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Banks in Dubai Gamble with Oil Revenue Securitization

Hi – Sunil here to talk about how banks in Dubai engaged in oil revenue securitization that contributed as just one factor to the demise of the Dubai financial markets in late 2008.

It is no secret that the world experienced a global correction in its economies in late 2008.

That said, certain economies were and still are stronger than others (others are weaker as a result).

It all comes down to market and economic fundamentals. Strong fundamentals = strong results, or at least better results than others.

One way economies can deteriorate their strong fundamental position is by gambling on future predictions.

Such was the case with many Middle Eastern countries, including the Emirate of Dubai when it gambled with its predictions about future oil revenues.

Business in Dubai was great until corporate earnings started hurting. As a result, companies laid-off people and others experienced heavy cuts in salary. You cannot retain your Dubai visa when you are no longer employed. Therefore people started to leave the Emirate.

The ones that remained had fewer discretionary dollars to spend and therefore companies kept on losing money. More lay offs followed and suddenly people defaulted on their car loans and mortgages. Do you see the never ending spiral?

Now add to all that the effects of gambling on oil revenues that contributed to banks in Dubai defaulting on their own loans (money they had borrowed to fund projects around Dubai). So while the individuals like you and I were suffering at the lower level, the banks in Dubai were suffering on a much larger scale at the top level. This was indeed the economic perfect storm.

What Happened?

The Dubai Government owns and initiates most projects and developments in Dubai. They also own most of the bigger industry drivers such as banks, real estate developers, mortgage and insurance companies, the list can go on forever.

So as you can imagine, it is very important for the government in Dubai to remain strong, soluble and profitable to be able to continue funding projects and developments. But Dubai got carried away with its success and started taking uncalculated risks.

One such instance was the Government’s effort to raise capital (cash) sooner to fund bigger and better projects. The way it raised this cash is by securitizing future oil revenues into hard cash today.

This is how it works. Dubai has some oil resources that it extracts, refines and sells to other countries. When a barrel is sold to a seller, the seller typically remits payments when the sale is made. The price of oil had reached a historical high in early 2008 (i.e. gas was over almost $5 per gallon in the USA for the first time in history).

Greed crept in and the Dubai Government started to borrow money from others to rapidly fund projects and developments. Communities, businesses, buildings were cropping up every single day. Dubai gambled on the fact that it could pay off those loans with the historical high oil revenues coming in.

In some cases, it also “sold” the oil revenues in advance to investors. You are probably wondering how can one sell something they have not extracted yet? This is essentially securitization. Banks in Dubai (many Government owned and driven) were banking on the fact that they will cash in from future oil profits.

Say a gallon might earn Dubai $4 in the future when extracted and sold. What the Government did is approached an investor and said we will sell you this gallon for $3 today. When we extract it and sell it for $4 tomorrow, you can pocket the $1 profit. It is a win-win for all. We get our money now and you make profits later.

Can you predict the disaster coming? Yes exactly. When oil prices tanked from over $100 per barrel to near the $40-50 range, what do you think happened? The investors who bought these future oil contracts weren’t very happy and they came after the banks in Dubai. Dubai defaulted on several of these contracts.

Dubai could no longer raise money this way and it had to postpone some developments and projects. Many got cancelled outright. Many experts predict that this core fundamental problem will continue to put downward pressure on prices and the Dubai economy in general through 2010 and maybe even 2011 until things fully stabilize.

As if this was not enough, people started suffering financially when the economy turned sour. Spending and investment in real estate declined severely. Since most developments were and still are Government owned, the Government started suffering more from cash flow problems. It just became insolvent.

- - -

The heavy effects were felt on several Dubai investments and the Dubai stock market. That said, the injury wasn’t as bad as it was to some other Emirates and countries which rely more heavily on oil revenues. Less than 7% of Dubai’s annual GDP comes from oil revenue. So in comparison to the rest, you can say that Dubai didn’t suffer as much.

The practice of securitization is very common in the banking industry. Many banks in Dubai (and elsewhere around the world) that underwrite mortgages actively engage in securitization. What typically happens is that the bank would bundle-up a bunch of mortgages and sell them to an investor so that it can cash out today and use the cash for other investments.

That is why sometimes your mortgage statements keep changing from one sender to another. Do you ever notice the bank’s name on your statement change suddenly? A lot is going on in the background and you might not always know every detail of what is going on. But now you know the rest of the story :-)

For the small business out there, this is very similar to factoring receivables wherein the business will pledge the receivables (money owed but not yet collected) owed to it by its customers to a third party for a discounted payment upfront. These types of deals come with or without recourse.

“With recourse” means that the buyer/investor has some protection if the deal does not go on to benefit the investor. “Without recourse” implies that the investor bears the full risk of loss after the transaction. Again, there are bigger and more widespread reasons to Dubai’s economic collapse in late 2008, and securitization of oil revenues is just one small component of it.

This is not a discussion focused on securitization, nor is it a website focused on complex business transactions, so I won’t continue with it for now. However this is a very interesting topic. Do read up on it if you get a chance and have the interest.

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