1. 2 3 Credit risk, also known as ‘counter-party risk’, is defined as the possibility of a loss occurring for a party due to the other party’s failure.

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Financing in Specialized Sector

Natherland Maritime Institute of Technology

byDr. Mansor Abdul

Rahman

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Shipping industry is CAPITAL

INTENSIVE, dynamic, volatile, and

full of risks: Asset price risk,

interest rate risk, exchange rate

risk, freight rate risk, operating

cost risk, bunker price risk, and

credit risk

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Credit risk, also known as ‘counter-party risk’, is defined as the possibility of a loss occurring for a party due to the other party’s failure to meet its contractual obligations in accordance with the agreed terms of a deal.

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Credit Risk

• Examples of credit risk include the failure of a debtor to repay a loan, or

• the failure to receive a payment for a product or service which a firm has provided.• Credit risk in shipping arises because most of the deals, trades and contracts are negotiated directly principal-to-principal basis, which means that• The two parties agree to do business with each other

and rely on each other’s ability to honour the agreement.

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Credit Risk….cont

• The agreement could be a charter contract between a shipowner and a charterer,

• A new building contract between an investor and a shipyard,

• A freight-derivatives transaction between two investors.

• A bunker transaction between a shipowner and a bunker supplier.

• In any case, parties to contracts can be exposed to each other’s ability to perform the contract or credit risk.

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Credit Risk….cont

• Credit risk can be further classified into three types; namely, ‘default risk’, ‘downgrade risk’, and ‘credit-spread risk’

• But we consider default risk as the major component of credit risk, especially in shipping markets and transactions.

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RISK & DEFAULT

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Default….cont

A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place:

(a) It is determined that the obligor is unlikely to pay its debt obligations

(principal, interest, or fees) in full;

(b) A credit loss event associated with any obligation of the obligor,

such as charge-off, specific provision, or distressed restructuring

involving the forgiveness or postponement of principal, interest, or

fees;

(c) The obligor is past due more than 90 days on any credit obligation;

or

(d) The obligor has filed for bankruptcy or similar protection from

creditors.

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Default….cont

• Credit risk is usually expressed in one of the following terms:

a) Probability of default (PD), which is defined as the likelihood of the counter-party failing to meet its contractual obligations fully on time; say one (1) year

• The PD of an obligor not only depends on the risk characteristics of that particular obligor but also the economic environment and the degree to which it affects the obligor. Thus, the information available to estimate PD can be divided into two broad categories –a. Macroeconomic information like house price indices, unemployment, GDP

growth rates, etc. - this information remains the same for multiple obligorsb. Obligor specific information like revenue/freight growth , number of times

delinquent in the past six months , etc. - this information is specific

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Default….cont

b) Loss-given default (LGD), which is defined as the financial loss which could occur in the case of the counter-party failing to meet its contractual obligations fully on time.c) Distance to default, which is a pure statistical measure of credit risk and is defined as the number of standard deviations drops in the asset value that can trigger a default.

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Default….cont

LGD is usually defined as the ratio of losses to exposure at default, but as usual the devil is in the details Once a default event has occurred, loss given default includes three types of losses:

• The loss of principal• The carrying costs of non-performing loans, e.g. interest income foregone• Workout expenses (collections, legal, etc.)

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Default ….cont

There are broadly three ways of measuring LGD for an instrument:

1. Market LGD: observed from market prices of defaulted bonds or marketable loans soon after the actual default event2. Workout LGD: The set of estimated cash flows resulting from the workout and/or collections process, properly discounted, and the estimated exposure3. Implied Market LGD: LGDs derived from risky (but not defaulted) bond prices using a theoretical asset pricing model.

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CREDIT Risk

Measurement/HOW?

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Qualitative vs. quantitative credit-risk analysis

Broadly speaking, credit-risk analysis can be

classified into ‘qualitative’ and ‘quantitative’

credit-risk assessment methods depending on

the methodology and variables used.

