Tuesday, December 1, 2009

Dubai Crisis Tests Laws of Islamic Financing

Posted in the New York Times by Heather Timmons:

The debt crisis in Dubai is about to test one of the fastest-growing areas in banking, Islamic finance, and put the city-state’s opaque judicial system on trial, according to bankers and experts in finance.

Many loans and bonds that comply with Shariah, or Islamic law, were issued in recent years by Dubai World, the investment arm of Dubai, and other Persian Gulf companies as oil-rich Middle East nations increased spending, and the global credit crisis fed debt investments in emerging markets.

But, because there have been few major defaults in this market, there is little precedent for arbitrating the unique terms of these instruments.

That is likely to create many legal issues for investors in Dubai World, which sent jitters through global markets by seeking to delay payments on $59 billion in debt. Abdulrahman al-Saleh, director general of Dubai’s finance department, said Monday that Dubai World was not guaranteed by the government, and the creditors would need to “bear some of the responsibility” for the company’s debt.

Shariah-compliant investments prohibit lenders from earning interest, and effectively place lenders and borrowers into a form of partnership. Yet there are no consistent rules about who gets repaid first if a company defaults on such debt, said Zaher Barakat, a professor of Islamic finance at Cass Business School in London.

The first test of what that means for investors may happen around Dec. 14, when payments on a $3.5 billion Shariah-compliant bond owed by Dubai World’s real estate subsidiary, Nakheel, come due. If Nakheel defaults on its payment, legal proceedings may be initiated.

It is unclear what may happen next. Nakheel bondholders have formed a creditors’ group representing more than 25 percent of the outstanding debt, a legal adviser to the group said Monday.

Holders of these bonds “are going to argue that they are in the secured position on the underlying asset,” said one bank investor involved in the issuance of some of Dubai’s Shariah-compliant debt. That means that bondholders could insist on being repaid before banks, upending the traditional bankruptcy hierarchy.

“No one has tested the legal system or the documentation,” a lawyer briefed on the situation said.

The 237-page prospectus for the Nakheel bond provides little clarity. In the case of a bankruptcy by Dubai World or Nakheel, bondholders have no guarantee of “repayment of their claims in full or at all,” it said. Under Dubai law, it added, no debt owed by the ruler or government can be recovered by taking possession of the government’s assets.

A default would also pose a major new test for Dubai’s courts, which have never handled a major bankruptcy of one of the government’s own companies, lawyers and bankers said.

Unlike its neighbors, Dubai has kept its judiciary system separate from the United Arab Emirates Federal Judiciary Authority. The decisions of the Dubai courts, which are controlled by the emirate’s ruling family, can be fickle, say lawyers in the region.

For example, in order to bring a court case against a government-owned or government-run entity, a corporation or individual needs to get permission — from the government. In the prospectus for Nakheel bonds, investors are warned that “judicial precedents in Dubai have no binding effect on subsequent decisions,” and that court decisions in Dubai are “generally not recorded.”

Global issuance of Shariah-compliant bonds and loans grew 40 percent in the first 10 months of 2009 from a year ago, Moody’s Investors Services said in a November note to clients. The total amount of Shariah-compliant debt outstanding is estimated at about $1 trillion, up from $700 billion just two years ago. About 10 percent of Dubai’s $80 billion debt load complies with Shariah, bankers and analysts estimate.

Malaysia was traditionally the hub of Islamic finance, but much of this new activity has been centered around Dubai, and foreign and local law firms and banks there helped the emirate raise much of its debt. Dubai even has a school that turns students into “certified Islamic finance executives,” whose stamp of approval is required for an instrument to be deemed Shariah-compliant.

The surge in Islamic finance has led to hiring sprees at banks, and given rise to a series of new financial indicators like the Dow Jones Islamic Market index. Hoping to appeal to the Middle East’s huge sovereign wealth funds, even non-Islamic institutions have started to raise money using Islamic finance.

In October, the British Treasury drew up rules that would soon allow Britain to issue Shariah-compliant government debt. The same month, the World Bank issued $100 million in Shariah-compliant bonds.

Editorial posted in the New York Times by Andrew Sorkin:

The investments were supposed to be blessed, and the bankers were desperately looking for more people to bless them.

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.

He was struggling to hire enough Shariah scholars, he said, and he needed them to bless the investments — apparently there was a shortage of properly trained Islamic scholars who did this kind of work.

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.

With hours to kill before a late-night flight, I ventured over to the Ski Dubai indoor ski run. It’s a pretty good bet that a city with an average temperature of 90 degrees and an indoor ski slope is probably living a little too large. On one ride up the chairlift, I sat next to a 7-year-old from London who had just moved to town. With a big grin, he proudly told me that his father was in “the real estate business.”

For the last couple of years, the running joke on Wall Street was “Dubai, Mumbai, Shanghai or goodbye.” If you were the C.E.O. of a troubled investment bank desperately looking for cash, you made a pilgrimage to one of those three cities with hat in hand. They were the places most likely to write a quick billion-dollar check; their eagerness should have also been a tip-off. Now you have to wonder about Mumbai and Shanghai, too. Are they next in line to take a fall?

Willem Buiter, a former Bank of England official who was hired as chief economist of Citigroup on Monday, says that Dubai’s credit crisis is just the natural progression of “the massive build-up of sovereign debt as a result of the financial crisis.” He wrote on his blog on The Financial Times’s Web site that the contraction of credit “makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral.”

With all the money pouring into the region, it would have been hard for any doomsday types to make themselves heard. But there were whispers here and there, pointing out the obvious. David Rubenstein, the co-founder of the private equity giant Carlyle Group who was in Dubai at the conference, remarked to me at the time: “You know, they don’t have any oil here.”

That fact was overlooked by many investors who didn’t want to miss out on a quick buck. What about the risk? The view was, and apparently still is, that if Dubai gets in trouble, its oil-rich neighbors in Abu Dhabi will bail everyone out to avoid damage to their collective reputation and, by extension, the region’s economy. Just as the United States stood behind its banks, in part, to avoid losing the confidence of foreign investors, Abu Dhabi might have to do the same.

That had to be what Citigroup, with its firsthand expertise with bailouts, must have been thinking when it lent $8 billion to Dubai last year. Oh, and here’s an interesting fact: Citigroup made the loan to Dubai on Dec. 14, 2008. Take a look at the calendar — that’s after it received tens of billions in TARP funds. Citigroup’s chairman, Win Bischoff, said at the time, “This is in line with our commitment to the U.A.E. market in general, and reflects our positive outlook on Dubai in particular.” Good call. 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.

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