To no one's surprise, Uncle Dhabi stumps up. But what's next?

Stocks, Futures Rebound as Dubai Gets Nakheel Funds; Oil Falls

Asian stocks and U.S. index futures rebounding from losses as Abu Dhabi provided $10 billion to prevent Dubai’s Nakheel PJSC from a default. Oil fell for a ninth day, the longest losing streak in eight years, after a report on Japanese business confidence showed exporters scaling back investment plans.

This is a well expected infusion of liquidity to abort the sinking Nakheel sukuk.

But, as has been pointedly pointed out before, and without putting too fine a point on the point, the Dubai "problem" is not simply liquidity but the fragile and untested structure of Islamic finance when tested by issues of solvency.

This has not gone unaddressed by Dubaii:

The Government of Dubai, acting through the Supreme Fiscal Committee ("SFC"), today announces a set of actions in relation to Dubai World: HH Sheikh Ahmad Bin Saeed Al Maktoum, Chairman of the Dubai Supreme Fiscal Committee said:

"Finally, today the Government of Dubai will announce a comprehensive reorganization law, a framework that is based upon internationally accepted standards for transparency and creditor protection. This law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations."

The devil will of course, in whatever religion or other bureaucracy, be in the details. In this particular case, the devil will have to finesse the principles of Islamic finance, as well as its religious principals. Will the more conservative Emirates be looking carefully over the shoulder of Dubai's Sheik Maktoum when its government proclaims new law on the subject?

This may get a more critical examination than implied by the statement. It is probable that what has not gone unnoticed by Abu Dhabi has not gone unaddressed by Dubai. But maybe more people will be paying attention this time around, from all sides of the debate. And likely, Islamic finance will be structured more to Abu Dhabi's scripture than Dubai's script.


Meanwhile, although it is certainly convenient to some that Abu Dhabi stumped up $10 Billion to pay off some of Dubai's debts, other debtors may be making more assertive efforts to get Uncle Dhabi to bail them out, too.

Dubai owes Japan firms $7.5 bln in uncollected bills: Nikkei

The Dubai government and its affiliated firms owe non-financial Japanese companies roughly $7.5 billion in credit that had not been
collected as of Oct. 31, a study by the Japanese government showed.

The study covered 18 projects that involved Japanese general contractors, trading companies and electric machinery manufacturers, the Nikkei business daily.

The figure includes public works projects, such as subways and roads, commissioned by the Dubai government, it said. It does not include bank loans.

It said some $1 billion of the accounts receivable have gone unpaid past their due dates, with some more than a year overdue.

FOLLOW UP:

Dubai adopts DIFC insolvency law for emirate

Dubai will adopt the insolvency code used in the Dubai International Financial Center for use in the emirate and establish a tribunal to hear cases submitted against its debt-laden holding firm Dubai World, the government said on Monday.

The policy change came in the form of a decree issued by Mohammed Bin Rashid al-Maktoum, the ruler of Dubai.

Guambat hasn't a clue what this means or its implications for anything. Stay tuned. As soon as Guambat hears/reads anything, he's certain to make a hash of it.

MORE FOLLOW UP:

Dubai World Promises, but the Damage May Be Done

In the event that a deal with creditors can't be reached, the new law promulgated Monday could provide a legal system of arbitration, in which lenders could, in theory, pursue asset sales or other attempts at getting their money back.

The law establishes a panel of judges who would preside over debt and corporate-restructuring disputes, Dubai said.

The new law is untested, and isn't likely to reassure other bond holders.

The Sultan's new clothes

The fable of the Emperor's new clothes is the theme here.

Guambat has tried to develop the plot line in previous posts that the real breakdown in the Dubai World meltdown is not the liquidity or support provided by UAE, and Abu Dhabi in particular, but the emerging realization that much of modern Islamic finance is structured in ways that only resemble Western bond finance, when, in truth, its structural features are untested by Western legal precepts of financial fault, particularly bankruptcy.

So, now, from plot line to punch line:

IMF cites Dubai debt in trimming its outlook

The debt restructuring at Dubai World will hit economic growth next year, the IMF said, as credit rating agencies downgraded more Dubai companies.

“Our anticipation is that there will be a significant reduction in that growth rate, down from 3 per cent, probably somewhere between 1 per cent and 3 per cent,” said Masood Ahmed, the director for the IMF’s Middle East and Central Asia department.

