Wednesday, September 8, 2010

I am the Great Barazi! Dr. Omar.... you are getting sleepy.... very sleepy... I'm now going to snap my fingers and when I do, you will pay me.

So I know I’m kind of a block behind the parade on this but I just got done reading the latest broadside from the good ship DIFIC against the HMS Barazi off the coast of Dubai. It seems like fairly weak soup to me. Most of the DIFCI response is taken up with a lengthy chronology of the various memos that went back and forth between the various members of the DIFCI management team and tries to clear up who knew what when. In my last post I ignored this but now I have paid much closer attention. This is a little more complicated than I would like because the court makes the letter from DIFCI public but not the attached exhibits so it is not possible to follow the evidence trail directly. Having read it now I think my initial instinct to disregard it was correct.

DIFCI goes through the lengthy chronology in order to show that in the first two drafts of the investment bonus memo he makes reference to a net income of $200 million. Between the first and second drafts Bisher was sent the unaudited financials which showed that the net income was a loss of $87 million and the second draft was not amended to reflect that. This is the core of their argument that Barazi misrepresented the financial condition of DIFCI. They go on to claim that Barazi knew all along that the DIFCI was in serious financial shape and provide an email he sent to that effect.

This doesn’t make a lot of sense to me. At no point in any of the memos does Bisher suggest paying out bonuses on net income. Instead he suggests paying out bonuses based on realized gains. Considering the business that DIFCI was in this makes some sense. They were running an investment fund containing investments which were highly illiquid either because they were in private companies or else such massive stakes in public companies that they could not be disposed of. To pay yourself based on the performance of a investments that you may not actually be able to monetize might not be best. So I can see the reasoning behind paying themselves based on realized gains rather than net income.

The net income reference was made for the purpose of comparison with the realized gains and was made before the unaudited financials were available. It is true that the second draft was not amended to take into account the new information in a subsequent draft all reference to net income was dropped. Note that this would not have affected the thrust of the memos because they were being paid on realized gains. The relevance of the loss of $80 million has to be taken in context. This is on a multi-billion dollar investment portfolio and the loss was the result of an accounting change. While I think it had some relevance I think it would make as much sense to pay them zero based on the $80 million as it would to pay them $30 million on the $200 million. In any case they were paid on the realized gains of $60 million, a figure which is not disputed at all by the DIFCI. Also at no point did Bisher seek to conceal the $80 million loss, the DIFCI makes a point of saying he signed off on those numbers. Had he attempted to conceal that and paid himself on the basis of false returns that really would have been fraud but DIFCI does not allege this because it did not occur.

As to the allegation that Barazi knew the DIFCI was in hot water at the time of the bonus the evidence they provide is pretty slim. They show an email pleading for additional funds from mid-November 2008. The final memo on the 2007 bonus issue was in July of that year and the most relevant documents were finished by April. Of course everyone knows what happened in September of 2008, Lehman brothers defaulted and the markets went over a cliff. To say that the financial position of the DIFCI post-Lehman should have influenced the 2007 compensation decisions which were made in March seems to me be kind of a stretch. Something may well have been amiss in the finances of the DIFC in the spring of 2008 but the DIFCI response does not show it.

The DIFCI leads their response by denying that “the claimant can not absolve himself from the liabilities arising out of his conduct with respect to the procurement of the 2007 investment bonus on the basis that Dr. Omar authorized that bonus.” It then quotes the handbook saying that management cannot be indemnified against moral turpitude or other misconduct. In the following paragraph they say that “Barazi was not a passive recipient of the bonus” and point out that he played an active role in determining it. This is the weakest part of the case and also the most central.

It is true that Barazi was not a passive participant. This is because, as the DIFCI points out, there was no established methodology for compensating the managers of DIFCI for their performance. Barazi was asked by Dr. Omar to come up with one. They allege that his methodology constitutes moral turpitude and therefore a fraudulent attempt to compensate himself. As mentioned above the centrepiece of this argument is that a change in net income was not reflected in the memo until its third version. I argue that this is not relevant for two reasons. First the net income played no role in the calculation of the bonus and therefore failing to change the memo to reflect the change in net income until the third version does not constitute moral turpitude as the change would have had no effect on the calculation. Also the $87 million loss was never concealed from anyone including Dr. Omar.

Far and away the most important reason that it doesn’t matter is the point they themselves make that the DIFCI “lacked a clear cut methodology.” What that really means when combined with the fact that compensation was “at the sole discretion of the chairman” is that Dr. Omar did not need to refer to anything but his own fancy in order to compensate himself and Barazi. He could have rocked out of bed one day, walked into the office and said “Bisher, that’s a great haircut. I’m going to pay you $10 million.” Or “That was some fine singing at karaoke last night Bisher, here’s $5 million.” Heck, we should be happy that they made any effort to come up with a plausible methodology at all.

The DIFCI ties itself in a pretzel when it argues that Bisher established a questionable methodology and then further argues that he did not properly follow that methodology which it has already alleged was questionable. The fact of the matter is that because of the way DIFCI and the DIFC were set up there was no requirement for a methodology whatsoever. The mysterious workings of the mind of Dr. Omar were all that were needed to pay them out. As a result the only practical way for Barazi to have fraudulently acquired his bonus would have been for him to put Dr. Omar in a hypnotic trance and fraudulently induce him to write him a check. I wouldn’t put it past Bisher to do that but I think it would be really hard to prove in a DIFC court.

Speaking of Dr. Omar and due process what does the DIFCI say with regard to the unspoken allegation in the previous Barazi response that no legal proceedings were brought against Dr. Omar to compel him to disgorge his bonuses? In paragraph 41 the DIFCI says “the defendant notes that Dr. Omar has returned $13,600,000 in bonuses he received from DIFC.” Interesting, there seems to be no mention of legal proceedings. Presumably this would mean that the proceedings used to get Dr. Omar to disgorge this bonus were extra-legal. There’s another word for that, “extortion.” But I’m sure Barazi is really quite familiar with that term right now. This will indeed be a very interesting case if it goes to trial.

Personally I think the DIFC should drop the suit, pay Barazi him his severance conditional on the completion of the forensic audit. If they have real evidence of actual fraud they should charge him with that, not go back and forth with him over whether or not he is entitled to severance based on whether or not he used a proper methodology when no methodology was required.

Monday, September 6, 2010

There goes the Stimulus Package on it's way to China.... the beginning of the end of the WTO.

Whenever everybody in the US political sphere agrees on something my instinct is to oppose it simply so there is opposition. The one thing the Bush and Obama administrations have in common (aside from their fondness for massive deficit spending) is their assertion that the maintenance of the global free trade system is essential for American prosperity. One of my favourite mantras from my time at the University of Chicago was: “If someone asserts it, deny it. If someone denies it, assert it.” So, I am going to deny the assertion that free trade is currently the optimal policy for the United States.

First, let’s remember the origin of the free trade system. Its original motivation was political/military rather than economic. The Second World War was a massive human tragedy which killed something like 3 % of the human population in just under ten years. For the American economy, however, this tragedy had a silver or rather gold lining: it was a war of annihilation between America’s main economic competitors. The war destroyed the industrial capacity of the Axis Powers and severely disrupted that of Central Europe and Soviet Russia. At the end of the war the United States was the only power in the world with an unimpaired industrial plant and as a result in 1945 the US accounted for nearly 50% of world GDP.

Despite its economic supremacy, America faced a severe political/military challenge from the Soviet Union. The Red Army had just crushed the Wermacht and was positioned in the Center of Europe and invaded Northern China near the end of the war. Americas grand strategy was to contain the Soviet Union with a ring of alliances that stretched around the periphery of the Russian empire. Unfortunately the allies who composed this ring were the battered former Axis powers and the supine allied European states.

America needed to revive the economies of the Western Alliance if the containment strategy were to succeed so it came up with a global economic plan with several features. The first was a massive influx of aid in the form of the now famous Marshall Plan. The second was the establishment of a stable foreign exchange regime which would simplify trade through the Bretton Woods agreements. Finally was the establishment of a trade liberalization regime under the General Agreement on Tariffs and Trade or GATT which became what we now know as the WTO. The first round held in Geneva in 1947 eliminated or reduced 45,000 tariffs. Subsequent rounds made great strides in bringing down tariff barriers all over the world. While the GATT was a multilateral organization, the fact that America was the only intact market on the planet meant that it’s most salient feature was granting more or less open access to the American consumer for our allies in the struggle against the Soviet Union.

The plan worked like a charm. Between 1948 and 1953 world trade grew by 40%. By 1963 the total volume of world trade was three times what it was before the war and twice its previous all time high. By 1971 it was six times what it had been in 1935. This is an extremely important point, the creation of the GATT system ended the generally mercantilist regime that predated the World Wars and international trade exploded as never before in human history. This channelled massive amounts of wealth to the various trading partners that would not have been possible without it and enabled a rapid recovery from the devastation of the war. By the end of the Cold War in 1989 Germany had the same share of world GDP that it had before the war and Japan had twice as large a share. America and its allies presented an economic, military, and political challenge to the Soviet Union that it could not overcome and it collapsed after a failed coup attempt in 1991. Mission accomplished, well and truly.

