Tuesday, December 8, 2009

Dubai and the "implicit" guarantee

In the last two weeks, we have seen the damage wrought by the potential default of Dubai World, a Dubai-government controlled company that funded some of the most extravagant projects on the face of the earth over the last decade.

While the magnitude of the default was large, it is interesting that it has shaken markets as much as it has. After all, there have been other large loan defaults in markets over the decades. So, why the panic? I think the reason lies in the unraveling of what I would call the "implicit guarantee".

What is the implicit guarantee? Consider a standard loan agreement, where a lender assesses a borrower's credit worthiness in determining how much to lend and on what terms. Through the ages, though, lenders have been willing to lend to borrowers who may not meet their credit worthiness tests, because their loans are backed up implicitly by others with deep pockets. Thus the money lender who granted a loan to the wastrel son of a wealthy merchant was trusting in the "implicit guarantee" of the father to pay back the loan; family honor was assumed to trump the absence of a legal obligation.

So, what does this have to do with Dubai World? Dubai is a city-state, with limited resources and economic capacity. The projects that were funded with the loans showed little potential of generating the cash flows needed to service the debt. However, Dubai is part of the United Arab Emirates, which has significant oil wealth and lenders assumed that the UAE would step in and provide backing, when the payments came due. At least so far, that has not happened.

Why does this have global consequences? Let's face it. A significant proportion of all lending is based on implicit guarantees. From bondholders in companies that are too big to fail (where the government is the implicit guarantor) to banks that lend to troubled family group companies (expecting the parent group to step in and save them), it is the implicit guarantee that allows for the lending. To those lenders, the Dubai World default is the stuff of which nightmares are made. The initial worry was that other implicit guarantors would use this crisis as the opportunity to walk away from their implicit obligations. While that has not materialized, it should serve as a wake up call to those who have been cavalier about implicit guarantees.

What is the bottom line? I am not suggesting that implicit guarantees are necessarily bad but they can pose a danger when too large a proportion of the debt in a system is dependent on them. Since none of the parties involved - the lender, borrower and implicit guarantor - make the obligation explicit, it is possible for them to misjudge the extent of their indebtedness and for investors to make the same mistake. I have seen many Asian and Latin American family group companies that have little or no debt on their balance sheets but have unconsolidated subsidiaries with massive debt on their balance sheets (backed up by the implicit guarantee). If we assume that these firms will honor their implicit guarantees, they should be treated as highly levered firms.


Mahesh Sethuraman said...

"If we assume that these firms will honor their implicit guarantees, they should be treated as highly levered firms."

Shouldn't this be the opposite. when I value a company which has no legal obligation to honour the implicit guarantee, why should I factor in that? Shouldn't this be fixed at the lending end?

If we lend to a company which may not clear the credit assessment requirements but for implicit guarantees, then the fix has to be here isn't it? If it is reasonable to assume that the implicit guarantee will be honoured when the situation demands, why shouldn't the guarantor give an explicit guarantee? In the case of Dubai - this may not be directly applicable since the implicit guarantor was the govt itself. But in the case of parent and subsidiary companies, this should certainly be more easy to implement.

If its not then the credit evaluation needs to factor in the probability of implicit guarantee not being honoured and then decide accordingly - to grant credit or not? If yes, then what pricing?

If this is done, its just like any other lending. isn't it?

Compendium said...

A good article about implicit guarantee. Thanks Prof for that. Always learning through your website in one form or another.

I think implicit guarantee is not included in the contract because that would set a bad example. For example, a rich lad with a propensity to loose cash in gambling, would have an implicit guarantee from his father to have him bailed out in case the bets fail. Each time the son gambles, he would factor in the chance that his father bails him out and then bet accordingly. But I personally think it would be impossible to set a probability that Mahesh Sethuraman suggested. The boy can set a probability himself, but he cannot sell that probability, and therefore would not be able to factor that into the gambling amount. I think we are looking at game theory in this case.

Unknown said...

Great post, "Dubai and the "implicit" guarantee"
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perpetual wonderer said...

@ Mahesh:

I think it depends on whose point of view you are considering. Assume you are a lender to a firm that has an implicit guarantee towards its subsidiary. In this case, although the firm you are lending to has no alarmingly high obligations itself, you know that should its subsidiary run into problems, the parent (the firm you have lent your money to) will be bailing it out. As such, you are in effect lending your money to a firm that will use it for paying off a debt obligation (albeit implicit). So, as a lender, you must factor this implicit obligation while valuing that company or lending your money to it.

