In Dubai, financial crisis looms

DUBAI, U.A.E. — Last year, when major banks in the U.S. and Europe were teetering on the brink of collapse, Middle Eastern and Asian banks that specialize in Islamic financing were riding high.

In the face of a global recession, the top-100 Islamic banks saw their combined assets grow by a gravity defying 66 percent in 2008, according to figures compiled by The Asian Banker.

But the increasing popularity and credibility of Islamic finance will be put to the test on Monday when Nakheel, the financially troubled property development arm of the Dubai government, faces default on a $4 billion Islamic bond known as a sukuk.

If Nakheel does default on the sukuk, bankers and lawyers will be entering uncharted waters as they try to restructure the debt or carve up Nakheel’s assets and those of its parent company, government-owned Dubai World.

“Most of Nakheel’s borrowing is in sukuk; the failure of Nakheel would be seen as a symbolic failure of Islamic banking,” said Kassim Dakhlallah, a professor of finance at the American University in Dubai.

But Dakhlallah thinks concerns about Dubai’s financial woes have been exaggerated in the Western media, mainly because of the West’s unfamiliarity with Islamic finance and its suspicion of all things Islamic.

Nakheel, he said, appears to be going through a liquidity crisis, not a wholesale collapse, and that both Nakheel and Dubai World, still have plenty of good assets.

Nakheel, which developed the famous artificial islands shaped like palm trees off Dubai’s coast, last week recorded first-half losses of $3.65 billion, but even after writing down its real estate investments, its assets were valued at $40 billion against liabilities of just under $20 billion.

Despite the looming mess in Dubai, Islamic banks came through last year’s financial meltdown in better shape than their conventional counterparts mainly because they tended to be more conservative in their lending practices and because they avoided things like derivatives and credit default swaps, said Dakhlallah.

“They also kept a high level of liquidity on their balance sheets, which helps in a crisis,” he said.

The Islamic banking system is predicated on the Quranic injunction against the collecting or paying of interest, so the key is to devise other means of realizing the value of money over time. Often, this is a simple matter of giving it a different name — like profit or rent.

But there are significant underlying differences between conventional banking and Islamic banking. In the Islamic system, borrower and lender become, in effect, partners in a risk sharing venture. If the venture fails, both parties share the loss, which tends to make lenders more cautious.

To comply with Shariah (Islamic) law, loans also have to be backed by actual assets. In the case of Nakheel’s sukuk, the asset is a Manhattan-sized strip of undeveloped waterfront property in Dubai that was valued at more than $4 billion three years ago.

But this is where things begin to get hazy. When the issuer of a conventional bond defaults, the first in line to get paid are the lenders, then the bondholders and then the shareholders. With a sukuk, it is not clear who has the first claim on the assets. Nor in the case of Nakheel’s sukuk is it clear whether this will be decided by courts in Dubai or in Britain.

Foreign creditors, including several large British banks, are believed to hold a 40 percent stake in bonds issued by Nakheel. Their lawyers and accounts have descended on Dubai, but Henry Azzam, chief executive of Deutsche Bank Middle East, which is the administrator of the Nakheel sukuk, has warned that taking Nakheel or Dubai World to court would be a “fruitless exercise.”

There is little legal precedent for what is happening now, although Nakheel’s expected default will be the third this year in the Gulf region. The Saudi Saad Group defaulted on a $650 million sukuk in June while Investment Dar, a Kuwaiti Islamic fund, missed a payment in April on a $100 million issue.

Despite the lack of clarity, Islamic financing seems likely to grow in the coming decade. Last month General Electric Co. became the first major American corporation to jump on the bandwagon when its GE Capital unit issued a $500 million sukuk. The loan is secured by income from aircraft leases.

These days, most major international banks have Islamic finance divisions, and the Harvard Law School now hosts an expanding Islamic finance program that grew out of university’s the Middle East studies department in the mid-1990s.

For Western banks, Islamic finance is simply seen as a marketing tool, a smart way to attract investors from Saudi Arabia and other wealthy Muslim countries who feel good about putting their money in Shariah — compliant investment instruments.

“At the end of the day, both systems are businesses trying to attract depositors and make a profit,” said Dakhlallah.

[Editor’s note: this story was updated to correct the date when Nakheel faces fault on a $4 billion Islamic bond known as a sukuk. The date is Dec. 14.]