“Dubai World’s debts do not affect the economic performance of Dubai or the UAE, and it is a matter of time before the company restructures its debts and honours its commitments as per a scheduled plan,” said Sultan al Mansouri, the Minister of Economy.

The Future of Islamic Finance

The dawning of Islamic finance

It is beginning to dawn on the financial press, ever so slowly, that there is a fundamental difference between Western finance and Islamic finance, as Guambat has railed on about of late.

The WSJ has a story today that, when read far enough down into it reveals:

Because Islamic law forbids the paying of interest, a sukuk isn't organized like a traditional bond. Instead, it is set up to collect a stream of income from a group of underlying assets.

At issue is whether the holders of the sukuk can take possession of the underlying assets, or whether they are simply entitled to the cash flows those assets produced.

Because there is no real precedent for this type of situation in the Dubai courts, and because the sukuk holders are effectively taking on the government, they will have to tread carefully as they try to protect their interests.

The NYT Dealbook has also reported similarly, but more expansively and first person, on the same notion during the last day, noting Dubai World was not just a one-off event but the leading edge of what was expected to be the development of new fields of global finance, and harvests of banking and legal fees, nearly as large as the oil fields of Arabia:

A Financial Mirage in the Desert

It was about two years ago, and I was in Dubai to cover an investment conference at a hotel along Jumeirah Beach. Hundreds of Western bankers dressed in Savile Row suits were packed into an enormous room to bone up on the intricacies of the next new thing in financial products: Shariah-compliant investments.

They wanted to sell them to wealthy, oil-rich Muslim investors who needed a way to increase their fortunes but whose options were limited. Any investment vehicle needed to conform to the spirit of the Koran, which forbids any investments that pay interest. No mortgages. No bonds. No clever derivatives. Just tangible assets in the so-called real economy.

It was a big honey pot — worth as much as $1 trillion that could yield billions in fees — and the bankers were determined to find a way in.

One discussion was led by a British banker from Barclays who had moved to the region to create an entire Shariah-compliance team. He shared tips about various ways to create “structured products” that would pass muster with Muslim investors. (To me, the investments looked like bonds, walked like bonds and talked like bonds — but he never called them that.) Some of the bonds that Dubai World is in jeopardy of defaulting on, by the way, are Shariah-compliant sukuk. Just don’t call them bonds.

With the benefit of hindsight — and you didn’t need much — there were plenty of other signs back then that Dubai was building a financial mirage in the desert.

And what became of all those Shariah-compliant financial instruments that were the hot topic of that panel I attended? It turns out that many of them that were sold prior to the crisis weren’t compliant at all.

The Shariah Committee of the Accounting and Auditing Organization for Islamic Institutions, which is based in Bahrain, ended up changing the rules to make them stricter because of widespread abuse. As Mr. Buiter described them on his blog, “these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts.”

Blessings, alas, can do only so much.

It's a great read. Please do.

Additional readings:

What can Nakheel sukuk holders expect in a default? This article is one post in a blogsite that has extensive coverage of the current Dubai crisis. In this post the blogger discusses in minute detail the structure and undertakings of the Nakheel sukuk that shookuk Dubai, concluding:

there are a tremendous number of uncertainties about the procedure for investors to enforce upon the various guarantees and collateral provided in the sukuk structures that would appear to give investors a claim on more than just the unsecured pledge of Nakheel and Dubai World, but in all cases, there is a lot of doubt about whether they will end up being legally enforceable.

These factors probably point towards some type of restructuring of the sukuk, rather than an outright default and legal challenge by investors.

Any restructuring would probably avoid a large mess, but would do nothing to clarify how the legal system would react in a similar situation in the future

From back in 2007:

Islamic Banking-Sukuk and Murabaha By Maurice Shohet 08/20/2007

Islamic banking is based on Islamic law and principles known as shari'a. It is equivalent to traditional banking in that payment for the investor, and for that matter collection for a borrower, is done through a share in profit rather than through interest. Islamic banking prohibits investment in companies, or lending to companies, that do business or trade in pork, alcohol, gambling, pornography, and entertainment.

Islamic banking has expanded considerably in recent years, and it is no longer restricted to banks owned or operated by Muslims. Increasingly, multinational banks have opened their own branches or windows dedicated to practicing Islamic banking. Some financial experts believe that as businesses diversify their investor base, Islamic banking will move to the mainstream as a viable financing option.

