Dubai's Debt Woes Could Further Unhinge U.S. Commercial Real Estate Sector

Stock markets around the world cracked on Friday with the Dow Jones industrial average down more than 150 points (Fig. 1), and commodities plunging as Dubai debt woes unnerved investors, and sent tremors of uncertainty throughout all markets.

The crisis flared after Dubai, a part of the United Arab Emirates (UAE) federation, asked to delay interest payment for six months on $60 billion of debt issued by the state-run conglomerate Dubai World and its main property unit Nakheel.

Concerns that a government-backed investment company risked default ripped through world markets. Investors read it as a sign of yet another sovereign implosion after Iceland and Ireland, and recoiled from risk and piled into dollars.

Las Vegas on Steroids

Dubai World has served as Dubai's main driver of growth, operating ports, transportation groups, spearheading real-estate & infrastructure projects both at home and abroad. Its real-estate subsidiary Nakheel built Dubai's iconic palm-tree-shaped island, packed with luxury villas and hotels, many still under construction. Real estate and construction accounts for about 23% of Dubai’s GDP.

With little oil, Dubai financed much of this rapid real estate development with debt. After incurring its estimated $80-$90 billion of debt in a four-year construction boom to transform its economy into a regional financial and tourism hub, Dubai suffered the world’s steepest property slump in the first global recession since World War II.

Deutsche Bank (DB) estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World's largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

On a global scale, Dubai World's debt problem seems relatively minor, but it illustrates the impact from one tiny country in an increasingly interconnected world. The Dubai news also cast doubt over the strength of the U.S. economic recovery, and the prospects for a bottoming of property prices.

Commercial Real Estate

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.” The Dubai debt crisis further reinforces this viewpoint.

The potential for contagion from Dubai's debt woes could further unhinge an already fragile U.S. commercial real estate sector, whose values have already fallen 42.9% from their 2007 peak, close to the lowest since 2002, according to Moody's. (Fig. 2) The latest Moody's projection is for prices to bottom at 45-55% below their peak, but could drop as much as 65% from their peak in a "stress case".

As commercial property values fall, debt defaults rise. The $3.4 trillion
outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession.

Housing Market Mortgage Crisis

So far, the appearance of recovery in the housing sector is being driven primarily by reduced prices combined with federal programs to lower mortgage rates with the goal of bringing more buyers into the market.

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it's becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since the report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn't expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai's moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai's own general creditworthiness. UBS cautioned that Dubai's overall debt "might be higher" than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation, however, is that there's a good chance that Dubai's problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won't risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year's Lehman Brothers (LEHMQ.PK) collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis. The debts of many emerging markets have risen even further as the countries' governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

Author's Disclosure: None

Comments

[Faisal Humayun]

Through the present policies, the Government and the Fed are sure that they can solve almost any problem in the world by printing money...So, if we have more trouble, there will be some more money printing...

For sure the global economy is still on shaky grounds...The recovery in the economy has been largely lead by Government spending where the private sector is still shrinking or stagnant...The recovery in asset markets have been largely lead by easy money which has fuelled speculation on all asset classes...

Thus, things are just being made to look good and I would not be surprised if the Government comes out with another stimulus package next year to try and make things look even better superficially...

2009 Nov 29 02:32 AM

[Dave Wrixon]

Yep, the biggest Banana Republic doesn't even grow that many bananas.


On Nov 29 02:39 AM chris coonan wrote:

> When California started writing IOU's to pay for services in the
> private sector, it wakened my interest in Government Default.

2009 Nov 29 06:18 AM

[conceptwizard]

Dubai World owners were caught up in the same heady debt-fueled commercial construction-binge that swept across the United States. The problem can be traced back to lax lending standards and low interest rates. Now demand has fallen off a cliff and credit is getting tighter. Dubai World can't roll over its debt or meet its obligations. That's what typically happens when credit bubbles burst.

On Thursday, Bank of America analysts issued a statement: “One cannot rule out — as a tail-risk — a case where this would escalate into a major sovereign default problem, which would then resonate across global emerging markets in the same way that Argentina did in the early 2000s or Russia in the late 1990s.”

