Two weeks ago, I wrote about the debt crisis in Dubai. The markets convulsed on news that Dubai World, the huge state-owned corporation which runs many of Dubai’s buildings and investments, might delay or default on its debt payments.

This week creditors, and markets, were relieved to hear that Abu Dhabi, the richest emirate and heart of the federal government of the United Arab Emirates, would bail out Dubai World to the tune of $10 bn and enable Nakheel PJSC, the real estate subsidiary, to pay back a $4 bn sukuk or Islamic bond.

Just as I predicted, Dubai World was too big to fail. The fallout from a default would have poisoned markets across the region and probably irreparably damaged the U.A.E.’s already tainted reputation. Authorities described the Nakheel sukuk as a linchpin of the ongoing debt negotiations, saying ““The whole capital structure was a web of cross-defaults – the only way to calm this was to pay off the sukuk.”

Anyone who bought the sukuk maturing on December 14 when it hit rock bottom at about 48 cents on the dollar made a tidy sum today as it jumped as high as 109.5 on the dollar. Nakheel was widely expected to enter into bankruptcy.

Dubai has always been the public face of the emirate while Abu Dhabi has always held an outsize portion of the oil revenues and thus, the emirates’ wealth. No doubt there will be a degree of control re-asserted over Dubai, although it’s difficult to say what that will entail – more conservative fiscal, religious, and social policies and priorities seem likely.

The city-state also pledged to push for “transparency, good governance and market principles” and passed a new bankruptcy proceedings law.

For now, it looks like Dubai World’s fat has been pulled from the fire. We’ll see how things develop as more of the debts come due.

Dubai did its best to drop the bad news into the Bermuda Triangle of reporting – just hours before markets closed for Thanksgiving and the day before the beginning of the Islamic holiday Eid al-Adha. Dubai World, the investment vehicle and holding company owned by the government of Dubai, asked all of its creditors for an extension on debt issued by Dubai World and Nakheel, its real estate subsidiary.

Dubai World is inextricably tied to the government of Dubai; everything from ports to investment to real estate in Dubai falls under the umbrella of DW and its 90 subsidiaries. Sheikh Mohammed al-Maktoum established the company by decree in 2006 and remains the majority stakeholder in the privately-owned company. Obviously, the corporation falls under the category of “too big to fail,” notwithstanding bureaucratic protestations of the company’s independence from the government.

I’ve seen too big to fail before – I thought the same of Russia in 1998, and I paid the price accordingly. More recently, the United States government declared everything from AIG to General Motors too big to fail. If the US can’t let an ailing automaker sink in a recession, it’s difficult to believe that Dubai would let its flagship enterprise implode. Almost exactly a month ago, I wrote about Dubai’s excessive leverage and the foundation of debt on which it was built. Once again, secrecy is a major problem here. The government sends mixed signals on the degree of backing it will provide for DW – one day lending the Dubai banking system money, the next eschewing responsibility. There are many in Abu Dhabi, whose money comes mostly from petroleum and its derivatives, who would not mind seeing Dubai’s speculative excesses humbled. But the prosperity and reputation of the Emirates is inextricable from that of its most famous member.

Dubai’s biggest problem is simple – it is standing at the edge of a long, unsteady beam overlooking a precipice, and there is an increasingly small amount of real money at the other end holding it steady. There is nothing in Dubai that does not require a constant inflow of liquidity to maintain it; the ventilation systems of its high-rises regularly clog with sand, the city needs armies of underpaid laborers to keep it running, and many of the most ambitious developments, like “The World” and the Palm Jumeirah, are finding that building on artificial islands of sand was perhaps less secure than they had imagined. In many ways, Dubai’s physical reality reflects its fiscal condition – supported with more ambition than common sense.

The consequences of DW’s financial woes will echo into many corners of the world, from subcontinental slums to the marbled halls of European and British banks. India alone estimates that almost 340,000 migrant workers received employment in Dubai and all Indian workers in the city-state sent back $43.5 billion in remittances last year. Conditions are infamously atrocious in Emirate construction companies; many workers have had their passports confiscated, been forced to live in squalid compounds and received far less pay than promised. The article above details how one crew was fired by text message while travelling home for the Eid al-Adha holiday.

On the other side of the scale, Credit Suisse estimates that perhaps half of Dubai’s $80 billion in debt is held by European banks, with Standard Chartered and HSBC the most exposed. These holdings probably won’t be wiped out – Abu Dhabi may let its neighbor take a few hits around the face, but they won’t tolerate a knockout blow. Witness the government’s statement that it would bail out Dubai’s commitments  ”on a case-by-case basis.”

Dubai World’s website still sports the fate-tempting slogan “The Sun Never Sets on Dubai World.” Unfortunately, as history teaches, the sun did set on the British Empire.

Over the past decade, a free-flowing ocean of capital brought unprecedented prosperity – and unfathomable risks – to everyone from Bangladeshi rice farmers to Bear Sterns brokers. The Gulf city-state of Dubai became one of the iconic symbols of globalization’s latest era, with ambitious, even hubristic development projects that challenged gravity and common sense in equal measure.

Now, however, the home of the Burj al-Arab and the Atlantis-like Hydropolis undersea resort may find that the receding tide of global finance has left it high and dry. The emirate owes nearly $80 billion, $50 billion of which will come due over the next 3 years, most of it in 2011 and 2012.  In the positive column is the rising price of petroleum, the original engine of the city’s growth. Investors tend to assume that the oil-rich federal government in Abu Dhabi will back Dubai’s obligations. On the other hand, Dubai’s finances are murky and secretive – local officials rarely speak about them, and foreigners who mention any negative facts to the press have been silenced, deported, or even prosecuted. In fact, Dubai still has no credit rating for its sovereign debt.

More than perhaps any other place in the world, Dubai relies on heavy inflows of foreign direct investment to fuel its enormous boom in property development.  The late Sheikh Rashid bin Saeed al-Maktoum helped funnel the profits from Dubai’s limited oil resources into long-term development in making the city a hub of trade, tourism and finance. This freed Dubai, to some degree, from the fluctuations of energy prices, but exposed the emirate to potentially devastating bubbles and crashes in trade and finance.

In order to cover its looming obligations, Dubai has moved to issue $6.5 billion in dollar- and dirham-denominated bonds, its first such sale since 2007. There are indications that investors may demand as much as 7 times the previous premium for these mid-term bonds, up to 400 basis points over the benchmark. Dubai’s raised $10 billion earlier in the year by selling bonds to the Abu Dhabi central bank.

Dubai still holds value, to be sure. But with the state’s propensity for obscuring what’s on the books, it’s hard to be sure what is safe and what sits on quicksand.  The sovereign wealth fund Istithmar World is freezing new investments as it struggles to deal with its current holdingsof over $25 billion, which is rumored to be leveraged as heavily as 90%. Property values have fallen 40% and could sink by up to 70%, a shattering blow to the foundations of a city built on the dream of eternally appreciating real estate.

Dubai’s prosperity hinges on a sturdy global recovery; even then, it requires sustained confidence that the high-leverage, high-flying model which built the city can continue. With Dubai World laying off almost 12,000 employees this year, it’s clear that the those days may have passed. The city must refocus on the core of its business in trade and finance, and step back from the publicity-grabbing but unsustainable architecture and acquisitions.