After its victory America, confident in its permanent supremacy, kept the global free trade regime open. Indeed it expanded it, bringing in its erstwhile opponents Russia in 1993 and China in 2001. The maintenance of this free trade regime after the end of the cold war has arguably had an even greater effect on the world than it did during the cold war itself. By enabling China and India to access the US consumer on a level playing field the global free trade system has helped to bring 400 million people out of poverty in the last 20 years. This is a reduction of human misery that has been without precedent. It has made the world economy as a whole more efficient and raised world GDP by a substantial amount. The huge American trade deficits have been a massive subsidy to the rest of the world particularly China.

To get a sense of how important this is to China you have to look through the numbers a little. In 2006 the Chinese trade surplus with the US was around $250 billion and Chinese nominal GDP was around $3 trillion (I use nominal rather than PPP because we are talking about international trade rather than domestic consumption.) So the Chinese trade surplus with the US in 2006 was 12% of the entire Chinese economy. This overstates the case somewhat because China has trade deficits with countries which supply it with raw materials but in turn those deficits are driven by and more than financed by the surplus with America. Considering that an additional 40% of the Chinese economy is investment which is largely export oriented the impact of the global free trade regime accounts for nearly half of the Chinese economy. These are just numbers, what this has meant in the quality of life for hundreds of millions of people cannot be overstated or really understood unless you go to China and see if for yourself. It is truly mind boggling.

So how has it been working out for the country at the center of the system? This is a complicated question and it comes with a complicated answer. From the perspective of the American consumer this has been awesome. The global economy is much more efficient and the increasing globalization and the addition of hundreds of millions of new workers to the global trading system has kept down the prices of labor intensive products. In the immediate post-war era Americans got used to consuming at a level commensurate with a country which was producing 50% of the worlds GDP. As America’s share of GDP has declined the American people have been reluctant to reduce their consumption. And they haven’t had to because America’s trading partners have been willing to lend their surpluses back to America in order to finance yet more consumption. Yep, from the perspective of the consumer it seems like a good deal all around.

So how is it working out for the American worker? This is kind of a mixed bag. From the perspective of the American knowledge worker it’s working out quite nicely. People in the intellectual capital intensive businesses can farm out of the labor intensive aspects of their business to China for manufacturing or to India for services where the labor costs are much lower. For unskilled and semi-skilled Americans this has been a disaster. They are now forced to compete with the 400 million other semi-skilled workers in the global trading system and this has been pushing wages down. Here in the future the global market clearing price for a year of work in a factory as a semi-skilled worker is somewhere in the neighbourhood of $8,000 per year. Naturally this is not enough to sustain an American lifestyle which is why, as mentioned above, the American lifestyle is increasingly debt financed.

You can hear the echo of the global free trade system whenever Americans bemoan the problems with the economy. “Wages for working Americans have been stagnant for 20 years;” this is because American workers are competing with another 400 million people that were not in the system 20 years ago. “The divide between the rich and the poor is getting wider,” the rich benefit from lower prices and the ability to tap cheaper foreign labor which increases their earnings, the unskilled now have to compete with that foreign labor which decreases their earnings. “The post housing bubble unemployment seems to be structural not cyclical,” many semi-skilled workers who’s manufacturing jobs moved abroad went into construction, now that the housing boom is over there is not much manufacturing for them to return to so they are structurally unemployed. “The stimulus package is not working,” the stimulus package was designed to generate consumption; much of what we consume is produced abroad so much of the stimulus money was ultimately siphoned off by our trading partners. “This recovery is anaemic and not creating enough jobs,” Q2 GDP was revised down from 2.4% to 1.6% because of the trade deficit was larger than expected. 0.8% of American GDP is $110 billion or about as much GDP as would employ 1.1 million people. The recovery is creating jobs, but in our trading partners, not here. Yep, there it is beneath the surface, the global free trading system the US built up is causing serious problems for the US worker.

So given that so many of the problems which confront policymakers are linked directly or indirectly to American support for the free trade system why is protectionism not gaining more supporters. I think I know. It’s a unique psychosis that I will call “Smoot-o-phobia.” In 1930 partially as an attempt to raise revenue and partially in an effort to shield American workers from foreign competition Congress passed the Smoot-Hawley Tariff Act. This raised tariffs on imports to the highest level ever and touched off a trade war as our trading partners retaliated with tariffs of their own. World trade collapsed fell 40% from 1930-1933. The Smoot-o-phobes believe that the Smoot Hawley tariff caused this collapse in world trade and which deepened and lengthened the great depression and therefore they believe that the last thing we should do in the middle of a recession is tamper with the global trading system.

I think this argument is nonsense for two reasons. First, though I have a degree in economics I will be the first to agree with my friends from the physical sciences who called economics a social “science.” That is to say, it is not exact. It is very hard to separate causal and coincident factors in explaining a phenomenon. It may well be that the Smoot-o-phobes are onto something with their theory but I would argue that the collapse of the global banking system was a much more powerful factor. As evidence of this I point to the recent credit crisis. Between 1930 and 1931 in the immediate aftermath of Smoot world trade fell by about 28%, between 2008 and 2009 world trade fell by 24% without any additional trade restrictions. Could it be that the greater factor was the collapse of credit rather than the imposition of tariffs?

The second reason is that the position of America in the global trading system in 2010 is completely the opposite of what it was in 1930. The American position in 1930 was analogous to the position of China today, it was the source of most of the worlds spare industrial capacity and a net exporter both of finished goods and raw materials. As such it had a lot to fear from a trade war because its trade balance was a positive contributor to GDP so it really was a Congressional miscalculation (one of many I’m afraid) to pass the Smoot Hawley bill. Here in the future the US is not only not a net exporter, it is running the largest and most persistent trade deficit in the history of the world. If world trade were set to zero tomorrow the GDP would INCREASE, we LOSE money to world trade. I think the Smoot-o-phobia which infects American policymakers is purely psycho-somatic.

Now that I have made my argument I think it is equally important for me to point out what I am not arguing. I am not arguing that limiting the global free trade system is the globally optimal solution. It is not. But it does not matter what is globally optimal, it matters what is optimal for the people who are in control of the largest consumption based economy in the world, namely: Americans. The only way for another country to limit American power over the trading system or to mitigate the effects of American protectism would be for that country to create a similarly consumption oriented economy, something which no one seems willing to do.

I am also not arguing that the limitation should be total. It should be just enough to mitigate or negate the labor cost advantage of the lower cost countries. Ordinarily this would happen over time with exchange rate adjustments but some of our trading partners are committed to maintaining a fixed exchange rate with the US dollar.

I am also not arguing that this would be costless. There would be increased inefficency in the US economy. The evaporation of our trading partners surpluses would also limit the avaliabilty of credit to the American consumer and the American government. I don't think this is bad thing because I think that is coming sooner or later. I simply think that the US would rather be in control of the timing and duration of that credit contraction rather than the bond vigilantes. Taking advance action like this would give the government the initiative.

What’s the cure for Smoot-o-phobia? That’s a complicated question but it comes with a simple answer: elections. The American consumer who benefits from the global free trade system and the American worker who is getting his head caved in by it are the same guys. At this stage of the game Americans need to do a lot more working and a lot less consuming in order to pay back all the money they borrowed over the past 30 years. In order to do this more effectively they need to negate the labor cost advantages of low cost countries which have enjoyed unfettered access to the American market for the past 20 years. To do that they need to place limits on the international trading system.

Lucky for them in addition to being the American consumer/workers these folks are also the American electorate and as such they are in control of the government most responsible for the maintenance of the international trading system. They can therefore vote in people who are in favour of limiting it. As the recession goes on and employment does not recover because the international trading system is limiting the capacity of traditional measures to revive the economy the Smoot-o-phobic arguments are going to fall on increasingly deaf ears and protectionist candidates will begin to win elections. You heard it here first.

Wednesday, September 1, 2010

Congratulations gentlemen on surpassing Bahrain. Beneath your chairs are some boxing gloves in case any pregnant women try to sit down at your table.

So I’m back from the break now and ready to go for September. A lot has happened in the interim so I have a lot of writing to do. But before I get into the bigger issues I want to write about some of the smaller, less noticed ones.

Speaking of small, Bahrain was downgraded by Moody’s last week. I found this out by reading an article in The National that was positively dripping in schadenfreude. My favourite part of the article was where they called the downgrade the first fora GCC government. Well, I suppose that’s true if you don’t count the total obliteration of the various Dubai government related entities and the restructuring of Dubai World. Personally I think those things do count but I’ll not quibble with the national. The GCC has now seen its first sovereign downgrade of the financial crisis.

Though this is not big news in the way that the downgrades on the Eurozone periphery have been, it was only one notch and is still investment grade, the report is still interesting. They point out that Bahrain has a 7% of GDP budget deficit and has relatively little in the way of foreign exchange reserves or sovereign wealth funds in contrast to Saudi Arabia or Abu Dhabi. This means that should the world economy slo significantly and drive down oil prices Bahrain will be in a bind without much room to manoeuvre. Interestingly they also make the point that political tensions between the Shia and Sunni on the island are a source of potential instability. Most interesting are the points they make about the financial sector.

Bahrain has long been a financial center for the Gulf and Moody’s seems to argue that the banking sector in Bahrain is a liability both because it is too large and because it is too small. It is too large because with bank balance sheets three times the size of GDP any serious deterioration of asset quality might require government intervention which would be beyond the capacity of the government to intervene given its already stretched fiscal position. At the same time Moody’s says that the banking sector is not large enough to diversify the economy away from its dependence on hydrocarbons. So the Bahrainis seem to have sought to diversify their sources of revenue but instead have simply added another liability, at least according to Moody’s.

