This post has had a long gestation period. I started looking at DVB Bank some months ago and then got sidetracked by other issues. But recently there has been talk of a “recovery”, and I accept the demand side may have reached a plateau, and may even show some minute and qualitiative signs of increase, but in an apology to Solow, this is showing up everywhere but the numbers (unless you listen to Tideaater and Bourbon where it is clear there is no recovery). However, you cannot have a healthy industry in the modern economy without access to credit, and that means the banks are significant actors as well. And DVB, as the most focused lender to the sector, seems a good barometer of industry health.
For those of you unlucky enough to have discussed economic history with me over a few beers, you will know one of my abiding fascinations is the behaviour of banks, central banks, and exchange rates/gold standard in the 1930s. I find the causation/correlation angle between macroeconomic and microeconomic fascinating and it has clear historical parallels with the Euro now and the 2007-2009 global financial crisis. The clear understanding amongst economic historians is that a broad contraction in credit led to falling asset values, reduced economic activity, and this imperilled the banks as reduced asset values wiped out their equity and further caused them to reduce lending and call in further loans (for both the 1930s and GFC). Such a cycle of interaction made the entire economy worse off and became self-reinforcing. Eventually normality at the macro level was restored only with endogenous events (either devaluation/ leaving the gold standrad or war induced expenditure) post the Great-Depression.
This is analogous for offshore because the industry, particularly for the last 10 years, has been built on credit. Vessels have traditionally been financed with anything up to 80% debt and on top of this businesses took out cash-flow based facilities to grow even faster. This is fine as the industry expands and asset values follow an upward trajectory (or in the case of vessel values tended not to depreciate as fast as book value would imply), as more credit was allocated to the industry causing further price inflation in a self-reinforcing pro-cyclical process. The problem comes on the way down…
At the moment no sane bank can lend to offshore on anything but the most secure transactions. Who is right on PSV pricing? The banks and bondholders in Farstad thinking fleets are worth .75c in the dollar or Standard Drilling at .30c in the dollar (no prizes for what I am thinking). The circumstances are different (sort of), particularly the controlled nature of the sale, but the bigger point is you could not get a new bank to back either deal, partly for cash flow uncertainty, but mainly because these assets, in only mildly changing circumstances, might actually be worth virtually nothing given holding and lay-up costs.
If all the assets in the industry need to be financed with signficantly more equity, because banks won’t lend, it becomes a self-reinforcing process on the way down because no one can afford to pay as much, and the whole fleet is worth less. Acquisitions have to be funded with either equity (and who has any) or debt. Retained earnings for acquisitions are going to take an eon to build up.
This leads me nicely to DVB. I want to be clear that DVB is no different to other banks in the industry, it is just that it is big in the industry and by virtue of its focus must disclose more than anyone else (although not for long). I started to look at DVB’s balance sheet exposure in 2013 just as the boom peaked. In the 2014 AR DVB reveals that it has asset exposure of €24.5bn and a tier 1 capital of €1.2bn, or ~5%. Banking is a risky business model, you borrow off one set of customers and lend to another set of customers, any shortfalls from the borrowers side and there is real a problem, I am reminded on Krugman’s comment that “if you borrow-short and and lend-long you are a hedge fund regardless of what you call yourself”. To put this in perspective a DVB needed only a 5% change in value of its asset base to wipe out the entire tier one capital (a 20.4x leverage level which is not excessive by banking standards). Another way of looking at this is that DVB funded this asset base with 89.9% in unsecured bonds and promissory notes/deposits: by definition a 10% drop is asset values would mean these people who lent the bank money would be getting less than 100c in the dollar back. Despite the institutional nature of this money these sort of investors regard bank bonds and deposits as sacred in a way mere mortals can barely imagine, and any hint that their interest payments indicated any risk at all is looked on akin to the end of the world (unless you are a Cyprus bank but that’s another post).
That €24.5bn is invested ~10% in offshore assets and ~53% in shipping. I make no real comment on portfolion diversification here. DVB shareholders (and funders) clearly knew this risk they when they purchased the securities and there is a rational (not one I really buy but we don’t need to get into random walks here) ; the point is a group of well informed institutions knew what they were buying. Frankly it was an assymetric payoff on a very small number of industries. By definition when these industries do badly the bank is at risk which is why banking has traditionally evolved into a far more broadly diversified structure these days… I digress… Bear those numbers in mind when you look at the DVB portfolio of 2014:
The total portfolio value is listed as ~€2bn. I could have used 2015 or 2016 but I want to highlight the value of the asset base going into the downturn because it is obvious from these numbers that a 50% write down in the value of the portfolio effectively makes DVB insolvent not merely illiquid (when a fair estimate of shipping losses are added). The AHTS and PSV fleet would of course be lucky to be worth 25% of their 2014 value.
And sure enough DVB recently announced that they are taking a massive writedown on the portfolio and that their parent company will in effect consolidate DVB. The statement is pretty bland but its no different to when SPV/SIVs were brought onto parent company balance sheets in the last financial crisis (its another sign of a credit bubble). DVB lost €156m on credit in the first 9 months of 2016 and expect a loss in the hundreds of millions for the year (they booked a small profit for the first half year). Offshore finance still represented 9.1% of the loan portfolio of €22.5bn c.2.05bn in the last accounts and no significant markdown of the portfolio has been taken. It just isn’t real. I don’t think banks should mark-to-market, but in this case you can’t pretend the loan portfolio isn anything like that on the books.
As a general rule when the major banks to an industry are becoming insolvent (or in this case burning though their entire equity base on c. 10% of their loan portfolio) the industry recovery is some way off. The problem isn’t unique to DVB with DBS having total exposure of USD 637m to EZRA and a total tier one capital of c. USD 31.5bn i.e. 2% of tier one equity dependent on one customer not including its other oil and gas loans. It’s not the knock to EPS that DBS needs to worry about its the hit to capital. I’m not suggesting DBS will become insolvent over EZRA but I am suggsting they will have to contract their balance sheet given leverage ratios and the amount is material. Try getting an offshore/oil and gas loan through DBS anytime soon?
Asset values are going to remain extremely depressed for a very long time because not only has the industry overbuilt capacity significantly but it will take a very long time for traditional banks to open up credit lines to such a volatile industry again (bank risk models really don’t like volatility). It will take years for bank credit and portfolio committees to start approving loans to this industry. Some vessels over 15 years old will never get a senior loan again and that will flow through the industry and as a negative event on equity and asset values for years. The only providers of credit are alternative lenders who not only charge high margins, in what may be a fairer reflection of risk one may argue, but there are signficant information and coordination problems to overcome in even finding them if you are a company.
I hope for the people involved in the industry that demand is starting to reappear, but we are long way from some sort of industry stability and a lot more downsizing needs to happen. Some of the transactions banks are involved still look to be based more on hope than reality, but when you see the expression zombie banks you don’t need to think of Italian property, this is it in reality: banks exposed to fleets of ships with very high running costs, no buyers and no clear value realisation paths, that are trying to prop up the book value of their assets because the amounts are material to their solvency. Such scenarios have traditionally ended badly (S&L crisis anyone?).