About a year before the news of the Dubai World quasi-debt default became headline news across the world, an event occurred on that well travelled stretch of highway between Dubai and its oil rich neighbor Abu Dhabi that bears re-telling.
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A Perfect Metaphor
On an usually foggy Tuesday in March 2008, a minor car collision on that highway quickly transformed itself into what would later be described as one of the world's biggest automobile pile-ups. A total of 60 vehicles were involved in the disaster resulting in 347 injuries and six deaths. Local police were later quoted as saying that speeding and the lack of safe distances between vehicles where contributing factors during a morning devoid of "human caution."
All this seems to be the perfect metaphor for what has now happened in Dubai: a mad rush through the fog with a predictably unhappy ending. The question now on everyone's mind is how many victims will wind-up slamming into this financial pile-up?
A Big Hit, But Contagion Unlikely
Already the first line of casualties are being tallied with the big British banks like Royal Bank of Scotland (NYSE:RBS), Standard Chartered (OTC:SCBFF) and HSBC(NYSE:HBC) holding a sizable chunk of the estimated $59 billion in exposure to Dubai.
U.S. banks appear to have much less at stake, holding only an estimated $9.9 billion in loans with Citigroup (NYSE:C) owed about $5.9 billion and JP Morgan (NYSE:JPM) carrying about $2.5 billion. But even in some fairly worst case scenarios, potential credit losses for even the most heavily exposed lenders are estimated to only increase provisions in 2010 by about 5%.
Sizable amounts to be sure, but it pales in comparison to the massive $400 billion in exposure that American International Group (NYSE:AIG) was saddled with last year. Based solely on the relative magnitude of the numbers, it seems reasonable to take the view that Dubai's default is unlikely to morph into Global Debt Crisis 2.0, and recent strong rallies in Asian and European equity markets appear to confirm this.
Bye, Bye Dubai
But while the rest of the world may be justified in breathing a sigh of relief that the "contagion" risk, which threatened to bring on a cascade of sovereign debt default among other weak credits like Ireland and Greece now appears to be contained, Dubai itself now seems destined to deal with the consequences of its excesses for years to come.
Given the emirate's geographic remoteness, extreme climate and little inherent commercial reason for existing, generating reasonable value from all that half-finished property in Dubai is going to be near impossible now that the Dubai "miracle" is more correctly seen as a "mirage."
Moreover, its proximity to its neighbor, Iran, who now appears irrationally bent on provoking a major military confrontation with the west, is now likely to impose an additional geopolitical risk discount on the already distressed property prices in Dubai.
The Bottom Line
It's now obvious that Dubai is a complete mess, and its tribal cousins up the road in Abu Dhabi are unlikely to squander tens of billions of dollars to save Dubai and its creditors from the pain of their follies. Nobody who put their money into Dubai is likely to get all their money back.
For U.S. investors, the lesson here is that the scale of failure with commercial real estate can be quite spectacular. With recent data showing default rates on commercial real estate loans hitting the highest levels in 16 years, and projected to move even higher, the potential for a home-grown Dubai-style crisis remains a very real possibility. (For related reading, take a look at Investing In Emerging Market Debt.)
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