Well I can tell you why the banking sector in Bahrain is not big enough, it’s because Dubai has totally stolen its mantle as the financial center of the GCC. Sure there are still a lot of bank assets in Bahrain but virtually all the growth in financial employment in the GCC has taken place in Dubai over the past five years. Some have even consolidated their operations in Dubai and closed their Bahraini operations, or rather left a skeleton crew in Bahrain to appease the government but functionally consolidated in Dubai.

Why is this? I’d say it’s for two reasons. One is that when Bisher and Dr. O were not too busy lighting Sheikh Mohammed’s money on fire with various investment schemes or paying themselves substantial bonuses for managing those fires, they were luring the wide world of finance to the DIFC. The DIFC legal system has turned out to be kind of a bait and switch but when choosing a location once you have taken the bait, it’s hard to switch. The other reason is that it is a lot easier to attract expat knowledge workers to Dubai than it is to attract them to Bahrain.

There are many reasons for this. Some people will point to the infrastructure, which is impressive. Personally I think Dubai is likely to be the red headed stepchild of the capital markets for some time to come so I doubt that they will be adding to this but the silver lining to the collapse of the real estate market is that there is still a lot of spare housing capacity in Dubai so they actually don’t need to add to it. Others might point to the relatively permissive moral environment of Dubai. This is a factor as well, bankers and traders like a martini now and again. Their girlfriends like to be able to weak little bathing suits on the beach and occasionally kiss their significant others in gratitude for rescuing them from the rain of London. To be sure the atmosphere is a bit chillier now than it was a few years back but it’s still not Saudi Arabia.

While the liberality and infrastructure of Dubai are impressive I don’t think they are the primary reason why it is easier to move people to Dubai than elsewhere in the Gulf. I think the reason for that is the human infrastructure. Over the past ten years Dubai has achieved a critical mass of expat human capital. People want to live there because everyone else does. It has become the regional headquarters for so many multinationals that the expat social milieu is not dominated by a particular industry. Finance is prominent to be sure but there are foreigners there in the media, pharmaceuticals, infrastructure, consulting, you name it. It’s a much more interesting place to live than any other city. Dubai has created this environment through massively leveraging itself to build the physical infrastructure and marketing the hell out of itself in the West. Those two things are not sustainable now that the good ship Dubai has struck the restructuring iceberg but the human architecture that it has build should be able to outlast either one of those two things.

If Dubai is ever to recover it ABSOLUTELY must retain its preeminent position as the place for international expats to live and work. Thus I was shocked to read a recent news article about an assault on expats in Dubai by three Emirati men. At the IKEA cafeteria a Canadian investor man and his marketing manager wife sat down at a table for twelve which was partially occupied by Emiratis. The Emiratis claimed the entire table and demanded the couple depart. The woman, who was seven months pregnant and has doubtless been walking endlessly around the IKEA which is designed to be walked around endlessly demurred the Emirati brothers proceeded to beat her and her husband senseless. A Syrian man came to the rescue when the Emiratis began beating the unconscious husband with a chair and they beat him senseless as well. They broke the jaw of the pregnant woman and there is some ambiguity as to whether or not her pregnancy was compromised. The last thing her husband saw before being knocked unconscious was one of the Emiratis beating his wife and blood rushing down her legs. My guess is that if her pregnancy had not been compromised the courts would have made a point of noting it as a mitigating factor.

Obviously an attack on a pregnant woman by three Emirati men in the middle of an IKEA cafeteria is horrific in its’ own right and pretty hard to understand. What’s more, Dubai is completely dependent on foreigners to do most of the work, to move there, buy apartments and set up businesses in order to dig Dubai out of its deep dark hole. You would think that the authorities would deal harshly with the culprits. Besmirching the reputation of Dubai as a tolerant multicultural hub poses an existential threat to Dubai itself. Alas, it is not so. The assault occurred in June of 2009, the first hearing was in August 2010. All three assailants are free men in a city where hundreds are in prison for bounced checks. Two of them failed to even show up for the hearing, the judge questioned this but was not given an explanation and no action was taken. It would seem that the Emiratis don't think this is a big deal or that they will suffer any consequences. They may well be right.

It’s their country, they can do what they want, but if you ask me this is no way to run a country completely dependent on its reputation among foreigners. As sad as the article itself is the comment at the bottom from an Emirati: “they should have moved.” They probably will, and not to the next table but rather to the next country and if enough foreigners decide to follow them the creditors will beat the hell out of Dubai.

Tuesday, August 17, 2010

Even if the volume goes to zero we can still hang out here right? I mean, we don't want to let these awesome leather couches go empty...

There have been some articles recently about the plight of brokers in both Dubai and Abu Dhabi. Initially these were reports of how volumes were tapering off as we move into Ramadan. While business networking takes off during the Iftar hopping season (I wish there was an analog to this in the West) trading on the regions exchanges tends to slack off. This volume decline and the economic effect it is having on the brokerage industry in the Emirates has attracted the attention of both Bloomberg and The National as well it should because it says something about Ramadan, more about the brokerage industry in Dubai and a great deal about what the function of equity markets in the region is and what it could be.

There are any number of reasons why people would want to scale back their trading during Ramadan. Perhaps in the same way that you shouldn’t go grocery shopping while you’re hungry maybe you shouldn’t go stock shopping while you are denying yourself basic sustenance. Maybe that dry feeling you get in your mouth when you’re betting the ranch on Saudi Livestock is particularly arid when you can’t drink anything till sundown. Or maybe people feel closer to Islam generally and so are less comfortable making or taking non-Sharia compliant margin loans. Perhaps the speculative nature of trading GCC shares seems a little too close to gambling for people to be comfortable during Ramadan. Perhaps the generally higher level of sobriety keeps people away from buying shares. Or maybe this year as Ramadan falls in August everyone is simply in Marbella or the Cote ‘d Azure or Geneva so no one is around. It’s been interesting to watch the number of people logging onto my blog from the marina in Monaco spike. Whatever the reason, volumes are seasonally light.

The articles in the press don’t stop there. Volumes in the Emirates have fallen off a cliff putting an extremely serious squeeze on the brokers forcing a great many of them to close their doors. Personally I have mixed emotions about this. I think I met with 80%-90% of the brokerages in existence between 2005 and 2008. The market structure was extremely fragmented, there were something like 95 brokers registered on the DFM and the largest one had a market share of under 15% the top ten were less than 30%. As a person trying to sell connectivity to the DIFX in November of 2005 this was deeply tragic because it meant I literally had to meet with everyone.

Things got better once my firm established our own market access business which we used to connect international investors to local markets channeling billions of dollars from abroad into local markets (this ended in tears I'm afraid.) At our peak we were trading between 10-15% of the daily volume in Dubai, Abu Dhabi, Qatar and Bahrain. It sounds crazy I know, but we were. International investors could not get enough of the place once upon a time. Naturally we became an extremely large brokerage client and that made the meetings a lot easier. They got easier still in the run up to the DPW IPO. It’s always easy to have a meeting with someone when you’re paying 10% of the brokerage in the entire market and you are handing out IPO candy.

So in this way I became acquainted with the entire brokerage industry in Dubai and Abu Dhabi and let me tell you there was quite a variety. There were several which operate efficiently with a wide range of services and had moved from being mere brokerages to full service local investment banks. There were some firms which focused on electronic execution of their client orders some of which had developed surprisingly sophisticated technology in house and which we viewed as potential partners. There were of course the brokerage arms of the large banks which thanks to their huge distribution networks were printing money. We had such confidence in these firms that we were able to put them together into a retail syndicate for the DPW IPO which in all operational respects was handled as if it were a major market IPO. Though these firms were pleasant to work with they were not the most interesting stars in the UAE brokerage constellation. Those were the bucket shops.

One of the trading classics is a book called “Reminiscences of a Stock Operator” a thinly disguised autobiography of Jesse Livermore. He began his career in bucket shops. Bucket shops purported to be brokerages but never actually executed client orders on the exchanges. Rather they operated as casinos where the “house” took the other side of every trade and the margin rules were such that the clients were systematically wiped out. Despite or perhaps because of this the bucket shops became a place where local men would come to socialize and talk about stocks cheer each other on and share their sorrows. Like a casino it was as much a social activity as an economic one. Eventually in the US the authorities caught on that these were merely casinos operating incognito and shut them down. Not so in Dubai. In Dubai they multiplied like rabbits.

I must have visited several dozen during my time there. Occasionally they would be in office parks but my favourites were the ones in out of the way places: above an auto-repair shop, in the back room of an auto-dealership, behind a narrow door in a rabbit warren of alleyways in Bur Dubai or Deira. The kinds of places that when you ask the cab driver for them you get that Pakistani look of bewilderment, followed by desperation, followed by resignation that these foreign idiots have asked for yet another non-existent address and are going to go ballistic when the meter runs out of digits because it cannot be found. When you finally did find the place it was always the same thing.

