Dubai struggled to ease fears of debt default on Thursday after its move to delay repayments at two flagship firms shook confidence in the Middle East as a center for investment and a source of capital.

Dubai's debt problems, a hangover from a property boom that produced the world's tallest building, have shaken trust among Western investors who turned to the oil-exporting Gulf region for help during the global financial crisis.

The emirate said on Wednesday it would ask creditors of Dubai World, the conglomerate behind its rapid expansion, and Nakheel, builder of its palm-shaped islands, to agree a standstill on billions of dollars of debt as a first step toward restructuring.

On Thursday, Dubai tried to revive confidence by saying its profitable DP World , which runs 49 ports around the world, would not be involved in the restructuring. DP World, which has $3.25 billion outstanding bonds, is majority owned by Dubai World but has shares listed on NASDAQ Dubai.

It might be a move to distinguish the solvent from less solvent companies in an attempt to shift the weight away from the less exposed entities, said John Sfakianakis, chief economist at Saudi Fransi bank.

But European bank shares, which had recovered in recent months on hopes that the worst of a global crisis was over, fell to lows not seen since May on Dubai's debt delay.

There was no immediate sign that U.S. banks were exposed, but it was difficult to ascertain, given Thursday's Thanksgiving holiday.

It is not so much that Dubai did what they did, but how they did it ... with no notice, said Andrew Brenner, head of emerging markets at Guggenheim Securities. Spreads on a lot of fixed income products have gotten to very rich levels and the Dubai default will force risk to get repriced downward. Either way, look for a flight to quality scenario tomorrow on a holiday-shortened day.

Shares in companies in which Gulf investors own big stakes, including the London Stock Exchange , UK grocer J Sainsbury and German carmakers Porsche
and Daimler , also fell sharply on concerns the holdings would be cut to meet obligations at home.

Exposure to Dubai World could be as high as $12 billion in syndicated and bilateral loans, including existing loans for Nakheel and Istithmar, an investment arm of Dubai's government, banking sources told Thomson Reuters LPC.

International banks are seeking to clarify their position as they formulate their response to the standstill request and are assessing the implications for lending to Dubai and the Gulf.

This is very serious and will have implications across the region, a senior banker said.

Sheikh Ahmed bin Saeed al-Maktoum, head of a top Dubai financial body, said he understood concerns in the markets and among creditors. However we have had to intervene because of the need to take decisive action to address (Dubai World's) particular debt burden, he said in a statement.

BONDS EXTEND LOSSES

In one of the first signs that Dubai's problems could hurt global fund-raising efforts for its neighbors, Saudi-backed Gulf International Bank pulled a bond sale due to price this week.

Dubai's move will likely lead to a risk reassessment of debt issued by the region's sovereign-linked firms.

Ratings agency Standard & Poor's said on Thursday it had placed the ratings of four Dubai-based banks on negative outlook due to their exposure to Dubai World.

S&P's and Moody's Investors Service had already severely downgraded several government-related entities on Wednesday.

Wednesday's announcement also sent the cost of insuring Dubai's debt against default soaring and bond prices tumbling.

Dubai World, whose slogan is The sun never sets on Dubai World has $59 billion of liabilities, a large proportion of Dubai's total debt of $80 billion.

Dubai's credit default swaps are being quoted as high as 500-550 bps, some traders said, while the cost of insuring Qatari, Abu Dhabi and Bahrain debt also surged.

Analysts downplayed the fallout for the wider region, however, pointing out that Dubai funded its growth through loans, whereas its neighbors are mostly major oil and gas exporters.

I would not rush into talking about contagion. Anything from Abu Dhabi or Qatar is backed by serious money. Dubai is a lot more leveraged, said Youssef Affany, a relationship manager at Citi who specializes in the region. There will be some level of solidarity from the emirates and the big neighbor, Saudi.

Analysts expect financial support from Abu Dhabi, also a member of the United Arab Emirates and home to most of the country's oil, to keep Dubai afloat. But Dubai will probably have to abandon an economic model that focused on heavy real estate investment and inflows of foreign money and labor.

Earlier this year, Dubai headed off investor concerns that it would default on its debt by launching a $20 billion bond program in which the central bank of the UAE, the world's third-largest oil exporter, bought the first $10 billion slice.

Dubai said on Wednesday it had raised a further $5 billion as part of that program, placing the debt with two Abu Dhabi-controlled banks. But the move raised questions over why Dubai had not raised the entire $10 billion tranche it had planned to sell on the international market.

OPTIONS FOR DUBAI?

If creditors reject proposals to postpone near-term debt obligations until May 2010, the Dubai government could be forced to hold a firesale of its international real estate.

International property advisers are bracing for a potential slew of instructions to sell trophy assets owned by Dubai World.

We do expect the Dubai government to step up efforts to raise capital via real estate sales, and sales of their UK assets in particular, James Lewis, a member of the Gulf capital markets team at property consultant Knight Frank, told Reuters.

One fund manager said Dubai could not separate the debts of DP World from the Nakheel bond at the heart of Dubai's problems.

The $3.52 billion bond, which was originally due to mature on December 14, 2009, traded as high as 110 percent of par value on Wednesday before the Dubai government said it would ask creditors for a standstill.

On Thursday the bond traded at 72, and Nakheel's Islamic bond prices extended losses, reaching their lowest level since February, Reuters data showed.

Trust is the basis of all credit. It can take decades to build up credit-worthiness and moments to destroy it. They have the money to pay the Nakheel bond, said the fund manager.

DP World can't be kept separate. If that's an asset of Dubai World and ownership of that can presumably be attached by Nakheel creditors.

(Writing by Lin Noueihed; Additional reporting by Ulf Laessing in Riyadh and Firouz sedarat in Dubai, Sebastian Tong, Steve Slater, Kristen Donovan, Natsuko Waki and Sujata Rao in London and Phillip Wahba in New York; editing by Elizabeth Piper, Erica Billingham, Andrew Callus and Dan Grebler)