Perhaps motivated by AHI’s thorough five-part post demonstrating its serious repercussions, the government of Abu Dhabi announced on Monday that it would be injecting $10 billion into Dubai to fund Dubai World’s upcoming sukuk (Islamic bond) payment and to provide working capital for Dubai World through next April.  In doing so, Abu Dhabi averted plunging Dubai and the entire universe of Islamic finance into the unknown world of sovereign bankruptcy without rules.

I can sleep at night, knowing my assets are invested in Dubai

Background: During December 7-11, I posted five parts on the upcoming sovereign bankruptcy of Dubai World, a shock of the first magnitude whose consequences that will reverberate for years if not decades.

Part 1 deals with the Dubai double standard of relations between debtors and creditors.

Part 2 reveals while the banking system, and by extension the world, now has a massive new problem.

Part 3 shows why this is a watershed event from which there is no going back.

Part 4 covers why the invention of bankruptcy in seventeenth-century Massachusetts was a critical advance in finance.

Part 5 asks the question, whither Islamic finance?

Just as one cannot overstate the threatened default, Abu Dhabi’s action is every bit as significant.  While the crisis is by no means over, this seeming flinch is more likely the beginning of wisdom, and the global maturation of the United Arab Emirates, and through them, of the world of Islamic finance.

I’ll use as texts three sources: Sunday’s Washington Post (Palatino), Monday’s Wall Street Journal (Arial), and a personal email from Charles E. Smith (Times New Roman), author of the article Economy Liberty and the Official Law Books in Colonial Massachusetts, which delves percipiently into Massachusetts’ invention of bankruptcy was a critical global innovation (referenced at length in Part 4 of the original post).

We begin with what Abu Dhabi did:

DUBAI – Dubai said Monday [Deceber 14, 2009 – Ed.] that it has received a $10 billion bailout from neighboring emirate Abu Dhabi to pay part of the debt held by conglomerate Dubai World and its struggling property unit Nakheel.

Past tense verb: has received.  Critical to show the cash now.

Of the amount, $4.1 billion will be used to repay Nakheel’s Islamic bond, or sukuk, that matures Monday. The remainder of the funds will be used to finance Dubai World’s needs up until the end of April 2010.

Keep those Nakheel flags flying?

By this action, Abu Dhabi has paid the creditors – removing the immediate threat of monetary default – and also funded a debtor-in-possession capital reserve that will keep Dubai World operational until roughly the next sukuk payment is due.

“We are here today to reassure investors, financial and trade creditors, employees, and our citizens that our government will act at all times in accordance with market principles and internationally accepted business practices,” Sheik Ahmed bin Saaed Al Maktoum, chairman of the Dubai Supreme Fiscal Committee, said in a statement.

“What, me worry?”

Sheik Ahmed affirms market principles

The affirmation is important: by it, Dubai acknowledged its subservience to the market and to international financial business practice.

All this was necessary to avoid financial chaos.  As I published last Monday (December 7):

From the beginning of this extensive post, I’ve been positing that one should ignore all the warm words emanating from the emirates, which are mere palliatives, and instead look at the brutal facts:

1. Dubai World has repudiated its debts and announced a monetary default.

2. Abu Dhabi is not making any commitments to guarantee the shortfall.

3. Creditors have miserable alternatives since they cannot repossess the collateral and will have to sue the sovereign.

4. The enforcement provisions of Islamic finance are untested.

The global financial markets read Dubai’s actions the same way I did, and during the week I was posting – AHI gets results! – the Dubai capital markets collapsed. 

What damage could a single default do?

The Islamic bonds, or sukuk, had been trading around 110 cents to the dollar before the government shocked investors on November 25 with a request for a six-month standstill on the debt of state-linked Dubai World.

The announcement sent the sukuk down to mid-40 lows –

A 60% drop is equivalent to the Dow falling from its current level [10,500 as of Monday, December 14 – Ed.] to 4,500. 

Kind of like this

Panic in the sheiks.

Watch out

– but closed on Friday at about 54 cents to the dollar.

Fund managers and bankers regard Monday’s outcome as the litmus test for Dubai World’s planned $26 billion restructuring and Dubai as a whole for resolving its debt burden.

Just as during September, 2008, the US regulatory structure was placed under intolerable pressure to resolve Bear Stearns and head off a Monday bankruptcy filing, so too did the weekend soften Abu Dhabi’s initial intransigence:

“It’s very hopeful people (speculating),” says a Dubai-based fund manager. “It seems very strange that if Dubai World intended to pay they would have gone through the last two weeks of pain.”

Nonsense; like many another sovereign regulator, Abu Dhabi underestimated both the scale and the speed of the market’s OODA loop.  As when our financial markets went haywire two years ago, the Islamic markets had their Minsky Moment, with the possibility of Dubai bankruptcy shooting up:

Reflecting rising repayment hopes, five-year Credit Default Swaps for Dubai fell more than 30 basis points on Friday to 533 basis points, according to CDS monitor CMA DataVision, compared with a peak of almost 700 bps at the end of November.

The level is still high given the CDS was quoted at about 300 bps before the November 25 announcement.

All this occurred by Friday, and it was apparent Dubai was heading for a financial explosion this Monday:

Do something or you’ll go over it Monday …

If Nakheel does not pay on Monday, it would technically be in default, but it would still give its restructuring team a two-week grace period to reach an agreement with creditors.

December 28 is the final cut off point. After that a cross default clause in its original prospectus will be triggered that covers Nakheel and its guarantor Dubai World, adding to the overall debt burden.

As I pointed out last week, a financial implosion would certainly have destroyed Dubai as a global financial center:

Without Abu Dhabi, what is Dubai but a dot of sand in a hot part of the world?