A recent "Standard & Poor's" report indicated that the current Islamic financial institutions can only provide services to 15% of the market needs (for financial services) of Muslims around the world. The report estimates the volume of financial assets compliant with Islamic law stands today at about $400 billion.

Islamic finance includes stocks, real estate investments, insurances, currency swaps compliant with shari'a, sukuk (Islamic bonds based on profit sharing rather than interest payment) and "Murabahat al-Sil'a" (a trading transaction where a bank sells a specific commodity at a price plus a specific profit agreed upon in advance).

The Islamic financial bonds (sukuk) are relatively new instruments and only came into existence during the past five years. They comply with Islam's ban on lending on interest and the trading of debt, and are backed by physical assets.

In the world of Islamic economies sukuk are equivalent to the financial bonds in the traditional world of the financial industry. They are tools used by financial institutions to raise cash.

The sukuk are proof of ownership title in a particular asset. They are distinguished by the need for the actual existence of the asset, as well as by their circulation potential in the Islamic financial markets.

Today's sukuk volume is estimated to be about $70 billion. The proceeds from Islamic financing are estimated to be $3 billion/day via London-the main center of the short and medium term financial transactions that are consistent with the provisions of shari'a. About 65% of the total value of the Islamic financial industry flow through the Gulf states and Malaysia

The term murabaha is derived from the Arabic word ribh which means profit. It is also known as mark-up or cost-plus financing.

This financial technique is the most popular and common mode of Islamic financing. It involves a contract between a bank and its client for the sale of goods at a price that includes a profit margin agreed upon in advance by both parties.

The process starts when a bank, at the request of a client, purchases for cash a certain object or commodity which the bank, in turn, sells to the client who requested the purchase at a profit. Since the client has no cash, otherwise he would not have resorted to the bank, the client buys the item on deferred payment. Repayment, usually in installments at certain intervals, is specified in the contract.

One important requirement of the murabaha sale process is that the sale contract through which the bank acquires the commodity and the sale contract through which it sells it to the client, are separate transactions.

Some critics have questioned the alleged religious foundation of murabaha because the profit margin attached to the total amount of the sale is tantamount to riba or interest in disguise. However, experience teaches that in theological disagreements on matters of finance, reality always gains the upper hand.

Islamic Sukuk & Capital Markets, A 3 day intensive course Venue: Dubai, UAE, 3 - 5 December 2007

Braking news: lenders actually bear risk

In stretched analogical terms, a sukuk is only somewhat like a bond, but not a bond as we know it, as Guambat has repeatedly shrilled.

First, its analogy is to a properly rated bond, not the AAA type ratings agencies have been so free with. This is the lesson from the news of the moment coming out of Dubai. Junk bonds are, after all, also bonds. And the Dubai sukuk have all the shine of junk bonds at the moment.

Dubai World’s Debt Not Guaranteed by Government (Update2)

“It is correct that the government owns Dubai World, but the decision when it was set up was that it should receive financing based on the viability of its projects, not on government guarantees,” Abdulrahman Al Saleh, director general of the emirate’s Department of Finance, said in an interview with Dubai TV, when asked whether the government was backing the debt.

“The lenders should bear part of the responsibility.”

It is this last notion that is so central to the theological principles of Islamic finance that Western financiers find so hard to embrace, even if they pretend to understand.

More of this braking news at Times Online: Investors face huge losses as Dubai abandons debt company

It has also emerged today that Nakheel has requested that all three of its sukuks (Islamic bonds) traded on the Dubai stock exchange be suspended. This includes the $4 billion sukuk due to mature on December 14, which triggered the current crisis.

The group’s statement said the three sukuks would remain suspended “until it is in a position to fully inform the market”.

This may yet turn out to be the feared solvency issue and not a "simple" liquidity one.

Dubai Update

However this isn't just a liquidity crisis - this is a solvency crisis (the assets are almost certainly worth less than the liabilities) - and this does nothing to address the solvency issues.

Dubai bonds sukuk

The Western financial full court press still does not get it. As Guambat has repeatedly pointed out in his last three posts, a sukuk is not a bond. There is an emerging world market of difference. And it is a difference with distinct implications for the Western order of capital, as a quick perusal of the prior posts would reveal.