First, it illustrates that the financial crisis is not over---households, businesses and countries are still deleveraging. This ongoing process will slow spending and increase defaults, bankruptcies and foreclosures. Government guarantees and stimulus programs will not reverse prevailing trends. More incidents like Dubai World should be expected. These "credit events" will disrupt the recovery and spur greater risk-aversion which will push stocks downward.

Second, when these incidents take place, there's likely to considerable collateral damage from the unregulated insurance policies (credit default swaps) which underwrite the bonds. These CDS derivatives are not sold on a public exchange so no one knows who holds them, in what amount, or whether the issuer has sufficient capital reserves to pay off claims. We should expect a repeat of AIG over and over again (although smaller) until the system is either regulated or CDS are banned. The bottom line, is that the current financial architecture is not designed to work; it is designed to make a handful of speculators very rich. These speculators own congress, the White House and the financial media, which is why there has been no meaningful change in regulations.

2009 Nov 29 08:45 AM

[Dian L. Chu]

I notified SA editors that Fig. 1 is missing here. Before this is corrected, please feel free to read my post with original title and charts on my blog or Zero Hedge. Thanks.
Dubai: Floating on an Island of Debt dianchu.blogspot.com/2...
www.zerohedge.com/arti...

2009 Nov 29 09:26 AM

[a. palmer jr.]

I don't think the Dubai resorts have the same amenities that Las Vegas has, gambling, drinking, prostitution, etc., which is part of the reason many people go to resorts, I think. Someone might have checked that out before lending them all that money. But they didn't check anybody else either, so.... This Dubai resort would be similar to starting an Amish liquor store, in my opinion.

2009 Nov 29 09:31 AM

[Fred Pollack]

One tie-in of Dubai World with US Commercial Real Estate is the $8+B City Center project in Las Vegas. Dubai World and MGM Mirage (MGM) are partners in this project. Here is a link to an overview that I found:
www.lvrevealed.com/art...

2009 Nov 29 09:47 AM

[nym]

I find Figure 3 unreadably small here, on your blog and at zero hedge.

2009 Nov 29 10:30 AM

[Tack]

The linkage between Dubai World and U.S. commercial realty prospects and cashflows is virtually nonexistent. This article, like most "scare pieces" has a provocative title and raises fears without demonstrating any relationships or causal effects other than self-fulfilling fear.

In fact, U.S. commercial realty entities may represent one of the best "bottom-fishing" opportunities in the market today. Share prices in the sector have been decimated, on a percentage basis, far beyond any past downturn, even though projected maximum default rates are not appreciably different than the 1989-1992 contraction. Debt and preferred shares in many commercial-realty entities represent especially good yields, while affording atypical capital appreciation opportunities.

2009 Nov 29 10:36 AM

[Moon Kil Woong]

Yes the US also has it's own vast overbuilding of commercial real estate that is sitting vacant. Unlike Dubai, the banks in the US have a fertile ground of depositers that they can sibsidize these losses with by fees and exorbinant interest rates. And then if that fails they can just change the rules and ask for even more accounting lienience or ask the Federal Reserve to buy up the debt or backstop it in case they don't want to monetize it by taking bank risk and transerring it to the taxpayer.

All in all, Dubai's situation is more transparent because it's less corrupt.

2009 Nov 29 11:07 AM

[aardvark]

The basic problems: First.How do you fill shopping spaces when people can't afford to shop? Second.How do you fill office spaces when business will be contracting as the US tries to compete on an aggressive international scale without lowering living standards? Where do you expect a demand for commercial real estate to come from when basic innovation for climate change and energy alternatives are considered irrelevant? Third. Depreciation will continue to accelerate as usage of commercial space declines which will impact an array of financial insturments originally based on explosive growth expectations.


On Nov 29 10:36 AM Tack wrote:

> The linkage between Dubai World and U.S. commercial realty prospects
> and cashflows is virtually nonexistent. This article, like most "scare
> pieces" has a provocative title and raises fears without demonstrating
> any relationships or causal effects other than self-fulfilling fear.
>
>
> In fact, U.S. commercial realty entities may represent one of the
> best "bottom-fishing" opportunities in the market today. Share prices
> in the sector have been decimated, on a percentage basis, far beyond
> any past downturn, even though projected maximum default rates are
> not appreciably different than the 1989-1992 contraction. Debt and
> preferred shares in many commercial-realty entities represent especially
> good yields, while affording atypical capital appreciation opportunities.