What are the assets of Dubai worth without a thriving global economy?  Dubai has nothing to attract it – it’s hot, dry, isolated – except its tempting ways to spend Western cash money.  Without the non-stop flights, the glitzy hotels, and the spectacular resorts, who would go there? 

Especially with an archaic and punitive legal system (New York Times, September, 2009):

The overall uncertainty of Dubai’s legal system — especially the risk of doing jail time for debt — has prompted many expatriates to flee when they are in financial trouble rather than filing for bankruptcy and setting out a repayment schedule.

Capital is the world’s fastest asset, even faster than people.  By announcing its intention to repudiate the debts of its offspring, Abu Dhabi and Dubai are telling the entire world they are tricky counterparties.  People who have choices, and the capital they have, will flee.

Last week, the Islamic capital markets stated clearly that they were fleeing:

We’re afraid of the gnus

Dubai rocked world markets in late November when it requested a freeze on $26 billion of debt payments by Dubai World in order to restructure the conglomerate.

“I think Abu Dhabi saw the adverse market reaction to Nakheel debt restructuring news play out over several days and perhaps decided they had seen enough,” said Saud Masud, head of research at UBS AG in Dubai.

Clearly the AHI blog post was the tipping point.

If David writes one more word …

Analysts said Abu Dhabi’s decision to provide a further $10 billion to Dubai restored confidence in the federation.

With the default, Dubai World had been trying the same trick that George IV tried with his creditors: borrowing against the bond of blood, and seeking to welsh by denying the bond’s validity.

What then is the relationship between the sovereign and its offspring?  The question goes at least two centuries back, to the tumultuous relationship between George III and George IV. 

 Ascetic father … and wayward son

A father and son less alike one would be hard pressed to imagine.  George III was upright, faithful, proper, thin, and controlled.  His son was dissolute, sybaritic, impetuous, fat, and notoriously promiscuous.  Yet for all those things, he was Prince of Wales, and as such both a living embodiment of sovereignty principles and the anticipated next head of state.  Adding to the complications, George III had a bout of madness – historians now conclude porphyria – which led Parliament twice to declare a regency, each occasion leading to a change in government.  All this family and political hubbub took place in the midst of the world’s first global war, the twenty-year struggle against France and Napoleon.

Dubai and Abu Dhabi now clearly recognize the link among finance and economics, debts and creditors, and the legitimacy of nationhood:

“This support confirms that the U.A.E. is one country and demonstrates the strong support provided by the government of the U.A.E. to the country’s corporate sector,” said Simon Cooper, chief executive of HSBC Middle East.

Cooper sees the UAE as a single country

As Charles Smith brilliantly put it to me in an email:

Abu Dhabi’s capital injection has merely bought it time, and a suspension by the creditors of their judgment of Dubai’s unreliability.  In the 1870’s, New York’s Erie Railway wars, with their blatant manipulation of stock prices for private benefit, compelled a rewriting and professionalization of stock market reporting and settlement procedures.

If it can be cornered, I’ll corner it: Jay Gould

As readers will recall, I’ve become intrigued by the history of affordable housing globally and of financial institutions and how the US housing finance ecosystem came to be, and it was in that vein that I read

John Steele Gordon’s history of the US banking system, about which I posted in Jefferson’s Curse.  That in turn led me to his history, The Scarlet Woman of Wall Street:  The subtitle is much less racy: Jay Gould, Jim Fisk, Cornelius Vanderbilt, and the Erie Railway Wars.

Vanderbilt bestrides the railroads.  The sign reads,

All freight must pass here and pay any tolls we demand.

In this lively book, Gordon covers executive-suite shenanigans, complete with barricaded corporate headquarters protected by cannon, a zaftig mistress and her handlebar-mustache impresario lover, financial hijinks such as trying to corner the supply of money, and stock-price manipulation of a kind to make Frank Raines green with envy. 

Jubilee Jim Fisk of the Erie Railway

His point is the emergence of Wall Street securities regulation – it was first professionalized through self-governance after the financial catastrophe known as the Erie Railway; government regulation came only later. 

In that financial crisis, the market itself, not government, imposed discipline on the sovereigns of securities.  The wakeup call has now been sent to Dubai: markets do not exist for the pleasure of insiders and the fleecing of outsiders, they exist to protect outsiders from insiders.  As Charles Smith puts it:

Large nations can always manipulate their currency and perform other ameliorative actions, so that we remain in the realm of national power negating true accounting; and one of the main reasons I wrote my article came from my impression that politics is the factor that plagues De Soto’s straightforward premises and solutions.

Dubai, and Abu Dhabi behind it, seem to have absorbed this lesson:

In its statement, Dubai also announced a bankruptcy framework in case Dubai World can’t reach agreement with creditors to restructure $26 billion of the conglomerate’s debts.

Remarkable: such is the power of mercurial global capital, that its immediate and severe withdrawal – a 65% drop in market capitalization in two weeks – brought Dubai not just back to the bargaining table, but bringing money merely to placate creditors.  Further, Dubai recognizes that the lacuna in Islamic finance – the absence of bankruptcy jurisprudence – must be filled, in an orderly way, and right away:

“Dubai will announce a comprehensive reorganization law, a framework that is based upon internationally accepted standards for transparency and creditor protection,” Sheik Ahmed said.

Hard to have accountability without transparency

As put by Charles Smith, whom I can do no better than admiringly quote:

In an international monetary system defined by paper deals, nations must soon realize that their power – and welfare of their citizenry – can only be protected, ultimately, on a transparent and equitable fiscal ordering, because what we’re really talking about systemically is the availability of economic data to determine the rationality of investments made.