Bloomberg:

Nakheel PJSC, the Dubai government- owned company that wants to defer payment of its $3.52 billion bond due in two weeks, asked Nasdaq Dubai to suspend the securities until it provides further information to the market.

WSJ:

Dubai World's real-estate unit Nakheel on Monday asked Nasdaq Dubai to suspend trading on all three of its listed sukuk, or Islamic bonds.

Reuters:

Dubai's Nakheel, developer of man made islands in the shape of palms, said on Monday it has asked for three of its listed Islamic bonds, or sukuk, on Nasdaq Dubai to be suspended until it is in a position to inform the market more fully.

Until the Western mind gets its head around the Islamic notions of debt (it doesn't exist as we know it), their mouths will continue to shoot off like a blind man at a shooting gallery.

Willem Buiter, Citibank's new Chief economist, is not one of those:

The intrinsic unimportance of Dubai World and the important wider message it conveys

It would make sense under normal circumstances for the creditors to put Nakheel into default and take control of and liquidate its assets to minimize their losses. However, Nakheel’s assets are mostly in Dubai - land and structures, finished and unfinished. We don’t know what creditor righs, especially foreign creditor rights are worth in Dubai. Will legal judgements reached in London be enforceable in the courts of Dubai? The jurisprudence of internationally traded sukuk (Islamic bonds), which comprise part of the debt involved, has not been fully tested before.

Meanwhile, back in Australia, the lot what told us the subprime events were a peculiarly American phenomenon from which Australians were immune are now telling us, again but this time about Islamic finance, no worries, mate.

Hands at the pump

For decades now it has been the hands at the pump of retail petrol stations throughout the West that have pumped up the assets of the oil pumping countries, primarily located in the Middle East, and particularly Saudi Arabia and more importantly little UAE's Abu Dhabi.

With the prospect of another leg down in the global meltdown of credit intermediaries, Abu Dhabi has held out a helping hand to ostensibly pump up the region's debtors, but more particularly its creditors.

Such pumping has allayed the fears of those worried about jumping from the high ledges of finance, especially brokerage, houses. Market's are rebounding fearlessly today.

So, time, again, for a bit of perspective on the situation, which has been characterized in Guambat posts here and here over the last couple of days.


Here's the latest teaser/hook on the developing story:

U.A.E. Eases Credit After Dubai World Debt Delay (Update1)

Dubai, the second-biggest of seven states that make up the U.A.E., and its state-owned companies borrowed $80 billion to fund an economic boom and diversify its economy. The global credit crisis and a decline in property prices hurt companies like Dubai World as they struggled to raise loans and forced the emirate to turn for help to Abu Dhabi, the U.A.E. capital and holder of 8 percent of the world’s oil reserves.

U.A.E. banks are already facing rising loan losses stemming from the global recession as the economy slowed and two Saudi Arabian business groups defaulted on at least $15.7 billion of loans. Provisions for bad loans at U.A.E. banks rose to 2.76 percent of the total as of the end of October from 1.92 percent a year ago, according to central bank data.

The U.A.E.’s banking industry is already the biggest among the six Gulf Arab states including Saudi Arabia, Kuwait and Qatar, with 1.54 trillion dirhams ($418 billion) in assets, central bank data shows.

Now, what about that UAE support for faltering Dubai?

First of all, it is not the end all and be all of everything gone wrong.

Abu Dhabi Extends Cautious Helping Hand to Dubai

Abu Dhabi says it intends to "pick and choose" how to assist its debt-laden neighbor Dubai. "We will look at Dubai's commitments and approach them on a case-by-case basis," a high-ranking government official in Abu Dhabi told Reuters on Saturday. "It does not mean that Abu Dhabi will underwrite all of their debts."

Al Jazeera on Saturday reported that the "case-by-case" support "is likely to disappoint many investors who assumed the city would provide a safety net for its neighbor."

U.A.E. Bank Pledge No Comfort to Dubai

The United Arab Emirates central bank said Sunday it would make fresh funding available to local banks if needed, but didn't offer specific support to Dubai. The federal government in Abu Dhabi, which bailed out Dubai to the tune of $10 billion earlier this year, hasn't yet indicated fresh support.

The central bank said it "stands behind" U.A.E. banks and would make available funds to local institutions, including local subsidiaries of foreign banks.

But the statement pointedly didn't mention Dubai. The central bank could still issue a more explicit statement of support.

Secondly, it ain't free.

