Dubai's Debt Woes: The Canary in the (Commercial Property) Coal Mine?
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The announcement that Dubai World intends to restructure at least $26 billion in outstanding debt has reignited fears that the volume of debt coming due over the next few years is simply too large to be paid down or refinanced. Dubai World received so much attention because it involves commercial real estate and emerging market sovereign debt, the primary areas of concern for credit markets. Much of Dubai World’s borrowing is collateralized by new commercial structures of questionable economic value – indoor ski slopes in the middle of the desert, for example – and that now seem entirely unaffordable in the midst of a deep global economic contraction. And while Dubai World is not a sovereign, but a government-owned company, its default has led to growing concerns about the ability of countries like Latvia, Greece, and Vietnam to meet their principal payments.
Globally, an estimated $2 trillion in debt secured by commercial property is set to mature in 2013, with little prospect for all of it to be refinanced at par. The problem in the commercial real estate business is two-fold: the income expected to be generated by commercial properties has fallen short of estimates due to the recession, which has compromised the ability of commercial real-estate owners to meet debt service payments. But, more significantly, the market value of many properties has fallen below the outstanding balance on the loan used to purchase it. As the U.S. government has discovered with attempts to rework past due residential mortgages, lower interest rates are insufficient to induce borrowers to remain in “underwater” properties. As a result, unless property prices rebound sharply, default rates on U.S. commercial mortgages are being projected to continue rising above the current 16-year high of 3.4%.
The critical issue going forward is whether the capacity exists for commercial real estate debt to be refinanced. It’s an open question, given the contraction in the banking sector, coupled with the dramatic increase in the issuance of sovereign obligations to finance budget deficits. According to the Bank for International Settlements (BIS), bank balance sheets have contracted by more than $3 trillion globally since the end of 2007. This figure omits the dramatic contraction of asset-backed securities (ABS) issued by non-bank entities, which has further compromised available financing.
Future balance sheet capacity is also impacted by the current policy stance of the Federal Reserve. The Fed finished the month of November with $2.1 trillion in assets, including $1 trillion of Fannie Mae and Freddie Mac debt and mortgage-backed securities (MBS). The purchases of these securities are expected to continue into the first quarter of 2010, at which point hundreds of billions of dollars of MBS issued to fund new mortgages will have to find a home somewhere else in the financial system.
At the same time as the capacity (demand) shrinks, supply will spike as major industrialized nations issue $12 trillion in gross debt this year. According to the Fed, total U.S. government debt (federal, state, and local) grew by $3.8 trillion from the end of 2003 to the second quarter of 2009. Yet this dramatic increase in outstanding debt is trivial relative to the $6.5 trillion in net new obligations the federal government plans to issue over the next six years. And, of course, this net figure does not include all of the new bonds the Treasury must sell just to rollover the $7.7 trillion in outstanding obligations. At some point in the near future it will not just be the solvency of the emerging market sovereign issuers that investors fret about.
Ultimately, debt needs to be scaled to income. The nominal dollar figures matter less than the size of the economy. Were the government to incur new debt now to expand the economy’s productive capacity, the short-term spike in sovereign debt would actually help generate the cash flows necessary to pay down the private sector debt burden. While this is partly the theory behind the stimulus, the trillions of dollars of out-year deficits are entirely inconsistent with a short-term, targeted approach. More ominously, the recent data on employment suggest that the stimulus has done little to alter the trajectory of the economy; job losses at this point are hardly different from that which would be projected in the absence of any stimulus.
The request by Dubai World for a debt restructuring is a reminder that even though the financial markets have stabilized, significant risks remain. These risks are being compounded by a U.S. fiscal policy that is creating trillions of dollars of new Treasury obligations, which are competing with private sector debt. Instead of generating economic activity that would allow private sector borrowers to pay down debt, the legacy of the stimulus may be adding a new asset class to the list of debt obligations about which creditors must be concerned.