There would be an extremely affable GM who would be calling you “habibi” before even shaking your hand. He would talk about the massive expansion he was planning, about how his firm would be the next EFG, Rasmala, you name it. These people drank the Dubai cool-ade by the gallon. Dubai would be the next Singapore and after that New York and it would be done by firms like his led by men like him. He’d introduce you to a few clients all of whom he assured you may not look like much but this was because they were overly modest in keeping with the tenets of Islam. This one here owns 3% of Emaar, that man in the shabby dishdash negotiating with the teaboy routinely flips millions of shares of Arabtec. Unbable to contain himself he’d insist on giving you the grand tour and show you what luxury you yourself might be able to trade in if you became a customer.

There would be at least one, often several strikingly beautiful receptionists, Arab girls from Morocco or Lebanon. I remember thinking that the Niqab made some sense because if Arab women were all like this it would be understandable that Arab men would be perpetually at war with each other over them. You would then go into the main room which would have plush carpeting and huge comfy leather sofas, a lot of fancy trading screens and TVs tuned to CNBC Arabia or Bloomberg TV. There would be tea boys and waiters aplenty to bring you some coffee or a snack to maintain that trading stamina. Some were built like nightclubs with an exclusive VIP area for the “whales” with even comfier sofas, more tea boys and gaudier decoration. There was even one, now defunct, that had a shark tank in the middle. “Our clients are the sharks of the market.” Said the GM. That may be, but they were sheep for the shearing for the brokerage.

These weren’t bucket shops in the traditional sense where house bet against the customers and rigged the leverage to blow them out. They did however achieve largely the same effect with high fees and by using the rumour mill to generate high trading volumes. My first boss on the Merc floor had a saying which seemed to me pretty useless at the time: “Bulls and bears make money, sheep get sheared, and pigs get slaughtered.” If the customers were the sheep the brokers themselves were the pigs. They ground up the clients and now the clients are gone and with them the volumes. But this is a tiny part of the story. The bankruptcies of the bucket shops and the demise of their denizens are merely a symptom of the deeper illness that afflicts the equity markets in the GCC. The real problem is not that a few impresarios have perverted the capital markets in order to separate a lot of fools from their money. The problem is that economically that is the only function they perform.

As I have written before the IPO market is a rigged game designed to spread the wealth of the business owning class to the masses. As a result all the IPOs are systematically underpriced and thus no rational business person would voluntarily sell equity in a profitable business via that method. This reinforces a cultural aversion to surrendering control or giving up equity, particularly among the merchant families. As a result the public equity markets in the UAE do not perform the important capital raising function that they perform elsewhere with massively negative consequences for the economy of the Gulf as a whole. It is impossible to exaggerate the degree to which this weakens the economy of the gulf because it forces all the merchant families to fund themselves with debt or with retained earnings. To some extent this is offset with government largesse but that creates a dependence of the merchant families on the ruling family. This suits the ruling family just fine but helps explain why there are so few globally competitive firms which originate in the Arab world.

Even once corporations are public GCC equity markets don’t provide a decent valuation function. There is no operational capacity to borrow or lend shares so it is impossible to short them. What you get as a result are a string of euphoric manias followed by buyers strikes which lead to collapse. This is why you can have things like Aabar and Kingdom trade so far away from the value of the underlying assets they own. They don’t function as a market for control either. Especially where the state takes a view as to what the outcome should be. Think of the decision of Sheikh Mohammed to form a national champion with the forced merger of National Bank of Dubai and Emirates Bank. The merger was announced before the terms were decided. The shareholders? No say. The original Arabtec merger? Abu Dhabi decides it wants something, it gets it. The shareholders? No say. The Aabar delisting? IPIC and then ESCA make arbitrary decisions, the shareholders? No say. Want to try to take out a local company as an international player? Forget it.

So the macro bulls and the bears are kept out of the equity markets in the GCC. This leaves pigs and sheep for the sharing and the slaughter. And maybe, before long, not even them.

Tuesday, August 10, 2010

UAE Banking Stress Tests brought to you by the shadow central bank: Shuaa Capital

When I first saw an article calling for stress tests of the Gulf Banks I laughed. My opinion was that the Western Governments that had enacted them largely to try to counter the market suspicion that despite the massively unpopular but massively necessary injections of capital that the banks were still in serious trouble. Knowing that they would struggle to muster the political will to rescue the banks again they decided to try to show the world that no more injections would be necessary and then market confidence might build on itself. It seems to me that this is totally unnecessary in the Emirates.

Given that the Emirates were unwilling let Dubai World fold, what are the odds that they’ll let the banks collapse? Zero. More to the point, since the banks will ultimately rely neither on the markets nor the voters for their rescues what is the point of reassuring either as to their health? At the end of the day the largesse which rescues the banking system will come from the Al Nahyan who answer to neither and indeed answer to no one. Thus rather than a statistical shock to the values of the assets on the balance sheets of the banks what a would-be stress tester would have to determine was the odds of the various banks winning the coin toss of Al Nahyan support. Given the fact that they allowed Dubai to pour $15 billion into the Nakheel black hole my guess is the coin they’ll use for banks has heads on both sides.

Apparently the UAE central bank agrees with my conclusion if not my reasoning and has decided not to conduct these stress tests. So it has fallen on the shadow central bank of the UAE, Shuaa Capital, to conduct them. I should say that I have a lot of respect for Shuaa. When I first got to the Gulf I tried to work out partnerships with a lot of local institutions whereby my firm would provide intellectual capital and they would provide the local connections. At the time intellectual capital was rarer than local connections so the deals I struck were generally pretty favourable. When I met with Shuaa they sent me packing. They had intellectual capital in spades which they showed me over the next two years as one of our stiffest local competitors for the equity market access business. They had a vastly more nuanced understanding of the legal and regulatory environment. They knew, in a way that my compliance department in Frankfurt could never know, that you can cross the lines but you can’t cross the men who draw the lines. They were a well led and effective firm.

They’re no fools with regard to how they played the stress tests either. The headlines in all the newspapers about it read in one form or another: “UAE Banks well capitalized.” I’m sure that the rulers and the regulators read that with pleasure which should serve the partners at Shuaa well indeed. Add to this the fact that the UAE Central Bank is now off the hook and it’s quite the coup indeed. Having read about them in the papers I was tempted to dismiss them but they’re pretty interesting and reward a good read. Despite my general scepticism of stress tests generally I think Shuaa did a good job. I could pick nits with their methodology. For example they limited themselves to loans made at the peak of the real estate bubble which is a de facto assumption that real estate prices which will not continue to decline, a precarious assumption in my view. I don’t want to go into the minutia of the tests but rather point out some features that I find salient.

The first thing I find interesting is that the headlines about bank solvency are a bit misleading. On the one hand they rightly make the point that the capital requirements of the UAE are more stringent than those of Basel II and that under none of their scenarios do the banks violate the Basel II capital requirements. They go on to say that under most scenarios the banks they survey are “on average” adequately capitalized but only “on average.” In every scenario at least one of the banks (ADCB) requires additional capital. Under their worst case scenario several do, up to $4.3 billion. They then say that this is well within the power of the authorities to commit to the recapitalization of the banks. Their confidence therefore is not necessarily in the banks themselves but rather in the governments’ willingness to supply that capital. I agree with this but it is not the same thing as saying the banks are well capitalized.

What I find more interesting than the report on whether the banks are adequately capitalized or not are the diagnosis of the problems which are affecting the UAE economy and the prescriptions for how the government can use the banking system to reverse them. First off they point out that the economic recovery in the Emirates has been sluggish and they lay the blame for this at the feet of the banks on account of the fact that their provision of credit to the private sector has fallen off a cliff. They point out that the banks have already been recapitalized once with an injection of cash from Abu Dhabi and a blanket guarantee on deposits. They then show that since the bailout the banks have focused on lending to the government or to government controlled entities. They then bravely assert that this is not evidence of risk aversion on the part of the banks but rather that the banks are owned by the government or allied families and they are consciously directing the flow of capital to themselves.

They then go on to describe two courses of action for the government to take to free up lending. The first is a more aggressive recapitalization of the banking system. They look at the Spanish and the Irish examples and strongly prefer the Irish case wherein the government swapped its own paper for the distressed assets held by the banks, effectively simultaneously recapitalizing and de-risking them. This is all well and good but it seems to me to not really go to the core of the problem. If the main issue is that the government and the merchant families are directing lending to their own enterprises then why would recapitalizing the banks change that?

I personally think that the main issue is neither that the banks lack sufficient capital nor that what capital is available is being directed to the government. Those two things may be true but the real problem is most likely that the excesses in the real economy and asset prices that had been built up in the system from 2005-2008 have still not yet been worked out. You can see this from the recent Aabar downgrades. Though I do not doubt the influence of the ruling and merchant families over the direction if credit flows I do actually think they are likely driven by risk aversion as much as by command.

To this end I think Shuaa makes a more effective recommendation when they suggest deep structural reform which would encourage private and foreign investment into the Emirates. Unfortunately all they do is use the favourite buzzwords for this “transparency” and “improved governance” without making any specific recommendations. I can understand why they keep it general rather than specific. This is because everyone knows what has to be done, but nobody wants to do it. This is because the only way to create a stable and predictable environment in which to deploy capital would require submitting the law of the ruler to the rule of law. No more arbitrary arrests of out of favor burecrats, no more turning a blind eye to local merchant families who rob investors blind. So far the powers that be have not connected the dots between these structural problems and the lack of access to capital but they are there.

Shuaa says some brave things in their report about the solvency of the system and the degree to which it actually responds to the market. They hint at what really needs to be done but don’t spell it out. Once again Shuaa crosses the line without crossing the men who draw the lines.