2009 Nov 29 11:48 AM

[fwi]

Dubai could not get where it was without the US financial system. THe notion that a couple of European countries have the exposure to Dubai is really false, in my opinion. At the very least, the USA and its financial derivatives empire "insured" and cross-insured these investments in DUbai. Of course, the money centers are vulnerable. The USA/AIG abomination? Of course.

El-Erian at PIMCO I really respect, but these guys were not positioned correctly for this one. Hence his statement on CNBC that this Dubai thing is an event, not a crisis. As soon as they are positioned correctly, I will bet that they change their tune.

Another comment was made that CRE is a great buy, and someone else argued the point that the occupancy rates just are not there. I agree with the latter--even if you believe that a genuine (not government induced) recovery is underway, businesses will continue to "right size" offices. For example, law firms, traditionally large leasers of space do not need as much, as the new law associates coming out of law school now , do most of their own word processing--hence no need for as many secretaries, work spaces, etc. And with the health care uncertainty , employers would rather upgrade the computers (who don't require health insurance) than hire a person or two.

2009 Nov 29 12:45 PM

[Tack]

In reply to a couple posts:

1) Dubai is already a non-event. The UAE has announced its backing its own and foreign banks. End of story. All the diatribe about unraveling and linkages is just the usual kind of stuff that appears every time the markets have a hiccup.

2) Regarding CRE, the mistake that many (most) people make in evaluating CRE is that they talk in absolute, rather than in relative, terms: "CRE is going to contract, rents will fall, values will fall, etc., etc....."

The realities are as follows:

1) The CRE industry, as a whole, has not suffered a single negative net-income or cashflow quarter --not one--throughout this entire crisis, so far, while everybody's been screaming that the sky's falling and that the shoes will drop.

2) Projected defaults, from multiple sources, not just industry insiders, have been pegged to max out at around 5.5% in 2011. That's not noticeably different than the 1989-1992 recession. Commercial realty financiers had the advantage of seeing the residential meltdown and most have aggressively sold assets, paid down debt, extended maturities, raised capital and added to reserves, so they're well positioned to ride out the storm.

Just the other day, one of the largest developers, DDR, completed a $400MM bond issue that was so oversubscribed that they didn't even use TALF funds or guarantees. Does that sound like an industry on the verge of collapse?

3) In spite of the above, during this recession CRE operators have seen their share prices plummet 80%, 90% and more from highs, way off the charts compared to other recessions, e.g., the 1989-1992 period mentioned. Some entities have recovered some value during the recent rally, but, as a whole, price still remain very depressed, both for common and for preferred shares.

The point remains valid --at least in this investor's opinion-- that CRE, properly researched, offers unusual opportunities because valuations are out of sync with actual current and projected performance.

2009 Nov 29 01:44 PM

[bob adamson]

Yes, recent events relating to Dubai World are a timely reminder that there are a lot of barely manageable local commercial and governmental debt bubbles across the world.

No, this particular commercial crisis will probably not morph into a default crisis for Dubai, the UAE or anyone else. There are too many indications that this crisis is being well managed from the tactical standpoint. The timing of the announcement before US and Islamic markets were largely in lengthy slow gear holiday mode and the announcement of qualified support by the UAE for Dubai banks but not necessarily for Dubai World. Both these steps set the stage for Dubai to negotiate with some tactical advantages with its creditors including creditors of Dubai World. The creditors will be forced to take a haircut; Dubai’s wings will be clipped. And defaults will be avoided.

Yes global markets will be more edgy about the sovereign debt default possibility for various weak sisters around the world but, unless one of these implodes soon, the economic and stock market implications will be minimal and transitory in the near term.

Yes, as the global recession recovery remains anemic, there will be other crises in other sovereign debt situations elsewhere in the world over time. Hopefully these will be handled as well as the foregoing suggests the Dubai World one is being handled. At some point in the future (hopefully after the economy becomes more buoyant and reforms to investment banking and related matters are being implemented with sufficient international consensus) the G20 augmented by India and Brazil and perhaps others may collectively agree to a controlled process to unwind the global debt bubble including some haircut element for creditors.

