What does Dubai mean to you? (El-Erian in The Daily Telegraph )

Dubai: what the immediate future holds
Until last Wednesday, most investors saw Dubai as an attractive tourist destination, a regional financial centre and an example of what bold and visionary leadership can achieve.

By Mohamed A El-Erian
Published: 12:23AM GMT 29 Nov 2009

Some worried that Dubai's impressive achievements came with a debt burden that would prove difficult to sustain after last year's financial crisis.

This weekend, investors around the world are united in wondering "what does Dubai mean for me?"


At the local level, the standstill is an explicit recognition that the Emirate's debt and leverage levels cannot be sustained in what, at PIMCO, we have called the "new normal". The question for Dubai is now two-fold: can an orderly extension of debt payments be achieved; and how will this impact the risk premium that is attached to other economic and financial activities in the Emirate?

The key issue at the national level is how Abu Dhabi, the largest and richest of the seven UAE Emirates, will react. Here, it is a question of willingness. The leaders of Abu Dhabi must strike that delicate balance between using enormous wealth to support Dubai and ensuring appropriate burden sharing among those that repeatedly failed to heed Abu Dhabi's past warnings about the excesses in Dubai.

The regional dimension is captured by a word familiar to investors in emerging markets: "contagion". The immediate reaction of almost all markets (and too many commentators) is to lump together countries in the region that have very different characteristics. Witness how market measures of risk have surged for all the oil exporters in the region even though they share none of Dubai's debt and leverage characteristics.
At the global level, the Dubai announcement serves as a catalyst to take the froth off expensive financial markets. For the last few months, massive injections of liquidity (primarily by the US), aimed at limiting the adverse impact of the financial crisis on employment, have turbo-charged financial market valuations rather than make their way to the real economy. While many have worried about the generalised over-extension of equity markets, most have hesitated to take money off the table as there did not appear to be a catalyst to break the general "trend is your friend" mentality. Dubai is that catalyst.

So, what next?

First, it will take time to sort out the Dubai situation. Inevitably, this is an uncertain and protracted process that involves both on- and off-balance sheet exposures. It will cast a cloud not only on companies in the Emirate itself but also on institutions that have large exposures there, especially in the banking and real estate sectors.

Second, the immediate indiscriminate sell-off in regional (and emerging market) names will, over time, give way to greater differentiation based on economic and financial realities. Those with strong fundamentals will recover (including Abu Dhabi, Brazil, Kuwait, Qatar and Saudi Arabia) while others, including countries with large deficits and debt burdens in eastern/central/southern Europe, may come under more pressure.
Finally, and most importantly, Dubai serves as a warning to those that were quick to find comfort in the sharp market rally of the last few months. Since the summer, the appreciation of risk assets has been driven predominantly by artificial liquidity injections rather than fundamentals. The Dubai announcement is a reminder that a flood of government-induced liquidity cannot mask all excesses, all the time.
Investors should treat last Wednesday's announcement as an illustration of the lagged financial effects of the global financial crisis. The Dubai situation is no different than that facing commercial real estate in the US and UK.
Let Dubai be a reminder to all: last year's financial crisis was a consequential phenomenon whose lagged impact is yet to play out fully in the economic, financial, institutional and political arenas.

Mohamed A El-Erian is CEO and co-CIO of PIMCO, the investment management firm

Demand for Build America Bonds (WSJ)

Investors Push to Extend BABs By ANDREW EDWARDS

The Build America Bond program isn't set to expire until the end of 2010, but portfolio managers and other investors in this new class of taxable municipal securities already are arguing to extend it. The reason: The bonds, known as BABs, have done their job. They have helped states, cities and other local government entities tap new capital markets and lower financing costs.

The credit crisis obliterated much of the demand for municipal debt. Money-market funds lost their appetite for variable-rate bonds, and funds that had borrowed heavily to invest in munis disappeared almost entirely.

Municipalities were forced to delay issuing new debt, or to offer unheard-of rates to attract enough individual investors to fund projects. BABs were meant to change that, and they did: New investors have come to the table and tens of billions of dollars in BABs have been issued.

"BABs are a much better foundation for the muni market," said Peter Coffin, president of Breckinridge Capital Advisors, which has $11 billion in municipal bonds under management. "It's a deeper source of demand."

The question is whether they are worth the long-term cost.

The most popular form of BABs pay higher interest rates than tax-exempt muni bonds and recoup 35% of the interest charge from the federal government. So, if a public university sells BABs with an interest rate of 5%, the university ends up paying only 3.25%, with Uncle Sam's subsidy effectively picking up the difference.

This makes BABs attractive to municipalities, which end up with an actual cost of capital even lower than on traditional tax-free muni bonds. The triple-A rated Virginia College Building Authority recently issued tax-free bonds due in 2027 at a par yield of 4.25%, said Ben Landers, head of taxable municipal-bond sales and trading at investment bank Morgan Keegan in Memphis, Tenn. Similar Virginia transportation BABs yield 5.72%, he said, but the actual cost to the state is 3.71%.

"If you're building something it makes sense to go BABs," Mr. Landers said.

However, that subsidy adds up. Assume that BABs yield an average of 5.95%, the average yield on Wells Fargo & Co.'s BAB index at the beginning of November, and that $48.3 billion of BABs have been issued this year. That means, year to date, the federal government has been put on the hook for $1 billion in yearly interest payments, a number that is only going to increase.

Advocates of BABs said that much of that figure is likely to come back in the form of federal taxes. They said these bonds potentially could end up costing the government less than the tax-free alternative if, and it is a big if, the taxable securities don't end up largely overseas or in the hands of nonprofit groups, pension funds and other institutions that aren't taxable to begin with.

Right now, those institutions shun lower-yielding munis because they don't benefit from the tax exemption on interest. They also are the major source of new demand for BABs.

"We really don't have a group of investor that can't buy BABs," Mr. Landers said. "For tax-free bonds, it's a very finite group of people."

BAB supporters argue that it is a more-efficient subsidy. The increased demand eventually will drive down yields, and the savings will be passed on to taxpayers. This is in contrast to the tax-free bonds, where the full benefits, they said, were never priced in.

Public advocates worry that the increased ease in raising capital could be an invitation to spend the easy money less wisely.

"It's an awful lot of money that's being put into the market without more transparency," said Michael Lakosky, at New York University's Institute for Public Knowledge.

Write to Andrew Edwards at andrew.edwards@dowjones.com