A little oil, a lot of land and 100% debt

November 2008 was a month that nobody in the markets will forget. The collapse of Lehman Bros. in mid-September sent shock waves around the world. The credit market seized up. Stock markets crashed. Financial giants fell and the entire world descended into recession.

A year later, a new shock has jolted the markets: Dubai's default. Last Wednesday the tiny, arid emirate, known more for extravagance than for natural resources, said it would delay payment on debt issued by Dubai World for six months. As of August, Dubai World owed $60 billion - accounting for most of Dubai's total $80 billion debt.

Dubai World owes money to banks in the Persian Gulf and also in Europe. It has business ties throughout the world. The question is whether the emirate's default signals another outbreak of economic malaise.

In the year since Lehman Bros. imploded, the world has by and large stopped thinking about the mess in the global property market. But in practice the crisis of 2008 was caused by mushrooming property prices in major real estate markets, mainly America's, which gave rise to a vast market for mortgage-based derivatives.

These derivatives were risky financial instruments that would pay investors as long as homebuyers continued to meet their mortgage payments. But when the American real estate market faltered, these derivatives, which were so convoluted that even most experts couldn't understand them, plunged in value.

Their collapse triggered a chain reaction that slammed the banks, which hurt their clients, which in turn hurt the clients' creditors. Every investment asset with even a whiff of risk withered in value. As credit dried up, a credit crunch ensued, dragging down the broad global economy.

Though Dubai's debt is large, it looks like a molehill when compared to the nearly $3 trillion in value lost by American and European financial institutions from 2007 to date. How did the tiny nation - one of the seven emirates and the most populous state of the United Arab Emirates - accumulate enough weight to rock the whole world? The answer lies in how Dubai advanced from a fishing village on the Red Sea to a global business powerhouse.

Modern Dubai has its roots in a sheikhdom established in 1799 by the Yas clan; in 1833 it officially separated from Abu Dhabi. The locals made their living chiefly from fishing and pearl diving, but the proximity to shipping routes to India made their village a natural business center for traders from the vast Arabian region. By the mid-1800s the emir of Dubai had grasped the importance of foreign investors, and lowered tax rates.

World War I ruined Dubai's pearl business, but armed conflicts with Abu Dhabi and the invention of artificial pearls in 1926 didn't help the emirate either, and it began to rely on global trading.

In 1966, oil was discovered in Dubai, and foreign workers and oil companies flocked in. But the amount of oil was small: Today revenue from selling crude generates only 2% of Dubai's annual GDP.

With the advent of the first Gulf War in 1990, foreign investors fled the region as Iraq rolled over Kuwait, and Dubai's economy was decimated. But during the following decade, foreign companies returned and set up headquarters in Dubai. The emirate opened up free trade zones. Business boomed.

The revenue stream from oil and trade spurred a trend that had all the trappings of megalomania: Dubai government companies began building tourism and real estate complexes of extraordinary extravagance.

Dubai's breathtaking real estate projects include the Burj Dubai, which at 800 meters is to be the tallest office building in the world. Construction on the 160-story edifice started in 2004 and is scheduled to end in 2010. The Burj is in a new neighborhood that also boasts the biggest mall in the world.

Dubai World also built artificial islands - for instance, one shaped like a palm tree, which it studded with hotels and luxury homes that have been sold to celebrities such as soccer star David Beckham and actor Brad Pitt. One island is home to the sail-shaped Burj Al Arab, which purports to be the only seven-star hotel in the world and features amenities such as a butler for each room and an underwater restaurant. Dubai also had planned to build a kilometer-high skyscraper, amusement parks and more.

Dubai developed these projects through government companies. Dubai World is the regime's holding company, pursuing projects not only in the emirate, but far beyond too. What characterized all its activities is leverage.

Dubai World bought U.S. high-end retailer Barneys and entered a joint venture to build the MGM Mirage, an $8.6-billion project in Vegas. It also bought shares in European banks. In February 2006 it tried to buy P&O, which runs 22 ports in the United States. The administration of George W. Bush approved the deal, but Congress vetoed it, citing national security concerns.

As cracks formed in the U.S. real estate market, Dubai made headlines again, albeit for the wrong reason. Abu Dhabi had bought a stake in AMD. A Fox Business news reporter announced to the world that the shares had been bought by Apple - a mistake she quickly rectified to "Abu Dubai".

Dubai's logic is sound. With a paucity of natural resources, it sought economic development in diversification of business. But the consensus is that its leadership, under Sheikh Mohammed Bin Rashid Al Maktoum, aimed too high and managed things badly.

During the five years that the real estate sector boomed, the Dubai government itself borrowed $10 billion and its government companies borrowed $70 billion. It seems that possibly Dubai lost control of the many business entities it created, and of their finances. Analysts claim it's very difficult to obtain the figures of the Dubai government companies, and add that the government has no consolidated financial statements to offer them. Nor does each emirate customarily announce its own financials: They report as a group. But analysts can say that Dubai's debt per capita is about the highest in the world.

As long as the real estate market prospered, nobody cared. But as property values plunged, troubles surfaced. As the world credit markets dried up, Dubai couldn't refinance its debts; meanwhile, the value of its real estate assets fell hard. HSBC estimates that Dubai's real estate market lost 50% of its value from the peak, falling below the value of debt.

Dubai's leaders have spent much of this year courting foreign investors, without much success, and Abu Dhabi seems reluctant to extend much aid. The culmination was Wednesday's announcement of default. The trouble had been known in advance - but the world hadn't realized just how bad the situation was.