The Dububble Pops

“This is the apocalypse now,” read a one-line e-mail sent to us in the very early hours of Thanksgiving Day. The author was Peter Cooper, our contact in Dubai… so much for the usual quiet holiday weekend.

The Dubai government’s primary investment vehicle, Dubai World, asked its creditors for a “standstill agreement” while we were enjoying our Thanksgiving birds. The government arm has $60 billion in debt that it simply can’t pay — not now, anyway. The agreement announced last week extends Dubai World’s repayment deadlines until at least May.

“Markets will be looking for some pretty speedy answers from Dubai this week,” Peter writes on his blog. “If the intention is to ring-fence a particular part of state assets, then creditors will need to know what they are facing. Just what does Dubai World have as assets? How much are they worth? What can be realized? And how much is available?

“There are always two sides to a debt crisis. The lenders are partly culpable. Why did they lend so much to an entity that now cannot pay up? What happened to their due diligence and credit assessment? Did they not see the soaring debt levels?…

“The Dubai government is also going to have to face up to the inconvenient truth that markets do not selectively apply government guarantees. If a sovereign gives its word on one entity’s debt and then goes back on it, then all its sovereign guarantees are open to question.”

Thus the market reaction: Dubai’s main exchange fell over 7%. While we Americans were convieniently on vacation Thursday, English traders sold down the FTSE 3.1%, its biggest daily fall in nine months. Even a shortened trading day Friday couldn’t stop the Dow from falling 154 points. The cost of insuring Dubai’s debt quadrupled. The ratings agencies issued downgrade after downgrade. And gold, quite naturally, found yet another record high — $1,195 an ounce.

But what about the real matter at hand: Will the ripples stirred up in Dubai turn in to tsunami waves elsewhere? “One cannot rule out,” reads an emergency report from Bank of America, “as a tail risk — a case where this would escalate into a major sovereign default problem, which would then resonate across global emerging markets in the same way that Argentina did in the early 2000s or Russia in the late 1990s.”

And speaking of BoA, what of the banks? Wherever there is a debt crisis, there’s at least a couple of bank CEOs sweating through their suits.

“The Dubai debt story is more like Bear Stearns and less like Lehman Brothers,” writes our colleague Dan Denning. “In fact, Dubai World is not nearly as large, leveraged or systemically important as either Bear Stearns or Lehman Brothers when both those firms failed. For those reasons, it’s unlikely that the failure of Dubai World (and we’re not saying it will fail) would, by itself, cause a global deleveraging.

“There is some risk, no doubt. But it’s nothing like the risk posed to the entire financial industry by Bear Stearns and Lehman Brothers. For starters, the Bear Stearns High-Grade Structured Credit and High-Grade Structured Credit Strategies Enhanced Leverage Fund were both massively leveraged. The first fund began with $600 million in assets but quickly borrowed on that to increase its asset portfolio to over $6 billion…

“Dubai World is likely to be backstopped — at some point — by Abu Dhabi. And although we’re sure it has its fair share of property assets falling in value, Dubai World owns assets all over the world that it can sell. And, importantly, Dubai World is probably not a counterparty to many other financial arrangements in the same way Lehman Brothers was, at least as far as we know.

“But still, you wouldn’t be alone if you had an odd sense of déjà vu this morning. We’d say the Dubai affair is more like Bear and less like Lehman because it’s a warning. Dubai may not be as systemically important as Lehman, but it is a reminder to all the world’s investors that global financial markets remain highly leveraged. And we know what can happen next.

“There are other, much bigger and much more leveraged markets that pose far bigger risks to the global economy. For example, in the United States, there is over $3.4 trillion in debt backed by commercial real estate owned by U.S. banks.”