Dubai, the Canary in the Coal Mine?

The S&P500 dipped 0.4% last week, notching two consecutive weeks of small drops.  Volume was very light due to the Thanksgiving holiday.  But the VIX (or fear) index jumped 12%, most of which occurred on the last day of the week when the markets sold off strongly on the news coming out of Dubai.

The economic data were mixed.  Existing home sales rose, but most of the rise was explained by the government’s home buyer tax credit program.  Third quarter GDP was revised down, from an initial 3.5% to 2.8%.  Consumer confidence rose slightly.  More troubling, durable goods fell; they were expected to rise.  Personal incomes rose 0.2%, as expected, and personal spending rose more than expected.  This raises the question of how much the government transfer payments are propping up incomes and spending, because these payments cannot continue–to this degree–indefinitely. 

The technicals are continuing to suggest that the rolling tops are sputtering, on a daily basis.  The 1,100 level has been extremely difficult to break through for over a month.  The uptrend, on the weekly charts, is still holding, but the force of the prior upward movements is getting weaker.  The monthly, two-year, downtrend is still in tact. 

Why did Dubai’s looming default scare credit and equity markets around the world, to such a great degree?

On the surface, the problem does not seem to warrant a huge response.  While Dubai owes its banks over $50 billion, much of this credit exposure is spread among dozens of banks and other lenders globally.  And after the financial events of 2007 and 2008, one would think–reasonably–that much of the Dubai credit exposure has been conservatively hedged.

But what if these hedges don’t hold up?  What if these hedges far exceed the amount of debt actually outstanding in Dubai?  What if firms such as AIG sold this insurance to these lenders?  If these sellers of insurance are forced to make good on their credit default swaps, what happens if they fail to pay up?

This leads to the ultimate risk.  What if the final backers of the debt in states such as Dubai (or what if the final backers of the insurance sold against the default of debt in states such as Dubai) are sovereign nations who fail to make good on this debt?  In other words, what if the government backstops around the world fail to hold?

Let’s remember that our problems began in 2007 with a credit (or liquidity) crunch stemming from sub-prime loans that went bad in the US.  This crunch expanded in 2008 to a global financial (solvency) crisis that exploded when most banks around the world lost access to funding and began to teeter.  But these banks were saved from falling by backstops from governments, governments that relied on massive amounts of borrowed (and printed) funds to prevent the collapse of not only the financial system but also the general economy.  Think of the U.S. saving Fannie Mae, AIG and Citigroup.  In Europe, think of the U.K. saving RBS and HBOS.

So here’s the great fear stemming from the Dubai crisis–what happens if the global credit markets begin to question the ability of governments to honor their backstops, especially when these governments themselves are in debt up to their eyeballs? 

If confidence in governments wanes, who’s going to bailout the governments?  God?

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