There is an expression that says: if you want to avoid falling from a great height, don’t look down. Or, to put it another way: it is only when you realise there is nothing beneath you that the act of falling is brought into being.

After years of booming confidence in the region’s banking sector – only slightly dented by the stock market crash of 2005-06 – it appears that in the summer of 2007 the sector finally paused, looked down and found that the ground beneath it was not as solid as it had assumed

The faults in the sector’s foundations stemmed from the non-repayment of complex structured products in the US housing market. The relationship between Middle East banks and loose lending practises to high-risk borrowers in the US mortgage market seems tenuous at first, but important links exist.

The increasing number of projects and corporate bond issues in the region being placed with international banks and institutions means appetite for risk in the US will now significantly impact on the pricing of debt in the Middle East.

Benchmark transactions – those of a significant size from stable entities, such as governments – in the Middle East over the past few months also call on investor pools outside the domestic market. This means international financial conditions will play an increasing role in influencing the pricing of deals globally.

Misplaced confidence

Having become accustomed to low interest costs for the past few years, Middle East banks and project companies were full of confidence that the tightening of global credit markets following the US sub-prime crisis would not affect activity in their markets. International banks may have been getting nervous about lending to each other and putting their prices up, but the booming oil price and state backing of projects allowed Middle East issuers to keep prices down.

However, as the situation in the US worsened, it became clear that the price of risk was being reassessed, and that high-risk practises popular in the US sub-prime mortgage sector had caught on elsewhere. Most significant was the process of project companies and their lawyers stripping out covenants that would protect financial backers, creating a so-called ‘covenant-light’ structure.

While conditions were good and interest rates low, nobody dared complain about this type of deal for fear of losing out to rivals. But as credit conditions worsened, banks became more nervous about the protection they were giving up.

In September, Qatar Steel Com-pany’s $1.3bn project finance deal was one of the first to stumble as banks demanded better protection for their money. Elsewhere, even the mighty Saudi Basic Industries Corporation (Sabic) had to downsize a bond deal because of reverberations from the credit crunch.

Delayed deals

Other deals have floundered or been delayed, including those with backing from strong issuers, such as the Dubai Electricity & Water Authority (Dewa) and Qatar Petroleum, through its Qatar Fertiliser Company subsidiary.

In September, one senior project finance head based in London said that by the beginning of 2008, pricing could be in three figures.

Some deals are there already. Ras al-Khaimah Investment Authority (Rakia), backed by the emirate, recently priced a deal at 125 basis points, while Dewa put off raising debt because its bond issue was priced at the same level.

Even National Bank of Abu Dhabi (NBAD), one of the biggest banks in the region and more than 70 per cent owned by the government of Abu Dhabi, put off raising debt while it waited for the markets to recover.

It is also looking at raising money in euros, yen and Malaysian ringgits to tap additional sources of liquidity and evade some of the weaknesses stemming from the US economy and the falling dollar.

The main reason for the delay in the credit crunch hitting the region, according to Arsalan Mustafa, banking analyst at HSBC in Dubai, is that overall liquidity took time to dry up. Liquidity from the local banking system had been helping to keep prices low after the summer rout began.

“Large corporate customers seeking to raise money in the international debt markets have been forced to borrow on local bank terms after the credit crunch,” he says.

The management of Abu Dhabi Commercial Bank (ADCB) has indicated that it will not lend at rates lower than 150 basis points above the Emirates interbank offered rate (Eibor).

Arul Kandasamy, head of Islamic financing at Barclays Capital, says most sukuk (Islamic bond) deals have been completed, although they were more expensive than issuers expected. “Most of the deals planned for this year have been done but pricing was higher than expected before the summer,” he says. “The only deal that was not completed was the Dewa sukuk, and that was a decision driven by the borrowers.”

The consensus is that prices are now up by about 15 basis points from before the summer, in line with what has been happening more generally even to European and US AAA-rated corporates. Debt that has been successfully raised over the past few months is generally a testament to the arm-twisting of the arranging banks.

“The deals that have been completed have done so off the back of huge amounts of work, calling in favours and phoning around the entire banking community to argue down pricing, while there is some uncertainty about how long the credit crunch will continue,” says one London-based project finance head. “But that cannot continue indefinitely.”

Any borrower aiming to raise in excess of $1bn is now being advised to think seriously about how urgently they need it. “In the current conditions, it is unlikely that you could raise much over $1bn,” says Kandasamy. “It is possible because it is not like the market is closed, but it is increasingly unattractive for borrowers of larger sums.”

Kandasamy points to Nakheel’s deal in early December to raise up to $1bn of sukuk as evidence that big deals can be done.

The uncertainty comes when considering that if the market improves by 15 or 20 basis points, it represents a lot of money on a $1bn debt. In that situation, it can be easy to hold on to the optimistic view that things will improve.

