Europe’s banks face shipping challenge.

By Alice Ross and Mark Odell

European banks battered by the downturn in the shipping market face a tough 2014: the European Central Bank has vowed to make the sector a core focus of its upcoming asset quality review and stress tests.

Lenders – in particular German banks – are increasingly seeking innovative ways to reduce their shipping portfolios before the regulator takes over direct supervision of about 130 European banks at the end of the year.

Yet there is a sticking point: bankers say it is not clear whether the more creative solutions will be approved under the new regime.

"Our auditors are getting nervous," says one German shipping banker. "If it was more clear what the guidelines are for the AQR it would be more helpful."

German banks are among the hardest hit by heavy portfolios of non-performing loans after a tough five years that has seen shipping volumes slow in the global economic downturn, compounded by an ordering spree by ship owners before the financial crisis hit in 2008.

One of the main problems is the German banks’ exposure to Kommanditgesellschaft funds (KG) – a traditional German way of ship financing that attracts private investors by offering a tax efficient structure with each fund typically owning one ship.

Hundreds of funds have already collapsed but there are still about 2,000 single ship companies, many of which are running out of working capital.

Banks including Commerzbank and HSH have already extended loan terms and offered holidays on capital repayments in an attempt to ease the pressure on the KGs, but the weak shipping market has meant the vessels are still struggling even to cover their operating costs. This is particularly true of container ships, which make up a larger proportion of the KG and German shipping bank portfolios.

Commerzbank created a special unit last year that can reclaim ships from distressed owners – with the aim of selling them again once the shipping market takes a turn for the better. It has so far reclaimed at least four vessels this way.

Others, such as HSH, are brokering deals to sell their debtors' loan portfolios directly to shipping businesses, such as its December sale of 10 vessels to Navios Maritime, a New York-listed ship owner. 

Described as "innovative" by HSH, the deal involved a partial sale of the loan book to Navios and a participating loan taken out by HSH. Such creative solutions are among those that could be questioned by the ECB.

"There are solutions out there that I believe are in the grey area. I know for sure that different auditors have different perspectives on the same structure," says one German shipping banker.

Stefan Ermisch, HSH’s chief financial officer, says that while he is confident about the ECB’s upcoming asset quality review because of the bank’s strong capital position, the outcome of the stress tests will depend on how much weight the regulator attaches to shipping.

BaFin, the German regulator, is already demanding regular updates from the banks in recognition of the severity of the situation. The regulator said it would remain vigilant in 2014. But the watchdog said that German banks’ volume of ship loans declined by 20 per cent in 2012, while impairments grew by 50 per cent, suggesting that the “lion’s share” of potential liabilities had already been digested.

Yet Basil Karatzas, a New York-based ship financier, believes that German banks in particular will be forced to take more drastic action with their shipping loan books after running out of ways to put off the inevitable.

Distressed debt investors are circling. US investor Oaktree Capital, which has long had an interest in shipping, told investors in a conference call in November that it was hopeful that European banks would continue to sell shipping loan portfolios during 2014 in preparation for the ECB’s stress tests. The distressed debt investor bought a portfolio of non-performing shipping loans from Commerzbank in December for €280m. UK lender Lloyds Banking Group has also sold portfolios of loans or large single loans to buyers on the hunt for distressed assets.

Yet shipping bankers question how helpful private equity buyers are.

“The inflow of private equity could lead to a situation like in 2006 where too many people are pumping money into a market they don’t understand,” says Torsten Temp, head of shipping at HSH, who believes the cut prices being offered by private equity buyers are still too low for his bank.

“It’s quite helpful to have this kind of liquidity as long as it goes into existing ships,” says Stefan Otto, head of shipping at Commerzbank. “[But] a lot of the money is going into new buildings, because there’s a lack of tonnage available in the second hand market.”

Some shipping observers believe regulators may continue to allow the banks to spin out the problem for long enough in the hope the shipping market will recover to bail out the loan book.

There have been some signs of a recovery in the shipping market in recent months, with a rebound in both dry bulk and tanker rates. This has been reflected in a couple of recent transactions by banks that took many in the industry by surprise. Both Royal Bank of Scotland and Norwegian lender DNB last year sold large tranches of shipping debt at about 90 per cent of face value – although both deals were in the dry bulk sector, one of shipping’s hotspots at the moment.

Both Lloyds and RBS, for example, have already taken significant writedowns on their shipping loans and do not expect to have to take further hits in the near future.

The official view of many large shipping lenders – including Commerzbank – is that the market will not improve until 2015. That means further loan loss provisions could still loom this year.

Analysts at JPMorgan think the shipping market will improve this year in line with their prediction of a rebound in global growth and an emergence from recession for the eurozone.

The question is whether for some lenders, any improvement will be too late.

Additional reporting by Sharlene Goff and

©The Financial Times Ltd 2014