Wednesday, August 4, 2010

“The Barazi Bruiser” encourages the "DIFCI Demon" to settle, or vice versa

When Muhammad Ali converted to Islam it was controversial. Ernie Terrell, an opponent, kept calling him Cassius. In 1967 Ali beat the hell out of the guy while yelling at him the whole time “What’s my name fool!?! What’s my name!?!” Ali, who won 2/3 of his fights by KO, never delivered a knock-out blow but rather won by decision. It’s been speculated that he did this in order to deliver a longer beating. As I read the Barazi response to the DIFIC counterclaim I imagine his attorney Imran Shafiq shouting “What’s my name fool!?! What’s my name!?!” at his computer while they delivering a solid beating to the DIFCI case all the while keeping his knock out blows in reserve.

The Barazi response opens with a description of Barazi’s background demonstrating that he is eminently qualified for the roles he held at DIFCA and DIFCI. It then goes into the detail of his compensation and his contract reaffirming what his salary was, its compensation, his entitlement to severance. Nothing too exciting. It begins to get interesting when it quotes the DIFIC Articles of Association to make the point that the Governor of the DIFC who is also the Chairman of DIFCI, that is to say Dr. Omar, who has the final say in the management of DIFCI and all other managers are appointed by and subject to his authority. This will be important later.

Next they use inconsistencies in the accounts of the DIFCI managers and the DIFCI counterclaim to shred the chronology and legality of DIFCIs actions in placing Barazi on the “investigative leave” and refusing to pay him. I highlighted some of this in an earlier post but the attack Shafiq launches is far more compelling and better researched. His alternate narrative is backed by quite a bit of documentation and a great many quotes from DIFC laws and DIFCI employee manuals. The core of the argument is that the claims of DIFCI are based on a manual that was not in force at the time of Barazi’s dismissal.

In the narrative that emerges, the people who took over the DIFC after Dr. O was forced out wanted to get rid of the old guard in a hurry. It looks like they did this without fully consulting Barazi’s contract, the DIFC employment laws or the DIFCI employee handbook. I have some sympathy with this, the guys who took over had bigger fish to fry and probably figured that they would get Bisher out of the way ASAP and cross the t’s and dot the i’s later. They didn’t count on Barazi trying to shake them down for $500,000. If they had left it at that and just disputed the circumstances of his unpaid leave then we would be having a boring discussion about which version of the employee handbook is relevant. They didn’t stop there.

No they went the extra mile and rather than debate the minutia of DIFC employment law their line of argument was that Bisher had been engaged in a fraud, or series of frauds and therefore was entitled to precisely zero and, sooner or later, would probably find himself standing tall before the man. Of course once you accuse someone in Dubai publicly of fraud they know what happens next and they’re going to pull out all the stops to defend themselves which is what Barazi and Shafiq do in their response.

The first thing they do is point out that KPMG has its own reservations about the investigation and that the allegations of the DIFCI are being made on preliminary reports all of which are heavily qualified by KPMG. Then the go after each item in particular.

At the very beginning of the discussion of the “fraudulent bonus” of 2007, they make reference to the fact that The Governor of the DIFC could award bonuses at his sole discretion. This was clearly a major error in the design of the governance of the DIFC but Barazi correctly points out that “Mr. Barazi was not responsible for the system by which such responsibility and accountability lay in the Governor alone.” Quite right, my guess is the governor isn’t responsible for it either despite being its chief beneficiary a point I make in an earlier post.

They then categorcally and effectively deny a litany of accusations that the DIFCI alleges but does not substantiate. For example the existence of a conspiracy between Dr. Omar and Barazi is alleged but no evidence is provided other than the fact they both received bonuses which they might well have done without a conspiracy.

The central attack on Barazi in the counterclaim is an allegation that Bisher justified a bonus on the strength of a $60 million realized gain when in fact the DIFCI had an $80 million loss. The DIFCI insinuates that this is a misrepresentation similar to accounting fraud. The argument on the DIFIC side is deceptively simple and the Barazi counterargument is obfuscatingly complex. In sum Barazi makes the following arguments:

1.) It is not formally necessary to actually make money to be paid a bonus
2.) Dr. Omar could decide bonuses at his sole discretion
3.) DIFCI executives benchmarked themselves against payout rates based on a study by Manpower (which implied a 20% payout rate) and their own experience of private equity (which implied a 50%) payout rate.
4.) Given these benchmarks their decision to pay themselves 10% of realized gains after $60 million was conservative.
5.) The decision to base the payouts on realized gains was made because it was conservative
6.) The payouts were made based on unaudited results which it was believed would not be materially different once the audit was completed.
7.) The discrepancy which is pointed out by the DIFCI counterclaim is the result of confusion about the chronology of when the audits were completed and...
8.) Some confusion which arose regarding the accounting treatment of two very large transactions: Bourse Dubai and the Deutsche Bank trade.

A few things stand out. No private investor would pay Bisher and Dr. O 50% fees to manage a PE fund. They had no track record and, as events have shown, would have been wiped out before they were able to create one. That said I personally don’t think their compensation of 10% was too outrageous. I have no view of the issues regarding chronology or realized vs. unrealized gains. Personally I don’t think they’re material. I do have to say that the fact that they contributed the DIFX to bourse Dubai at a valuation in the hundreds of millions justifies a bonus at least twice what they actually got. Don’t get me wrong, I dearly loved the DIFX and I spent nearly a fifth of my working life on it so I have every reason to claim it was more valuable than it was but to get the price they got for it was a miracle.

All in all I think they at least do a pretty good job of explaining in minute detail why the simplistic DIFCI contention of fraud is not what it seems on its face and this should sow a lot of doubt in the minds of the judge.

DIFCI also alleges that Barazi asked for a personal loan after they had been banned and characterizes this as a breach of his fiduciary obligation. More damning they allege that he agreed to buy billions worth of off plan real estate without conducting due diligence another grave breach of fiduciary obligation. The defence regarding the loan is pretty straightforward. Dr. Omar had the right to grant them, he did and Bisher paid it back within weeks of being granted it. Case closed. They also make short work of the allegation of the Pearl due diligence by producing text from the agreement that allows DIFIC to back out ex post facto if their due diligence turns up a material issue even though it is going to be conducted after the first payment is made.

So, all in all, the response from Barazi and Shafiq is a pretty effective refutation of the counterclaims of DIFCI. In cases where they can just shoot down the DIFCI they do it with dispatch and in areas where there is some nuance they seem to have used the “if you can’t convince them, confuse them” strategy so sow doubt about the veracity of the DIFCI claim. As effective as the overt defence buried in the document are two covert defences which will come into play if the DIFCI press their case.

The less powerful one partially emerges in the section on the due diligence. The document points out that in the fall of 2008 the Dubai real estate market was in free fall and the prospects for Cityscape, the annual real estate conference were grim. Then it says “Mr. Barazi was instructed that DIFCIL should make a substantial property investment in a development in the Dubai Technology and Media Free Zone known as “Dubai Pearl” and owned by Pearl Dubai FZ LLC which might be announced before the start of Cityscape in that year." This is not a surprise but it sure does shed some light on why that due diligence was not done before the transaction was executed. What it does not shed light on is who precisely it was that instructed Barazi: the sentence is in the passive voice. The subject is secret, that is until Barazi and his lawyer choose to reveal who precisely it was that was seeking to have DIFCI create a false impression of real estate demand in Dubai by channeling billions of dirhams borrowed by the state into privately owned off plan development. Whoever that was now has a real interest in Barazi not getting prosecuted.

My favourite however comes much earlier in the document. In my first post on this subject I thought it was really odd that the DIFCI counterclaim cited a Gulf Business story about the release of Dr. Omar as evidence that Barazi should have known that he was under investigation. I thought that was preposterous and so does the Barazi legal team who point out the obvious that it does not oblige him to admit any knowledge of the “nature or extent of such investigations as may have been and/or still are being conducted by the DGAT, or as to the alleged charges brought against Dr. Omar or any other employee of the DIFC.”

That’s all well and good but the final clause conceals the knock-out blow: “If and insofar as DIFCIL may seek to assert the truth of (i) any such report (ii) any such investigative findings and/or (iii) any charges that have been laid against any person, they will be put to strict proof of same.” (emphasis mine) This is code for: “if you attempt to pursue me for fraud I will use the higher burden of proof within the DIFC legal system to attack your actions against Dr. Omar in Dubai proper and, (considering we can assume Barazi and Dr. O are in constant contact,) I will very likely be able to show that YOUR ACTIONS AGAINST DR. OMAR HAD NO LEGAL BASIS WHATSOEVER AND THEREFORE ARE INDISTINGUISHABLE FROM EXTORTION.”

What’s my name fool. What’s my name.

So then it will come down to just how much embarrassment the Dubai establishment is willing to take at the hands of Bisher Barazi. I’m not sure, what will happen. They might cave and pay him to go away, or they might say, “Listen little man, its not a secret that this is an autocracy and we can dispose of Dr. Omar as we like. As for public opinion, try to imagine how little we care. As for you, if we don’t win in the DIFC we’ll get you in Dubai proper so either way you’re going to jail. Enjoy.” It may turn out that Barazi, with his elaborate overt and deviously subtle legal arguments, has done nothin more than bring a very elegant knife to a gun fight. Either way the stakes are high for all involved. It’s going to be interesting.

