Dubai Debt Derivatives Doubts

One mystery of the Dubai debt crisis is the extremely limited information about derivatives contracts for Dubai debt. Credit default swaps protecting debt holders were rising rapidly in price last week as the crisis reached a head. That's hardly surprising, nor is it terribly significant from a systemic question.

The key question is whether we have another AIG--i.e., a financial institution that wrote a large portion of the credit default swaps, or insurance, for Dubai debt protecting debt holders in the event of a default. AIG made a concentrated bet on the value of the real estate market, without any government agencies knowing until it was too late. U.S. taxpayers paid the price. Although the AIG situation should serve as the impetus for meaningful reform of the derivatives market, Wall Street banks have been lobbying vigorously to limit change. Efforts at reform in Europe haven't made much progress, either.

Thus, there is no easy way for regulators anywhere in the world to figure out whether the derivatives risks stemming from the Dubai debt crisis are under control or not. It appears that the banking system of the United Arab Emirates, of which Dubai is a member, is at significant risk. The UAE central bank has already announced a new credit facility to support its banking system. This is what central banks typically do--protect the banking system but not the debtors. Investors holding Dubai debt, especially those in Europe and the U.S., might not benefit much from stabilization of the UAE banking system.

Abu Dhabi, Dubai's oil-rich neighbor, has announced that it will support select Dubai companies, but will not provide blanket protection for Dubai debt holders. In addition, Abu Dhabi may not pay out debt holders 100 cents on the dollar. One suspects that Abu Dhabi will select those companies whose defaults would seriously injure Abu Dhabi's banks and citizens. Holders of other Dubai debt will likely be left looking for any port in the storm.

The problems aren't necessarily limited to Dubai. These crises always have secondary and tertiary effects. Some market participants are getting nervous about debt of other UAE members, and also the debt of certain nations in Eastern Europe and elsewhere. What if credit default swaps for the debt of these other nations were written by a major financial institution that also wrote a lot of Dubai credit default swaps? A major Western financial company could be in serious trouble, but there's no straightforward way to find out if this is the case.

The Dubai crisis is a reminder that the financial crisis of 2007-08 has continued into 2009, as the global economic slowdown takes its toll wherever leverage was used in abundance. And that would include lots of places. Banks worldwide continue to sit on substantial potential losses from residential and commercial real estate. And consumer loan losses have grown along with rising unemployment levels. We're still in the woods, even if some green shoots are visible.

European and U.S. banks have said little or nothing about their Dubai/UAE exposure. Their regulators have said even less. Very possibly, everyone's still scrambling trying to figure out where the problems are. The possibility of another AIG cannot be ignored. After all, the number of financial institutions that are large and well-capitalized enough to be credible issuers of credit default swaps would be quite limited, especially after the AIG mess. If there is a financial institution with concentrated Dubai/UAE/whatever risk, it will probably be a large and well-known one in Europe or the U.S.

Since Abu Dhabi and the UAE won't fully protect holders of Dubai debt, it goes without saying that they won't protect any Western financial institution that's hurting from writing too many Dubai credit default swaps. Perhaps large financial institutions have learned from the AIG experience not to concentrate too much risk in credit default swaps. Then again, movement up the learning curve cannot be assumed. Would it not be possible that Dubai debtholders were willing to buy credit default swaps from a single large dealer because they would anticipate another AIG-style 100 cents on the dollar bailout if bad things happened? Would the Fed hold the line and make them take losses? Or do we think that its still vivid memories of Lehman's collapse would lead it, once again, to speed up the printing presses and churn out more dollars?

As we write this blog, Asian shares are up 2% or more in the belief that the Dubai crisis has been overblown. Maybe so. But remember that it took 15 months or more for the impact on AIG of the real estate and credit crises to become publicly known. And even if there is no AIG, Part Deux looming in the future, the sudden shakiness of a lot of developing world debt will probably lead major banks to pull back even further on lending, contracting the money supply all the more so, and creating more drag on economic activity.

The Dubai crisis illustrates how the government interventions of the last year have slowed, but not prevented, the deleveraging process. Market forces will have their way sooner or later, one way or another. A lot of potential bad debt remains extant, which means that deleveraging will persist for years and demand for credit default swaps will continue to be strong. The risk of another AIG is real, and substantial reform of the derivatives market should be undertaken now, before the Fed and Treasury Department fail in their quest to prevent a second Great Depression.