U.S. investors should feel very familiar with the financial crisis that broke out in Dubai last week.
The names are different but the story is striking similar to the U.S. mortgage crisis.
And if you’re trying to figure out the dangers and the opportunities in this crisis, it’s most useful to see it not as something new but as an extension of the global real estate meltdown. The crisis in Dubai should remind us all that the global real estate collapse hasn’t finished playing out. The crisis now seems to be sucking in quasi-government companies around the world. The assumed government guarantees that led lenders to extend credit to companies in Dubai, the Ukraine, Russia, and other emerging markets are now turning into hollow promises. And that’s leading to another round of re-pricing of global assets.
This time in Dubai we’ve got a very over-extended real estate developer, Dubai World, facing the collapse of real estate prices. The government of Dubai, one of the seven members of the federated United Arab Emirates, had sparked a real estate boom by opening the local market to foreign investors. Dubai World, one of a group of competing state-owned conglomerates that dominate Dubai’s economy, ran up $59 billion in debt to expand businesses that include a very profitable port-management unit and vast real estate projects.
That real estate projects ran into deep trouble with the collapse of the global real estate market. That collapse hit Dubai harder than any place in the world. Prices are down 50% from their peak in the third quarter of 2008, according to Deutsche Bank. And could well fall another 30%.
The collapse in prices and in occupancy rates in new projects dried up cash flow at Dubai World and with one of its subsidiaries, Nakheel, facing $3.5 billion in bonds coming due on December 14, on Wednesday November 25, the company announced a six-month standstill in its debt payments.
As in the U.S. mortgage crisis where the assumed government guarantee behind Freddie Mac (FRE) and Fannie Mae (FNM) kept investors gobbling up those companies’ debt, in Dubai banks all around the world have been eager to lend an obviously over-leveraged real estate operation all the money it wanted because the banks assumed that someone else guaranteed those loans. In the case of Dubai World that someone else wasn’t the government of Dubai—Dubai itself doesn’t have significant oil reserves and doesn’t have the oil revenue to bail out Dubai World. No, in this case the someone else was Abu Dhabi, the richest member of the United Arab Emirates.
Back in February the central bank of the United Arab Emirates had picked up $10 billion of a $20 billion bond issue by Dubai with the proceeds targeted to help Dubai’s most troubled companies pay their bills.
Looking at that, it was reasonable for banks to assume that the United Arab Emirates and Abu Dhabi would indeed guarantee Dubai World’s debt.
Wrong. Abu Dhabi and the federal government of the United Arab Emirates haven’t stepped up this time. The central bank has said that it will provide capital to local banks and to overseas banks with loans in Dubai but stepping in to save Dubai World from suspending debt payments? So far not a word.
Global banks apparently misread the politics among the members of the federation. Abu Dhabi has its own plans to diversify from oil into finance and other industries and this crisis gives it a chance to quash a very ambitious neighbor that had plans to become a global financial center.
In addition Abu Dhabi seems unwilling to bail out its neighbor because it’s extremely hard to tell how large that bailout would be. Dubai World owes some $60 billion. Dubai itself owes a total of $80 billion at a minimum but some estimates put the figure at $120 billion.
Before Abu Dhabi steps in, you’d expect that the country would like to know exactly how deep the water is.
Which leaves global banks and investors trying to sort out who might be on the hook to whom if Nakheel or Dubai World go into default. Dubai World has $20 billion in loans and bonds coming due in the next 18 months.
The international banks with the biggest exposure to Dubai World and Dubai are Royal Bank of Scotland (RBS), HSBC (HBC), Barclays (BCS), Lloyds Banking Group (LYG), Standard Chartered (SCBFF) and ING Groep (ING). The exposure isn’t likely to be immense in any of these cases. Estimates put Royal Bank of Scotland’s loans to Dubai World at $1 billion. But this group includes some of the banks that have been hit hardest—such as Royal Bank of Scotland and Lloyds—in earlier stages of the global real estate crisis.
If you believe that the crisis in Dubai puts loans to the entire United Arab Emirates in danger of default—I don’t think that is at all likely—then the damage is much more extensive. HSBC, for example, has about $17 billion in loans to the United Arab Emirates as a whole. Standard Chartered has about $8 billion.
It’s more likely that the crisis will reach out to other heavily indebted countries around the globe and to situations where banks have made big loans to companies that had what at the time looked like government guarantees. Investors were nervous about these loans even before the Dubai World crisis broke because a few had already gone bad. In September, for example, Naftogaz, Ukraine’s biggest company defaulted on a $500 million bond and had to go into a debt restructuring. Up until the default, lenders had assumed the company had a government guarantee.
Defaults of what are called quasi-sovereign debt—loans and bonds that were assumed to have government guarantees—are bleeding over into a re-evaluation of sovereign debt too. How safe is sovereign debt, that is debt issued directly by a sovereign government, if that government can’t pay its bills? Here concern is focusing on countries with huge debt loads as a result of the global financial and economic crisis such as Greece and Ireland. Eastern Europe is big worry.
And, of course, this crisis will keep up pressure on the British pound, since the United Kingdom’s fiscal condition has taken a huge hit from the financial crisis. (The United States and Japan are big debtors too but at the moment I’d say that’s balanced out by the role of their currencies as a safe haven at times of crisis.)
The opportunity for investors in a crisis like this comes when the market in a rush to get out now and think later mis-prices risk. Worries about emerging market sovereign debt should take down prices on say, Hungarian or Baltic debt and equities, but a drop in Brazilian asset prices would be simply guilt by association and a buying opportunity.
Same with banks. Banks with troubled balance sheets and a billion or two in exposure to a troubled quasi-sovereign or sovereign debt offering should sell off. Banks with exposure to loans that are only troubled by association and that have solid balance sheets are buying opportunities if they sell off. I’d put Standard Chartered and HSBC in that category.
I think the crisis in Dubai could rattle markets for a while. It comes on the heels of big currency devaluation in Viet Nam and China’s announcement last week that its biggest banks needed to raise capital. That news already had investors on edge.
If you were concerned at that news, the announcement from Dubai is certainly enough to ratchet concern up to full scale worry.