Why Dubai Matters
Market Update – November 30, 2009
I’m back…after four months of not writing, I’ve decided to get the blog going again. I appreciate all of the people who have written to me and asked me to resume writing. If I didn’t respond to you…sorry. If I’m going to blog, I really can’t respond to individual emails about the blog.
The purpose of this blog continues to be financial education. Hopefully, we will use current events as well as academic research to think about financial issues.
Why Dubai Matters
In the past week, we have seen world markets decline and this drop has been attributed to Dubai and their desire to delay their debt payments. Yet, if you look at the amount of debt involved (probably close to $80 billion) and the fact that this will not be a total loss (the collateral is worth something), it seems strange that world markets could drop so much. As a result, it’s interesting to think about what is really going on.
This paper is divided into four sections:
1. Background on Dubai and Dubai World
2. What Happened This Past Week
3. The Market’s Reaction to The Events
4. Lessons Learned
Part I: Background on Dubai and Dubai World
1. Dubai is one of seven emirates (think of these as territories) that comprise the United Arab Emirates. It is the second largest emirate; Abu Dhabi is the largest.
2. Dubai’s state-owned investment entity is Dubai World. Dubai World has been Dubai’s main driver of growth.
3. Dubai World has interests in real estate, ports, casinos (working with MGM Mirage to develop the $8.5 billion City Center in Las Vegas), golf courses (Scotland and South Africa) and retail (Barney’s in New York).
4. Dubai World’s real estate subsidiary is Nakheel. Nakheel has built Dubai’s palm-tree shaped island which is full of luxury condos and hotels.
5. Dubai World also owns 77% of DP World. DP World operates the Middle East’s largest container port. DP World was in the headlines in 2006 when they bought an entity that owned some US ports. DP World sold the right to those ports.
6. Dubai doesn’t have much oil. As a result, they financed Dubai World with debt. Dubai World has approximately $60 billion of debt. This is the vast majority of Dubai’s $80 billion of debt.
7. Dubai World’s real estate subsidiary (Nakheel) has a $3.5 billion bond that matures in December.
8. Dubai’s real estate sector has collapsed and this has left the country in crisis. Real estate prices have fallen 50% since last year.
9. International speculators have left the market because they are unable to obtain credit. That killed demand. At the same time, supply is growing at a crazy rate. Even after many projects were canceled, new construction is expected to double Dubai’s supply of office space by 2011.
10. Office occupancy rates are 41% for projects that have recently been completed. Prices for office space are 58% lower than last year.
Part II: Last Week’s Events
1. Last week, Dubai’s government said that it would restructure Dubai World and asked creditors to accept delayed payments. The government asked investors to wait six months for interest payments on $60 billion of debt.
2. The government’s goal is to negotiate with creditors during the next six months. There are $20 billion of loans coming due in the next 18 months.
3. The company said that the restructuring would not include DP World (the port business).
4. Investors were surprised by this news because the government had been making positive comments. Investors believed that Dubai and the UAE (the federal government) would step in. Just last Wednesday, Dubai said that it had raised $5 billion from Abu Dhabi banks (and apparently this was part of a UAE bailout). (Abu Dhabi has oil money while Dubai has very little.)
5. It is estimated that European banks have $40 billion of exposure to Dubai. This is part of the $83.7 billion of exposure that these banks have to the UAE.
III. The Market’s Reaction to Recent Events
1. The $3.5 billion bond that was issued by Nakheel dropped by approximately 50%. This had been trading at 110 cents on the dollar prior to the news. On Friday, it traded for approximately 57 cents on the dollar.
2. The cost of insuring $10 million of Dubai’s sovereign debt for five years (i.e., credit default swaps) increased to $664,000 per year. On Tuesday, prior to these events, the cost was $318,000 per year.
3. The cost to insure Abu Dhabi bonds rose $83,000 in the past few days to $183,000.
4. Insurance on other risky governments (such as Bahrain, Qatar [$120K], Hungary, Turkey [$207,500), Greece, Russia [$207,500], Bulgaria, Brazil, Mexico and Ireland) also increased significantly.
5. After the government’s announcement, S&P put four Dubai banks on credit watch because of their exposure to Dubai World. Wow…they really saw this coming didn’t they? At the same time, S&P predicted that Barack Obama would be elected President in 2008.
Part IV: What Everyone is Thinking About
1. Emerging nations may have trouble paying their debt, even as the global economy improves. (Personally, I’m not sure why everyone is simply talking about emerging nations – the US will never be able to pay back its debt either.)
