The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Feb. 25. With permission, we're reproducing it here in its original form.
Of the myriad statistics that demonstrate just how badly the global financial markets had lost their minds in the late 2000s, this one, to me, is the most mind-boggling.
In 2007, you could buy credit default protection on Dubai for four basis points.
OK, let me break this down another way. Let's say you owned $10 million in debt guaranteed by the government of Dubai and wanted to insure it against the risk that the government wouldn't have enough money to pay you back. If you decided to buy a swap that would pay you $10 million should Dubai default, the cost would have been $4,000. Four grand to get 10 million in protection!
And because it's a swap, you didn't even have to own $10 million in debt; you could just speculate that things would be worse than expected for Dubai and make a massive profit.
Remember, in 2007, oil had hit $140 per barrel, sending gushers of money to the oil sheikhdoms in the Middle East -- measured in the billions of dollars per week. Dubai default? How?!?
Here's what four basis points means: The market believed that Dubai would default one year out of 25,000, despite its economy being dependent on revenue from oil, a commodity that has at times suffered spectacularly volatile price swings.
Dubai's rulers believed it, too. They built one new downtown -- now anchored by the Burj Khalifa, the world's tallest building at 2,400 feet. Then they started building another, with hundreds of thousands of square feet of office, hotel, retail, and residential space. Just inland, construction continues on Al Maktoum International Airport, which will, at 160-million-passenger annual capacity, be the world's largest, by far.
Dubai accomplished its plan to become an elite tourist destination and financial center to perfection, except for two things. First, for an oil sheikdom, Dubai is blessedly devoid of oil. Sure, the United Arab Emirates, the country which Dubai became a part of in 1971, has tons of oil and gas, but it is concentrated in Abu Dhabi. In turn, Abu Dhabi has provided much of the financing for Dubai's building boom (sometimes quite resentfully so).
The second problem is that sometimes entities with ultra-low borrowing costs start to believe that they are bulletproof. In 2009, Dubai World, Dubai's massive state-owned conglomerate, had to restructure $26 billion of its estimated $60 billion debt load. It was only a $10 billion rescue package from Abu Dhabi that spared Dubai World (and thus Dubai) from default.
"Look around you," one slightly defensive Emirati exhorted me, "Dubai isn't in a crisis anywhere except in real estate."
He was right. Dubai's ports and airplanes were full, its centuries-old position as a major trading center for the Middle East well and truly intact. Warehouse space in Dubai ranges from expensive to unavailable.
But saying everything in Dubai is OK "outside of real estate" is sort of like saying that a flight was really great except for the part where it crashed. Dubai's torrid growth over the past 20 years has property values at its core. While Dubai's strengths as a trading and transportation hub as well as its popularity as a tourist destination remain untarnished, collapsing property values may still prove to be the cause of the emirate's economic collapse. More Dubai debt comes due this year, and it's an open question whether the emirate will make good.
You've seen pictures of partially built casinos in Las Vegas, abandoned houses in California, deserted neighborhoods in Florida. In Dubai, developers have stopped building islands. Just off the coast near the oldest part of Dubai stands a bridge to nowhere, the moorings of a multilane highway that may someday whisk people to the Palm Deira, which may someday be the world's largest man-made island.
Lest you lament the loss of a giant island in the shape of a palm tree, the good/bad news is that Dubai has two more of them, the already completed Palm Jumeirah, and the completed but abandoned Palm Jebel Ali, plus an offshore (also largely mothballed) project to recreate the world. All told, an estimated $300 billion in planned real estate projects in Dubai lie in purgatory. Others have (and continue to) come online simply because the path of least resistance was to open and hope for the best rather than allow the massive sunk cost to founder.
In the end, Dubai can't get out of its own way. You see buildings by the dozen with cranes on top, beautiful graphics promising massive new developments, and meanwhile, according to Deutsche Bank, property values in the emirate have dropped 62% on average from their peak, with rents not far behind at a 54% decline. Even just thinking about Dubai's property market from a basic economic perspective, it's a bit much to ask investors to buy into existing projects or homes when there is the promise or the potential for an almost ceaseless amount of additional supply. In January, values dropped another 2%, with no real catalyst in sight to turn things around.
