Bank Loan to Shipping Corporation

Bank Loan to Shipping Corporation

Describe the categories that a bank is considering when granting a loan to a Shipping corporation in order to expand its fleet.

Categories that a bank is considering when granting a loan to a Shipping corporation in order to expand its fleet

It is the goal of every business undertaking to expand and grow in terms of coverage and capacity of handling work, the same applies to any shipping corporation. The process of expanding is usually a gradual one and takes many forms or methods, for a shipping corporation there are basically two methods through which they can expand their fleet, these are retaining earnings and issuing shares. Retained earnings has been mentioned as the most logical form of expanding a fleet over a period of time, however, this method may not be easily applicable when the expansion involves the acquisition of a newly built vessel because such an acquisition needs a lot of funds that are far much more than any retained earnings. Most modern vessels are complex in construction thus making them more costly to acquire. In issuing of shares the company decides to sell additional shares and get funds out of it. The issue of shares may have the complication of the current shares representing assets whose value is beyond the original cost of the shares. The increase in share capital can bring difficulties and the only solution will be the existing shareholders providing additional funds. The challenge with this form of expansion is that private companies cannot use it since they are not allowed to publicly advertise their shares and the only option for them is to go public which is not an easy process.

In order for a company to expand they need funds and these funds can be obtained from different sources. The type of finance source depends upon several factors such the type of company, the company's existing capital structure, the availability of the different sources of finance, and the current and projected profitability of the company.

1.1 Sources of finance for a shipping corporation

A shipping corporation can get government backed cheap finance where security needed is not that tightened. Even though the government states that the borrower should give adequate security this is usually not applied and even doubtful security can be accepted. The ship can also decide to finance itself in which case the finance is provided for the particular vessel rather than the expansion of the company in general since it is considered to be a distinct new asset. A shipping corporation may also decide to lease a vessel instead of buying a new one; this gives the ship-owner all the advantages and disadvantages of ownership with no need of providing the initial capital. The involvement of the 'lessor' is purely financial operation and all the ship owning risks are covered by the shipping company who is the 'lessee' in this case.

The other methods that can also be used to raise finance are sale and lease-back, financing through tax savings, and government subsidies. In sale and leas-back the shipping company sells a ship that it owns to a third party and then leases it back. This method gives the shipping company the advantage of gaining cash immediately and retaining full use of the vessel even though it will pay higher for the lease period. The benefits of this method solely depend on a country's taxation policy and the current tax position of the firm. In financing through tax savings, the shipping company takes advantage of the accelerated depreciation on ships offered by the government for taxation purposes. Therefore, acquiring a new ship may save the company tangible amounts. The government subsidies usually come through the ship builders so as to lower the price for shipping companies but in some cases the subsidy can be paid directly to the owner to help in financing the purchase, this source is only available in some countries.

The most common source of finance and the one that is of interest here is the commercial loans which are obtained from banks. Since banks are also commercial institutions just as any other business, they must set their mode of operation that would enable them achieve their goals. With respect to this there are a number of considerations that a bank takes before offering a loan to any shipping corporation. These considerations are in terms of the cost of financing, security for the loan, and the interest on the loan.

Chapter 2

2.0 Considerations before granting a loan

2.0.1 Loan security

The most crucial aspect of any loan whether a commercial loan or a government subsidized loan is the security to be provided to the lender by the borrower which should act as a surety to the lender that he will recover the amount lent. Even when the season is that of high lending this aspect cannot be totally ignored since all lending institutions desire that the entire loan and the accrued interest is paid and in time. Initially, banks satisfactorily accepted charges on assets as security but this later changed and the track record of a shipping company was brought into consideration.

In order for banks to ensure that there is adequate security for their loans there conditions that are set to also protect the borrower so that he is in a position to service the loan conveniently. When lending to ship-owners the banks know very well that the borrower can become bankrupt thus the conditions set to safeguard the ship-owner is that in the process of constructing a vessel all the material and equipment ordered under the contract are owned by the ship-owner ones they get into the yard. The bank further guarantees from the shipyard to cover repayment of installments.

Banks must also asses the value of the security offered to them by the borrower, for instance if a mortgage on a vessel is used as security, banks will in most cases accept a first mortgage on a vessel as being worth 50% or 60% of the contract piece provided the vessel is of a type for which is an established second hand market. If the vessel is highly specialized one, then because of the uncertainty as to its resale value, a first mortgage is likely to be accepted as worth only about 40% of the contract price. The major concern of the lender is the market value of the vessel therefore the contract price becomes completely irrelevant in this case. There is a tendency of banks enforcing security at a time when values are very low, even lower than the contract price. In case of an existing vessel purchase during a period of slump, the lender may feel that the values are not likely to fall further and be prepared to lend even 80% of the purchase price. One way of assessing the effectiveness of the first mortgage as a security is through the use of 'Hull to Debt ratio' which is the ration of the market value to the outstanding loan, this ratio is expected to range between 130% to 140% by the lending banks.

The use of a mortgage is also viewed as an attractive form of security by the borrower since its cost is limited to that of drawing up the mortgage agreement itself. The other advantage to the borrower is that the agreement includes clauses that will ensure the vessel is properly insured but the lender has the first claim on insurance money in the event of total loss. The other securities that can be considered by lenders include bank guarantees assignment of charter parties, and mortgages on further vessels or assets. Bank guarantees are preferred by lenders where the case involves export finance. Such bank guarantees are sought from the borrower's own bank and the bank guarantees the first six payments after which the bank has no further involvement. There are other forms of security that are attractive to the borrower such as an assignment of the vessel's charter earnings. This kind of security can only be used if the vessel is being built to service a profitable long-term charter from a major company of undoubted financial strengths. When such an agreement is made the payment of the charter hire is made by the charterer to the lender who deducts the due loan repayment and pays the balance to the owner, this assures the lender that the vessel's earning are used first to repay the loan.

Banks may also require personal guarantees from the senior executives of the borrowing company thus banks ensure that the executives will take a real interest in the success of the vessel. The actual guarantees are usually small and there is less likelihood of them being pursued by the banks unless they sense recklessness or negligence from the individuals. Lenders are usually prepared to consider any other form of security provided the form of security can be seen to safeguard their position. In a case where the borrowing company is a subsidiary of a large corporation of undoubted financial strength the lender may accept or require a guarantee from the parent company in a lieu of a bank guarantee.

2.0.2 Interest on loan

Before any loan is granted, the borrower must clarify the position as to the payment of interest on the loan draw-downs during construction. The mode of payment of this interest may vary and may be payable every six months from the date of the first drawdown with a final payment in respect of the pre-delivery draw-downs on the day of delivery, this is the standard pattern for years. It is a usual tendency to allow the 'roll up' of the interest and added to the total loan outstanding when the vessel is delivered, this leads to a substantial reduction on the cash sums that the owner has to pay prior to the vessel entering service. As an alternative to the owner drawing down the favorable loan to help make his payments during construction, in some countries the yard itself arranges to borrow the equivalent funds and pay the interest thereon, in such cases the contract price is increased to take this into account.

The interest rates applied by the banks to the shipping corporation depend on the base rates of the banks. When the base rate for the bank is used the rate payable by the borrower will change as the base rate changes.