Perhaps, over the next ten or more weeks, the ‘buy on the dip’ stock market will continue in place for a while longer.

2009 Nov 29 04:09 PM

[snagglesnarf]

Dubai has only a few hundred thousand citizens and 60 billion dollars of debt. What genius banker decided this was an acceptable credit risk?

2009 Nov 29 10:10 PM

[LKofEnglish]

great article as usual on our interconnected world. the idea that this is just some blip has been proven wrong by the media--black friday isn't the news, is it? and it's not like the media wants to talk about this story in any negative way, either. witness CNBC which didn't even cover the story when it broke--then only covered it with a "small amount for a non-oil nation" bent on friday as the stock market plunged. hmmmm. can you say WORRIED TO DEATH. lot of media bucks coming HOPEFULLY from Dubai perhaps? what was it that inspector Cluseau said in the Pink Panther movie? "That WAS a priceless Steinway" but "not anymore." we'll never know the scale and scope of this disaster because the clowns who bid this stuff up aren't talking. the markets are, though, which should make for an interesting week. that's why CNBC aptly names one of their shows "squawk box." we've got SQAUWKIN' goin on when all those former bankster types are screaming for silence. i see this as supportive of "free money" Ben and so believe it to be yet again another bullish sign for the American economy and stock market but absolutely terrible once the inevitible inflation comes roaring in like a virtual Katrina that has already blown apart our financial "levy system."

2009 Nov 30 12:15 AM

[globalview99]

The greater risk that Dubai highlights is that many countries who underwrite private development, which is most of the world, are in a similar situation facing sovereign default due to high debt, declining GDP, lower revenues, deleveraging and the credit squeeze.

But like Retail (think Walmart, Target, specialty fashion shops) , CRE has it's prime operators (Boston Properties, et al) whose portfolios are top draw with manageable debt levels who wwill get stressed out but will not break. Others who bought cookie cutter properties at high prices and over-leveraged will be thrown to the proverbial wolves.

To what extent will we see sovereign default and CRE defaults by big property owners remains to be seen. But this is not 1989-92 redux. The economy then was in fundamentally good shape, just lost momentum due to Bush 41's (read my lips: no new taxes) tax increase. This time will be different, but how different is anyone's guess. Stay tuned.

2009 Nov 30 04:34 AM

[DeepValueTrader]

It will likely trigger temporary huge market meltdown soon.

2009 Nov 30 01:37 PM

[bob adamson]

A good background article on the Dubai situation in the electronic version of The Economist today. See link below.

www.economist.com/busi...

2009 Nov 30 07:14 PM

[bob adamson]

The following article in today's 'The Australian' describes the subsidiaries of Dubai World that are the subject of the proposed restructuring.


www.theaustralian.com....

2009 Dec 01 02:02 AM

[Youri Carma]

The more conservative rich brother Abu Dhabi and UAE saved the day for Dubai and Dubai World again, which is not the same thing is stressed by Dubai, so it’s time for some good PR in which “reassurance” is the key word.

Although Dubai likes to down play the situation a little bit, for obvious reasons all together, it has taken a severe blow in the real estate market with price drops as much as 50% in a very short time and in some areas it still may go down in this double whammie global crises but, understandable.

This is merely an interlude to awaken the professional “soldiers” in the negotiation business like Rothschild, on the Dubai World side and KPMG who’s going to act as the sparring partner on the HSBC, Royal Bank of Scotland and Lloyds side. That’s going to be an interesting match.

But with an eye on an uncertain future one can’t help to wonder if this really is going to be their final meeting. When the future hasn’t arrived yet one tends to be more optimistic which unfortunately, looking at the current fundamentals, don’t show for. But to stay realistic, not everybody can say he has such a rich brother living next door. Hopefully the Black Swan will stay away this year, and it probably will but next year could be different.

Current trends show future events and if we look at Iran and the United States today we might get a little worried.

The Geopolitics Of The Dubai Debt Crisis: It's Iran vs. The United States tinyurl.com/y9xom8s

2009 Dec 02 01:02 AM