Dubai's Debt Troubles Should Trigger Caution

(MoneyWatch)  Dubai sent a scare through the markets last week with its decision to delay making interest payments owed by its primary investment vehicle, Dubai World. Given the fragile nature of the global economy, it's a good idea to double check your investment strategy and make sure you aren't taking more risk than you can handle.

What's the big deal? Dubai is a relatively small player in the global markets and the amount of money we're talking about isn't huge. But that's not the point. The issue is expectations, and the markets weren't expecting a potential default from a sovereign-type debtor.

• Consider that a few weeks ago one of the country's largest lenders, CIT Group, filed for bankruptcy. But it didn't even register as a blip in the markets that day. Why? Because investors expected it. The problems at CIT were known for well over a year, and investors had already priced their bankruptcy into the markets.

New Risks. The Dubai issue is a bit different. It highlights another layer of risk that may not have been fully considered by investors, and that's the risk that weaker governments may default on their debt. If this risk had already been priced into the markets, you wouldn't have seen a sell-off at the end of last week.

• At this point, nobody knows whether Dubai is "the canary in the coal mine" or just a single dead canary. And only hindsight will tell us whether this event has any long-term significance. Personally, I hope it's just a little speed-bump on the broader road to recovery. But what I hope for has little bearing on the reality of the situation. When it comes to your life's savings, it's always a good idea to make sure you're prepared to handle whatever the markets might throw at you.

Short Memories. One thing you'll notice in the world of finance is that investors tend to have very short memories. A number of market commentators have already expressed their opinions that Dubai is a non-issue; it's nothing to worry about. In general, they feel the potential default is contained to one small country that made some foolish decisions about debt. I can't help but feel that this assessment sounds strangely familiar:

• When the first signs of mortgage trouble emerged in early 2007, lots of people, including those at the Fed, felt very confident that the mortgage problems would be contained. They saw the crisis as limited to a small and economically insignificant percentage of the population that just made some foolish decisions about the amount of debt they could handle.
• Unfortunately, they were completely wrong. Sub-prime debtors were just the first ones hit by the crisis. And remember it took almost a year and a half for the full nature of the sub-prime crisis to make itself known.

Thus, I wouldn't be so quick to dismiss Dubai in this current environment. Maybe it's just the last gasp of the credit problems, but maybe it's not. No one has enough data to accurately make that assessment right now.

Bottom line. Recognize that Dubai's debt troubles introduce a new risk into the global financial markets, and double check your risk profile.

As with all investment matters, consult your individual advisor prior to making any financial decisions.

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