You know, that entire implosion of Dubai World thing over the past week.

I think that it is clear that Dubai was created with a lot of other people’s money. (see pics)

What’s more, these people got pretty good returns for their investments.

The fact that everyone is shocked that high return investments are risky is to ignore a basic fact of investment.

Tobin Harshaw of the New York times thinks that this indicates that this points to greater fragility in the world financial markets than was previously believed, which I file under, “After Lehman, I thought we knew that it was all a house of cards.”

Felix Salmon also notes that once again, investors were surprised when a broke creditor admitted it, because, after all it looks bad:

I remember the days when investors felt that in the world of emerging markets, publicly-traded bonds were implicitly senior to bank loans. But those days came to an end in the late 1990s with bond defaults in Pakistan, Ukraine, and Ecuador — and they’ve never returned. And it’s not even obvious at this point that restructuring loans is easier than restructuring bonds.

It was nuts then, and it’s nuts now. If you are getting a lot of interest it is because you are lending to a poor credit risk.

I would also note that in this case, “broke” does not mean illiquid, but insolvent, meaning that a short respite to get cash flow back does not work, and it has been clear for some time that Dubai has borrowed well in excess of any assets that it possesses.

One of the more interesting developments here is that many of these debts are neither bank loans nor bonds, but rather the rather arcane, though nominally publicly traded, Islamic financial instrument called the sukuk (Arabic: صكوك‎), and I have no clue as to the jurisprudence of the default of such an instrument….I don’t think that anyone has a clue as to how this will play out, at least not on such a grand scale.

I think that the repercussions in Islamic finance, both in how resolution is handled, and the willingness of investors to buy those instruments, will play out for decades.

In terms of a bail out, it appears that the Central Bank of the United Arab Emirates is going to help make lenders whole, but the government of Dubai is saying that it will not guarantee Dubai World’s debt, so things are still rather fluid, to put it mildly.