Monday, November 30, 2009

The Problem With Dubai

Dubai World, builder of man-made palm tree shaped islands and lover of other absurdly ostentatious and expensive property development projects, has run into a bit of a problem. Lacking oil, or any other valuable commodities, it fueled its building ambitions by issuing debt, piles of it, roughly $60 billion or so. Banks were eager to lend because government-backing of Dubai World's debt was implied. So when Dubai World came out with its shocking announcement right before the Thanksgiving holiday that it just wasn't in the mood to pay its debt investors anymore, markets around the world were miffed and sold off. They regained their composure a bit when all those savvy analysts and commentators assuredly pointed out that a $60 billion debt default was no big deal. The markets had overreacted blah blah blah.

But this is a big problem: it's not the size of the debt but the wider implications of a sovereign nation defaulting on its debt. This morning, the Government of Dubai said that it would not stand behind its wholly-owned subsidiary Dubai World. So much for that implied government guarantee. For the past year, vast government guarantees have boosted markets around the world on the belief that sovereign nations don't default. There's no need to actually do any due diligence into the value of the assets backing the debt if the government is just going to step in and bailout the lenders. Except that sometimes, governments change their minds. Certainly emerging markets have been guilty of this in the past, so you'd think investors would have learned their lesson. But with near-zero interest rates permeating the globe, it's that much easier to ignore these risks and plow head-first into risky investments, some with a host of massive unfinished construction projects around the world, just because some government is supposed to bail you out. Not all bailouts will stand the test of time. Defaulting on your debt is theoretically supposed to make it extremely difficult for you to borrow money at reasonable interest rates in the future, if at all. But if a few adventurous sovereigns start to do it, then the stigma related to default might just go away. So how does that make you feel about Fannie and Freddie's debt? GE Capital's? How about GMAC?

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