Many investors associate the bankruptcy of Lehman Brothers with the apex of the 2007/2008 credit crisis. Indeed, after Lehman Brothers failed, the stock market plummeted, credit spreads blew out, and numerous banks and companies required bail-outs. Many might believe that the losses from the largest bankruptcy in the United States triggered the collapse in the markets, but in reality it was merely the exposure of risk that spooked investors and triggered a stampede to the exit doors.
Lehman Brothers served as a shining confirmation of just how much leverage and low-quality loans resided in the financial system as well as how vulnerable financial companies were to liquidity strains. At $60B in debt, Dubai is not large enough to take down many banks and the concrete losses in the United States (besides $1.2B held by CitiGroup) will be minimal. The true harm comes from the fact that the frailty of Sovereign guarantees has been brought to light. Many believed that Abu Dubai would come to its neighbor’s rescue in time of financial need, a gamble that simply did not pay off. Needless to say, this event has put other countries with high debt burdens under the microscope and might be the start of a renewed wave or risk-aversion.
The default of Dubai only raises interesting questions for investors: How do countries with high debt burdens and ties to the Euro, a currency that they cannot freely print, manage their way through the financial strain? What would happen if a country as large as Greece or Ireland defaulted? Would Japan or the United Kingdom be the next countries under the gun? Instead of seeing the possibility of a domino collapse of banks, could we instead see a domino collapse of countries? Who is able to bail out a developed nation and what lasting consequences would that have on the world financial system?