If such data is not available, every investment can only be a bet or gamble at best, or based on an outright fraud at worst. An international derivative type meltdown seems entirely plausible considering the events of the last several years if such international agreements are not put in place; and no one state should be able to “cook the books” and put everyone at risk.

Even with these statements, global Islamic capital has a long way to travel and only five months in which to cover the distance, but the signs are incredibly promising:

In a separate statement Monday, the UAE Central Bank said it stands behind local banks, including those with exposure to Dubai World and Nakheel.

Gentlemen, welcome to the global markets.

Don’t get Zappa’ed

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[Continued from yesterday's Part 4 and the preceding Part 1, Part 2, and Part 3.]

This multi-part post covers the upcoming sovereign bankruptcy of Dubai World, a shock of the first magnitude whose consequences that will reverberate for years if not decades.

Part 1 deals with the Dubai double standard of relations between debtors and creditors.

Part 2 reveals while the banking system, and by extension the world, now has a massive new problem.

Part 3 shows why this is a watershed event from which there is no going back.

Part 4 covers why the invention of bankruptcy in seventeenth-century Massachusetts was a critical advance in finance.

Part 5 asks the question, whither Islamic finance?

I am using as texts three principal sources: New York Times (Arial black) on the Dubai World default; New York Times (Palatino indigo) on Dubai’s personal-financial system; and Charles E. Smith, Economy Liberty and the Official Law Books in Colonial Massachusetts (Times New Roman dark red).

I find your lack of confidence in my reassurances disturbing

From the beginning of this extensive post, I’ve been positing that one should ignore all the warm words emanating from the emirates, which are mere palliatives, and instead look at the brutal facts:

1. Dubai World has repudiated its debts and announced a monetary default.

2. Abu Dhabi is not making any commitments to guarantee the shortfall.

3. Creditors have miserable alternatives since they cannot repossess the collateral and will have to sue the sovereign.

4. The enforcement provisions of Islamic finance are untested.

How much cash is that worth?

The news came as a shock to the markets as well as Dubai’s bankers. The bonds of Dubai World’s property developer, Nakheel, dropped sharply and the cost of insuring against a Dubai government default soared.

Subsequent to that Times story, Dubai’s bond market has recovered a little, but that this is wishful thinking.

Dubai’s creditors have terrible choices.  Even assuming that the sovereign can be held to account in a neutral court of law, the contractual commitments that will be interpreted are untested.

But its very success, and the large number of foreign investors and businesses it has lured here, have led it to be judged by Western criteria as well — and often found wanting. Dubai’s laws are largely based on Egyptian civil law and Islamic law, or Shariah, with no real effort to encompass the tremendous volume of its commerce.

I doubt that sharia has a concept of bankruptcy.

The root of the problem, analysts say, is that Dubai’s legal structures have not kept pace with its frenetic development. In just a few decades, a sleepy pearl-diving town has been transformed into a hypermodern metropolis that aspires to be a financial hub like Singapore or Hong Kong.

Technology always outruns regulation and jurisprudence – that’s why catastrophe is a precondition of fundamental financial reform.  The US has been facing it now with TARP and the GSE conservatorship.  The Islamic world is about to face it with Dubai’s insolvency.

Dubai is rightly proud of its economic miracle, and of its relative tolerance and openness compared with other parts of the Arab world.

All of it financed with global capital

Now the question arises, will Islamic finance ‘work’?

[4] The decision to take such a step comes just weeks before Nakheel, the developer of Dubai’s signature palm-shaped islands, was scheduled to make payment on its $3.52 billion of Islamic bonds.

The debt payment will not be made.  Islamic law sounds unforgiving to debtors.  Will these two reconcile, with Islamic finance coming of age, or will they come apart?  This is a crisis of the first magnitude.

The conglomerate, which also owns Dubai’s huge port operations and has taken stakes in glamorous overseas properties like Barneys and MGM Mirage in Las Vegas, has billions of dollars of payments due in the months that follow.

Think the creditors won’t seize this? MGM Mirage, from the original Las Vegas

Dubai’s isn’t the only legal system that will be tested.  Global creditors will attach Dubai World’s assets located in other jurisdictions, and will seek collateral enforcement based on that country’s laws.  When two sovereigns’ laws conflict, who wins?

Executives at Dubai World have said they will not engage in any distressed asset sales and that they are sure of recovery in real estate prices that have dropped by as much as 40%

Nonsense.  If Dubai World is not compelled to surrender its other properties, particularly those in foreign countries (like the US) that can be attached according to those collateral-seizure laws, then no multinational financier will ever do business with any Islamic-finance sovereign debtor again.

“Here, business relationships are based on integrity and trust developed over time, and so, traditionally, there has been less recourse to legal procedure for dealing with bankruptcy and insolvency situations,” said Andrew Tarbuck, a Dubai-based partner at Latham & Watkins.

You can be sure Andrew Tarbuck bounces no checks

That was said in September, 2009, and the context was individual insolvency.  If the government of Dubai proves itself untrustworthy, and seeks to hide behind the sovereignty immunity (de jure or de facto), it will pay a huge price in the global markets, as will every other country that uses Islamic finance as the basis for its international lending.

Sooner or later, Dubai World will have to sell off all its other properties.  No one will let a delinquent borrower keep the excess and be able to look its creditors’ committee in the eyes.

There are also vast untested legal complications.  Because of Mohammed’s antipathy toward usury, as I wrote 2½ years ago, Islamic finance uses a variety of workarounds:

Work-arounds begin as rough approximations and gradually improve, as their presence encourages symbiotic growth of the financial ecosystem, such as the enabling environment for capital (one of the four housing-finance roles of government).  In the Islamic countries where I’ve worked, lack of mortgage finance has been a recurring problem. Turkey has just enacted a mortgage finance law, which will cause a housing and property boom. Egypt lacks a mortgage-finance infrastructure, which is inhibiting homeownership and distorting the rental and ownership markets.

