Wednesday, December 02, 2009

Dubai: news & thoughts about the crisis

The National Day in the UAE has quieted the flow of news on the Dubai World debt crisis, which is on its way to becoming more of a Nakheel debt crisis (although there are certainly other companies within Dubai World like Limitless with debt issues). A press statement (pdf) released by Dubai World on December 1 clarified what will and will not be included in the restructuring:
”The proposed restructuring process will only relate to Dubai World and certain of its subsidiaries including; Nakheel World and Limitless World. The process will not include Infinity World Holding, Istithmar World and Ports & Free Zone World (which includes DP World, Economic Zones World, P&O Ferries and Jebel Ali Free Zone), all of which are on a stable financial footing. The total value of debt carried by the companies subject to the restructuring process amounts to approximately US$26 billion, of which approximately US$6 billion relates to the Nakheel sukuk.”
The restructuring process is described in several phases:
”It is envisaged the restructuring process will be carried out in an equitable way for the overall benefit of all stakeholders and will comprise several phases including: long term plans and commitment of stakeholders; determination of maintainable profit and cash generation; assessment of deleveraging options, including asset sales; assessment of funding requirements and the formulation of restructuring proposals to financial creditors and their implementation.”
In short, this sounds like they are going to assess the willingness of creditors to delay repayment for quite a while, then determine whether the businesses have a chance of being profitable and capable of making a profit over that period of time. From there, they will dispose of whatever assets fall outside the profitable parts of the businesses to reduce the debt load on the companies.

While that sounds like a good idea (find out how you can make a profit to pay debtholders), I think it comes down to finding out whether there is any way that the businesses included in the restructuring can repay the debts either through asset sales or through future profitability and then adjust the expectations of the creditors with that reality, which will likely lead to a sharp haircut. The terms of the restructuring that will happen will probably be somewhat negotiated through the media if the investors think they are getting a bad deal. The negotiations are just getting under way

The other event that happened today is a general revaluation of the risks of the other Dubai-linked companies. S&P downgraded six GREs (DIFC Investments, DP World, Dubai Holding Commercial Operations Group, Dubai Multi Commodities Centre Authority, Emaar Properties and Jebel Ali Free Zone to high-yield from investment grade (with the exception of DMCCA which was previously rated BB). In their note, they state that under their ratings criteria “a standstill is a default”. Additionally, “Standard & Poor’s is of the opinion that, as evidenced in the case of Dubai World and Nakheel, the Dubai government is either unable or unwilling, or both, to provide extraordinary government support”.

This last note is the reason for the downgrade and for a lot of the frustration by investors who believed that the government would support the government-related entities, even though they were not legally obliged too. Reuters has a good description:
“‘Companies such as Dubai World can no longer be seen as having the protection of their respective governments. This is true all over the region and not just in Dubai," said Anshuman Jaswal, an analyst with Celent, a Boston-based financial research and consulting firm.

Foreign banks had lent to Dubai government-linked firms on the implicit understanding that they were backed by the UAE -- the world's third largest oil exporter flush with cash from a six-year boom in oil prices.

‘Something that has irritated international investors is that the government distanced itself from Dubai World, which legally speaking is true, but morally speaking, they had gone out of their way before to make that tie,’ one investor said.”
In contrast to that view, Prince Alwaleed says that investors made poor assumptions about the government backing for the GREs, “These banks are very mature banks, and they have to differentiate between a corporate loan and a sovereign loan”.

The Dubai crisis still has a way to go before it is resolved and the impact of the restructuring (of Nakheel more than any other sukuk) will see a return of the uncertainty that plagued the sukuk markets after the AAOIFI ruling and the Saad & Algosaibi, East Cameron Partners and The Investment Dar sukuk defaults. The sukuk market was just returning to a ‘new normal’ with slower growth and smaller sukuk from higher quality issuers than before the crisis, but there were sovereign sukuk from the Islamic Development Bank, Dubai, Indonesia and quasi-sovereign sukuk from the World Bank’s IFC and high-grade sukuk issued by Petronas and GE Capital. This will continue although there will probably be higher yields on non-sovereign government-related corporate to compensate for the “Dubai World” risk that the government might step away in a default.

The Dubai crisis has done one thing; it has empowered the critics of the Islamic finance industry. In the cases where the suggestions are positive this is a great thing. The industry has not done everything perfectly and still has many gaps where a second-best alternative has been adopted (e.g. commodity murabaha/tawarruq for liquidity management). There are also some over-engineered products that do not serve the benefit of anyone but the people who put them together. Critiques of these areas is justified, particularly when sukuk like the Nakheel sukuk which is in essence a relatively simple, uncontroversial structure (with a couple bells & whistles like the pre-IPO rights feature), can lead to such great confusion on the part of investors.

However, other critics argue that Islamic finance should have emerged unscathed from the credit crisis had it not created financial products that mimicked those used in conventional finance. This is false and the longer the recession has continued, the more apparent this has become. Islamic finance is no panacea. It is vulnerable to the economy’s booms and busts and we are definitely facing the latter on a worldwide scale. To deny that an industry that bills itself as being more connected to the real economy than conventional finance could be susceptible to a recession in the real economy, especially this deep into the recession, seems to me to be denying reality.

It has been clear to me that the credit crisis would have an impact on the Islamic finance industry, although not by the same transmission mechanisms as conventional finance. The impact would be secondary. As I wrote in February 2008, “In my opinion, however, the credit crisis does not pose much of a threat to the industry; not because it is fundamentally insulated from the conventional financial industry but because oil prices are still high. The stability of the Islamic financial industry will face its greatest test if oil prices drop significantly, something not particularly likely unless the credit crunch produces a significant fall in demand across the world.”

I underestimated the impact of the credit crisis at that point, but as the recession deepened and oil prices began to fell, I reevauated the impact of the recession on Islamic finance. In October 2008, I focused on the impact of the property bubble that was starting to burst: “Islamic financial institutions are realizing that they're exposed to the credit crisis through their investments in the GCC real estate market which has begun to slow.” Now, the property market collapse in Dubai is spreading into the sukuk market. Fortunately, the UAE Central Bank has stepped in to minimize any transmission from the sukuk markets to the banking institutions, including Islamic banks. If the systemic risk from the Nakheel sukuk is limited, then—amid the writedowns by investors—the Islamic finance industry will have passed another test and should come out stronger on the other side.

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