Liquidity prop for UAE banks

The United Arab Emirates’ central bank set up an emergency facility today to support bank liquidity.

The bank said it was making available to domestic and foreign banks a special additional liquidity facility linked to their current accounts at the central bank, at the rate of 50 basis points above the three months Emirates interbank offered rate.

Which may go a little ways towards helping things if this is simply a liquidity issue and not a solvency issue -- see AS THIS STORY GATHERS MOMENTUM....

Finally, and to Guambat most critically, none of this addresses the fundamental structural flaws in the whole concept of Islamic finance.

Dubai Illustrates That Sukuks May Be Junk Bonds

It seems as though shariah-compliant bonds issued to expand this Islamic Beverly Hills are deemed to have little asset quality behind them. One bond analyst stated on Friday "We are of the opinion that the underlying assets are worth very little."

In short, unless Dubai or their neighbor Abu Dhabi ponies up with government backing, sukuks as an investment may be in deep trouble throughout the Islamic investment community. So much for trying to do an endaround on a religious principle.

Dubai Debts Test Islamic Finance

CAIRO – As the world is still recovering from an economic meltdown, an unfolding debt crisis in the flashy lifestyle-Gulf state of Dubai is sending shockwaves around the world, putting the booming Islamic finance to a test.

Islamic finance is one of the fastest growing sectors in the global financial industry.

Starting almost three decades ago, the Islamic banking industry has made substantial growth and attracted the attention of investors and bankers across the world.

A long list of international institutions, including Citigroup, HSBC and Deutsche Bank, are going into the Islamic banking business.

Currently, there are nearly 300 Islamic banks and financial institutions worldwide whose assets are predicted to grow to $1 trillion by 2013.

The Asia Legal Business website has coverage on the subject of so-called Islamic bonds and finance from a perspective of the business of lawyers. One such article discusses the attempts to issue them in North Asia, such as Japan and Korea. It notes,

The Korean Ministry of Strategy and Finance announced earlier this month that it had submitted a tax revision to the National Assembly, which if approved would pave the way for local companies to start issuing sukuk (Islamic bonds). Yet even if the law is passed Islamic finance faces stormy times. Regulators and lawyers may benefit from looking at the troubles that Japan has had in kickstarting its own industry.

Under existing Korean legislation uncertainty surrounds whether a sukuk meets the definition of a bond.

And it quantifies and characterizes some of the impetus of these non-Arab/Islamic countries to run with the other financial bulls with these statistics and comments:

In the past fear may have been a deterrent to the success of the Islamic finance industry, yet worldwide this is something that Korean companies can no longer afford to be frightened of.

Latest estimates indicate that Islamic financial assets are expected to surpass US$1trn in 2010. Sukuk issuance grew five-fold over the past four years to reach US$120bn in 2008 and the mutual fund market is estimated to reach more than US$11bn.

Korea's chaebol have made no secret of their desire to tap into the Gulf region's ever-increasing pool of investors to feed their infrastructure activities in the region. But as the GFC dries up financing funds from traditional funding markets, this "want" is quickly transforming into a "need".

The sub-prime crisis “as well as the bankruptcy of Lehman Brothers“ has limited the sources of funding available for Korean companies: and while this has started to improve, Korean companies may still find it difficult to raise and obtain capital in traditional markets like the US and Europe, said Park Soo Man, a partner at Kim & Chang.

No doubt, to be continued.

On the inconvenience of principal

Or principle.

Whatever.

When staunchly held principles come face to face with real life, ingenuity and artifice are called upon to sustain the principle against overwhelming proof of expedience. In the end there is either blind faith passing as ignorance (or vice versa), or the rise of skepticism, the death knell of most other isms.

And that is what the financial world is up against as the Financial Wizards in the Middle East and South East of Asia together with their brethren in London and other financial circles try to keep their principles from destroying their principal.

In a word, it's called sukuk.

Ali Arsalan Tariq's Masters thesis describes the context and evolution of sukuk, with these brief excerpts doing no justice to his work, which should be read in full:

Debt markets are an integral part of the financial sector and effectively supplement the funds provided by the banking sector. Islamic law (Shari’ah) prohibits the charging and paying of interest.

In addition to prohibiting interest, the Islamic law also prohibits trading under conditions that exhibit excessive uncertainty and ambiguous outcomes (Gharar).