The political and theological endorsements are critical. Law, government, institutions, capital markets, consumer confidence — they all move together, they all reinforce one another. That’s why creating democracy out of the ruins of psychotic dictatorship is so difficult; you have to change so many things simultaneously, and some of them simply take a while to work.

I’ve previously posted about capital’s skittishness and the slow waltz between capital and property. Bankers have no recourse against the unbindable sovereign except to flee, taking their capital with them. When capital is sunk in real estate property, the property cannot flee, so capital is understandably cautious.

I’m not sure I want in

Though rival Islamic banking and capital-markets centers have since sprung up in Dubai, Bahrain and London, Malaysia still accounts for two-thirds of the world’s Islamic bond issuance.

The rough approximations have become asymptotically improved work-arounds, replicating the economics capital understands, in the shariah terms that strict Islam requires.

The country has achieved “the closest possible replication of conventional finance while giving it an Islamic label,” says Mahmoud El-Gamal, Egyptian-born chair of Islamic finance and economics [And financial blogger! -- Ed.] at Rice University in Texas.

All those balls in the air, floating like bubbles

In Islamic finance, interest is simulated through a combination of purchases and repurchases (loan and its repayment), plus interim rent payment (the interest).  As I wrote before, here’s an expanded description of the Malaysian version:

1.  You identify the property you wish to buy and agree the purchase price with the seller in the normal way.

2. You approach us for assistance and complete an application form (see section ‘do I qualify’)

3. If we are able to help, AUB (UK) will buy the property in its name, after solicitors have confirmed that everything is in order.

4. We will then sell the property to you as detailed in an agreement titled ‘Promise to Purchase’. The purchase price between AUB (UK) and yourself is the same price as the original purchase price.

5. At the same time you will enter into a lease with AUB (UK) which details your rights to occupy the property.

6. Once the property is purchased you will make monthly payments to AUB (UK). These will be claimed by Direct Debit automatically from your normal bank account.

7.  Each monthly payment is calculated so that part is applied towards the purchase of the property from AUB (UK) and part of it is rent.

8. The payments are fixed every 12 months, April to April. At the beginning of April each year, we will reassess the rent and payments are likely to vary.

9. You may purchase the property from AUB (UK) at any time by paying us the balance of the purchase price.

If in fact Dubai World has used something similar – I’m uncertain, and invite readers to point me to sources that can answer the question – then the creditors may technically own the property right now.  In which case the idea of foreclosure has a new twist, as Dubai World will be seeking to recover ownership.

Wanna buy an island off Dubai

Law does not work unless it is written down in words, adhered to by all parties, and broadly understood.  Dubai World’s insolvency will test whether sovereign-influenced finance will be adhered to, according to a set of written principles, or whether it will be subject to the monarch’s whim.  

Will justice without fear or favor be found inside?

As Charles Smith’s article put it:

“The provision of legislative enactments to the public is key to an equitable and efficient administration of property registration, credit regimes, and market regulations.”  413. 

“Only a year after the Massachusetts Bay Colony had issued its first Book of the General Laws and Liberties of 1648 colonial legislators acknowledged the ‘great benefit’ of ‘putting the laws in print.’  They promptly appointed a new law committee to prepare supplementary editions.  415. 

“With the provision of official laws and regulations colonists alerted their representatives of necessary revisions to existing laws, and subsequent amendments were thereby realized.”  416. 

“With the dissemination of laws, citizens gain insight, and power, into the halls of their legislature and courts, so that they can judge for themselves whether legislators and judges are wielding authority properly, and for the public good, instead of private gain.”  427.

Will sovereign Islamic finance adopt a posture of equal treatment under the law?  Or is it a two-tiered game where the rules are that my side wins and your side loses?  On this hangs the future of Islamic finance, at least at the international level, and hence the future of Islamic countries as investment partners and potential capital-markets nexuses.

This business of binding the sovereign is tricky.

“A great economist”?

Finally, before we in the West get too cocky, let us remember that the State of California will be the next to go bust.

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[Continued from yesterday's Part 3 and the preceding Part 1 and Part 2.]

As I’ve covered so far, the Dubai World default announcement is a megashock to the global capital markets, particularly Islamic ones, for it thrusts Dubai and all of Islamic finance into a realm of uncertainty.  A nation that lacks bankruptcy as an alternative is forced to navigate between debtors’ prison and amnesty, neither of which is acceptable to the capital markets, and so will doom itself to a cash crisis and economic decline. 

What damage to property rights?

This multi-part post covers the upcoming sovereign bankruptcy of Dubai World, a shock of the first magnitude whose consequences that will reverberate for years if not decades.

Part 1 deals with the Dubai double standard of relations between debtors and creditors.

Part 2 reveals while the banking system, and by extension the world, now has a massive new problem.

Part 3 shows why this is a watershed event from which there is no going back.

Part 4 covers why the invention of bankruptcy in seventeenth-century Massachusetts was a critical advance in finance.

Part 5 will ask the question, whither Islamic finance?

I am using as texts two principal stories: New York Times (Arial black) on the Dubai World default, and New York Times (Palatino indigo) on Dubai’s personal-financial system.

We know this for a fact, because it was this set of circumstances, 350 years ago, that nearly busted the Massachusetts economy of the 1640’s. 

