There are always areas of excess in every market boom phase.? Dubai is an example of that.? Why can they build the tallest building, and construct islands in the Persian Gulf?? Cheap capital, riding on the oil boom, sent Dubai to incredible heights.? In an economic game of crack-the whip, Dubai is at the end of the line — they don’t have much energy production, but they have grandiose ideas that benefit if those with oil wealth decide to spend money nearby for fun, rather than abroad.

Now the Dubai government’s champion development corporation, Dubai World, faces bankruptcy.? Given the debt guarantees of the Dubai government, what happens?? Dubai is not big, and as part of the United Arab Emirates, is reliant on help from the other Emirates, particularly Abu Dhabi.? The worries are that there could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World.? Most of those are either UAE-related or European banks.? This isn’t a US issue, unless it becomes a big European issue — unlikely, but remember that European banks are more levered than US banks.? The US Dollar has been gaining on this news.

Secondary aftershocks would be entities similar to Dubai — other places in the world that have borrowed a lot in an attempt to grow rapidly.? Thus many emerging markets are getting hit in this mini-crisis.? What investors should remember is that in ordinary circumstances (peace, absence of famine, plague, or rampant socialism), the economy tends to grow at about 2%/year.? One can try to increase that by borrowing, and at the right opportunity that can be a winner.? But most of the time, huge increases in debt levels are eventually associated with default.? In a highly leveraged financial system where lenders are themselves indebted, defaults can cascade.? Also, as mentioned above suspicions get raised with similar entities for a different type of cascade.? A third aspect can involve a reduction in general willingness to take risk on the part of most investors.

Often at such a time, various government ministers/bureaucrats come forth and say, “There is nothing fundamentally wrong here.? All we need is to restore confidence.? This is not a solvency issue, it is a liquidity issue!”? Uh, maybe, but keep your hand on your wallet.? One has to examine how separable the various economic issues are.? Where contagion exists, it is like a massive arrangement of dominoes.? The more leverage on any entity, the taller that domino is.? The more leverage in the system, the more tightly the dominoes are spaced.? That arrangement can be stable for a time.? Stable, that is, until someone knocks over a key domino.

Now, most analysts are saying that this situation is contained, and after falling hard for the two prior days, European markets are rallying today, including financials.? Values for debts closely related to Dubai World have fallen hard, and S&P and Moody’s have downgraded them, and may declare the payment delay to be a default. (Also, with credit to Moody’s — they did downgrade many Dubai-related entities earlier this month.? Remember, with rating agencies, smart investors ignore the ratings, and look at what the analyst says.? The Moody’s analyst highlighted the lack of any explicit guarantees from Dubai.)

I would simply say be careful.? The total debts of Dubai-related entities are not clearly known, and the degree of willingness of friends and lenders to support them is unknown.? In the credit business, relying on the kindness of strangers is not a wise strategy.? The challenge is to see that in advance and avoid debt situations where informal reliance on third parties is a large part of the case for creditworthiness.? I would add that investors in junior debt issues, including Islamic pseudo-debt issues have to be cognizant of the lack of guarantees involved.? Study the prospectuses with care in such situations, and avoid risks that are less clear, particularly during bull markets, where the rewards for being correct are small.

Other selected articles on the mini-crisis:

• Dubai Crisis Means ?Correction? to Mobius, Risk Aversion to Das
• European Banks Face Potential Dubai World Losses
• Time to Reread the History of Austria’s Creditanstalt in 1931… (h/t CR — banks failing can really drive a crisis)
• Dubai Government Shock May Not Be Last
• ?The Sun Never Sets on Dubai World.? Really?
• Barclays Capital ?change their view? on Dubai (Izabella Kaminska writes well, as do most of the writers at FT Alphaville.? In this case, Barclays had been quite bullish on Dubai World, and recent events have caused them to shift.)