Holders of sovereign debt are not having a very good week. Last weekend, beleaguered conglomerate Dubai World reportedly was thinking of asking creditors to accept a settlement of 60% of the face amount of their debt, or taking a debt for equity exchange. The Dubai stock market dropped away when this story ran, even though Dubai World denied making such a proposal and Dubai debt holders rejected the proposal that Dubai World denied making.
At the same time, the Greek government and EU authorities swapped proposals. The EU wanted the Greeks to put together a detailed program of fiscal reform and the Greeks wanted the EU to announce a detailed bailout package. Aside from issuing dueling press releases, both sides largely eschewed progress.
Neither the Dubai debt kabuki theater nor the EU-Greece Alphonse and Gaston routine disturbed stock markets. From Asia to Europe to North America, stocks rose today, with the Dow Jones Industrial Average increasing almost 170 points on an unexpectedly positive manufacturing report and a drop in the dollar, along with some favorable earnings reports. The stock markets' bounce is bad news for sovereign debt holders.
When a debt crisis clobbers the stock market, governments have to step in. Recall how the mortgage crisis made nervous Nellies of stockholders in 2007 and 2008, forcing the federal government to take over Fannie Mae and Freddie Mac. Then, when the collapse of Lehman Brothers imperiled AIG and Merrill Lynch, the government bailed out AIG, paying its creditors 100 cents on the dollar, and persuaded (that's one way of putting it) Bank of America to purchase Merrill. When Congress initially rejected the TARP legislation in the fall of 2008, the stock market tanked, voters' 401(k) accounts nosedived, and outraged constituents berated Congress back to a second vote that heartily endorsed TARP.
But when the stock market holds up, governments have more latitude to step back and just say no to creditors. That throws the battle for repayment back into the more traditional arena of contention between debtor and creditor, with taxpayers on the sideline.
Since the 2008 government subsidized sale of Bear Stearns to J.P. Morgan Chase, this has been the best of all possible worlds for creditors. Whenever they could conjure up even a faint specter of systemic risk, stock markets panicked and governments paid them out, often at 100 cents on the dollar, no matter how reckless their loans had been. The more stocks dropped, the more leverage lenders had to put the squeeze on taxpayers. But when stocks hold steady or rise, the creditors' cries of wolf sound less compelling. If the stock markets correctly assess that these crises aren't systemic threats, the music will stop playing at creditors ball. As shocking as it may sound, bond holders may have to bear risk and losses.
To be sure, short term price movements in the stock market are often misguided, and the picture may be quite different by the end of this week or the beginning of next week. The European debt crisis doesn't appear to be in a hurry to let up; news stories of a time bomb outside J.P. Morgan Chase's Athens, Greece office indicate that someone's trying to instigate something. The Dubai situation hasn't materially improved since it first blew up last fall, which means that it's deteriorating. Debts fall due as time passes, and the more time that passes in Dubai with no progress, the closer we get to defaults. So taxpayers shouldn't breath easy yet. Lenders may yet find a way to pick their pockets.
Showing posts with label Dubai debt. Show all posts
Showing posts with label Dubai debt. Show all posts
Tuesday, February 16, 2010
Thursday, February 4, 2010
The Sovereign Debt Crisis: A Constitutional Moment for Europe?
After today's 268 point drop in the Dow Jones Industrial Average, it's clear that the sovereign debt crisis has investors rattled. What started late last year as a smallish, but high profile anticipatory default by Dubai last fall, quickly smoothed over with a partial bailout from Abu Dhabi, has morphed into a European problem. Greece seems to be in the worst shape among Euro bloc nations, with credit default swaps for its debt imitating a jack-in-a-box. Portugal, Ireland and Spain increasingly receive unflattering coverage in the financial press. The wealthier Euro bloc nations--Germany, France and the Netherlands--noticeably squirm when the news coverage turns to the question of bailouts. The European Union puts on the appearance of threatening to get a buzzcut and administer tough love. But it's hard to imagine that the EU would actually give Greece the boot. That would almost surely result in Greece defaulting on its sovereign debt, which would escalate the pressure on other weak European nations and turn the crisis into a panic. It would be like letting Lehman Brothers fail, only on an international level. We remember how the Lehman thing turned out.
So a European bailout, however distasteful to French, German and Dutch palates, is likely. The question is what conditions the bailors will impose. The problem is that the European Union prescribes fiscal conditions for membership (i.e., member nations are supposed to limit their governmental budget deficits to 3% of gross domestic product), but doesn't have much control over member nation finances. While the EU can kick out offending members, that's a nuclear remedy that can't feasibly be used in the real world because it would only make things worse. But handing over bailout Euros would reward the profligate nations at the expense of the prudent ones. (Does this sound familiar to American taxpayers?) The German, French and Dutch may refuse to simply write checks.