Jānis Dubrovskis, CFA said...

But do lenders always know about implicit guarantees?
I think one has to gather information on a potential borrower for years before making any lending in order to properly price in the risk of implicit guarantees.

perpetual wonderer said...

@ Janis:

Well its your money! You need to do the groundwork. In fact, I suspect in some cases, the parent company might deliberately establish subsidiaries to accumulate debt and have implicit guarantees. That way the parent remains relatively debt free, and thereby gets access to cheaper funds for projects that would have otherwise had a hard time raising money!

But I also believe there are some regulatory norms (particularly while issuing IPOs) where the company does need to disclose info like this. Not sure though.

RW said...

Dear Prof.

You seem to imply that lenders kept lending on the basis of implicit guarantee. Guarantees, especially of this magnitude, are never implicit. The pertinent problem is that of

1. Agency Costs
2. Moral Hazard

The "implicit guarantee" guarantee is always the fall back excuse. Its the symptom, not the crime.

The reason for panic pointed out by you is correct. (Although they have bailed out, at least for now).

Let me know your thoughts.

Aswath Damodaran said...

Perhaps your argument is that they should be explicit but they are not. Dubai World is a classic example. Every banker who lent to Dubai World assumed that the UAE would come in and bail them out. None of them put down the guarantee explicitly.

As for Mahesh's point about whether we should factor in the probability that an implicit guarantor will come through, it is a legitimate one. I am not arguing that we compute debt ratios, using the implicit guaranteed debt as well, since that may be close to impossible to do. I am just saying that we have to start with the presumption that the debt ratios for family group companies are deceptive and do our due diligence.

perpetual wonderer said...
This comment has been removed by the author.
perpetual wonderer said...

Prof, I agree with your point that we need to factor in the implicit guarantees and expect returns taking the implicit debt obligations into account. However, out in the real world, isn't that being too wishful?

Because, good or bad as it is, the marginal investor (usually large institutions) is the one setting the prices. And as long as they don't factor in these implicit guarantees, there is very little a standalone 'smart' investor can do. He can only consider the securities overpriced and choose not to buy them. And miss out on the returns in the good times. Sure, when his fears realize he will be the one laughing. But how does he know when the implicit guarantee is likely to be invoked? It then amounts to the same case where someone knew an asset bubble was building up in say, 2004. Even though his fears turned out to be real, he could have made a lot of money if he was party to the madness. On the other hand, being 'smart' only left him as-is or marginally richer.

The point is, as long as we don't have a probability of the implicit guarantee being invoked by a certain time, does it make sense in simply saying that the company is not valued appropriately?

RW said...

Dear Prof

What I meant to say was that there were no guarantees, either implicit (cannot be factored in any decision making by the lending committee) or explicit (obviously there were none).

The business models prepared to justify giving loans were flawed and based on assumptions which were too optimistic (infinitely increasing demand/ rising real estate prices etc. You may call it a slightly sophisticated, Middle East version of subprime loans)

Implicit Guarantee appears to be a concept used to justify poor lending decisions, post facto and is now in vogue, after the global bailout of TBTF corporations.

Your logic is sound in theory, but in practice, I do not believe it happens.

Anonymous said...

It's very interesting to notice that the arguments presented here about an implicit guarantee, goes hand in hand with the austrian business cycle and their explanations about GDP fluctuations.

Isn't anyone forgetting about them, while discussing defaults and financial crisis?

Another thing; To factor in an implicit guarantee would increase the cost of lending. If you are a bank, such higher interest rates would probably reduce the total amount of lending such institution would be able to provide. And very likely reduce the overall return of its investments during the time span before the implicit guarantee has to be used (boom period). And if the implicit guarantee does occur, then the pricing was correctly done, if it doesnt, then there was a mispricing. It is a very big prisioner's dilemma, that can be solved only through the impicit guarantor expliciting its commitment not to step in, or to step in. Until then, the due diligence will remain uncertain, with the doubt about including or not, that a company might or might not be an implicit guarantor for one of its subsidiaries. The Dubai World case is even harder, for there are more incentives for giving cheap loans due to the existance of the UAE governemnt.