Therefore, in countries where Muslim population constitutes an important segment of the society, traditional debt markets cannot flourish. Hence there is a high demand and need for developing alternatives to traditional debt markets that can be acceptable to the Islamic law.

In Islamic capital markets, interest rate swaps and other conventional forms of derivative instruments such as credit derivatives and detachable options are not available as Islamic law also prohibits these.

As a result, there has recently been a rapid growth of a thriving multi billion dollar market in Shari’ah compliant sovereign and corporate Islamic structured financial instruments known as Sukuk.

Due to the very novelty of Sukuks themselves there is a relative dearth of comprehensive research studies.

Mathew Goldstein outlined some of the chief characteristics of sukuk:

Islamic finance has five 'pillars':

1. The ban on interest.

2. The ban on uncertainty or speculation.

3. The ban on financing sectors deemed haram, or forbidden
-- such as weapons, pork or gambling.

4. The profit and loss sharing principle -- parties share
risks and rewards.

5. The asset-backing principle -- each transaction must
include an identifiable underlying asset.

Current risks are focused on 'pillar number five' -- asset
securitisation -- and vary according to which of two general
types an investor chooses: 'asset-based' or 'asset-backed'
sukuk.

ASSET-BASED, ASSET-BACKED: WHAT'S THE DIFFERENCE?

The difference lies in ownership and sale of assets.

Asset-based sukuk allow the inclusion of assets that may
not be legally recognised as being owned by the investors.

The assets fulfil sharia compliance in form. But they may
not ensure that investors can recover capital, through sale of
the asset, for example, in the case of originator bankruptcy.

Asset-backed sukuk stick more closely to the ideal of
granting the investor a share of a concrete asset or business
venture, and a share of the risk commensurate with such
ownership.

In this case, sukuk securitisation is structured around
investors' rights, or legal ownership, of a plot of land,
building, or other asset.

WHY ARE THESE RISKS SHOWING UP NOW?

The widespread loss of liquidity and lack of investor
confidence wrought by the post-September 2008 global financial
crisis sent ripples through the world of Islamic banking, due
to originator insolvency, defaults and debt restructurings.

The website with the unfortunate name "sukuk.me" is a financial news site dedicated to this corner of the finance world. It offers these insights/opinions:

Basics of Islamic finance

The conceptual difference between an Islamic finance and a conventional finance transaction lies in the fact that in conventional finance, the financial institution generally lends cash for a length of time, often direct to the client or borrower, of course based on a credit rating or evaluation, on the basis that the borrower would return the borrowed amount plus an interest amount. The interest amount and the original borrowed amount is required to be repaid to the lender over the loan period or by the end of the loan period. Thus the transaction in essence is the lending of cash against the return of a higher amount of cash, and not necessarily for a specific purpose. One of the basic ideas behind the interest rate is the time value of the money lent. The excess cash returned to the lender over and above the borrowed amount is considered "riba" in Islamic finance.

In Islamic finance, there is no direct lending of cash against return of a higher amount of cash, unless the transaction is "asset backed" implying that the transaction has to involve the sale and purchase of an asset. In a typical financing transaction, the Islamic financial institution will purchase assets required to be financed by a borrower at a price and sell them to the borrower at an agreed (higher) price allowing the financial institution to make a profit. This purchase and sale of an asset basically renders the financing as "Shariah-compliant". Islamic Shariah laws allow cash to be lent, but generally only as "Qard Hassan" where only the same amount of cash is required to be returned, if returned at all.

The point to note is that in an Islamic finance transaction, the financier takes an element of risk, that of ownership of an asset and consequent non-payment by the client of the asset's sale price. Any default penalties imposed to encourage payment on time do not accrue for the benefit of the lender but get paid to charity. There are other inherent risks in the transaction but the idea is that this risk-taking is what allows the Islamic financial institution to make a profit on the financing transaction. Therefore, even though the payment terms in a conventional and Islamic financing contract may look alike, there are differences in the conceptual structure of the transaction. Usually the profit margins charged by Islamic financial institutions are about the same as interest rates of conventional financial institutions, but this is largely due to competition, the required profits of shareholders of such institutions, and also quite possibly driven by higher legal and administrative costs pertaining to the financing transactions.

Banking on sukuk in a crisis

Abu Dhabi, Dubai and Qatar all have issued billions of dollars worth of conventional bonds in recent months.

