Why the Dubai "debt freeze" gives early warning to investors everywhere...
The DUBAI DEBT STORY is more like Bear Stearns than Lehman Brothers, writes Dan Denning in Melbourne for the Daily Reckoning Australia.
Meaning the news from Dubai could be the catalyst for fund managers and traders to take profits on all of their 2009 winners. This could lead to steep falls in emerging market stocks, including Australia.
But first things first. Dubai World is not nearly as large, leveraged, or systemically important as either Bear Stearns or Lehman Brothers were when those firms failed. For those reasons, it's unlikely that the failure of Dubai World (and we're not saying it will fail) would, by itself, cause a global deleveraging.
Dubai World has $59 billion in debt. That makes up the majority of the $80 billion in debt of Dubai itself. According to Reuters, international banks are exposed to $12 billion in debt. Incidentally, the Commonwealth Bank of Australia said it has exposure to Dubai but doesn't expect to make a loss.
There is some risk to CBA, no doubt, just as there is risk Dubai's other lenders. But it's nothing like the risk posed to the entire financial industry by Bear Stearns and Lehman Brothers.
For starters, the Bear Stearns High-Grade Structured Credit, and High-Grade Structured Credit Strategies Enhanced Leverage Fund were both massively leveraged. The first fund began with $600 million in assets but quickly borrowed on that to increase its asset portfolio to over $6 billion.
The trouble with that is Bear geared up to buy collateralized debt obligations (CDOs). It may not have known it at the time, but the CDO quality sucked. The CDOs were chock-full of subprime mortgages. In 2006 alone, $503 billion worth of CDOs were issued. It was a $2 trillion market by 2008. A fall in the value of Bear's assets – a big chunk of which were CDOs – was enough to wipe it out.
Dubai World is likely to be backstopped – at some point – by Abu Dhabi. And although we're sure it has its fair sure of property assets falling in value, Dubai World owns assets all over the world which it can sell. And, importantly, Dubai world is probably not a counterparty to many other financial arrangements in the same way Lehman Brothers was, at least as far as we know.
But still, you wouldn't be alone if you had an odd sense of déjà vu this morning. We'd say the Dubai affair is more like Bear and less like Lehman because it's a warning. Dubai may not be as systemically important as Lehman, but it is a reminder to all the world's investors that global financial markets remain highly leveraged. And we know what can happen next.
There are other, much bigger, and much more leveraged markets that pose far bigger risks to the global economy. For example, in the US, there is over $3.4 trillion in debt backed by commercial real estate owned by US banks. A presentation by a Federal Reserve analyst in late September suggests that the US banks have failed to set aside adequate capital to cover losses in commercial real estate. It's safe to say the US banking system – and by extension Australia's – would not survive another real estate collapse without major casualties.
And that is just one debt bubble. The other large debt bubbles are in China – which hedge fund manager Jim Chanos calls "Dubai times 1,000" – and in government debt worldwide. The China bubble and the US Treasury bond bubble are systemically important. And that's what we should be worried about now. But what's happening in the short-term is not quite what you'd expect.
Emerging market stocks are selling off. In fact, don't be surprised if Dubai is just the excuse fund managers use to take profits on a lot of 2009 positions. It will make this year's performance statistics look great by crystallizing a profit now. And who can blame a manager for being cautious?
Already the cost of insuring sovereign debt from default – as measured by credit default swap rates – is rising. Yes, it does seem a bit absurd that debt crisis in emerging markets is driving investors into US Treasury debt. But that's what's happening in the short-term. You may get a Dollar rally and lower short-term US rates.
How will Australian share markets fair, then? Good question. It depends on how the rest of the world views Australia. If it's viewed as essentially an emerging-market, commodity-related, high-yield risk asset play, stocks are going to get sold off. The Aussie Dollar will give some ground against the greenback. And the market will wait to see how exposed Aussie banks are to any of the bourgeoning debt bubbles.
The bigger issue is the exposure of the Australian economy to the Chinese economy. According to the government and the media, that is the difference maker for the Aussie economy. It's what guarantees future surpluses, growth, and prosperity. But if the Aussie economy is hitched to China on the upside, surely it's hitched to China on the downside too.
Not that any of this potentially catastrophic news should stop Aussie houses from getting bigger or more expensive! CommSec released a report yesterday showing Aussie houses are now the biggest in the world. The floor area of the average Aussie home is now 215 square meters. That's a 10% increase in the last ten years. Maybe Australians just need more living room!
The world's growth is built on a debt bubble. The bubble is popping. Dubai is a tiny bubble by comparison. The bigger pops are coming.