In a bit of synchronicity, it seems that some mainstream commentators are starting to to take interest in a topic we’ve commented on in recent weeks, namely, how the difficulty in getting letters of credit is playing a significant role in the contraction in international trade (see our related post earlier today).
John Dizard in today’s Financial Times provides a useful long-form treatment which we hope will start to get this topic on the official radar screen. There is only one aspect of the story we quibble with. He calls letters of credit “plain vanilla”. That isn’t an accurate characterization.
Now if nothing rates as complex unless it involves very fancy math and lots of market risk, then yes, L/Cs are plain vanilla. But they have a lot of operational complexity. Financial letters of credit are pretty simple, but a second type, which is vital for the conduct of a lot of types of trade, documentary letters of credit, are not.
When an international seller is unsure that he will be paid, and an international buyer worries that he might receive something quite different than what he was promised, a documentary L/C is the answer. The buyer’s bank must release the funds once certain DOCUMENTARY requirements are met, hence the name. Some of them relate to the national tax and customs requirements of the port of origin and port of arrival; there may also be port-specific requirements. And there are a whole host of documentary requirements particular to the goods shipped (third party verification of quantity/weight and grade, in some cases multiple quality validations). So the requirement are in fact very complex: and vary with the port pair and the goods involved, and there may be additional wrinkles depending on buyer stringency.
Any one document being out of order means the shipment will be rejected, even if the shipment itself is in fact exactly what the buyer wanted. You then get into matters of custom: for some ports and goods, the buyer may be willing to waive exact conformity to the documentary requirements; some banks are not flexible; in some ports, it is ill advised. So the business requires a good deal of accumulated knowledge of a rather nerdy kind. That doesn’t fit my definition of plain vanilla.
From the Financial Times:
There’s been some low-bandwidth chatter lately about the plunge in the Baltic Dry Index, which is intended to track the price of shipping dry cargo along key routes. In the sort of “oh . . . wow . . . ” manner passing drivers remark on multiple collisions on the highway, it’s been noted that the BDI is down. A lot.While the BDI has been dropping for months, the real collapse took place from the week after the Lehman bankruptcy. From a level of 4949 then, the BDI had, by last week, come down to 1149, for a decline over about a month of 76 per cent. This doesn’t represent some piece of high-concept securitised paper meeting its maker in front of a judge; this is the real world of physical assets being employed to do actual work.
I had followed shipping in past years, but had never seen a rate of change like that. So I called friends of mine in that world to get closer to the car wreck.
I had wondered if the BDI was truly representative of real-world values, or if it was oversold in the way some credit default swap indices might be.
Nope. Ships really are that cheap. As one broker told me: “I just chartered a Handymax to go to the US Gulf from India for $1,000 a day. So the BDI really is pretty accurate.” A Handymax vessel would typically displace about 40,000 deadweight tonnes. You would notice it if it dropped anchor near your dock. The cash operating costs are at least $1,500 to $2,000 a day. On top of that, figure another couple of thousand dollars a day for the capital costs.
To put that in Presidential election language, what does that mean for hardworking, middle class, average, families who are sitting around the kitchen table playing by the rules? Why should they care that some Greek or Lebanese is under water, so to speak, on his ship?
How about because what you need to stay middle class and average, or hardworking, is being carried on those ships? Those low charter rates indicate that not much is being shipped, apart from cargoes going from one corporate subsidiary to another, or from one highly creditworthy entity to another.
It all goes back to that Lehman bankruptcy. Among the more serious casualties of that colossal failure of leadership was the letter of credit business. There is nothing more vanilla than the l/c for an international shipment. One bank tells another bank that it will accept the credit risk of an individual importer or exporter. They document that, with forms that have been around forever, clerks and computers shuffle the paper around. A fee is charged and goods are released for shipping, inspection, and delivery. The most boring business in the world. Until it stops.
After Lehman those clerks, and their computers, stopped trusting the clerks and computers at other banks. Treasury secretary Hank Paulson’s ignorant and clumsy attempt to avoid moral hazard and systemic risk resulted in uncounted quantities of goods piling up on loading docks, and customers living off inventories and consuming less.
No, I don’t think the Lehman leadership, or the shareholders who went along with them, deserved to be saved. It was not, however, necessary to sacrifice the worldwide flow of goods and credit to make them an example.
The government and banking leaders might think that those clerks and computers will have been reassured by the business cable channels telling them that things will be fine. Well, it hasn’t happened yet.
Some critical institutions were caught in the middle of this. Wachovia, as I mentioned last week, did a lot of letters of credit for the Latin American trade. Royal Bank of Scotland has huge exposure to shipping. The line people working on trade finance need to be told that it is okay for them to take these risks, that they won’t be laid off if they make one good-faith mistake.
Maybe secretary Paulson could go down to the docks in New Jersey, Norfolk, Long Beach, or Jacksonville to symbolically sign some documents. I know, it’s the unfamiliar real world of production and transportation, but the pain of walking around the Port Newark-Elizabeth Marine Terminal will be over quickly.
The BDI will not recover to its bubble highs, of course, and a lot of marginal ships will need to be scrapped over the next few years. This is normal. Shipping people are bipolar by nature, and now we have to go through the depressive phase.
As for freight rates, they will have to recover to the point where the owners can cover their operating costs. That could take a few months longer than you would think, because the cost of mothballing a ship for that period could be higher than keeping it going at today’s rates.
The Chinese shipyards that have taken on a lot of new orders can expect many of those to be cancelled, if there is any leeway in the contracts. As one ship broker told me: “Values are down by half within the past six months, but nothing is actually being sold right now. The problem isn’t with a single trade route. It’s global.”
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This is clearly one of John’s finer works in recent weeks. He seems like he is getting back to his old form.
Matt Dubuque