2. A default by Dubai World may set a dangerous precedent that will result in other government defaults.
3. Governments change the rules when they feel the need. Governments may be less predictable than we had thought.
4. There is a tremendous amount of debt that is facing governments and private businesses. Government intervention in the bond markets (as well as government stimulus programs) have helped bonds rally. But this intervention will have to stop and that shouldn’t be good for interest rates.
5. Governments are facing slower economies with less tax revenue, more people in need of government assistance and pressure to control their debt levels. This is a horrible combination.
6. There may be many aftershocks to the global financial crisis.
7. This could be the start of higher interest rates, as credit markets start to perceive more risk.
8. Markets generally overreact (on the negative side) to uncertainty. Dubai made a big mistake in making this announcement prior to their Eid holiday – thereby limiting the market’s access to information. There is incredibly uncertainty as to what the government plans to do, the value of the assets, who holds the debt and what will happen in the legal system.
9. There is fear that banks may face a series of possible defaults similar to this situation. In other words, Dubai World may be the first of many similar problems. This may be analogous to late July / early August 2007, when two Bear Stearns hedge funds went under. These two hedge funds weren’t large enough to impact the market – but their failure sent a clear message.
10. International banks saw the Middle East as a pool of oil money and this may turn out to be false.
11. Be careful of extravagance. Much has been written about the Dubai Chairman Ahmad bin Sulayem hosting a $20 million party to celebrate a property opening. Whenever we hear of these financial disasters, we often also hear of extravagant expenses prior to the disaster.
12. There may be end-of-year profit taking and the money may flow out of riskier assets.
13. The real risk will occur in the next two years as governments cut back on their support and subsidies. In addition, investors may start to focus on government deficits.
14. The UAE is apparently unwilling to bail out corporate entities. There may also be strife between the emirates and the UAE.
15. The banks that have made loans in Dubai will have losses and that will hurt future lending.
16. There will be increased distrust of doing business in the Middle East. Fortunately, investment bankers have a three-month memory.
PDF version of this post: Market Update Nov 30.pdf
Sandy Leeds, CFA is a Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and also serves as President of The MBA Investment Fund, L.L.C.
Prior to teaching, he had careers as a lawyer and a money manager. He did his undergraduate work at The University of Alabama and also has a law degree from The University of Virginia and an MBA from the University of Texas. At UT, he has received many teaching awards, including Outstanding Professor in the MBA Program.
He is married and has three children.
Very good condensed explanation.
But it is frightening to read you about the US never going to repay it’s debt.
An elaboration about that and the possible consequences of a US default will be welcomed
Thanks for the high-evel clear analysis of the Dubai situation. A few years back, we were considering condo-hotels as an investment (spurred by an article in now-defunct Business 2.0). Dubai was/is rampant with these opportunities. I’m glad I didn’t get into it then.
Another thought: your comment on the possibility that this is the tip of yet another iceberg, rings true with me. I hate to be a doomsayer, but the recent gains in the financial markets since March, feel false. I’m expecting a large correction. Sadly.
Dr. Sandy,
Thank you. Publication quality blogs are a real treat.
As big investors watch their money disappear to yet another apparently not-so-”unsinkable ship,” I wonder/marvel about the ideal of “Accurate Bond Ratings & Betas.” Markets and pundits (and the banking & the other business thugs manuevering to become “Too big to fail…”) respond as if the risks of their “lucrative” investments were never discounted.
In that same risk assessment ideal, avaricious business practices and their progenitors (sadly, albeit with their portfolio parachutes)are discounted,too.
Yuan and Euros and delayed market efficiencies aside, the “floating peg” (cf., Trillion(s)-Dollar-check-writing Congress…)that suggests U.S. debt will never be repayed is still one of the most reliable (beta) dynamic financial floatation devices.
Risk/Beta-alert-actuaries (“Quants”) don’t “buy the sizzle.”
However, they sre going to the party and chatting up the chef…..
Thanks again.
DJ Dodson MA-MBA UT-AUSTIN 1995
Great explanation. Can you please elaborate on why US will not be able to pay its debts? It will be very helpful to understand the reasons.
Perhaps I can help clarify Mr. Leeds’ comment regarding the U.S. government not being able to pay its debts. The question comes about through differing definitions of the term “default”.
First, we have to remember that the U.S. dollar and all other U.S. government debt (the dollar is simply unsecured, non-interest-bearing debt of the U.S. government**) are predicated on the “full faith and credit” of the U.S. government. What that means is that the U.S. government says “Trust Us” and promises to never allow its financial house to get too far out of order whereby investors in U.S. dollars and U.S. interest bearing debt would have to worry about 1) the U.S. government’s ability and willingness to pay the interest on the debt, 2) the government’s ability and willingness to pay back the principal on the debt ON TIME, and 3) the U.S. government paying back the interest and the principal with a currency — the U.S. dollar — that has lost significant purchasing power from the point at which the original investment was made and the point at which the interest and principal repayments are made.
