidations. The HSH Nordbank transaction, with regular 6-monthly replenishment dates, provides mechanisms for replacing loans, with Moody’s adding that “…loans replenished through this channel should always be of at least an equal quality to the loans that have been replaced…to insure that the diversity and credit quality of the pool is not adversely affected. In the Ocean Star 2005 transaction, replenishment provisions are carefully designed to insure that “the level of over-collateralization in the base case scenario is not affected when new loans are added to the portfolio.” Likewise, no loans can be added to the portfolio where the exposure is greater than US $10 Million. Rating agencies are required to approve any additions to the pool portfolio. Diversity is part of risk reduction- limits in sector concentration are in place limiting maximum exposure to certain sectors (with containerships at 75%, tankers at 50% and bulk carriers at 45%). Securitization will have important impacts on shipping finance. NIBCapital’s Mr. Jan Jaap Meindersma, a Director- with a background in ship finance and now heading the bank’s Commercial Mortgage Backed Securities group who had

heavy involvement in its 2002 deal, said, “I think the capital markets are currently exceptionally receptive for securitised shipping risk. Not only have the shipping markets performed very well the last years, also the enormous amount of liquidity that is available in the capital markets has pushed spreads down.” DVB’s Mr. Kappel talked about asset classes such as LNG tankers- in the midst of a construction boom (see JTF # ?? 3 Nov 2005), with vessels costing $200 Million each. Mr. Kappel described the intermingled opportunities and challenges, “The industry needs $Billions of funding, and the charterers are usually good solid credits. But LNG vessel financings, although tied to a comprehensive ‘Project Financing’, are not being unbundled in a manner well suited to a securitization.” This methodology, where financings are undertaken at the outset with later securitization in mind, differs markedly from HSH Nordbank’s approach in the Ocean Star transactions, where the refe rence portfolio is a cross section of the bank’s entire pool of shipping loans, reflecting the main segments of the shipping portfolio. NIBCapital’s Meindersma did point out one impediment that must be overcome: “I think that one issue needs to be resolved in order for securitization technology to be applied in the shipping finance industry on a large scale; Standard & Poor's has (in contrast to its competitors Moody's and Fitch Ratings) not yet adopted the view that shipping securitisations could achieve triple A ratings. As long as S&P does not change its stance on this issue investors will expect a relatively high compensation on the largest part of the transaction (compared to other securitisations), which obviously leads to some hesitation on the side of the shipping lenders who ultimately have to pay for the spreads to investors.” When asked about the future, NIBCapital said: “Although we still benefit from the capital relief gained through Latitude, we are currently actively exploring how we can apply securitisation techniques (both traditional and synthetic) to our transportation portfolio, where a large part of this portfolio relates to shipping finance.” Picking up on the real estate angle expressed by a number of bankers, DVB’s Mr. Kappel talked about his institution’s role as being an “origination conduit,” bringing the merchant banking mentality to the no longer sleepy world of ship finance.