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When Allan Meltzer Ceased Being a Real Economist...

Dubai: Why, Yes, Our Collateral Is Underwater. Why Do You Ask?

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Paul Krugman is judicious and sober:

Rashomon in the desert: Dubai or not Dubai — that is the question. Dubai’s sorta-kinda default (a state-owned enterprise seeking a rescheduling of its debts) is, by itself, not that big of a deal. But who else looks like Dubai? What kind of omen is this for the next stage in the financial crisis?

As far as I can tell, there are three ways to look at it — three stories, if you like, about what Dubai means.

  • First, there’s the view that this is the beginning of many sovereign defaults, and that we’re now seeing the end of the ability of governments to use deficit spending to fight the slump. That’s the view being suggested, if I understand correctly, by the Roubini people and in a softer version by Gillian Tett.

  • Alternatively, you can see this as basically just another commercial real estate bust. Either you view Dubai World as nothing special, despite sovereign ownership, as Willem Buiter does; or you think of the emirate as a whole as, in effect, a highly leveraged CRE investor facing the same problems as many others in the same situation.

  • Finally, you can see Dubai as sui generis. And really, there has been nothing else quite like it.

Gillian Tett is less happy:

Greece and Dubai show system remains unstable: A watershed in the derivatives world could be reached this week: the cost of insuring against a bond default by Greece, using credit derivatives, may rise above the comparable metric for Turkey for the first time.... [O]n Thursday – as markets reeled from the Dubai shock and investors fled from risk – the bid-offer spread on five-year Greek CDSs was 201bp-208bp, according to Markit. That of Turkish CDSs was 207bp-212bp, leaving them neck and neck (and according to Bloomberg data, in some trades the Greek CDS was even higher than Turkey). All this is a bitter blow to Greek pride. However, there is a much bigger moral here, which cuts to the heart of the Dubai saga, too.

Two years ago, global investors generally did not spend much time worrying about so-called “tail risk” (a banking term for the chance that seemingly remote, nasty events might occur). After all, before 2007, when the world was supposedly enjoying the era of the “Great Moderation”, the world seemed so stable and predictable that it was hard to imagine truly unpleasant events occurring. But in the past two years, a seemingly safe financial system has crumbled, and – to paraphrase Lewis Carroll – investors have repeatedly been asked to believe six impossible things before breakfast, ranging from the collapse of Lehman Brothers to the implosion of Iceland (and much else). Tail risk, in other words, has leapt into investor consciousness. And while the financial markets have stabilised in the past six months, that lesson about tail risk cannot be easily unlearnt... has left investors looking like veterans from a brutal war. Long after the fighting has stopped, the mere sound of a “bang”, is apt to leave them running for cover.

All this does not mean – let me stress – that it is correct to expect the world to melt down imminently.... [But t]ail risk has resurfaced with a vengeance.... For while investors used to assume that it was just emerging market countries that were prone to suffering truly nasty fiscal shocks, the debt fundamentals in Dubai are not necessarily so different from those in developed nations... the fundamental imbalances that created the crisis in the first place – such as excess leverage – have not yet disappeared. Beneath any aura of stability huge potential vulnerabilities remain. If Thursday’s events prompt investors to remember that, so much the better; not just in Dubai but in Greece, too.