Dubai World Restructuring: Sovereign Risk Shock or No Big Deal?

Today, a story about the need to restructure state-owned Dubai World created a bit of a frisson. Dubai is proposing to delay debt payments as it negotiates to extend maturities. According to Bloomberg:

Dubai World, with $59 billion of liabilities, is seeking to delay debt payments, sending contracts to protect the emirate against default surging by the most since they began trading in January.

The state-controlled company will ask creditors for a “standstill” agreement as it negotiates to extend maturities, including $3.52 billion of Islamic bonds due Dec. 14 from its property unit Nakheel PJSC, Dubai’s Department of Finance said in an e-mailed statement. Moody’s Investors Service and Standard & Poor’s cut the ratings on several state companies, saying they may consider the plan a default.

“Extending the maturity of Nakheel debt is feeding the market’s uncertainty on which debt Dubai will honor in full,” said Rachel Ziemba, a senior analyst covering sovereign wealth funds at New York-based Roubini Global Economics. “They look desperate and the market is concerned that in the long term Dubai’s indebtedness is rising not falling.”

Dubai accumulated $80 billion of debt by expanding in banking, real estate and transportation before credit markets seized up last year. Contracts protecting against default rose 116 basis points to 434 basis points yesterday, the most since they began trading in January, ranking it the sixth highest-risk government borrower, according to credit-default swap prices from CMA Datavision in London. The contracts, which increase as perceptions of credit quality deteriorate, are higher than Iceland’s after climbing 131 basis points in November, the biggest monthly increase since January….

Investor concern is growing because the emirate hasn’t disclosed how it will pay more than $9 billion of debt coming due in the next four months. Dubai said yesterday it borrowed $5 billion from Abu Dhabi government-controlled banks, half the $10 billion Dubai ruler Sheikh Mohammed Bin Rashid Al-Maktoum said he planned to raise by yearend.

“There is no clarity about what exactly is happening,” said Emad Mostaque, a London-based Middle East equity-fund manager for Pictet Asset Management Ltd., which oversees more than $100 billion globally. “They have to clarify if there is going to be a voluntary rollover or if there is going to be a forced rollover. If there is a forced rollover it will mean technical default. If they don’t clear this up then the whole market will want to sell.”

Dubai, the second biggest of seven sheikhdoms that make up the United Arab Emirates, and home to the world’s tallest tower and the biggest man-made islands, suffered the world’s steepest property slump in the global credit crisis as home prices fell 50 percent from their 2008 peak, according to Deutsche Bank. UBS AG predicted a further 30 percent drop in a report last week.

Yves here. On the one hand, there has been a reassuring announcement:

The Department of Finance said yesterday it raised an additional $5 billion from two Abu Dhabi lenders as part of its $20 billion Dubai support fund geared toward meeting its financial obligations.

However, Dubai is seeking a standstill on its debt while it renegotiates. I’m not a credit default swaps expert, but that sound like an event of default to me, and if so, that has the potential to have all sorts of repercussions. First, creditors who are not fully hedged who are subject to mark to market reporting will show significant losses. Second, the CDS protection sellers will also be showing losses and posting collateral.

One analyst has already deemed the risk to be overblown, and if the restructuring happens quickly and does not involve much in the way of losses to creditors, this indeed may not be a big deal.

But I got a message from someone who was on the conference call that suggested otherwise. Some European banks may be on the wrong side of this trade. As readers may know, EuroBanks went into the crisis with even lower capital levels than their US counterparts, and have taken fewer writedowns of their dodgy exposures:

The standstill announcement…was a massive surprise. One could sense the panic in those asking questions….this could be the turning point in spreads and could be viewed similar to the Russian debt crisis in 1998 or the Bear situation in 2007…based on companies and the accents of the people asking questions, it is obvious European institutions will be hit hard…Dubai made this announcement at the beginning of a four day holiday, so there will be little news until next week…There is another wave of pain out there. This information does not seem to be making its way to other markets. It will.