According to the Financial Times, some of Dubai's creditors have begun offering their loans in the secondary market.
This shouldn't be viewed with either alarm or amazement. This is a perfectly natural development. Some small lenders with no core relationship will be looking to remove themselves from a potentially messy situation. And there well may be reasons why larger creditors would want out.
A restructuring is an uncertain proposition. One doesn't know how much one will get back or how long it will take. With a secondary sale one knows exactly how much cash one is going to get. And there is no uncertainty about the timing of payments. No present value issues to consider.
Some math may help illustrate this point. Assume a $100 debt as this will enable a quick calculation of the percentage "haircut" or discount from face on a net present value basis ("NPV").
An equal principal payment of US$20 for five years at a 4% per annum interest rate (3 month Libor is currently at 0.25%) results in a cash flow of $24, $23.2, $22.4, $21.6, $20.8. Let's discount that cash flow using three costs of capital.
| Discount Rate | IRR |
| 9% | $88 |
| 10% | $86 |
| 13% | $79 |
But, the restructuring is probably going to involve an uneven cash flow. There is no way of knowing what it will be at this point. Let's assume principal payments of $0, $10, $15, $25 and $50. As I've posted before it's fairly typical to have a light amortization for the early years dramatically increasing in the later ones. With the same 4% interest rate, the yearly cash flow is $4, $14, $18.6, $28 and $52. Using the same discount rates the NPVs are.
| Discount Rate | IRR |
| 9% | $83 |
| 10% | $81 |
| 13% | $73 |
Another key consideration for lenders is the cost of personnel and management time that will be spent on the negotiations and crafting of the restructuring and then the subsequent monitoring. Dubai World is likely to be a complex task: a very large amount involved, wide diversity among creditors and financing instruments, etc. Decisions are likely to tie up not only senior loan officers, who might otherwise be out hopefully making good loans, but more senior management as well.
Some might suggest that some lenders might sell off a portion of their debt to get the remaining amount below the need to go to the very senior levels of management or the board. Of course, AA never would.
Considering all of the above, it's not to hard to see some lenders willing to exit at 20% to 30% discounts just on a present value and hassle factor basis. From a credit perspective, the greater the uncertainty about the ultimate recovery the higher the discount rate.
That may make it sound like lenders will be rushing for the exit. The situation is a bit more complicated. The decision involves an initial calculation of the trade-off of the pain of the loss to be recognized versus the economic benefits. But other factors are also important. Sometimes it is a question of capacity. An institution is facing bigger problems elsewhere. Loss recognition needs to be rationed with some losses deferred to future periods. Large enough losses can also harm one's career. In either case, extend and pretend provides a convenient way out. A miracle may happen. If not, then the problem has been pushed forward, often onto someone else's watch.
That may make it sound like lenders will be rushing for the exit. The situation is a bit more complicated. The decision involves an initial calculation of the trade-off of the pain of the loss to be recognized versus the economic benefits. But other factors are also important. Sometimes it is a question of capacity. An institution is facing bigger problems elsewhere. Loss recognition needs to be rationed with some losses deferred to future periods. Large enough losses can also harm one's career. In either case, extend and pretend provides a convenient way out. A miracle may happen. If not, then the problem has been pushed forward, often onto someone else's watch.
Purchasers of the loans will be looking at cash-on-cash returns. Their goal a high IRR. They have no interest in a "relationship" with Dubai. They don't care if they offend someone in the UAE, the GCC, MENA, etc. They will, as QVT did with the Nakheel bond, play hardball. They will be looking to maximize their price on exit.
Their exit can take place two ways. First, a 100% discounted cash payout – probably not likely here given the large amounts involved. Second, via a secondary sale of the loan after it is restructured and the usual price bump occurs. Third, if the buyer is a fund, it may choose to retain the restructured debt as the ongoing return (based on its original cost) will enhance the overall fund return. And the asset can be opportunistically sold to enhance returns if other investments' returns decline. Just the asset for one's Emerging Markets Fund.
Their exit can take place two ways. First, a 100% discounted cash payout – probably not likely here given the large amounts involved. Second, via a secondary sale of the loan after it is restructured and the usual price bump occurs. Third, if the buyer is a fund, it may choose to retain the restructured debt as the ongoing return (based on its original cost) will enhance the overall fund return. And the asset can be opportunistically sold to enhance returns if other investments' returns decline. Just the asset for one's Emerging Markets Fund.
Turning back to the FT article, the estimate of potential secondary sales of 20% of DW's debt is uncomfortably close to the 25% that could block the approval of a restructuring plan under the DIFC Insolvency Law. It would take just a few additional recalcitrant creditors to join them and frustrate a deal. That could complicate Dubai World's life.
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