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Dubai World: The Freddie Mac of the Middle East

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It's the same theme: The market demanding implicit "support" become explicit "obligation."

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On November 27, the editorial page of the Financial Times offered:

For its part, Abu Dhabi should give whatever help is needed to bring this episode of incompetence to a close. Abu Dhabi allowed it to be believed that it was backstopping Dubai, so it should make good its promises. This will require a public guarantee of Dubai's debts -- and soon. The reputation of the whole UAE depends upon it.


Replace Dubai with Freddie Mac (FRE) and the Abu Dhabi/United Arab Emirates with the United States of America and I'd offer that you come perilously close to any number of editorials written during the summer of 2008 as the US Government contemplated the fate of the Agencies.

But consider, too, that if you replace Dubai with CAFCO and the United Arab Emirates with Citigroup (C), then it's the summer of 2007, and the banking industry's bailout of its various off-balance sheet asset-backed commercial paper vehicles and SIVs.

Or how about inserting Royal Bank of Scotland (RBS) and The Bank of England?

They're all variations on the same theme: The market demanding that implicit "support" become an explicit "obligation," and, as a consequence, off-balance sheet guarantees turning into real on-balance sheet liabilities.

It started two years ago with the most overleveraged entities closest to the US mortgage industry and is now working its way around the globe as more debt-burdened borrowers surrender to slower economic growth and lower asset values.

But note the consequences: Within moments of Dubai World's debt repayment moratorium, CDS swaps on the United Arab Emirates spiked. Not only does the troubled borrower suffer, but so too does the "lifeguard." See also Dubai Debt Issues Send Markets Into a State of Flux.

There are trillions of dollars of guarantees, support agreements, and other footnoted contingent obligations out there. And I suspect that the longer this crisis goes on, the more these contractual (as well as reputational) "commitments" will move on to the right side of the balance sheet of governments, banks as well as industrial entities.

From where I sit, current spreads in the credit markets don't come anywhere near reflecting this risk. And neither do equity prices when you factor in the associated shareholder dilution that will be necessary to restore "lifeguard" leverage ratios when all is said and done.

But I'd also note that to date, the metamorphosis of implicit third-party commitments to explicit liabilities has, for the most part, gone smoothly -- some would even argue too smoothly. But Minyans would be wise to consider the enormous obligations that have been assumed by third-party "lifeguards" over the past 24 months, particularly by sovereign nations around the globe, as a result.

I suspect that at some point soon, the financial health of some "lifeguards" will be drawn into question. And at that point, troubled swimmers will be on their own.

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Position in SPY, SRS, and JPM.
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