Tuesday, August 3, 2010

So I'm not sure what a "Cascade Agreement" is but I think it has something to do with a waterfall. Hey! Look! There goes a Damas shareholder!

The long suffering shareholders and creditors of Damas are now able to see the full extent of the damage that has been done by the Abdullah Brothers. The annual report puts a brave face on things. With justifiable pride they point out that the company earned 9.8 million AED not including extraordinary items. This grain of good news needs to be taken with a pinch of salt, or rather a pillar of salt because those extraordinary items weigh in at 1.9 billion AED. So if Damas can keep up the good work, they’ll have repaired the damage from these one off write downs in 200 years. Unfortunately for the creditors, and fatally for the shareholders, Damas’ auditor said the company has to come up with a restructuring plan by the end of the month or it may close its’ doors.

I have to admit that in continuing to write about The Great Damas Heist I feel a little bit like George Orwell in “Shooting an Elephant.” I’ve written so much about it that people seem to expect me to continue even though the story has its’ edge because it is obvious how it ends. Alas, my inbox is full of requests, and some of you are new to my writing through its recent syndication. So I’ll point out a few things and tell you how it’s going to end.

The first thing you have to do is get around the Dubai Newspeak that is used to describe what has gone on with regard to the “unauthorized transactions.” They are universally described in the Damas documents and in the press as monies “borrowed” or “owed” by the Abdullah Brothers. The documents in the DFSA undertaking demonstrate that the at the time of the transfers the Abdullah brothers were not obligated to pay the monies back nor were they charged interest. From my perspective an unauthorized interest free loan for an indefinite period is called “theft.” This makes it easy to interpret their actions through the simple expedient of lip reading. If their lips are moving, they’re lying. If their lips are not moving, they’re stealing.

The next thing you have to do is connect the dots that the DFSA is unwilling and the Dubai press is unable to connect. The first thing that stands out is how ridiculous the continued involvement of the Abdullahs as advisors to the company because of their “relationships” and “reputation.” Their reputation for fraud caused a massive liquidity crisis.

The brothers “borrowed without authorization or interest for an indefinite period” or “stole” depending on your frame of reference, two tons of gold from Damas. Interestingly it turns out that the gold that the Abdullah brothers stole was not even the property of Damas. Damas had borrowed it from other merchants and banks. When the other merchants and banks discovered that the Abdullahs were able to simply drive up in a truck and make off with the gold they had lent to Damas they quite reasonably either called in or demanded substantially greater security against the loans. This in turn caused a massive liquidity crisis at Damas which itself resulted in further losses.

It would seem to me that given the fact that the Abdullah Brothers reputation for theft has made it impossible for Damas to acquire the raw materials of its main business on commercially favourable terms would be a pretty good reason to exclude them from the management of the company even in an “advisory” capacity. The people who say that the business depends on reputation are not wrong but the Abdullah’s have a reputation which is commercially fatal to the business of Damas, yet there they are back in the saddle. Now wait a minute you say, doesn’t Damas have an entirely new board? Aren’t the Abdullah Brothers working in a “non-executive” capacity? Surely this will put the gold lenders at ease. Personally I don’t think so. Anybody who has two tons of gold stolen out from under them is going to be understandably sceptical. There was a board at the time the Abdullahs absconded with the gold last time, what makes this board different. They didn’t even have the willpower to stand up to the Abdullah Brothers and keep them out. I’m sure it wasn’t their idea to bring them back in.

There are also some interesting items in the write down list. One of them is the $80 million Dubai Ventures loan. This was money that the Abdullah Brothers had Damas lend to Dubai Ventures, a private equity firm, to invest in the Damas IPO when it turned out that not enough buyers could be found to give the Abdullahs the valuation they wanted. This created the illusion of interest at the higher price and enough of it to clear the 25% hurdle of independent investors necessary to conduct an IPO on the DIFX. Of course since the shares were purchased with Damas’ own money they were not at all independent. This effectively rigged the book build (auction) and forced the foreign investors to overpay. This helpfully increased the amount the Abdullah’s were able to steal. And of course whose money was used to force the shareholders to overpay? Thiers. At least that’s what it looks like now that Dubai Ventures won’t be paying that loan back. Who owns Dubai Ventures? Dubai Holding. Who owns Dubai Holding? Sheikh Mohammed bin Rashid Al Maktoum the Ruler of Dubai. Naturally Sheikh Mohammed is not going to take the hit, the Damas shareholders and creditors will be doing that. Dubai wins again! Thanks for playing gentlemen shareholders. Can we interest you in some off plan real estate?

Another interesting item that they are reserving against are the shares of Damas that the Abdullah Brothers pledged in the event that they cannot repay the loans. Apparently there are some issues with transferring those shares and so they cannot be properly valued. I pointed this out quite some time ago.

Finally, and unsurprisingly Damas thinks it wise to reserve against the possibility that the Abdullah Brothers will not in fact pay back the money and the gold that they “borrowed indefinitely with neither interest nor authorization.” This makes a lot of sense considering that they’re quite a bit overdue with regard to their payment obligations under the Settlement Agreement. There is even some talk of shredding the Settlement Agreement upon which the DFSA unenforced enforceable undertaking is based in favour of something called a “Cascade Agreement.” I’m not really sure what that means but I like the sound of it. It reminds me of going over the falls in a barrel. Joking aside apparently the Abdullah Brothers owe money to other parties aside from Damas. Apparently what they did was steal money from Damas, use that money as a down payment on some real estate and borrow the rest of the purchase price against the asset. That means that the Abdullah brothers, and with them the Creditors and Shareholders of Damas, are behind the banks in the capital structure of these investments. This is what is meant by the Dubai Newspeak “uncertain title.” If you put 20% down on real estate that has declined 50% in value using funds you have stolen from a company you control your equity has been wiped out and so you no longer have title. Nice.

It seems that the parties involved have decided to indulge themselves in the fiction that if they just don’t sell now but wait a while all will be well. While it is perfectly understandable that this is not the optimal time to liquidate Dubai real estate, and I’m sure the banks would agree, the fact remains that this is beside the point. If the Abdullah Brothers investments in real estate using stolen and borrowed funds are underwater so be it. The remainder of the Abdullah fortune should be being auctioned off and the proceeds should be going to Damas. That is not happening. The fact that the investments made with the “unauthorized interest free loans of indefinite duration” have been wiped out does not mean that the Abdullahs did not steal the money. They did. They should be on the hook for it and the DFSA and the Dubai Courts should be liquidating their personal assets in order to pay back the creditors of Damas. ALL their assets not just the ones that they purchased with Damas money supplemented by banks.

But of course this will not happen. The Abdullah Brothers are rich and connected Emiratis. They won’t have to sell their assets, they stole almost 70 years worth of earnings from Damas in 18 months that should last them a good long time. The Damas Creditors will probably roll the debts in the hope that something can be collected over time but they will be disappointed. The shareholders will be wiped out entirely. This is because the shareholders are unconnected international investors. They bought into the idea that inside the DIFC they would be operating in a legal environment that would protect them supervised by a regulator that was operating according to international best practice. Well they won’t make that mistake again.

Monday, August 2, 2010

Ban the BlackBerry today, keep the Indian Navy Away-- A fanciful conspiracy theory from wallstwtf

I want to write a few words about the potential blackberry bans in the UAE and potentially Saudi Arabia. As a person who sleeps with my blackberry under my pillow my first reaction was one of horror at the idea that the blackberry email functions will no longer work on the UAE and perhaps Saudi. On the other hand, I do remember how nice it was to be unreachable while I was in the Arab world when I first began travelling there regularly in 2005. So while the downside will be reduced productivity this will be balanced by the chance for the bankers who visit Dubai to get an extra martini unmolested by the folks in back in London.

I want to take a minute to think a little more deeply about what this means. The issue it seems is that the nature of the blackberry encryption and network organization makes it impossible for the Emirati security services to scan the communications of blackberry users without the cooperation of Research in Motion, the maker of the device. What’s more given the structure of the network and the jurisdictions in which RIM operates the UAE is concerned that it might not be able to use the local legal systems in which it operates to compel RIM to cooperate and hand over data.

OK, so it’s well known that the Emirates are absolute monarchies and it’s not really a secret that they monitor electronic communications within their territory. This is evident in a variety of ways from the occasionally annoying fact that many websites are blocked to the extremely efficient exposure of the Mossad hit squad earlier this year which demonstrated the impressive capabilities of the Emirati counter-espionage services. That said I think this episode is still somewhat revealing.

First of all it shows the willingness of the Emirati government to inconvenience the people who make their living and their homes in the Emirates as well as the international business community. There are 500,000 blackberries in use in the UAE or almost 10% of the population uses them. They are particularly prominent among the international business community which has increasingly been making Dubai the regional business hub. It also put the Emirates which have carefully cultivated an image of openness in a position where Qatar, which announced that it has no intention of limiting blackberry use, to tweak them.

This was also sure to get a lot of press, which it is indeed getting. That press is more favourable than say the issues Google had in China but this is largely because of the presumption that the new restrictions will be used to cut down on Islamic extremism and Iranian sanction busters. Interesting how the freedom of speech and the rights to privacy are more important in American adversaries than in our allies. A similar crackdown on facebook or twitter in the Islamic Republic of Iran would no doubt cause a great outcry. Well, as a famous American once said, a foolish consistency is the hobgoblin of little minds.