The nascent colony, mid-seventeenth century

This is explored in detail in Charles E. Smith, Economy Liberty and the Official Law Books in Colonial Massachusetts (Times New Roman dark red):

In England and its American Colonies, debtors were imprisoned until repayment of creditors in an era devoid of credit agencies, instant credit checks, or fine print on bills of sales. Contract law was a 19th century development, and since its arrival successive generations assume that everyday economic transactions have usually occurred without litigation. Before the era of contract such ordinary events were anything but ordinary, as each transaction raised the real possibility of a lawsuit and even imprisonment (Mann 2002).

In early-Colonial Massachusetts, all debts were personal and recourse, and the debtor got thrown into debtors’ prison, from whence many never escaped. 

A view of debtor’s prison, circa 1650

“During the same era English common law protected real property from attachment for debts, but debtors were imprisoned routinely until they remunerated their creditors.”  418. 

Like individuals today in Dubai and throughout Islamic finance.

Furthermore, debtors’ incarceration “tendeth to none other end then to the enrichment of lawyers, attorneys, solicitors and jailers, and to the utter ruin of thousands of us your oppressed brethren, and of our wives and children.” A Pittiful Remonstrance (1648) craved “deliverance from this unjust, inhumane slavery of imprisonment for debt, illegally fastened as on us, so, on this whole nation and their posterity, contrary to the law of God, and the fundamental great Charter of England’s liberty.”

This acted as a gigantic brake on economic expansion and the growth of commerce.  It clogged the courts even as it effectively impoverished anyone whose wealth was expressed in land, because land could not be seized to settle debts. 

“Each transaction raised the real possibility of a lawsuit and even imprisonment.”  419. 

“Debtors’ incarceration ‘tendeth to none other end then to the enrichment of lawyers, attorneys, solicitors and jailers, and to the utter ruin of thousands of us your oppressed brethren, and of our wives and children.’ (A Declaration and Appeal, 1645).”  420. 

Fortunately, for its first twenty years, the Massachusetts Bay Colony survived on continuous capital importation by immigrants (like Dubai until recently).  When the English Civil War broke out in 1640, the flow of immigrants, and their specie, was curtailed:

“The colony had been plunged into economic depression when the numbers of English immigrants dropped off dramatically in 1640, and their importation of desperately needed hard currency of gold and silver bullion was reduced proportionally.  With a seemingly inexhaustible supply of land, colonial legislators decided to require registration of real property and incorporate it into its exchange economy.  No aristocracy controlled land ownership in the colony, as it rested with the towns, and no legal profession existed to safeguard such an interest.”  418. 

Boston’s own Increase Mather, Harvard AB 1656

When the flow of foreign capital dried up, Massachusetts found itself in a liquidity crunch that in turn drove down the economy:

Massachusetts’s incorporation of real property into its market economy was prompted by a severe economic crisis caused by the decline in new colonists and hard currency that they brought with them from England, which in turn initiated a deflationary cycle.

Ever since Bear Stearns many folks, from Paul Krugman through Tim Geithner and Paulson’s Principles, have feared that drying up liquidity would plunge the world into a great depression.  The fledgling Massachusetts colony was on the verge of a similar economic catastrophe:

When the ships stopped coming, the colony had no cash

The General Court described this dilemma in an act passed on October 7, 1640, the same day that it established the colony’s land registration system:

Many men in the plantation are in debt, and there is not money sufficient to discharge the same, though their cattle and goods should be sold for half their worth –

As we’ve seen domestically, when everyone is selling, the clearance price is well below an intrinsic ‘fair value,’ leading to further asset writedowns and further disappearance of wealth.

– as experience hath showed upon some late executions, whereby a great part of the people in the country may be undone, and yet their debts not satisfied, though they have sufficient upon an equal valuation to pay all, and live comfortably upon the rest.

Recognizing that the debt-liquidation laws then in plac were actually strangling the Commonwealth, the Great and General Court created the world’s first bankruptcy principles:

It is therefore ordered, that upon every execution for debts past, the officer shall take land, houses, corn, cattle, fish, or other commodities, and deliver the same in full satisfaction to the creditor [Shurtleff 1853: vol. 1, 306–7].

In 1641 the colony had foregone the arrest of any colonist for debt if the “law can find competent means of satisfaction otherwise from his estate,” if not then an arrest should be made (Whitmore 1889: 41). 

Governed by printed laws: Massachusetts General Laws, circa 1650

Here’s the 1640 law:

“For avoiding all fraudulent conveyances, and that every man may know what estate or interest other man may have in any houses, lands, or other hereditaments they are to deal in, it is therefore ordered, that after the end of this month no mortgage, bargain, sale, or grant hereafter to be made of any house, lands, rents, or other hereditaments, shall be of force against any other person except for grantor and his heirs, unless the same be recorded, as is hereafter expressed.”

Several reforms came together:

• Improved and mandated land registration (417, see quote)
• Ability to seize land in settlement of debts.
• An early form of Chapter 11 bankruptcy, the Five-Pound Act (see 421).

The global innovation of asset-based bankruptcy then migrated back across the Atlantic to Britain:

After the execution of Charles I in 1649, Parliament passed a series of laws aiming to reform creditor-debtor relations.

Charles, we have a government of laws

In the same year its members enacted the initial reform popularly known as the Five Pound Act (Firth and Rait 1911: vol. 2, 240–41). Prisoners were to be discharged upon an oath that their total possessions did not exceed £5, an amount not to include “necessary wearing apparel and bedding for himself, his wife, and children, and tools necessary for his trade or occupation.”

The five-pound act realized that commerce was thwarted if overleveraged debts could not be discharged, and balanced that with the debtor having to demonstrate that he had been stripped of all liquefiable assets.

A subsequent ordinance enacted in 1653, An Act for the Relief of Creditors and Poor Prisoners, established county courts to hear creditor-debtor litigation; the necessity of county courts, or accessible justice, was one of the most common demands of reformers.

