There's a growing level of concern in local financial circles about how Dubai will handle the December maturity of Nakheel's $3.5 billion Islamic bond, or sukuk. Many say it has no choice but to pay off Nakheel's bondholders, who bought the bonds on the understanding that government-owned Nakheel enjoyed the backing of the government.

In some ways, therefore, the situation is akin to the troubles experienced by Fannie Mae and Freddie Mac, which last year fell victim to the subprime lending crisis. When the extent of their financial difficulties became apparent, investors realised that Fannie and Freddie enjoyed merely implicit backing from the US government, not an actual Federal guarantee. Investors started dumping Fanne and Freddie's so-called "agency paper," putting further stress on the US housing market. Eventually, the US government provided explicit backing to Fannie and Freddie's debt.

Economists, analysts, bankers and lawyers are unanimous in saying that the same is true of Nakheel. A cat was thrown among these pigeons back in April when Nakheel itself suggested that a restructuring wasn't out of the question. The National's Asa Fitch and Bradley Hope wrote an excellent piece on the issue in May.

Conventional wisdom is that if Nakheel attempts to restructure the bonds, or reschedule them, the investment community will punish Nakheel by demanding it pay much higher interest rates in the future, or shun its debt altogether. The same impact, they warn, could be felt by other companies in Dubai Inc., with repercussions for Abu Dhabi and the rest of the GCC's government-linked companies.

Government-related entities, and even governments, do default, however. If they didn't, they would all have AAA ratings. The fact that they don't implies that there is a risk of default, even a technical default such as a restructuring.

And Nakheel's bonds, according to the prospectus Nakheel issued for the bonds when it sold them back in 2006, do not enjoy any government guarantee. They are, in some cases, guaranteed by Dubai World. Both Nakheel and Dubai World are government owned, but are joint stock companies, meaning the government's liability for their credit is limited to their paid-up capital. Other than the threat of facing the outrage of the investment community and having to pay higher rates to borrow for years hence, the Dubai government has no apparent legal obligation to pay Nakheel's creditors.

It may be financial heresy to do so, but one can make a case for Nakheel demanding that bondholders take at least some of the pain. For one thing: the prospectus itself outlines a variety of risks to Nakheel's ability to pay off the bonds. During the global liquidity bubble, when even Iraq could borrow at 400 basis points over US Treasuries and individual investors in America were buying Zimbabwean bonds in search of yield, no one may have believed that any of those risks were real. That's why economists at the time called it a "mispricing of risk."

But the risks were real. Here's one the prospectus spells out that now looks like something investors might have considered more closely:

"The Co-Obligor Group's financial performance could be adversely affected if the demand for
residential or commercial property in Dubai were to decrease.

Since the inception of the Co-Obligor Group, the demand for residential or commercial property in Dubai has increased substantially. Part of this demand has been based on speculation that the demand for residential property in Dubai will continue to grow which may rely on, amongst other factors, the continued economic growth of the UAE, continued political stability in the UAE, foreign investment continuing to grow in the UAE and the stability of foreign exchange rates. If this demand does not materialise, it could have a material adverse effect on the Co-Obligor Group's business, financial condition and results of operations."

The issue is complicated by the fact that this is not a conventional bond, but a sukuk al-ijara, a certificate of trust governed by the precepts of shariah. Thus it is not a security bearing interest, which is haram, but is rather an asset-backed loan, or rather a leaseback arrangement with a built-in profit margin. Nakheel has essentially sold its properties to a holding company which has distributed the purchase cost among investors, in return for which they collect a percentage return from Nakheel. Half of it they get on a periodic basis, and half of it on maturity, when Nakheel buys the properties back.

This may lead one to conclude that if Nakheel cannot buy back its loan in full, with the lease income due, that it must therefore sell off part of its properties. But Islamic finance becomes much more favorable to debtors when it comes to the issue of default. It is un-Islamic to lend money to a borrower knowing they cannot repay. And it is un-Islamic for a lender to get a guaranteed return without sharing in the risk of the venture. Thus, the lender actually ends up owning the property, or collateral, in an Ijara loan. If the value of the property declines, it is a decline on the lender's books, not necessarily on the borrower's, even though a declining value may affect the borrower's ability to repay the loan. Thus, in the event that a borrower cannot repay, the loss should be shared by both the borrower and the lender. There are no guarantees.

In this case, however, Dubai World has guaranteed payment, so it may be Dubai World that has to figure out how to make good on Nakheel's debt. There are some who might say that international investors should bear at least some of the loss from Dubai's ill-fated property bubble. Presumably, some already have. The holders of Nakheel's sukuk now are undoubtedly in some cases distressed debt investors who bought them for pennies on the dollar from investors eager to write off their losses and move on. Getting paid in full would represent a massive windfall to such investors. And even those who bought at issue and held to maturity, may not be justified in expecting to receive the full expected yield in light of events subsequent to their purchase. That is why the bonds carried a coupon, er, profit margin, of 6.345 per cent, to compensate buyers for the risk that Nakheel might not be able to pay them back.

The ramifications of a restructuring would clearly be severe, but not permanent. Financial nationalists would perhaps support this outcome, arguing that with their massive accumulated oil revenues and accumulated reserves, Gulf governments can easily supplant international credit markets. But doing so would reverse a process of privatisation that the region needs to reduce its dependence on oil and government spending for growth and instead promote the development of new value-added industries that can provide the jobs needed to maintain prosperity and ensure social stability.