Europe is facing a dilemma not unlike the newly independent United States in the 1780s. The Revolution had been very expensive, and both the individual states and the Continental Congress incurred substantial debt to pay for the war. At the same time, their ties to each other were far weaker than today, while their differences led to no end of commercial disputes and debates about who should pay the Revolutionary War debt. The infant democracy was in danger of falling apart, and convened a constitutional convention to try to redraft the nation's legal framework. The result, so deeply flawed that it led to a bloody civil war 72 years later, was nevertheless workable enough that today we still limp along with it, in somewhat amended form, in spite of the legislative dysfunction it allows where Senators need to work only when 60 of them are so inclined. But one benefit of the Constitution adopted in 1789 was that the newly reconstituted United States government assumed responsibility for all Revolutionary War debt, whether incurred by the states or the earlier government under the Articles of Confederation. Thus, the price of a national bailout of the states was a far stronger federal government.
Just as the original thirteen American states couldn't afford to splinter apart, with covetous, imperialistic European nations waiting to snatch them up, the European Union cannot afford to splinter apart. This is not so much about the economic benefits of unification--lowering trade barriers and other costs of doing business and thereby spurring production and growth--as it is about the renewed financial crisis a failure of the European Union would create. But to hold the EU together and legitimize the bailout(s) for the electorates in the wealthier member nations, greater authority would probably have to be given to the central government in Brussels, especially over fiscal matters. Getting there would be difficult, just as the drafting and ratification of the U.S. Constitution was difficult. But survival may well depend its success, and necessity is the mother of invention.
If the EU achieves greater fiscal unity as a result of the sovereign debt crisis, its populace can take comfort from the world's recent rediscovery that prudence is a better long term strategy than profligacy. And other big spenders--such as Japan, the U.K., and, of course, the United States--should take notice that lunches aren't free, not even for sovereign nations, even if it takes a while to get the bill.
So a European bailout, however distasteful to French, German and Dutch palates, is likely. The question is what conditions the bailors will impose. The problem is that the European Union prescribes fiscal conditions for membership (i.e., member nations are supposed to limit their governmental budget deficits to 3% of gross domestic product), but doesn't have much control over member nation finances. While the EU can kick out offending members, that's a nuclear remedy that can't feasibly be used in the real world because it would only make things worse. But handing over bailout Euros would reward the profligate nations at the expense of the prudent ones. (Does this sound familiar to American taxpayers?) The German, French and Dutch may refuse to simply write checks.
Europe is facing a dilemma not unlike the newly independent United States in the 1780s. The Revolution had been very expensive, and both the individual states and the Continental Congress incurred substantial debt to pay for the war. At the same time, their ties to each other were far weaker than today, while their differences led to no end of commercial disputes and debates about who should pay the Revolutionary War debt. The infant democracy was in danger of falling apart, and convened a constitutional convention to try to redraft the nation's legal framework. The result, so deeply flawed that it led to a bloody civil war 72 years later, was nevertheless workable enough that today we still limp along with it, in somewhat amended form, in spite of the legislative dysfunction it allows where Senators need to work only when 60 of them are so inclined. But one benefit of the Constitution adopted in 1789 was that the newly reconstituted United States government assumed responsibility for all Revolutionary War debt, whether incurred by the states or the earlier government under the Articles of Confederation. Thus, the price of a national bailout of the states was a far stronger federal government.
Just as the original thirteen American states couldn't afford to splinter apart, with covetous, imperialistic European nations waiting to snatch them up, the European Union cannot afford to splinter apart. This is not so much about the economic benefits of unification--lowering trade barriers and other costs of doing business and thereby spurring production and growth--as it is about the renewed financial crisis a failure of the European Union would create. But to hold the EU together and legitimize the bailout(s) for the electorates in the wealthier member nations, greater authority would probably have to be given to the central government in Brussels, especially over fiscal matters. Getting there would be difficult, just as the drafting and ratification of the U.S. Constitution was difficult. But survival may well depend its success, and necessity is the mother of invention.
If the EU achieves greater fiscal unity as a result of the sovereign debt crisis, its populace can take comfort from the world's recent rediscovery that prudence is a better long term strategy than profligacy. And other big spenders--such as Japan, the U.K., and, of course, the United States--should take notice that lunches aren't free, not even for sovereign nations, even if it takes a while to get the bill.
Sunday, November 29, 2009
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.
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.
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