Investors are not elephants

Richard Kapsch

The financial world appears to have escaped the worst of Dubai’s request for a standstill in its debt repayments. But investors once more went for returns without considering the risks involved.

Elephants, we are told, have extremely long memories. Investors apparently do not. Nine days ago, Dubai officials asked creditors of Dubai World, one of the emirate’s major conglomerates, to agree to a standstill, until May 30, 2010, on debt repayments associated with Dubai World’s $59 billion worth of debt. The announcement threw international markets into turmoil. On Thursday (Thanksgiving in the US), emerging nations’ stock markets fell almost uniformly, with those markets in the developed world following suit. Since US markets were closed on Thursday, US stocks fell sharply when they opened on Friday.

By this past Monday, however, investors determined the news was not as bad as first believed and most markets recovered, except in the Middle East where markets had been closed for a religious holiday. While the government of Dubai said it would not guarantee Dubai World’s bonds (many creditors had assumed it would), the Central Bank of the UAE said it would stand behind local banks affected by the payment standstill. Investors also determined that Western banks’ exposure was minimal. So, while most investors would survive the Dubai crisis, it was obvious that the financial world had just dodged another bullet.

In our opinion, the Dubai crisis is simply another example of what we feel is a major failing among investors in general: a tendency to pour money into those investments that promise the greatest returns while ignoring the risk associated with those returns. While the Dubai situation was certainly not of the same magnitude as the Lehman Brothers bankruptcy, it still possesses many of the same characteristics.

In this article, we will try to support this premise while looking at the Dubai debacle in greater detail.

Background

For the last decade, Dubai had been the epitome of unbridled growth. The projects it has undertaken during this period have no parallel anywhere in the world: the world’s tallest hotel (84 stories, with an underwater restaurant), projects built on land reclaimed from the sea and shaped like palm trees or a map of the world, an indoor ski mountain (inside a shopping mall, to boot), the world’s tallest building (the Burj Khalifa, 810 meters - 2600 feet), the world’s largest indoor shopping mall (surpassing the Mall of America) and hundreds and hundreds of housing units. The money needed - and supplied - to build these projects seemed limitless.

The developers of these projects had no trouble raising those funds. Investors believed the government of Dubai stood behind every project. Investors also behaved as if every project was imbued came with a degree of moral hazard -- the fact that a party insulated from risk may behave differently from the way it would behave if it would be fully exposed to the risk. They couldn’t lose. And, if the backing of the Dubai government wasn’t enough, there was always the reassuring presence of the UAE government, backed by Abu Dhabi and all its oil money.

The Reality

I had the opportunity to visit Dubai in October, my first time back in almost seven years. I too was overwhelmed by the magnitude of the projects and the work that was going on. However, I was also struck by the work that wasn’t going on: two palm projects that had been started were virtually completed but a third, and larger, project had been started and abandoned. Office buildings stood as empty shells, the developers (smaller than Dubai World) having already gone bust. Many of those hundreds of residential projects looked like ghost towns in the middle of the desert.

People I talked to in Dubai said they thought the government was committed to completing the projects. They said that Dubai wanted to show it could still move forward. I wasn’t so sure. I wondered who would occupy the new offices, who would live in the housing developments.

According to a census conducted in 2006, the population of Dubai was 1,422,000, of which 1,073,000 were males and 349,000, females. Based on a 1998 breakdown, 17 percent of the population (about 240,000 in 2006 terms) was made up of UAE nationals, the rest were expatriates. Of the expatriates, 85 percent were Asian, with a little more than half of those from India.

These numbers were of course compiled before the global crisis. When the crisis hit Dubai and real estate development slowed to a standstill, there were stories of droves of expatriates driving to the airport, abandoning their cars, and fleeing the emirate.

Many experts believe that, as the global economy recovers, Dubai will recover as well: the expats will flock back and business will continue as before the crash. I believe the events of the last week are a signal that business will not return to normal. There are a number of reasons why. First, Dubai must find the funds to service its existing debt. Dubai World had an estimated $59 billion in debt. Moody’s has estimated that the emirate’s total debt approaches $100 billion. Dubai recently received $10 billion from Abu Dhabi. That’s a long way from $100 billion.

Second, Dubai will need to find additional financing in order to be able to complete the projects currently underway. The UAE central bank said that it would stand behind regional banks that had lent to Dubai institutions. But that doesn’t mean they will be ready or willing to lend in the near future. Nor will European banks, even though the exposure of those banks in the current crisis was relatively minimal.

Third, expatriates will be in no rush to return to Dubai, unless the economy recovers more rapidly than is now expected. And finally, without a dramatically expanded expatriate base, it will be exceptionally difficult for Dubai to find enough buyers for the hundreds of housing units under construction. Much of the housing that was purchased in the past decade was for "spec" purposes, in a bubble-like scenario. Any housing that is sold in the future will have to be to people wanting to occupy their units. But the Dubai government does not make it easy for foreigners: resident visas are good for six months only, are difficult to come by, and are onerous to renew. With UAE nationals constituting only about 17 percent of the total population, it is unlikely that this policy will be changing soon. In addition, outright ownership of property will certainly continue to be "off the table". So we don’t expect a return to the "boom" times.

Lessons Learned

There were several factors leading to Dubai’s problems, with the primary cause being the overreach of ambitious developers and fed by an easy access to financing. With apparently unlimited funds available, their plans knew no bounds.

Dubai’s expansion arose initially from the desire of Dubai’s rulers to create an economy that would compensate for Dubai’s lack of oil (when compared to its rich neighbor). Dubai first created free trade zones and other lower-key projects that would enable the emirate to function as a commercial hub, becoming, in effect, "the Singapore of the Middle East." As money began to flow in, however, Dubai developed financial centers, media centers, shopping malls and, ultimately, the headline-grabbing projects mentioned earlier.

Investors poured money into the Dubai projects, expecting extraordinary returns. Those investors included both individuals and institutions. The biggest lenders, outside the region, were the British: British banks held as much as $5 billion worth of of Dubai World debt alone.

For the better part of the decade, the returns were extraordinary, with property values showing steady appreciation, year after year.

Risk appeared to be minimal. The markets moved in only one direction: up. And just about every one believed his investment was guaranteed by the Dubai government (wrongly, as they were to later learn).

The events in Dubai were eerily reminiscent of the events leading up to the "Asian contagion" of 1997-1998. At that time, countries like Thailand and Indonesia were offering the same type of returns Dubai promised. In the years leading up to the Asian contagion, lenders simply threw money at Thai and Indonesian borrowers, only to be burned when the bottom fell out of the markets. Ultimately, the "contagion" almost brought down the global financial system as well.

What investors in Asia in 1997, with Lehman Brothers in 2008, and in Dubai in 2009 seemed to forget was that returns don’t come without risk: the higher the expected return, the greater the associated risk. There are no exceptions in this relationship.

In 1997-1998, the investors believed they compensated for the risk through complicated mathematical models. In 2008, triple-A ratings assigned by the ratings agencies to sophisticated investment vehicles led investors into a false sense of security. In 2009, the lenders assumed that any losses would be made good by the Dubai government. In all cases, they were wrong.

With the exception of a number of Middle East investors, and individuals who had the misfortune to buy residential properties, which may or may not ever be completed, or even built, the fallout from Dubai will be limited. But the fact that many investors will escape unscathed will no doubt lead them into a false sense of security. By the time the next "opportunity" rolls around, they may not be so lucky, unless they somehow develop long memories.