The big question for 2008 is not necessarily whether deals that have been delayed will get done, but how much they will cost. As soon as the need for additional capital outweighs the fact that in waiting a few months the market may have recovered, deals that have been postponed will return to the market.

That is because while it is true that some fundraising has been delayed or cancelled, other deals have continued to complete, and some have not been too expensive, given the market climate.

Adjusting returns

Abu Dhabi Commercial Bank (ADCB) said in early December that it had managed to raise $544m at margins close to those of a European bank of comparable size, although it refused to confirm the exact details. Shortly afterwards, an HSBC report stated that ADCB losses were $77m, owing to investments in US assets affected by the sub-prime crisis, a figure ADCB says is over-inflated.

Deals that have been put off because of adverse market conditions could have been pushed through if financial models of returns were adjusted to better reflect the market conditions. “There is still a process of realisation going on in some companies that the market is not the same as it was six months ago,” says Dale Summervile, managing director of loan syndication and head of Central and Eastern Europe, Middle East and Africa at French investment bank Calyon.

There are ultimately two likely outcomes for the market in 2008, according to Kandasamy. Either it stabilises and prices recover, or there is a sustained repricing of risk in the capital markets. The latter looks more likely. “Eventually, borrowers will get used to the fact that debt is a bit more expensive and adjust to it,” says Summerville.

“The situation has deteriorated very quickly in the Middle East, after a long period of people thinking the region would escape the credit crunch,” says one London-based banker who concentrates on Middle East syndications. “But every international bank is seeing its funding costs go up and we have no choice but to pass that on to lenders.”

Servicing debt

The liquidity is there if sponsors are willing to pay the price. So perhaps a reassessment of financial models is all that is needed to push deals through. Once this has occurred, it will be back to business as usual, just with more money being spent on debt servicing.

Key deals that will be watched closely by the market as an indication of risk appetite include a $5bn facility being arranged for Borse Dubai by HSBC and Emirates Bank, linked to the exchange’s attempts to purchase Nordic exchange operator OMX.

The $4.6bn Emirates Aluminium (Emal) project, which includes a $2bn bond tranche, will also act as a bellwether for the market. The bond’s arrangers – Citigroup, Goldman Sachs and Abu Dhabi Commercial Bank – say it will not be launched until conditions improve, although it is unclear how long they will wait. Another $2bn commercial bank tranche is expected to complete before the end of 2007.

The Middle East’s financial market still has some pitfalls to beware of in the coming year. Pulling away from the market because of a failure to read the current climate is forgivable. But if borrowers are still hoping to force banks into lower spreads next year, they will be disappointed.

Meanwhile, with lending conditions expected to remain unstable in 2008, even the booming oil price will not be enough to convince banks to throw caution to the wind and start lending like its 2006 all over again. Investors must adjust their expectations accordingly.

Key fact

$10.16bn – the value of regional deals so far affected by increased borrowing costs.

Source: MEED

Impact of credit crunch

  • QASCO (Qatar Steel Company): $1.3bn refinancing deal is delayed until 2008.

  • QAFCO (Qatar Fertiliser Company): Successfully raises $1.6bn worth of project debt but mooted bond tranche is dropped in late October.

  • DEWA (Dubai Electricity & Water Authority): Plans to raise up to $2.5bn are pulled.

  • SABIC (Saudi Basic Industries Corporation): $2.76bn bond tranche linked to the GE Plastics acquisition is almost cut in half to $1.5bn as interest rate rises in mid-August.

  • RAKIA (Ras al-Khaimah Investment Authority): £325m Islamic bond, backed by the government of Ras al-Khaimah, prices at an expensive 150 basis points in late November.

  • EMAL (Emirates Aluminium): Emirates Aluminium puts off a $2bn bond sale until the market recovers.

  • AMLAK FINANCE: $250m bond is delayed in October.

Source: MEED

Timeline: Interbanking lending rate (%)

  • 31 July 2007: American Home Mortgage Investment sparks fears that sub-prime losses will spill over into other asset classes

  • 15 August 2007: Sabic cuts a $2.76bn bond to $1.5bn

  • 17 August 2007: US Federal Reserve cuts rates by 50 basis points in a bid to boost interbank liquidity

  • 21 August 2007: Barclays is forced to borrow £314m from the Bank of England, the first bank to do so to fill funding gaps

  • 13 September 2007: UK mortgage lender Northern Rock calls on the Bank of England for emergency support, sparking a run on the bank.

  • 18 September 2007: Fed cuts rates by 50 base points.

  • October 2007: Citigroup and Merrill Lynch report massive losses relating to sub-prime assets.

  • 19 October 2007: Financing plans for Qasco are pulled.

  • 26 October 2007: Qafco announces it has dropped plans to raise bond funding for its Mesaieed complex expansion.

Source: Jadwa; MEED; Samba