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Credit Risk Measurement

• Qualitative credit-risk analysis is based on firm specific factors that are not quantifiable, which include:

1) The business history and reputation of the firm;2) Managerial expertise, experience and ethics;3) Relative standing in the market and the business

share of the company; 4) Financial flexibility and structure in terms of

accessibility to cash or other types of assets to cover any losses;

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5) Strength and operational flexibility to change and adapt under difficult market conditions in order to cut losses; and 6) Strategic plans and contingencies for bad days and financial distress.

Overall, although these variables cannot be directly measured, companies can be assessed and compared given such information.

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• Quantitative risk analysis, on the other hand, utilizes variables that can be measured to assess the credit risk and capability of an entity to honour its financial obligations.

• These variables include firm-specific factors such as:

a. Financial health in terms of profitability, return on assets, turnover, return on capital, other financial ratios etc.;

b. Earnings and interest coverage; c. The firm’s size and its market share; andd. Its capital structure in terms of leverage and balance sheet

items.

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Other quantitative variables to consider are market factors such as:e. General market and economic conditions;f. The level of long-term and short-term interest rates; and, most importantly, g. The cash flow and revenue uncertainty of the firm.

Quantitative risk analysis generally involves statistical or mathematical models which use quantifiable factors to estimate the probability of default.

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Sample qualitative variables

• Reputation/business history • Managerial expertise and track

record• Relative standing in the market • Financial flexibility and capital

structure• Strength and operating

flexibility• Strategic plans and

contingencies

Sample quantitative variables• Financial health of the firm• Firm size• Earnings (interest coverage)• Gearing (debt-to-equity

ratio)• Turnover and ROC• Market conditions• Interest rates• Cash-flow uncertainty

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Credit Ratings and Rating Agencies

• Who are the users of credit risk and credit-risk assessment?...... investors, lenders and market participants

• Reporting system has been developed to evaluate corporations in terms of their ability to meet their obligations to investors who purchase corporate bonds, or lenders who provide funds for corporations.

• Independent rating agencies are Moody, Standard & Poor, and Fitch assess the credit risk of companies and to publish their findings for the benefit of investors.

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Credit Ratings and Rating Agencies

• Rating agencies use a variety of techniques and models to assess the relative creditworthiness of corporations and companies,

• To provide objective, consistent and simple measures to indicate the likelihood of a company honouring its debt obligations.

• To provide a simple and consistent way of reporting their views on the creditworthiness of corporations, rating agencies developed rating scales or classifications which are more or less similar.

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Fitch, Standard & Poor’s and Moody’s rating scales

Fitch Standard & Poors Moody’s Investment grade AAA+ AAA+ Aaa1 AAA AAA Aaa2 AAA− AAA− Aaa3 AA+ AA+ Aa1 AA AA Aa2 AA− AA− Aa3 A+ A+ A1 A A A2 A− A− A3

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BBB+ BBB+ Baa1 BBB BBB Baa2 BBB− BBB− Baa3– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – Speculative grade BB+ BB+ Ba1 BB BB Ba2 BB− BB− Ba3 B+ B+ B1 B B B2 B− B− B3 CCC+ CCC+ CCC CCC Caa CC CC Ca– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – Default D D D

Source: Data from rating agencies.

Fitch, Standard & Poor’s and Moody’s rating scales

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• Shipping is a risky business, and agents involved in it are exposed to freight and price fluctuations due to market risk.

• Therefore, there is always a possibility that agents may not be able to fully meet their contractual agreements and therefore default.

• Credit risk in shipping can be viewed from the point of view of a financier (banker) who provides funds to a shipowner to purchase a new ship, an investor who purchases shipping bonds,

Credit Risk in Shipping

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• A private investor who provides private equity for shipping companies,

• A supplier who provides credit for purchases to shipowners and operators, or even

• A derivatives trader who enters into a derivatives contract with a shipowner.

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• By the same token, credit risk can be viewed from the shipowner’s side when he enters into a charter contract with a charterer who may not perform

• The required contractual obligations and make payments on time, or

• When a shipowner places a newbuilding order and the shipyard fails to deliver the vessel on time, or even when

• The shipowner enters into a derivatives contract with a counter-party who fails to settle the contract at its maturity.