Personally I think that presumption is largely misplaced, it is not impossible for the UAE to gain access to the data that is carried over blackberries they would simply be subject to judicial review in Canada. Presumably if what they were after were terrorists or sanction busters they could expect this cooperation. No, they want to be able to scan all secrets for the same reason that Iran and China want to crack down on the use of information sharing, they want to stifle domestic opposition. This is an acute problem in the Emirates.

The analogy I like to use for this is Sparta and the Helots. If you are a classical scholar or have watched the movie “300” you will know that the Spartans had the best and most effective army in ancient Greece. Why was this? It was because the Spartans had, years before, conquered and enslaved another people called the Helots. The Helots outnumbered the Spartans by a substantial margin. So the Spartans developed a highly militarized culture which was designed to terrorize the Helots into subservience and it worked. In addition the Spartans were also able to intimidate the other Greek city states eventually destroying the power of Athens in the Peloponnesian War.

The demographics of the Emirates are similar to those of Sparta. The Emiratis themselves are vastly outnumbered by expatriate workers. A few tens of thousands of those labourers are the white collar European or American workers for international firms, who will be most inconvenienced by this. The teeming majority of them however are workers from the subcontinent and Southeast Asia who while substantially better off than most of their countrymen who are still at home are nonetheless at the very bottom of the social ladder in the Emirates. They are therefore potentially the most subversive force with which the regime has to contend and the one with which the Canadian government is least likely to cooperate with wholesale monitoring.

When I first noticed the massive demographic imbalance I wondered why the Emiratis were so militarily complacent. I would have expected mandatory military service and lifetime membership in the reserves in a country where the natives are outnumbered ten to one by foreign labourers who earn less than 10% of the incomes of the locals. Add to this that the mother country of this relatively poor and occasionally persecuted minority is a major power with increasing capacity for power projection. Then someone explained to me the two reasons why this was the case. First, the Emirates are functionally an American protectorate and if there were ever a threat to the regime the American forces stationed there could be relied on to protect the various ruling families against a violent upheaval. The second is that while largely a distant and benign force in the lives of white collar expatriates the Emirati government is a coercive police state in the lives of many of the immigrants from the sub-continent and uses its power of communications to thwart efforts by them to organize.

So why have the Emiratis chosen this moment to square off against RIM over control of the information sent across the blackberry network? Why now and not 2005 or 2007? Could it be that the Gulf Arabs are watching events in the US and beginning to question the American commitment to their security? The American departure from Iraq is imminent. America seems to be reconciling itself to the existence of a nuclear armed Iran. In Afghanistan the destruction of the American commander by Rolling Stone of all thins and the release of 90,000 classified documents by wikileaks is laying bare the fact that American will is being sapped even with regard to the nation from which the 9-11 attacks were launched. Is it possible that these signs of American fatigue in the Arab world are leading governments in the region to realize that they are going to have to be more aggressive in the suppression of domestic unrest solely through the use of domestic resources? It's farfetched but it’s something to think about.

Tuesday, July 27, 2010

Here's the plan: we liquidate Dubai World in slow motion and hand out the money starting to my left, if the creditors agree they can sit between us...

Last week there were some seemingly minor developments in the Dubai World saga. These were the Nakheel restructuring plan and the presentation of the Dubai World restructuring plan to the general lending community outside the Lenders Committee which had blessed the proposal back in May. On the surface of it this presentation carries with it no new news, the proposal is more or less identical to what the big lenders agreed.

I’ve written about this before at length, but to summarize, the lenders will be asked to roll their loans out into tranches of five and eight years. There will be no haircut on principal but the interest rates will be cut to 1% on the 5 year tranche and between 1-3.5% on the eight year tranche. Apparently the 8 year tranche will have several choices for the lenders on repayment type and the degree to which there is a “shortfall guarantee.” Presumably the more risk the lender takes the higher the rate. It seems kind of a Hobson’s Choice to me because even 3.5% is substantially below a market price for that risk and the word is that there is some question as to whether the guarantees would be enforceable in UK courts.

So what is different about this announcement than the one that was made in May? Well, several things. One is that the lenders are not in a position to negotiate the terms, it is a take it or leave it deal. The big banks had an opportunity to challenge Dubai on the nature and structure of the deal back in May but they were more concerned about not taking too big an immediate loss. They successfully blocked Dubai’s opening gambit of a partial write down of principal but conceded on the structure of the deal and on concessionary interest rates. By doing this they basically enabled the government of Dubai to drain the DFSF, channel the vast majority of the funds to Nakheel, and through Nakheel to the Sukuk holders and the local contractors which had trade claims against Nakheel. The Nakheel creditors, who are also mostly local are getting a much better deal than the creditors of the parent company. Well that’s what happens when you put immediate loss avoidance ahead of your long term strategic interests but considering that this decision was made by western banks it should come as no surprise.

Interestingly the new sources of repayment seem to acknowledge that Nakheel is doomed and the DFSF transfer was mostly to rescue local firms rather than actually revitalize Nakheel. Back in May there was talk about how the cash injection into Nakheel would enable it to finish it’s projects and contribute to the repayment of the Dubai World parent company creditors. In the new proposal there is a lot more discussion of asset sales, it seems that Infinity and Istithmar will be liquidated entirely and that some of the holders of the Dubai 10 year tranche will be repaid with the sale of “strategic” assets which can only mean Dubai Ports World. There is also some talk of the creditors in the 10 year tranche being paid off “in kind” whether this means shares of DPW or non-existent crescent shaped islands I do not know. My guess is most banks other than perhaps NBD-Emirates would avoid that option.

It also sounds like the tone was a bit more aggressive. The package was delivered as an ultimatum: “Take this or take your chances with a liquidation.” To add insult to injury it has been insinuated that the DFSF may take precedence to the original creditors in the event of liquidation. Additionally the procedure would be executed in the DIFC under a special tribunal established for the purpose rather than the original jurisdiction of the contracts. This is a point made in an interesting interview of the former head of the DFSA. Before the Damas fiasco I would have said they were better off in front of a DIFC panel but given the impunity with which the Abdullah Brothers have gotten to skip out on their payment plan without having to either actually pay their fine or even disclose that plan I think the creditors are quite right to be fearful of what would happen in the event of default.

The question on everyone’s lips seems to be whether the creditors will accept the proposal or not. Personally I think it is a near certainty that they will take it because at this stage they have no other option. Nakheel had already taken its’ cash infusion and divided it among the largely Emirati Sukuk holders and the trade creditors there’s no more help from Abu Dhabi on the way. While it’s questionable that DFSF might be in front of the creditors it’s a good thing that Dubai is swapping its own debt for equity and getting behind the creditors. So what in essence is happening is the DFSF is jumping to the front of the creditor queue and Dubai is getting in back with the banks in the middle. My guess is that this was forced on Dubai by Abu Dhabi: pay us off first, then the foreigners so the UAE saves face, then whatever’s left you can have.

In strategic terms the creditors have no interest in forcing a liquidation because, if you assume that Nakheel will not recover within 8 years, most of the repayments are going to be funded by the liquidation of the Istithmar, Infinity and the eventual sale of DPW and other “strategic” assets. You can think of the restructuring as a slow motion liquidation. A slow motion liquidation is probably much better than a liquidation adjudicated by an authority which is ultimately under the control of the wounded former equity holder. As an added bonus, the slow motion liquidation will be masterminded by Abu Dhabi which has every incentive that it come off because it, is in front of the creditor queue. The bank creditors probably prefer this because Abu Dhabi has more power over Dubai than they do.

The interesting question to me is just how much are the assets that are for sale going to bring in. What will Dubai be left as the equity holder of? My guess is they would be happy if they could pay everyone off with all the international assets and keep JAFZA and Nakheel. It’s still an open question though. This is something that won’t be known for many years. I think the banks mostly did not push harder because most of the people making the decisions know they will be elsewhere when the falcon comes come to roost.

Sunday, July 25, 2010

Is a muscular indepedent judiciary coming to a self-legislating financial free zone near you? Inshallah.

In my last post I suggested that Bisher Barazi get out of town because the DIFCI counter-claim reads more like a vendetta than a defence against his lawsuit to recover his severance pay. It looks like he agrees and according to The National, a respected paper in Abu Dhabi, he has sent his family home to Syria and has himself asked the judge to lift the travel ban on him so that he can defend himself from the comfort and relative safety of Damascus. The judge said no dice. This is a little interesting to me because the judge in this case seems to be adjudicating remotely as well as he conducted the hearing from London by video link. This is of particular interest because the DIFC is qualified to hear commercial disputes only. It can only fine and censure its members, it has no criminal authority and therefore cannot imprison Bisher. It can however refer criminal cases to the Dubai courts for adjudication and enforcement. We may be seeing a preview of coming attractions in the DIFC court’s refusal to allow him to leave, which is of course all the more reason for him to do so.

Additionally he has been asked to detail all his assets and sources of income in the UAE. Still more interesting he is required to demonstrate that he actually owned the villa he just sold. This seems a little odd because presumably the buyer would have also checked that he was buying the villa from the actual owner before handing over the cash no? I think I know what the judge is after in this case. When I was in Dubai I heard a lot of rumors about expat civil servants being paid under the table by the various organizations that employed them with certain high value gifts like villas, cars, and everyone’s favourite: off plan real estate. I imagine that in Dubai proper this is not a big deal but given how much emphasis is being placed on “unlawful compensation” on the former management of the DIFC I think this policy, if indeed it took place, is going to get a lot of scrutiny. If Bisher did receive extra undocumented compensation from the DIFC he is almost certainly not the only person to have done so. It will be a cliff-hanger for everyone else living in gift homes as well. My guess is that more than a few people will be watching the Barazi-DIFC litigation with their real estate agent on hold and their travel agent on speed dial.

