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.
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.
Filed under Financial Crisis, Islamic Banking Dubai by on Dec 9th, 2009. Comment. 
Palm Jumeirah – a palm shaped island off Dubai - cost over $12 billion USD to build, and is still underpopulated
Expensive Real Estate Investments Precipitated Financial Crisis
Hock’s Viewpoint – By Choong Khuat Hock
The Star Online
THE financial turmoil arising from the Dubai debt crisis is merely one of the visible signs that the excesses from the debt fuelled asset bubbles are continuing to surface.
Dubai World, incorporated only in 2006, managed to accumulate debts amounting to US$60bil as it went on a shopping spree. Some of the assets like Emirates Airlines and DP World (which controls over 50 ports worldwide) are quite attractive. Others like the QE2 cruise liner and a stake in MGM Mirage (Las Vegas gaming operation) are more ostentatious but it was the expensive real estate investments that precipitated the financial crunch when demand dried up.
Excessive Real Estate Developments
Dubai World had spent over US$12bil on Palm Jumeirah – a palm shaped island off Dubai. Other than the super luxury Atlantis Hotel and some residential units, the island remains under-populated.
Other developments include The World – a group of artificial islands costing US$14bil to build. As money ran out, some of these islands are facing erosion.
The soon-to-be completed Burg Dubai, towering over 800m or almost twice the height of Petronas Twin Towers, has become an epitome of past excesses. No doubt Dubai has achieved a lot but excesses built on debt often crumble when credit is removed.
Hidden Liabilities
The true liabilities are probably higher as there may be commitments to finish construction of ongoing property projects. When investments banks like Lehman failed, the true liabilities were higher as the bank used many off balance structures to mask the true level of gearing.
Special purpose vehicles (SPVs) were set up to lure investors in and the investment bank would earn fees for structuring the deal and managing the SPVs, which often geared up to buy asset-backed securities.
Other ways to hide liabilities are to get associates to borrow or to guarantee loans taken up by friendly parties as was the case in Enron. Fortunately for Dubai, Abu Dhabi, the richest of the seven emirates forming United Arab Emirates (UAE), has the financial muscle to help Dubai.
Abu Dhabi has the largest sovereign fund in the world estimated at around US$700bil-US$800bil, and the sixth largest proven oil reserves in the world. Failure to resolve the issue would result in loss in confidence not only in Dubai but also in UAE and the Middle East in general.
Nevertheless, Abu Dhabi is likely to demand something in return for its help while Dubai is likely to seek a haircut from the banks for US$26bil of loans to be restructured. Dubai World may also have to sell stakes in some of its crown jewels to Abu Dhabi or other investors.
Default by Dubai Could Impact the Islamic Debt Market
Any default by Dubai would also result in large losses by UAE banks. In an interlinked world, European banks with large exposure like RBS, HSBC and Standard Chartered would also have to make provisions.
Banks had lent assuming implicit state guarantee and were carried away by the over-optimism that Dubai’s property market could only go up. The Dubai debt crisis could also adversely impact the sukuk (Islamic) debt market which has already seen a sharp decline in issuance. Islamic banking often structures interest as a profit-sharing venture but under Islamic principle, there should be a sharing of profits and losses.
Many Islamic scholars and the Bahrain-based Accounting and Auditing Organisation for Islamic Institutions have stated that Islamic bonds with quasi-principal protection are unislamic as it goes against ethos of Islamic finance.
Holders of Islamic bonds might find that they are competing with a general body of creditors rather than being paid first if they are holders of conventional bonds. The possibility of not being ranked above normal creditors could hurt the valuation of Islamic bonds.
The Dubai World bonds are unsecured and have a form of principal protection.
The bonds are governed by English law and should it go to court, the verdict by the British courts would have tremendous ramifications for the Islamic bond market including Malaysia’s substantial Islamic bond market. Is the principal protection legal or Islamic? How would the Islamic bondholders rank?
Other Debt-Fueled Asset Bubbles
Other than Dubai, trouble lurks for countries that had indulged in debt fuelled asset bubbles. The Spanish economy was so geared towards real estate that when the bubble burst, unemployment surged to 24%, a level that is as high as the level in the US at the worst of the Great Depression. Great Depression conditions also exist in the Baltic states where the economies have collapsed.
The gross domestic product (GDP) of Latvia plunged by 18.4% in the third quarter compared with a year ago while unemployment surged to 15%. Swedish banks have the largest exposure to the Baltic states while German and Austrian banks are exposed to some of the ailing Eastern European countries.
When the dust settles, investors are likely to differentiate among countries. Countries with large debts and current account deficits are particularly at risk. It is no wonder that Vietnam, with a current account deficit, has had to devalue twice.
Investors are also getting jittery on highly indebted countries like Japan, Mexico, Ireland, Greece and many Eastern European countries.
Fortunately, Malaysia enjoys a current account surplus and a stable banking system but Malaysian construction companies which were keen on development projects in bubble economies like Vietnam and the Middle East will become more cautious on such projects.
US banks could also be sitting on a potential time bomb in the form of commercial real estate loans, estimated at US$1.7 trillion. US banks may not have fully written down the loans and the day of reckoning will come when around US$500bil of the loans mature over the next few years.
Most exposed are the regional banks. No wonder they are reluctant to lend despite ample liquidity, starving small and medium enterprises of funds and slowing any recovery in employment. Nevertheless, a collapse of the banking system is unlikely as the Fed and other central banks have discovered a new weapon – print money to inject capital or liquidity into troubled banks.
Printing money may become the preferred tool as borrowing becomes more difficult.
Even the cost of Japanese debt is rising. Its savings rate fell from 15% in 1990 to only 2% currently. A series of fiscal stimulus has boosted its debt to GDP from 60% in 1990 to 180% currently. Japan cannot continue to rely on domestic savings to fund its fiscal stimulus.
In the US, money printing is even more tempting especially as the government is expected to post a budget deficit of 12.3% of GDP this fiscal year and high unemployment makes tax hikes difficult.
With so many minefields in the form of hidden debts and crouching defaults, it is no wonder that the Fed and other central banks have decided to flood the financial system with liquidity hoping that it would help the situation through lower debt servicing and higher asset prices.
The sea of liquidity may cover up the minefields to provide an illusion of normality but some of the minefields will continue to explode from time to time. Flooding the system with liquidity would just delay the clearing of these minefields.
Choong Khuat Hock is head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd.
Filed under Financial Crisis, Islamic Banking News by on Dec 7th, 2009. 2 Comments.
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