[**NOTE: The U.S. dollar USED to be secured by the U.S. government's gold bullion ("Fort Knox") up until 1971 when President Nixon "closed the gold window" on the European banks who were hastily redeeming their U.S. Dollars for the U.S.'s dwindling gold reserves after the U.S. government started overspending on the Vietnam war and on Johnson's "Great Society" entitlement programs during the mid- to late-1960s.]
Where China, Japan, Saudi Arabia and other large holders of U.S. government debt (both interest-bearing and non-interest-bearing) are getting nervous about their vast U.S. holdings is on #3 above. What good is an investment in the debt of a government when the government can — if it freely chooses to do so — multiply the size of its money supply and credit facilities (see http://www.chartingstocks.net/2009/03/chart-of-the-us-money-supply-1917-2009/) such that the purchasing power of the currency issued by the government falls, say, in half? In real terms, the present value of the investment falls dramatically and the holder of the debt is screwed when it receives future repayments in a highly devalued currency.
On the surface, it is currency risk. In reality, it is political risk: the investors made an investment in a government that, to the investors’ collective chagrin, could not be trusted to stand behind its promises. This has happened to many investors in developing country debts over the decades (e.g., Mexico, Argentina, Zimbabwe, etc.) and the investors in U.S. debts are beginning to question — and rightfully so — the integrity and veracity of the U.S. government in keeping its promises to never allow its financial house to get too far out of order.
So, what I — and maybe Mr. Leeds too — am suggesting is that the U.S. government will EFFECTIVELY default on its debt obligations by continuing to expand the money supply and its credit facilities (through the machinations of the U.S. Treasury and the Federal Reserve System) such that the purchasing power of the U.S. Dollar falls precipitously, thus screwing over its creditors (see http://en.wikipedia.org/wiki/Beggar_thy_neighbour). Yes, NOMINALLY the U.S. government could make its interest and principal payments to its creditors and thus legally not be in default; but, in REAL terms, the U.S. government will have proven to its creditors (and any future investors) that the government is not to be trusted to keep its promises and will have effectively defaulted on its creditors by paying them back in paper currency worth far less than the same paper currency the creditors lent to the U.S. government only years earlier. It is important to note that this default action is under 100% control of the U.S. government since it and it alone controls — via the U.S. Congress (see Article 1, Section 8 of the U.S. Constitution) — the monetary policy, the money supply and the credit facilities that determine the value of the U.S. Dollar at any given time (Congress sets policy that the Fed is supposed to follow; i.e., the Congress can redirect the Fed IF Congress has the willpower and collective knowledge to do so). Therefore, the ‘default’ will be a conscious decision of the U.S. government, not a market-based outcome.
Alas, the U.S. government has shown little sign as of late in keeping its financial house in order as it bails out private, politically-favored companies under the guise of “too big to fail”, layers on even more entitlement programs under the guise of “health care reform”, funds a vast empire of 800 military bases scattered throughout the world that cost nearly $1 trillion per annum just to MAINTAIN, and fights multi-trillion dollar wars in Iraq, Afghanistan, and Central and South America (the “War on Drugs”) caused by its own misguided foreign and economic policies. And these trillions don’t even begin to touch on the UNFUNDED obligations (estimates I’ve seen are $50 TRILLION to $80 TRILLION in current dollars) that the U.S. government faces over the coming years as the entitlement programs of Medicare and Social Security become effectively insolvent through poor social policy and bad government program design stemming all the way back to FDR (1930s) and Johnson (1960s) and their ill-fated attempts to ‘socialize’ the United States in the same vein as many European countries (who, however, don’t share the same Constitution as the United States, which itself effectively makes ‘socialist’ government policies unconstitutional — i.e., the whole point of the U.S. Constitution is to LIMIT the size and power of the U.S. federal government, not to expand it!).
So, unless the U.S. government completely reverses course and begins to shrink itself by slashing spending and cutting departments and programs wholesale — a highly unlikely occurrence with either of the two major U.S. political parties currently in power who lack the political will to do what is right by the American people who will also be screwed by a hugely devalued U.S. dollar — the U.S. government is on a straight and narrow path to a massive currency devaluation fully under its control that will effectively lead to a ‘default’ on U.S. government debts over the next two to ten years, I suspect. At that point, yield to market rates on U.S. Treasuries will be in the double digits as investors demand far more compensation for the risks they are taking by investing in a demonstrably untrustworthy government.
It’s sad, and I wish it weren’t so; but, here we are.