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Credit Risk Management and credit derivatives

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• The main objective of credit-risk management is to eliminate or minimise the credit-risk exposure of a party to a deal.

• There are a number of methods which can be used for such a purpose

• For example, for many centuries, lenders, even after careful consideration of the reputation of their borrower, preferred to have some sort of (a)collateral (reduces the cost of recovery in case of letigation)

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• Alternatively, lenders could ask for an endorsement from a third person with a very good reputation, which is now quite commonly issued by bank as a ‘bank guarantee’ or ‘letter of credit’.

• Other methods used are downgrade triggers, contract design and netting and diversification, as well as recently developed instruments such as credit

derivitives

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(b) Downgrade triggers allows a party to close out or change the terms of the contract if there is a downgrade in the level of the counter-party’s creditworthiness or if the credit rating of the counter-party falls below a certain level. For example• Under the terms of this contract, the borrower (shipping company) agrees to provide additional security (cash or additional collateral) if the hull-to- debt (HTD) ratio falls below a pre-specified level.

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(c) Contract design and Netting CDN is to design the contract in such a way that it incorporates clauses for default and non-performance compensations. • For instance, netting of outstanding contracts is a clause that states that in a bilateral transaction, if a party defaults on one contract, then all outstanding contracts will also be considered in default. This means that the innocent party can use the netting clause and offset part of its losses against the other contracts.

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(d) Diversification The bank designs a well-diversified shipping loan portfolio across different sectors of the shipping industry (for example, dry bulk, cruise shipping, fishing, offshore)• The overall credit risk may be reduced, because the correlation between the default probabilities of borrowers would be lower or even negative. • Moreover, lenders can diversify their loan portfolio in terms of credibility, industry, country to reduce overall exposure to credit and default risks.

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Credit Derivitives

(5) Credit derivatives, are said to be the most innovative products in finance and risk management.

• The credit derivative market was developed in the 1990s and the growth in trade in these instruments has been increasing ever since.

• According to the British Bankers Association, the global trade in the credit derivatives market (excluding asset swaps) had reached US$1.2 trillion by the end of 2001 and US$20 trillion US 100 trillion in 2006 n 2012 respectively.

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Credit Derivitives

• A credit derivative is a financial instrument whose payoff depends upon the performance and/or creditworthiness of one or more commercial or sovereign entities in meeting their contractual agreements.

• Thus, credit derivatives allow credit risks to be exchanged, or even traded, without the underlying assets being exchanged.

• As a result, managers and investors who do want to enter into certain deals or invest in certain assets but do not want to be exposed to the credit exposure of the counter-party to the deal can use credit derivatives to control or eliminate their default-risk exposure.

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THANK YOU

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Credit default swap (CDS)

TYPES (1) CDS is a contract under which an investor buys protection from a protection seller (Company B) against default on a reference bond or a claim issued by a reference entity (Co C)• Under this contract the protection buyer makes regular (annual, semi-annual or quarterly) payments, known as the premium, to the protection seller over the period for which the protection is bought.• In the event of default by reference entity C, the protection buyer has the right to sell the reference bond to B for its face value, or the protection seller pays the buyer the difference between the market value and the face value of the claim

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Credit default swap (CDS)

• Therefore, credit default swaps simply work like an insurance policy on the reference bond or claim and financially indemnify the protection buyer in the case of default.2) Total Return Swap (TRS)3) Credit Spread Option (CSO)• These credit derivative instruments that can be used to effectively and efficiently manage credit exposure and default risk.

Exercise : USD 10m bond yield 5% maturity June 2018 issued by MISC, bought by Hedge Fund. Knowing the risk involved, HF entered into an agreement with Bank MOCHA….90 basis points annually.

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THANK YOU

1. 2 3 Credit risk, also known as ‘counter-party risk’, is defined as the possibility of a loss occurring for a party due to the other party’s failure.

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