One thing implies another

The financial innovations thus called into being legal innovations, and the development of a legal-adjudication ecosystem.  Authority to abrogate contracts was placed in the hands of neutral observers – judges – on whom both debtor and creditor were obliged to rely.  It also created a valuation and appraisal practice:

The 1653 Act also authorized judges to expeditiously determine the estate of imprisoned debtors, and if a prisoner had property the court could use it to satisfy his creditors.  

Inventing bankruptcy led to creating a new court system, and new professionals, all of these adding to the ecosystem’s complexity and overall effectiveness.

Most important, real estate could now be seized to satisfy debts. Previously only merchants could be declared bankrupts, and as such, subject to a confiscation of their “lands and tenements” to satisfy creditors. Therefore the 1653 Act fundamentally altered creditor-debtor relations in England.

Oliver Cromwell, Lord Protector of bankrupts

This is what Dubai World’s creditors will seek.  They have to be able to seize the debts, or place them into receivership with a neutral party – a court system independent of the debtor.

Real property at large was subject to confiscation in order to satisfy debts, and debtors would be incarcerated only if they willfully refused restitution (Firth and Rait 1911: vol. 2, 753–64).

This is what Dubai World’s creditors will seek.  They have to be able to seize the debts, or place them into receivership with a neutral party – a court system independent of the debtor.

In 1647, Massachusetts forbade the seizure of a debtor’s “necessary bedding, apparel, tools, arms, or other implements of household which are for the necessary upholding of his life,” just as Parliament would do two years later in its own Five Pound Act (Shurtleff 1853: vol. 2, 204). Finally, under continuing deflationary pressures the General Court authorized marshals to forcibly seize a debtor’s land or person six years before Parliament allowed county court justices to seize real estate to satisfy creditors (Shurtleff 1854: vol. 4, part 1, 197).

Faced with a capital and cash crisis, Massachusetts invented bankruptcy to revive the flow of capital and the economy.  Dubai World’s insolvency, and the necessity to invent a globally acceptable form of Islamic bankruptcy, represents a crisis for Islamic finance.

It’s written in the sands, the creditors need help

[Continued tomorrow in Part 5.]

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[Continued from yesterday's Part 2 and the preceding Part 1.]

Following on the Dubai World default notice, as reported in the New York Times, so far I’ve contrasted the proposed leniency that the government of Dubai expects of its creditors, and the inflexible severity it has shown individual debtors (from this New York Times story in Palatino).  We’ve also touched on the unprecedented crisis this presents – a sovereign nation hiding behind a thin corporate veil in the expectation that creditors will be forced to take massive discounts. 

This multi-part post covers the upcoming sovereign bankruptcy of Dubai World, a shock of the first magnitude whose consequences that will reverberate for years if not decades.

Part 1 deals with the Dubai double standard of relations between debtors and creditors.

Part 2 reveals while the banking system, and by extension the world, now has a massive new problem.

Part 3 shows why this is a watershed event from which there is no going back.

Part 4 will cover why the invention of bankruptcy in seventeenth-century Massachusetts was a critical advance in finance.

Part 5 will ask the question, whither Islamic finance?

I am using as texts two principal stories: New York Times (Arial black) on the Dubai World default, and New York Times (Palatino indigo) on Dubai’s personal-financial system.

Massive they unquestionably are:

For the banks that financed the debt-fueled ascent of Dubai — analysts’ estimates put its total debt at about $80 billion — the move by Dubai to obtain a standstill highlights a truth that many in the region had been trying to make clear to bankers. It is that Abu Dhabi, the oil-rich governing emirate of the United Arab Emirates, will not unconditionally bail out its more profligate neighbor.

Like George III disowning his son’s spendthrift ways, Abu Dhabi was content for the financial world to infer that Dubai would be backed, without in any way committing itself.

You know what they say about me and my money

Everyone in the Arab world, you see, needed a Dubai to come into being.  Arab wealth depends on the global economy and financial system.  Oil has no value unless engines are burning it, and the only thing rich countries can use to pay for oil is money, which has value only if invested into producing assets.  The Arab world needed a pleasure spot, a secular sanctuary of sin, complete with all the world’s sophisticated networks and temptations. 

Dubai Airport, 3:00 am

Everybody needs Dubai and nobody wants to pay for it.

I’ve touched on this before (March, 2006), when Sherlock Holmes confronted the problem of the noble benefactor. 

Paul D. Wolfowitz, read the neat card on Holmes’ salver, Worldly Philosopher.  “Sir,” asked the Great Detective over his pince-nez, “how may I help you?”

Our guest was distinguished

“Long have I admired your treatises on the hundred and seventeen types of tobacco,” began our guest, twisting the brim of his brushed black silk top hat.  “I have the honor to administer a trust operated by a small philanthropic society,”

“You do yourself too little honor,” murmured Holmes.

“Yes, this is the economic hostage problem,” the detective commented.  “You financed a worthy scheme with pay-before-performance capitalization and incentive structures.  Now your enforcement conundrum is made worse because you are not dealing simply with a capricious and spiteful individual who had breached his pledge to provide you valuable service, but rather with economic hostages.:

When one lends on a project-finance basis, one underwrites the collateral and expects to reclaim the collateral upon default.  When one underwrites on a sovereign-finance basis, one overlooks the collateral and instead concentrates on the borrower’s credit-worthiness.  This tends to blind one to project-level risk, and encourages extravagant risk-taking by the borrower, who will realizes he wins either way with moral hazard:

1. The property performs well, and the sponsor makes a ton of money.

2. The property fails, but the sovereign bails out the loan, and the sponsor makes some money.

3. The property fails, and the sovereign balks, the sponsor defaults … and you lose, as everyone suddenly discovers they need the sponsor to rescue the property, because there is no other way to recoup their money.