Property developers in the United Arab Emirates have had their shares crushed over the past few years, with firms like Emaar, Deyaar Development, and Aldar trading at less than half their tangible book values. Book value for property companies is always a funny thing, because the value yield is deeply affected by liquidity. If you have a house in Dubai, you can probably sell it for close to going market rates without too much problem. But if you have thousands of square feet of office space, or hundreds of houses, or acres and acres of land, you can't flood the market and liquidate them at once. You'll never get anywhere close to the cash value that the market says these combined units are worth.
This is Dubai's big problem, which makes it Abu Dhabi's problem as well. Oil and gas revenues in the UAE are skyrocketing once again, which gives the country on the whole a bit of protection. But at the end of the day, the rulers in Abu Dhabi in particular may have to decide whether it's better to throw good money after bad and guarantee Dubai's debts, or to let the system wash clean by letting bad investments run their course. I predict the former. Not only would a Dubai default be extremely painful for Abu Dhabi, but Abu Dhabi, which has occasionally displayed public displeasure at its upstart neighbor, may see it as an opportunity to bring Dubai to heel.
"You'd think this place is paradise, turns out lots of people who come here to live don't like it that much."
My friend was right, Dubai seems downright unreal, a proud member of that small fraternity of cities where the superlative can seem downright commonplace: Las Vegas, Orlando, Singapore, Dubai, Shanghai. It's rare that you meet an Emirati, some estimate fewer than 10% of the people in the UAE are natives.
Dubai is Arab. It is an Islamic society, but long experience as a global trade center has created a sense of tolerance greater than elsewhere in the Middle East. And while Dubai has an extremely active, decadent nightlife, there are constant reminders (including the ferocious cost of alcohol!) that this is no go-along-to-get-along society.
There is no path to citizenship for foreign workers living in the UAE. Further, the government practices an overt form of discrimination. The amount of pay a worker will receive for a job is directly tied to his nationality of origin: Indians earn less than Egyptians, who earn less than Europeans. And Dubai is certainly a young person's realm -- foreign retirees are much less welcome to remain in the country than the actively employed.
The end result is that many people's relationships with their adopted home are more transactional than emotional, something that author Christopher Davidson refers to as "rentier pathology." It's easy to love Dubai; it's truly a magnificent city. But talk to people who spend lots of time here and you begin to hear a refrain: Dubai's polyglot nature leaves it culturally rudderless, it's difficult to meet Emiratis, the city's great desire to reinvent itself on an ever-grander scale comes at a cost of bulldozing its past. (Unexpected observation: I asked several Western expats who lived in Dubai which place in the Middle East they enjoyed the most. The majority said Saudi Arabia, the reason being that it was a place where they could most easily interact with locals. I'm not making this up).
I spent my last evening in Dubai with an old college friend who expressed ambivalence at raising his family in a place where the greatest landmarks were primarily shopping centers. He's been in Dubai for nearly 20 years and clearly loves his life there, the fact that in Dubai you truly feel like you are in the center of everything. Dubai's (and the UAE's) political situation is quite stable. The Emir is genuinely beloved and admired for having wrought such an economic marvel out of so little. But the financial condition of the city is an open question, simply because the property overhang is just so huge.
Dubai is a miracle, a place that has taken its best attributes (location, location, location ... and the weather) and maximized their importance. It has won the battle over much larger, better-heeled cities in the region to become the economic and commercial center, the Singapore of the Middle East. But what happens if its financial crisis overwhelms it? Dubai cannot manage its debt load without either a miracle or a benefactor, or both. Given the unrest throughout the Middle East, it's quite possible that neither will be forthcoming. What then?
For further reading I suggest:
Arabia by Jonathan Raban (from 1979, still an amazing primer on the Middle East)
City of Gold: Dubai and the Dream of Capitalism by Jim Krane
Dubai Dreams: Inside the Kingdom of Bling by Raymond Barrett
Best English-language local news source: Al-Jazeera, or any Egyptian taxi driver
Best English-language news source actually from the UAE: Gulf News
Secret ingredient for interior decorator at Burj al-Arab Hotel: More gold
Under-the-radar restaurant in Dubai: Al Beyt Al Baghdadi
Editor's note: Bill Mann is not able to engage in discussion on the boards or in the below comments section. Bill does not own shares of any companies mentioned.