Monday, November 30, 2009

A short (and somewhat technical) Note on the goings on in Dubai

I am working on a longer article about Dubai but I thought I would share a short note about what is going on there before I publish a longer article.

What is going on?

Last week the Dubai government asked for a standstill agreement on the debts owed by Dubai World with the exception of Dubai Ports World. This announcement came on the heels of the announcement that Dubai had placed another $5 billion of bonds with Abu Dhabi banks as part of a $20 billion stabilization fund that Dubai is raising from Abu Dhabi to help it through the financial crisis. The markets traded up on the placement of the $5 billion and then collapsed on the announcement of the standstill request. This request has cast a large shadow of doubt over the finances of Dubai and since many investors who invest there also invest in other debt laden emerging markets it has the potential to spread more generally to other markets.

What is Dubai World and how is it connected to Dubai?

Dubai World is a state owned conglomerate containing several companies related to infrastructure investments as well as real estate and the Dubai Free Zones. Two of the real estate companies, Nakheel and Limitless, are large and very leveraged. Nakheel is famous as the developer of The Palm Jumeriah, the palm tree shaped island that Dubai has built in the Persian Gulf. Nakheel and Limitless have been adversely affected by the real estate collapse which swept the world in 2008 and harmed Dubai in particular on account of the large role that real estate played in the economy.

Dubai World is a “GRE,” or “Government Related Entity.” That is to say that it is owned by the government of Dubai and had the implicit backing of the government of Dubai. Think of it like Fannie Mae or Freddie Mac in the US. Neither entity had the explicit guarantee of the federal government but there was an implicit understanding that if worse came to worse the federal government would step in and help support them. Indeed last summer when the two entities became insolvent the federal government wiped out the common and preferred stockholders but took over the assets and debt to prevent a mass liquidation of US mortgages that would have occurred in the event of a default.

The government of Dubai is neither willing nor able to perform a similar function for Nakheel which has $3.5 billion of debt due for repayment on December 12th. Therefore it has asked for a standstill agreement and as of this weekend disclaimed any responsibility for the debts of Dubai World. The bondholders are on their own.

What happens next?

There is a fair amount of uncertainty about this so what follows is my opinion.
The Dubai government made their announcement before a long weekend for the Eid holiday and the Emirati National Day. A quorum of 75% of the bondholders needs to vote with a 75% majority to extend the maturity of the bonds which then has to be sanctified by a fatwa as the bonds are certified Islamic. If this doesn’t happen a second meeting has to be called where 25% of the bondholders would constitute a quorum. There is a 14 day grace period after December 14th meaning that in order to avoid a technical default Dubai has 28 days inclusive of several weekends, Christmas and Boxing Day to get the bondholders to agree to the standstill agreement.

Personally I think this is a virtual impossibility so I don’t think there is any way for Nakheel to avoid a technical default. Therefore I cannot explain why the bonds traded higher in the late European session today other than to say if someone showed me a bid I would sell it. The bonds are guaranteed by Dubai World and so a default of Nakheel will become a default of Dubai World unless Dubai World pays off the bonds on time. If that was the plan then I think it is unlikely in the extreme that they would have called for the standstill agreement.

The reason I don’t think a default can be avoided as well as a very public determination of this the likely recovery rates and therefore the chances of a successful restructuring has to do with changes that were implemented in the Credit Default Swap (CDS) market this year.

CDS are derivatives that banks use to protect their investments. They are a lot like insurance only for bonds. If a bank lends money to a client it can buy a CDS that will make up its losses in the event of default. CDS are extremely useful products and have been the fastest growing derivative market since their invention in the mid 1990s. A shortcoming of CDS markets was that they had the effect of blurring the balance sheets of the largest US banks last year such that the government could not tell what would happen to the system as a whole if there was a major default of a CDS counterparty and this led to the bailouts of Bank of America, Citibank, and most famously AIG. In an effort to reform the market the industry group ISDA has tried to standardize CDS and centrally clear that. They made some changes to the CDS market this year called “The Big Bang.”

The “Big Bang” in the CDS market created something called the ISDA Determinations Committee (DC.) Any ISDA member can submit a request to the DC for clarification as to whether a default has occurred or not and they can do so anonymously. If the DC chooses to review such a request, as is likely, it will then make a determination as to whether a default has occurred as in this case seems very likely. If the DC determines that a default has occurred they will then set in motion the settlement process for cash settling the outstanding CDS on Dubai World. This will happen like clockwork regardless of the wishes of the Dubai government or the Dubai World as neither of them are parties to the CDS transactions over the Dubai World debt nor are they members of ISDA.