Most importantly of all, they will get to watch it. The DIFC Court ruled against a request from both parties to close the hearing to the public. Having had my hopes for the DIFC dashed repeatedly I am wary of reading too much into this but I think it might be significant. Firstly, as a point of journalistic honor I have to concede that as with the ESCA ruling on Aabar, I have perhaps taken too dim a view of the DIFC courts and described them as a tool of Sheikh Mohammed in his quest to punish Dr. O and Bisher. But now the DIFC courts have denied two requests from the government: 1.) that the trial be conducted in secret, and 2.) that they cripple Bisher’s capacity to fund his defence by demanding a 500,000 AED deposit. It may not be a first but having a court in the GCC deny a request of an agent of The Ruler is pretty unusual. Is it possible that we are seeing the creation of a independent judiciary in the DIFC? This will indeed be an interesting court case to watch.

Inshallah the Abdullah Brothers will get their day in court as well if the DFSA ever musters the thrasos to take them on.

Thursday, July 22, 2010

In the Emirates, as in life, if you mess with the bull, you get the horns. Maybe moreso.

In this post I put forth a theory as to why Dr. Omar and Bisher Barazi are in so much trouble. Check here for the previous article.

Sometime in late 2006 or early 2007 I sat in a conference room in the DIFC, the one with the imperial view of the massive construction site which composed the vast majority of the Gate District at the time. I was at a meeting with the representatives of the other investment banks and the then CFO of the DIFC Bisher Barazi. Bisher had a voice both nasal and high pitched, kind of like beaker on the Muppets but with a severe head cold. When he became excited he seemed to be out of breath and on the verge of sneezing at the same time. At this particular meeting he was certainly excited.

We were discussing the proposed IPO of Dubai Ports World. It was being proposed that DPW execute a dual listing on the DIFX in Dubai and the LSE in London and we were hoping to convince them to do a DIFX only listing. This was going to be the biggest thing to happen in the DIFC and would prove to Sheikh Mohammed that the guys who were running the Center had not merely snookered a bunch of foreigners into renting expensive real estate but had actually created a functioning financial center. Nothing makes people nervous like scrutiny and, as we now know, the guys who ran the DIFC were not used to scrutiny. So there we were in our meeting with a nervous, and therefore excited, Bisher Barazi.

Bisher had good reason to be nervous. The international banking community had been drinking the DIFC cool-aid for over a year but so far we had little to show for it. My firm in particular, Deutsche Bank, was massively committed. We had moved aggressively into the center and has helped build much of the legal and technical infrastructure that enabled the DIFX to launch on time in September 2006. We intended to use our first mover advantage to establish a dominant position in the center. If you wanted to trade, clear or settle on the DIFX odds were that somewhere along the line you were going to have to pay us. We stood to benefit massively if the DIFC worked out and the DIFX became a major exchange. That said, at the time there was precious little business going on and we in the region were starting to have a hard time explaining to our Lords and Masters in London why we were devoting so much time and effort to the project.

I had seen this before when I worked on an exchange start up in the US. The exchange had an 80% cost advantage over its rivals and still took 18 months to gain market traction against entrenched rivals so I wasn’t too worried. The difference however was that we owned equity in that exchange and made a substantial windfall on its IPO and subsequent trade sale. The DIFC had steadfastly refused to grant us equity in the DIFX which would have helped us justify the efforts we were putting forth. This being the Arab world, with its’ penchant for retaining control, we were continually told no dice. I had confidence that it would work out eventually but it was getting hard for me to keep co-opting the folks back in London and the other DB support centers to continue to pour resources into the project.

So as nervous as Bisher was, it was pretty frustrating to have him pace back and forth and harangue us in his high pitched squeaky voice about all the work that was going to have to get done in order for the DPW IPO to come to the DIFX and for it to come off without a hitch. We need a retail offering, we need DMA access to Europe, we need... we need... as he got more excited he spent more and more time looking at me and his tone switched from “we need to..” to “you need to..” “You need to connect us to Saudi, you need to provide connections to the exchange for UAE brokers, you need to...” I had already been thinking of all the things I was going to have to do to muster the resources within DB to do all these things. I would have to call in favors, I would have to fly to Amsterdam to rally the troops in GTB, I’d have to go through multiple New Product Approval procedures and I would have to go all over the firm making presentations about the bright future of DB in the MENA region. I had practically emptied my account and would now have to blow my own personal credit bubble at the DB favour bank.

Then all at once it hit me that it was entirely possible that all this would be for nothing and I would be holding the bag. So I interrupted the lecture, pointed accusingly at Bisher and said, “Listen here, I don’t work for the DIFC. I’d like nothing more than to build out this infrastructure but you have denied us the opportunity to take equity in the DIFX or any other upside in the success of the DIFC. Nonetheless you continue to demand millions of dollars in infrastructure investment and millions more in free consulting. You have to understand that I work for the shareholders of Deutsche Bank not the DIFC stakeholders and it’s going to be the DB shareholders who decide whether this gets done, not you.” (I really did say that, I was a great believer in the cult of the shareholders)

I’ll admit, I felt pretty clever. I thought that this might open the door a crack and make them cough up some equity in the DIFX so we could really see some upside when the rest of the world joined us in drinking the DIFC cool-ade. Not for the last time in the region did it turn out that I thought myself a good deal cleverer than I was, for Bisher Barazi had a plan.

Unbeknownst to me, DIFCI and my management at Deutsche Bank had been in negotiations for DIFCI to become a massive shareholder of Deutsche Bank. By June of 2007 they had acquired 2.2% of the company and became our fifth largest shareholder. And let me tell you, as far as the DIFX was concerned, Bisher’s plan worked like a charm. No more wisecracking from Ken Monahan about how the DB shareholders would decide the fate of the DIFC, the DIFC was the shareholder. It was worse than that. I had to give Bisher my cell phone number. And whenever it rang no matter the time zone or circumstances in which I found myself I would have to answer it. For the next six months at random I would get phone calls from Bisher demanding status updates, did I do this, did I do that, was it really possible that we would deliver on time and in full? Did I understand how important this was? Where was I? What was I doing? Why was I doing whatever I was doing instead of working on this? Mercifully he did not call all that often but when he did, it was not awesome.

And wherever I was at whatever time and however sober I had to reassure Bisher in as soothing a voice as I could muster that indeed at this very hour an army of people in London, Amsterdam, Dubai, Hong Kong and Bangalore were working night and day to ensure that we delivered on time and in full. And we did. We executed, with a single listing on the DIFX, the largest IPO in the history of the GCC with a simultaneous retail offer in the UAE and an international book build. We created a link to Euroclear so that international investors could buy the shares in their existing accounts and we connected clients in dozens of countries to the DIFX all over DB infrastructure. Yep, as far as the DP World IPO went, the DB investment was a stroke of genius.

Yep, a stroke of genius except for one small detail. DIFCI completed its’ purchase of DB shares in June of 2007, the all time high for the stock. At the time of the announcement the stake was worth $1.8 billion. Then fate took a hand and the financial crisis got underway decimating the values of financial institutions the world over, even companies like DB which took no government money. Today DIFCI’s $1.8 billion investment is worth $720 million and $1.1 billion has been sacrificed to the trading gods. So while from the tactical perspective it was a stroke of genius, from a strategic investment perspective it was a complete fiasco. Add to this the $2 billion loss that Bourse Dubai took on its NASDAQ and LSE shares, a transaction on which the DIFC advised, and it doesn’t look like the guys doing the investing in financial services firms did Dubai any favors. I’ll bet they wish they just let us invest in the DIFX like we asked.

This brings us back to the present, there’s nothing like losing a cool 3 billion of Sheikh Mohammed’s money, or rather money Sheikh Mohammed has borrowed, to put you in the crosshairs of the UAE and the DIFC legal systems. Perhaps Sheikh Mohammed cannot imagine that so much money could disappear without some kind of malfeasance. After all it did take outright theft in order for $165 million to vanish from Damas, surely $3 billion can’t vanish without some fancy footwork by some light fingered subordinates. From my perspective $3 billion did get lost but it got lost the old fashioned way, bad decision making, not fraud.

But there’s a difference between robbing a bunch of international investors and legitimately losing a bunch of Sheikh Mohammed’s money. If you’re an international shareholder you’re forced to rely on the law which is why you get nothing but laughter and forgetting from the Brothers Abdullah. Sheikh Mohammed IS the law so no matter how legitimate your poor decision making if you lose his money you are in serious trouble. No laughter. No forgetting. He doesn't have to rely on the DFSA, he can just throw you in jail until you pay him what he thinks you owe. Don't like it? Too bad. You mess with the bull you get the horns. This is no longer about $544,000 in back pay for Bisher Barazi, it is about Sheikh Mohammed getting some payback. Bisher Barazi had better call up that guy with the submarines and leave town because he is going to get a lot more than $122,000 in emotional damage from Sheikh Mohammed.