Islamic finance market turns to securitization
Islamic finance has grown exponentially in recent years. Now many believe securitization is the next financing method to be adapted to comply with Islamic law. By Tamara Box and Mohammed Asaria.
Regular visitors to the Middle East will agree that the region has evolved beyond recognition over the past decade. The Middle East is able to claim three world-class financial hubs in Dubai, Bahrain and Qatar. A significant proportion of this growth has been in the Islamic finance sector and a number of Islamic banks have opened in the region. There are 27 such institutions in Bahrain alone, for example.
As regards Islamic banking, it must be remembered that until recently many Islamic banks provided depositors with so-called gifts rather than financial returns on their investments. This is no longer the case and Islamic retail and investment banks are able to offer a range of investment products to match their conventional counterparts. In addition, Islamic banks are able to provide investment products with a similar investment profile to their conventional counterparts. The growth of the Islamic finance industry has been remarkable and last year the industry grew at a rate of over 20%. Some commentators claim that assets under the management of Islamic banks exceed $500bn. The market is driven forward by investor demand. An illustrated example of this being that, to date, the almost all sukuk (Islamic bond) issues have been oversubscribed.
Bankers, lawyers and regulators are now investing considerable resources in the development of the Islamic capital markets. Particular focus is on the area where most market participants believe the next stage of development to be - the development of the Islamic securitization market.
Humble beginnings
The emergence of the Islamic capital markets is recent. Its roots trace back to the Malaysian government's inaugural sukuk issue in 2002. Since 2002 the market has grown exponentially and the size of this market is stated to be in the region of $8bn.
The sukuk market was originally the domain of sovereign issues. The governments of Malaysia, Qatar, Pakistan and Bahrain and quasi-sovereigns of Dubai and the German State of Saxony-Anhalt (the first non-Islamic sukuk issuer) have all tapped this market. It is rumoured that the governments of Indonesia, Turkey and Iran are looking to enter this market.
More recently, a number of corporates in the Gulf Co-operative Council (GCC) region (in particular in Bahrain, Saudi Arabia and the United Arab Emirates) have begun to tap the sukuk market. Emirates Airlines recently launched a $500 million issue.
This sector is neither confined to countries in the Muslim world nor is it the sole domain of Islamic financial institutions. Increasingly, sukuk linked to assets based in the UK, continental Europe and the USA, are being structured as Islamic investors want to include securities with these risk profiles in their portfolios. In addition, non-Islamic issuers are seeking to take advantage of the increased liquidity in the Islamic world. A clear example of this trend was seen when the German Federal State of Saxony-Anhalt issued a $100m sukuk in 2004. The regional finance minister said that the rationale for issuing a shariah-compliant instrument was twofold:
"On the one hand [for] economic reasons. There are investors out there and it makes sense to provide them with a product. On the other hand it is a matter of international courtesy. We want to send out a message of respect for other cultures that have different regulations on investing."
The demographics of investors in sukuk are varied with non-Islamic investors increasingly participating in these instruments. Middle Eastern credit risk has become more appealing for European investors. For example, in a recent sukuk issue, conventional investors purchased 48% of the issue. The breakdown of investors revealed 11% were fund managers, 24% were institutional investors and 13% were central banks and government institutions.
The legal structure of a sukuk
Sukuk is frequently referred to as an Islamic bond, but a more accurate translation of the Arabic word would be an Islamic investment certificate. The distinction being that, at its simplest, a bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal. In comparison, under a sukuk structure the sukuk holders each hold an undivided beneficial ownership in the underlying assets. Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk assets as well as being entitled to share in the proceeds of the realization of the sukuk assets. The legal structure and format of sukuk certificates may be considered analogous to US Trust Certificates and can be listed and rated. Under modern Islamic jurisprudence, investors can receive periodic payments under a sukuk issue that are benchmarked to Libor. Hence sukuk certificates are frequently priced using identical pricing technology as conventional Eurobonds.
Rating agencies will not apply a different rating criteria to an instrument just because it is Shariah-compliant. But the rating agencies' analysis will take into account the specific nuances of the legal regime in which the sukuk assets are located. As the international rating agencies have to date had limited exposure to the Muslim world, they have voiced concerns relating to the legal regimes in these jurisdictions. For example, in Saudi Arabia, the lack of a system of binding precedent, the application of ijtihad (principles of Islamic equity) by the Saudi Arabian courts in deciding disputes and the absence of a clear bankruptcy regime are concerns. However, these issues are not as grave as they first appear and a recent report published by the rating agency, Fitch took a positive view on developments in (Shariah-compliant) securitization in Saudi Arabia.
Most sukuk issues to date use full originator recourse structures and are structured around the sukuk al-ijara concept [insert diagram one]. The current market trend is for sukuk issues to be more highly structured. The $200m DMCC (Dubai Metals and Commodity Centre) sukuk arranged jointly by Dubai Islamic Bank and Standard Bank illustrated this trend. Sukuk holders were able to elect to receive the periodic payments payable under the sukuk certificates in gold bullion.