Bahrain went a step further and issued a $750 million sovereign sukuk that attracted an order book of about $4 billion with strong demand from the Middle East. (Islamic bonds, or sukuk, are underpinned by physical assets whose returns are used to pay bond-holders, to account for Islam's prohibition of interest.)

Are these isolated instances of Gulf governments trying to increase their liquidity?

They are not. Regional governments are co-coordinating efforts to develop secondary bond trading. In the past creditors tended to hold the few bonds that were issued to maturity. The new government issuance will help develop a yield curve, which will make for more efficient pricing and give corporate issuers a benchmark to price against.

Also, it is a push by the region to further develop their debt markets and shift the pressure of bank lending to fund the mega-projects that have come to characterise the region.

The high-cost and long-term nature of these ventures, which include new economic cities, refineries and airport expansions, requires longer-term financing that has been increasingly difficult to secure as the global recession has tightened credit markets and sapped liquidity.

Kuwait and Saudi Arabia would be next in line to issue sukuks. Saudi Electricity plans to issue sukuk that could be worth about 5 billion riyals ($1.33 billion). Saudi Arabia also launched its new market for both conventional bonds and sukuk to offer firms new sources of funding amid tight credit conditions.

But, despite all the euphoria the fact remains that sukuks are more often illiquid.

Which brings us to the dubious world of the ego investing of Dubai. You see, if one of these sukuks were to blow up, how is the fall out handled? In bankruptcy court?

Not if it's a western court because the very first order of business in bankruptcy courts is to separate the debt from the equity, and shift the balance of powers to the debt holders. But a strict application of shariah would, at first blush, mean there is no debt: all is equity. What then? Who has priorities, and over what?

That is likely one main reason the world's markets are in a bit of uncertainty and dither over the latest from Dubai World and its tentacles, particularly since this is not the first shoe to fall on the matter.

Fears rise over Islamic bonds

Dubai’s request for a debt standstill for one of its largest state-owned conglomerates has raised the possibility of the largest Islamic bond default on record and rattled the global Islamic debt markets.

Nakheel, the Dubai developer behind many of the emirate’s gaudiest projects, has to find $4bn to repay an Islamic bond, known as sukuk, by December 14.

The Nakheel sukuk has been seen as an important indicator of how Dubai will manage the liabilities of its multifarious government-related entities, but a failure to repay the bond fully and on time could impact the global sukuk market, estimated at over $100bn.

“There is a lot of shock and a little bit of anger,” said Nish Popat at ING Investment Management in Dubai. “This is a major blow to the sukuk market. If it defaults, it would be the third one in the Gulf, and the largest Islamic bond default ever, and we’re still waiting to see how sukuk-holders are treated in situations like this. There aren’t any precedents.”

Western investors watch nervously as worth of Islamic bond is tested

According to Neale Downes, a Bahrein-resident partner at Trowers & Hamlins, the law firm, it is not clear how creditors will rank in an insolvency.

Islamic bond problems herald due-diligence era

"If there are lessons to be learned here, it is that due diligence is all important. Compliance to sharia in its structuring does not ensure the success of a sukuk or of any product or business," said Yusuf Talal DeLorenzo, chief sharia officer at fund management company Shariah Capital

.
Dubai Government Shock May Not Be Last

With sovereign finances stretched, investors need to remember that governments can and will change the rules when necessary. Asset prices buoyed by a faith in policy support may need to adjust to that.

Dubai's decision may mark a watershed. Throughout the crisis, governments have so far looked to prop up key assets: after the global banking bailout, support was extended to key automakers in the U.S. and Europe. At a sovereign level, countries have banded together to provide support to peers in trouble, such as Latvia. Dubai itself set up a Financial Support Fund for its government-related companies.

But all of this support carries a cost. Governments are under increasing pressure to rein in their borrowing, particularly as central banks start to withdraw their extraordinary policy measures, thereby removing some of the support for government bond markets. As a result, they may no longer be able to provide such wide-ranging support. The result could be more nasty surprises as government cast other unviable investments adrift.

AS THIS STORY GATHERS MOMENTUM....

Dubai Debt Woes Raise Fear of Wider Problem

“Dubai shows us that what we are now facing is a solvency issue, not a liquidity issue,” said Jonathan Tepper, a partner at Variant Perception, a research house in London that has been outspoken on the debt problems facing European economies.

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