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Forget Greece, Dubai will default first

While all eyes are focused on Greece, Dubai is quietly trying to work out a deal to restructure USD 22 billion of debt that is coming due soon. Dubai World rocked global markets on Nov 25, 2009 with a request to delay repaying $26 billion in debt linked to its main property units Nakheel and Limitless World. Then big brother Abu Dhabi stepped in with a USD 10 billion bailout (later reduced to 5 billion) which was enough to stave off a default on a $4.1 billion Islamic bond linked to Nakheel. Abu Dhabi’s bailout calmed investors down for a little while but it looks like round two of the problem is starting now.

In the news recently, you would have no doubt heard the term “Credit Default Swap” or CDS. I knew it was some form of debt default insurance but I did not really understand some of the related terminology like “basis points” or “CDS spreads”. I decided to educate myself a little bit more about them and came across this article by forex specialist Kathy Lien which I thought explained it very well in layman terms.

What are Credit Default Swaps? A credit swap is like an insurance contract. The buyer of a credit default swap receives a payment if the underlying (company or country) defaults which basically means that he or she is buying insurance for a default. In return, the seller will require regular payments from the buyer. The best way to describe a 5 -year credit default swap is to compare it to a 5 year term life insurance contract. You make a payment at regular periods of time so that if the “credit event” or “death” occurs within 5 years, a lump sum is paid. If it does not happen, then the seller simply retains the payment and your “insurance” expires.

What are Credit Default Swap Spreads? Credit default swap spreads are the cost of the protection expressed as an annualized percent of the notional amount. So for example if the 5-year swap spread on Greek debt is 400 basis points it means that it costs 4 percent of the notional to protect against a default of Greek government debt within 5 years. On a $10 million bond, investors would require an annualized payment of $400,000 in this case to be willing to bear the risk of Greece defaulting on their bonds.

The cost of credit default swaps (also known as CDS spreads) is measured in basis points (bp). If the risk of default is higher, the cost of insurance naturally goes up, so the CDS spreads are a good measure for risk of default. Despite all the seeming panic over Greek debt, Greece’s 5 year CDS spread is only 400 bp compared with Dubai’s CDS spread of 627 bp as of last Friday. Based on the CDS spreads, it looks like Dubai has a higher risk of default than Greece.  Dubai stock markets fell 4.1% on Sunday but European and most other markets gained on the hope of a bailout for Greece. Maybe investors do not realise it yet as Reuters seem to the only news agency still covering Dubai after the initial panic passed in late 2009.

Looking at the Dubai debt crisis as an example, I think the same thing will happen with the Greek debt crisis. The total debt for Greece is now €254 billion, and they need to finance another €64 billion this year, €30 billion of it in the next few months. I think Germany and France will reluctantly fork out €30 billion for the first bailout but funds for subsequent bailouts will be much harder to come by. I don’t hear Abu Dhabi coming forth with more bailout money this time around. I think Dubai World’s creditors will have to be prepared to take a 40% haircut and wait a long time to get the rest of their money back. When this happens, lenders’ mindset will change from “maximizing profits” to “minimizing risk” and credit will be much more expensive and difficult to obtain (in other words, its credit crunch time again!).

In the meantime, lets enjoy this optimism over the pending bailout for Greece while it lasts. Australian markets are up 2% as I write this.

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