This is an edited transcript of the response given during our live Market Briefing on Thursday the 3rd of December, 2009, by Nils Marchant.
The Question
I have been asked: “What will be the effects of the Dubai World crisis on the market?” I treat financial news delivered with such emotional over-reaction with suspicion. The media often elaborates news out of proportion.
The Situation
The Dubai government controlled “Dubai World” can’t repay interest on at least US$60B of debt, possibly more than US$80B. Dubai is one of seven semi-autonomous United Arab Emirate states. Dubai World invests in shipping and other transport businesses, and property development.
Dubai World experienced problems earlier which saw UK, German and other banks lend more to Dubai. It is estimated UK and German banks have $50B and $10B exposures, respectively, but those figures can not be confirmed. I believe that the UAE government has not agreed to bail out Dubai World and cover their debt obligations.
The German government announced today that the Bundesbank is taking emergency measures to shore up German banks to prevent another wave of debt crisis. It is not clear whether this was caused by the Dubai World. The Bundesbank has revealed German banks face a further 90B euro of write downs.
Reality
The best reflection of reality are market prices. Although UAE stock market prices fell significantly, as did some European financial institution stocks, global markets have remained relatively steady. Market prices do not verify the media’s cause for concern. Therefore the Dubai World crisis appears not to have damaged global market perception. When you trade stock options, price is reality.
Fundamentals
To gain an insight into possible scenarios we need to understand the world’s perception of future reality.
As the old saying goes, if you can’t repay your bank $60B, it is the bank who has a problem, not you. The risk of default by Dubai World not only destroys investor confidence in the lending banks, but more significantly, it destroys confidence in what should have been good quality debt. The potential Dubai World default further undermines trust in credit ratings, and casts further doubt on the trustworthiness of bank balance sheets around the world, as has been happening since 2007. The Dubai World crisis is simply another case of supposedly good quality debt going bad, and this has been happening around the world for two years now. We have warned before the global financial crisis that it is not possible now to trust the value of assets underpinning large financial institutions. Search for the word “trust” in “A Fundamental Overview of the US Financial Market”, which we presented at our Market Briefings in early 2008.
Bail-Outs
There is talk of a bailout. But bail-outs can’t fix the problems which underly the global financial crisis. The GFC was not caused by a lack of money in the system, so injecting money doesn’t fix the underlying problem. Rather than fixing the problem by establishing misplaced trust and delusional security, bail-outs amplify the underlying problem by rewarding bad practice and creating moral hazard.
Financial Prudence
The Dubai World crisis demonstrates that the underlying problems indeed have not been fixed. They reconfirm that the recent lack of financial prudence has been widespread and large. Even those in positions of high financial authority get caught up in the euphoria of asset bubbles. (See “About Tulips and Other Bubbles“.) Despite trillions of dollars injected around the world, problems such as Dubai World remain.
The Real Problem
We have long argued that the problem underlying the GFC is a problem of trust between lenders and borrowers, of trust in credit ratings, and of serious failures in financial regulation. Because the regulatory and prudential environment has not been fixed it is possible that more serious problems such as Dubai World lurk waiting to be discovered. Trust can evaporate very quickly, but trust takes much time to restore.
There is a great incentive to hide problems such as that of Dubai World. In a sense a game is being played between major players of who can hide their problems the longest, until the problems are fixed by others.
Innovative Instruments
To comply with Sharia principles, some of the Dubai World debt is structured in non-standard ways, as “sukuks” or Islamic bonds. Unravelling rights and obligations in the event of a default will not be straight forward. Sukuks add to the mountain of opaque structured investment vehicles, such as collateralised debt obligations. New complex non-standard financial instruments such as CDOs and sukuks will likely require lengthy court battles to reach settlement. The unknowability of any future outcome is increased.
Conclusion
Surprises like Dubai World further undermine trust in the global financial system. The global financial crisis will not be over until trust is restored in credit ratings and balance sheet asset valuations. That will take a long time, especially while it remains possible to hide balance sheet difficulties behind “mark to model” guidelines.
Dubai World is simply another reconfirmation of the consequences of over-extended borrowing on false hope. It is very possible that more such cases will emerge. Personally I have not had any bank or financial investments for at least four years. I still have no reason to return.
The lack of market reaction suggests the markets were not as surprised by Dubai World as was the media. From the lack of market reaction it appears that wider market sentiment has factored in a few more such surprises. Therefore if the rate of further surprises can be kept low, debt defaults might not cause market sentiment to turn negative. However, sentiment might not be able to cope if too many large default scares occur too rapidly. This underpins the incentive to hide problem assets instead of dealing with them. And one possible consequent scenario of hiding big problems is that the problems get bigger, with delayed but worse consequences.