A visitor takes a photograph at Ski Dubai, an indoor ski slope in a shopping mall in the emirate.
A visitor takes a photograph at Ski Dubai, an indoor ski slope in a shopping mall in the emirate.

In an article for the New York Times, Andrew Ross Sorkin looks at the lead-up to the financial collapse in Dubai, and argues that Dubai built its banking reputation on Islamic financial instruments that were not in fact Shariah-compliant, were no different from interest-based bonds, and were “mathematically equivalent to conventional debt and mortgage contracts.”

Here’s the story:

A Financial Mirage in the Desert

By ANDREW ROSS SORKIN
Published: November 30, 2009

The investments were supposed to be blessed, and the bankers were desperately looking for more people to bless them.

It was about two years ago, and I was in Dubai to cover an investment conference at a hotel along Jumeirah Beach. Hundreds of Western bankers dressed in Savile Row suits were packed into an enormous room to bone up on the intricacies of the next new thing in financial products: Shariah-compliant investments.

They wanted to sell them to wealthy, oil-rich Muslim investors who needed a way to increase their fortunes but whose options were limited. Any investment vehicle needed to conform to the spirit of the Koran, which forbids any investments that pay interest. No mortgages. No bonds. No clever derivatives. Just tangible assets in the so-called real economy.

It was a big honey pot — worth as much as $1 trillion that could yield billions in fees — and the bankers were determined to find a way in.

Jumeirah Beach, Dubai, site of an investment conference.
Jumeirah Beach, Dubai, site of an investment conference.

One discussion was led by a British banker from Barclays who had moved to the region to create an entire Shariah-compliance team. He shared tips about various ways to create “structured products” that would pass muster with Muslim investors. (To me, the investments looked like bonds, walked like bonds and talked like bonds — but he never called them that.) Some of the bonds that Dubai World is in jeopardy of defaulting on, by the way, are Shariah-compliant sukuk. Just don’t call them bonds.

He was struggling to hire enough Shariah scholars, he said, and he needed them to bless the investments — apparently there was a shortage of properly trained Islamic scholars who did this kind of work.

With the benefit of hindsight — and you didn’t need much — there were plenty of other signs back then that Dubai was building a financial mirage in the desert.

With hours to kill before a late-night flight, I ventured over to the Ski Dubai indoor ski run. It’s a pretty good bet that a city with an average temperature of 90 degrees and an indoor ski slope is probably living a little too large. On one ride up the chairlift, I sat next to a 7-year-old from London who had just moved to town. With a big grin, he proudly told me that his father was in “the real estate business.”

For the last couple of years, the running joke on Wall Street was “Dubai, Mumbai, Shanghai or goodbye.” If you were the C.E.O. of a troubled investment bank desperately looking for cash, you made a pilgrimage to one of those three cities with hat in hand. They were the places most likely to write a quick billion-dollar check; their eagerness should have also been a tip-off. Now you have to wonder about Mumbai and Shanghai, too. Are they next in line to take a fall?

Willem Buiter, a former Bank of England official who was hired as chief economist of Citigroup on Monday, says that Dubai’s credit crisis is just the natural progression of “the massive build-up of sovereign debt as a result of the financial crisis.” He wrote on his blog on The Financial Times’s Web site that the contraction of credit “makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral.”

With all the money pouring into the region, it would have been hard for any doomsday types to make themselves heard. But there were whispers here and there, pointing out the obvious. David Rubenstein, the co-founder of the private equity giant Carlyle Group who was in Dubai at the conference, remarked to me at the time: “You know, they don’t have any oil here.”

That fact was overlooked by many investors who didn’t want to miss out on a quick buck. What about the risk? The view was, and apparently still is, that if Dubai gets in trouble, its oil-rich neighbors in Abu Dhabi will bail everyone out to avoid damage to their collective reputation and, by extension, the region’s economy. Just as the United States stood behind its banks, in part, to avoid losing the confidence of foreign investors, Abu Dhabi might have to do the same.

That had to be what Citigroup, with its firsthand expertise with bailouts, must have been thinking when it lent $8 billion to Dubai last year. Oh, and here’s an interesting fact: Citigroup made the loan to Dubai on Dec. 14, 2008. Take a look at the calendar — that’s after it received tens of billions in TARP funds. Citigroup’s chairman, Win Bischoff, said at the time, “This is in line with our commitment to the U.A.E. market in general, and reflects our positive outlook on Dubai in particular.” Good call. And what became of all those Shariah-compliant financial instruments that were the hot topic of that panel I attended? It turns out that many of them that were sold prior to the crisis weren’t compliant at all.

The Shariah Committee of the Accounting and Auditing Organization for Islamic Institutions, which is based in Bahrain, ended up changing the rules to make them stricter because of widespread abuse. As Mr. Buiter described them on his blog, “these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts.”

Blessings, alas, can do only so much.