The CDS settlement process uses a two step auction of the bonds of the defaulter to determine the market value of the bonds and therefore the payments owed to the protection buyers of CDS. That is to say that whether or not Dubai World is in default MAY BE DETERMINED BY INVESTORS WHO MAY NOT EVEN BE BONDHOLDERS. And additionally, if that happens then THE MARKETS WILL, LIKE CLOCKWORK AND IN A VERY PUBLIC FASHION, ASSESS THE CHANCES OF SUCCESS OF ANY RESTRUCTURING BEFORE IT IS EVEN FULLY ANNOUNCED THROUGH THE CDS SETTLEMENT AUCTION.

The above is my speculation as to what is likely to happen, it may not but I think it is likely. None of this is good news for the Dubai government which was probably hoping to negotiate with a small number of bondholders a reasonable restructuring of the debt.

What happens if Nakheel and therefore Dubai World Default?

This is also a big mystery and why I think it is possible that the CDS auction process might become a rout as it will be one time that people will have a relatively liquid pool into which people can dump their Dubai World obligations. The restructuring process is likely to be very complicated with given the complex structure of Dubai World and the large number of creditors and bondholders. As difficult as the restructuring negotiations are likely to be a liquidation would be just as chaotic and probably economically worse for the creditors. Given how hard it is to assess the outcome of a restructuring or a liquidation I think the bondholders will be tempted to try to liquidate their holdings during the CDS settlement auction.

This is because most of the assets of Nakheel are local real estate projects in Dubai which are therefore dependent on the government of Dubai for infrastructure support. The very government whose equity will be wiped out in a liquidation.

Then there is the issue of the judicial process by which this will all be decided and any conflicts resolved. Dubai is an absolute monarchy, its’ ruler rules by decree. The judiciary is not independent, it is beholden to him. Sheikh Mohammed is both the equity holder and the head of the judiciary which will adjudicate the restructuring. Moral hazard anyone? Even with regard to jurisdiction there is an interesting twist. Nakheel bonds are listed on NASDAQ Dubai which is located within the DIFC. The DIFC has been one of the more successful developments in Dubai as it has become the financial center for the Middle East. This is partially because the DIFC is a self legislating free zone, that is it makes up its own laws. While the rest of the region is governed by a Sharia system based on the Koran, the DIFC is based on UK law and is believed to have an independent judiciary. If Nakheel litigation is brought in the DIFC and the DIFC courts uniformly find for the ruler that independence and a lot of the perceived security brought by the DIFC courts would disappear and potentially threaten Dubai’s status as the regional financial center.

In short, whether the Dubai government realizes it or not their decision last week to call for a standstill agreement is very likely to result in a technical forced default and severe tests of market confidence in Dubai far beyond who gets how much in a restructuring.

What does this mean for the region and the wider world?

In many ways Dubai is a special case. It has one of this highest debt to GDP ratios in the world, somewhere between Zimbabwe and Sudan. Additionally the asset quality in Dubai which secured that debt has fallen faster than elsewhere, the Byzantine structure of corporate Dubai as well as the implicit government guarantees have obfuscated the severity of the problem for quite some time. Therefore there is reason to think that the collapse of Dubai World is a one off event.

The one concern I would have is that the blurring of the lines between what has government support and what does not has been common in the Middle East for some time. Many investors and lenders to the region have put their capital at risk on the assumption that state support would be forthcoming in the event of trouble and those assumptions will have to be reconsidered. It was hard for me to understand at the time but a lot of people felt that Arab culture would not stand for a major humiliation like the one now befalling Dubai but we can see that going forward investors will be reading the fine print and charging higher rates to firms without an explicit guarantee. This should raise the cost of capital to some extent across the region.

In the wider world I think the fallout should ultimately be muted. The Dubai debt, while large relative to the size of Dubai, is small relative to the GCC and relative to the balance sheets of its major creditors. The only connection it has with the circumstances of other emerging markets is sentiment. Sentiment can be a powerful thing though and as the Dubai World default unravels you may see people trim their risk but if this sparks a major retrenchment I would see it as a buying opportunity. The world asset price party will be in full swing until Ben Bernanke decides to close the helicopter door.