Translation: Heads I win big, tails I win small, and at worst I walk away scot free.

The recoupment paradox is especially evident in Dubai World.  What are the assets of Dubai worth without a thriving global economy?  Dubai has nothing to attract it – it’s hot, dry, isolated – except its tempting ways to spend Western cash money.  Without the non-stop flights, the glitzy hotels, and the spectacular resorts, who would go there? 

Monuments to global capital, and not yet finished

Especially with an archaic and punitive legal system (New York Times, September, 2009):

The overall uncertainty of Dubai’s legal system — especially the risk of doing jail time for debt — has prompted many expatriates to flee when they are in financial trouble rather than filing for bankruptcy and setting out a repayment schedule.

Capital is the world’s fastest asset, even faster than people.  By announcing its intention to repudiate the debts of its offspring, Abu Dhabi and Dubai are telling the entire world they are tricky counterparties.  People with choices, and the capital they have, will flee.

All I leave behind are my fixed assets

Early this summer, Simon Ford, the British founder of a travel company called bluebanana.com that closed down, issued an emotional letter to “the Dubai public” that was reproduced on Web sites after he fled the city with his family rather than face arrest for his rising debts.

The thing is, powers such as these are only effective as deterrents; once they are exercised, the observant herd decides now to put itself at risk.

If that’s the way you protect our capital, we are outta here

“I am not running away from debt, I am purely protecting those dearest to me and getting out of a country which, due to the lack of structured bankruptcy laws and a banking system which has zero flexibility on loan repayments, drives people to make horrible decisions,” Mr. Ford wrote.

Over a year ago, when the world got a crisis of confidence regarding the US financing arms, Fannie Mae and Freddie Mac, the Federal government stepped up, and backstopped all their debt.  That is the responsible move.  What Dubai and Abu Dhabi are doing is a different strategy.

Instead, a genuine restructuring of Dubai’s debt, with pain being shared equally between Dubai and its bankers, needs to take place.

‘Needs’?  Says who?  And if Dubai succeeds in forcing creditors to take less, without gaining control, will Dubai ever access the capital markets again?

Your money or your ice

Some financial analysts say the risk of arrest for debt could also drive away potential new investors and businesspeople as Dubai struggles to recover from the current economic slump.

When a sponsor’s plans fail, as Dubai World’s have done, creditors may be prepared to take a discount, if they have confidence in whoever is controlling the property.  That means believing the controlling sponsor is capable, motivated, and honest.  It also means testing property values in the marketplace.

Dubai World, meanwhile, is stating that despite being horribly in debt, it and not its creditors will decide what happens to the assets:

Executives at Dubai World have said they will not engage in any distressed asset sales and that they are sure of recovery in real estate prices that have dropped by as much as 40%.

Dubai World’s statement is a further declaration of war.  Creditors are certainly going to challenge it.

But while Abu Dhabi may sit upon 9% of the world’s oil and manage the largest sovereign wealth fund, it is evident now that it is not willing to just write a check to cover all of Dubai’s mounting debts — at least not right now

Dubai and Abu Dhabi have presented the creditors with a wholly intolerable situation.  On the one hand, they are unilaterally breaching their agreement.  On the other, they are blocking the creditors from accessing the assets.

Dubai’s played this card, and can play it again

A civilized financial system needs a mechanism whereby, when a venture has gone spectacularly wrong, the following things can happen:

[1] The creditors can gain access to the collateral and assets.

[2] The assets can be disposed of for fair value.

[3] The proceeds can be distributed to the creditors in order of priority and security.

[4] The debtor can then be relieved of any uncleared debts.

Such a system exists.  It’s called bankruptcy, and it is an invention of the capital markets. 

Once a judicially defined bankruptcy structure is available, then both debtors and creditors can proceed to recapitalize a busted transaction according to a set of rules.  Further, although this sounds debtor-friendly, it’s actually more creditor-friendly – it breaks the impasse present in a system where the choices are debtors’ prison or unilateral abrogation.  Once a bankruptcy code exists, the capital markets will then reverse-engineer their underwriting standards, taking default and discount into consideration, rather than living in the fool’s paradise of believing that sovereign father will always cover the debts of dissolute son.

You may despise my character, but I will be sovereign soon

When bankruptcy does not exist, it will be necessary to invent it, for the overall benefit of creditors, capital markets, and the nation’s economy.  This is a lesson the world first learned 350 years ago, in my home state of Massachusetts.

From this tiny peninsula of Boston, a financial revolution

 [Continued tomorrow in Part 4.]

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[Continued from yesterday's Part 1.]

What’s the difference between you and a mega-developer? 

When you owe the bank a thousand dollars, you have a problem.  When you owe the bank a billion dollars, the bank has a problem.

Treasury, we have a problem

[This multi-part post covers the upcoming sovereign bankruptcy of Dubai World, a shock of the first magnitude whose consequences that will reverberate for years if not decades.

Part 1 deals with the Dubai double standard of relations between debtors and creditors.

Part 2 reveals while the banking system, and by extension the world, now has a massive new problem.

Part 3 will show why this is a watershed event from which there is no going back.

Part 4 will cover why the invention of bankruptcy in seventeenth-century Massachusetts was a critical advance in finance.

Part 5 will ask the question, whither Islamic finance?]

At issue is the multi-billion-dollar default announced by Dubai World, the real estate development arm of the Government of Dubai which, as reported in the New York Times, is merely the opening salvo in a lengthy and expensive debt cramdown:

The terse statement came in the middle of negotiations between creditors and Dubai World, the corporate arm of Dubai, which has led many of its most ambitious real estate projects, but is now struggling under the burden of $59 billion in liabilities.

What then is the relationship between the sovereign and its offspring?  The question goes at least two centuries back, to the tumultuous relationship between George III and George IV. 

…

Ascetic father … and wayward son

A father and son less alike one would be hard pressed to imagine.  George III was upright, faithful, proper, thin, and controlled.  His son was dissolute, sybaritic, impetuous, fat, and notoriously promiscuous.  Yet for all those things, he was Prince of Wales, and as such both a living embodiment of sovereignty principles and the anticipated next head of state.  Adding to the complications, George III had a bout of madness – historians now conclude porphyria – which led Parliament twice to declare a regency, each occasion leading to a change in government.  All this family and political hubbub took place in the midst of the world’s first global war, the twenty-year struggle against France and Napoleon. 

You see that swaying fop behind my left shoulder?  That is the heir

The free-spending prince was not merely a trial to his parents, he was a positive burden to the state, running up mountainous debts:

The problem of the Prince of Wales’s debts, which amounted to the extraordinary sum of £630,000 in 1795,^[28] was solved (at least temporarily) by Parliament.  

From 1787 onward, there was a dalliance of convenience between the Prince of Wales and the Whigs, with political support by the former traded for economic support by the latter, and in a move worthy of Silvio Berlusconi or Jacques Chirac he used his position of power for crass personal advantage.

Charles James Fox: what are a few IOUs if I can form the government?

Being unwilling to make an outright grant to relieve these debts, it provided him an additional sum of £65,000 per annum.^[29]  

In effect, Parliament converted the Prince’s obligations into a long-term bond, thus on the one hand backing him in full but on the other making creditors wait years for repayment.  What with the inflation that always attends upon a war, Parliament was economically settling the Prince’s debts for some number of pence in the pound.  (One can easily imagine a similar solution being imposed on Dubai World’s creditors by a combination of blandishments and a little additional capital from Abu Dhabi.) 

Brighton Pavilion, the Dubai World of its time, and the Prince’s pleasure dome

This annuitized sum Parliament later topped up:

In 1803, a further £60,000 was added, and the Prince of Wales’s debts of 1795 were finally cleared in 1806, although the debts he had incurred since 1795 remained.^[30]

You caught that last part?  Parliament having once bailed out the Prince, he immediately plunged back into running up more debts, which creditors extended him because they were convinced Parliament would have to cover them as well.

Dubai World’s creditors face a similar paradox.  They have only two ways to recover their money: compel Dubai’s parent (Abu Dhabi) to come across with additional cash, or make Dubai’s real estate succeed.  the debts and force daddy to bail you out.  They have been hijacked into being economic allies even if they are financial adversaries.

I learned it all from the Prince of Wales

Even worse for the creditors, if Dubai were to become a pariah in the Arab oil, its earning power would be further diminished.  So the sponsors have a scorched-earth threat.

This arises because Dubai is not really real estate in the sense that we are used to; the location has no intrinsic value unless the enterprises within it succeed, all of them dependent on global liquidity flowing.  In appraisal terms, the replacement cost is astronomical, the asset value is low, and the enterprise value is management-dependent.

Are the assets held by Dubai World durable or perishable?  How much will Abu Dhabi pay to backstop its wayward child?

To some extent, the announcement of the standstill request was mitigated by earlier news on Wednesday that Dubai had raised $5 billion from Abu Dhabi banks. Still, that figure was considerably less than the $20 billion Dubai had been hoping to attract from investors in the region as well as abroad.

Remember, virtually everybody in Vegas went bust multiple times.

Everybody loves you when you’re throwing your money away

“What is interesting is the timing,” said Chris Davidson, an expert on the region at Durham University. “This indicates that the money from Abu Dhabi is not to be spent on Nakheel and Dubai World.”

No one should be under any illusions as to coincidence here.  Like a sequence of poker bets, these moves have been orchestrated by Dubai World and Abu Dhabi to create an impression, so as to set up the showdown.

 “As a first step,” the statement said, “Dubai World intends to ask all providers of financing to Dubai World and Nakheel [A] to ‘standstill’ and [B] to extend maturities until at least 30 May 2010.”

Just give us six months to decide what to ask for next

As we go through this, it’s worth recalling the principles I recommended 2 ½ years ago for delinquent borrowers.  Rule 1: Announce the problem – in writing.

Of the two elements in this purported ‘request,’ the first [A] is a unilateral action dressed up as a request.  The next debt service payment will simply not be made, and the creditors are now forewarned about this. 

The decision to take such a step comes just weeks before Nakheel, the developer of Dubai’s signature palm-shaped islands, was scheduled to make payment on its $3.52 billion of Islamic bonds.

The second half [B] is something of a dare: extend the maturities, says Dubai World, and waive your right to default us for six months.  Or else …

You won’t like the alternative

Dubai World is run by Sultan Ahmed bin Sulayem, a close adviser to Dubai’s ruler, Sheik Mohammed bin Rashid al-Maktoum, who has insisted publicly that Dubai and Abu Dhabi will work together to reach a solution on the debt question.

Sultan Ahmed bin Sulayem: Now that we’ve opened it, we’re praying you’ll see reason

‘Reach a solution on the debt question’ is code.  There’s an easy solution to the debt question – pay it.  If not, there’s a slightly harder solution – foreclose.  Neither of these requires parties to work together.  The subtext is unmistakable: expect a discounted settlement.  As a further subtext, play hardball and it’ll cost you more because you will offend our bankroller, Abu Dhabi.

In short, Dubai World has just announced that it expects its creditors to sit still for a negotiated and discounted payment.

Why should they?  Why not try to ram through enforcement of rights?

Fear the mouse

[Continued tomorrow in Part 3.]

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