As the financial infrastructure and education in the region increases and pools of assets that are suitable for securitization develop (such as consumer finance assets) market participants are looking to structure non-collateralized, non-recourse, Shariah-compliant securitization transactions.
Shariah-Compliant Securitization
Conventional securitization structures incorporate guarantees, interest-bearing receivables, synthetic instruments, derivative products, interest-bearing liquidity facilities and other features that are arguably derivatives of interest rates. At first glance, it is difficult to see how such a financing structure may ever be deemed to be compatible with Shariah.
But Islamic financing generally requires that the advancement of funds be linked to the performance of the assets that back the financings. This is one of the basic tenets of securitization and has led Shariah scholars to form the opinion that in principle, securitisation (with the removal of some of the features that are listed in the preceding paragraph) as a financing technique is likely to be compliant with Shariah law.
For a securitization structure to comply with Shariah, the assets being securitized must themselves also comply with Shariah (that is, they must not offend the principles of Shariah, such as being a securitization of pools of interest bearing loans, being uncertain in nature or being a securitization of prohibited items such as alcohol, pork, gambling or illicit activities). In addition, the relationship between an underlying obligor and the originator should fall within one of the accepted Islamic financing schemes (eg Murabaha, Mudaraba, Ijara and Istisna'a). For example, when structuring a Shariah-compliant mortgage securitization, the underlying assets must be Shariah-compliant mortgages (usually structured around Ijara (the typical Islamic mortgage structure) or Istisna'a (mortgages over properties that are being constructed) or in the case of a Shariah auto-finance securitisation, the underlying finance contract must be structured in accordance with Murabaha or Ijara principles.
Basic principles
Asset backed and tradability
A key principle of Islamic finance is that financing schemes should be asset backed. In the context of a Shariah-compliant securitization structure, this means that some degree of ownership in the underlying assets should be transferred to the Issuer (rather than a mere assignment of the cashflows). A transfer of absolute registered title in the underlying assets is not necessary and would prohibit securitizations of Middle Eastern assets as legislation in a number of Middle Eastern countries bars non-resident entities from purchasing or leasing certain locally domiciled assets and local entities from issuing debt securities.
The transfer to the issuer (from the originator) of a package of rights akin to ownership that allows the issuer to participate in the revenues generated by the underlying assets is enough to satisfy the constraints of Shariah. If the Shariah scholars are satisfied that the risk and reward associated with the sukuk assets is vested with the issuer of the sukuk certificates, the Shariah scholars are generally satisfied that the structure will conform with Shariah.
However, if the Shariah scholars feel that too few rights over the sukuk assets have been transferred to the issuer the Shariah scholars can opine that the transaction is not Shariah-compliant. Alternatively, the fatwa (opinion) may be qualified and state that the sukuk certificates may not be traded in the secondary market at a premium or discount to their face value.
In addition, when considering a Shariah mortgage securitization, to obtain an unqualified fatwa allowing the sukuk certificates to be freely traded in the secondary market, the underlying mortgage pool must comprise at least 51% (although this may be permitted to fall to 25% in extreme circumstances) of ijara mortgages and up to a maximum of 49% 'istisna'a' mortgages. The rationale for this prohibition is that the Shariah scholars classify 'istisna'a' mortgages as merely receivables.
Credit enhancement
Shariah-compliant securitization structures may incorporate credit enhancement techniques providing that the underlying assets are not recharacterized. First loss accounts, non-interest bearing liquidity facilities (although these may be structured as Murabaha arrangements so that the finance provider may realize a profit on such facility), overcollateralization and, arguably tranching, may be incorporated into a Shariah-compliant securitization structure. As more issuers seek to tap the market this is an area that will develop.
Shariah Securitization in operation
To date, only a handful of true Islamic securitizations have come to the market. It is felt that this is an area that will grow with considerable pace. The Shariah-compliant consumer finance market across the GCC region and Western Europe is growing at an aggressive pace, and these provide a natural choice of assets to securitize. In addition, for some Arab States, an export finance securitization in respect of oil and petrochemicals would again provide a suitable pool of assets to securitize.
Transaction structures that have been previously considered non-compliant with Shariah, such as flow securitization transactions, are being reconsidered by Shariah scholars. This type of transaction was traditionally rejected by Shariah as it was felt by scholars that there was not enough certainty as to the regularity of the payment streams and that assets backing these transaction were not real assets. Market participants are investing time and resources in an attempt to modify the structure of traditional future flow securitization transactions so that they may comply with Shariah. If these discussions yield a positive outcome, this is a sector with enormous growth potential - airline ticket and toll road revenues may all be securitized in a Shariah-compliant manner.
Market solutions
The article has briefly focused on the principal features of a Shariah-compliant securitization transaction and some of the opportunities that exist across the Muslim world.
As with any industry that is in its infancy, certain challenges need to be tackled. For example, Shariah has traditionally rejected derivative transactions, making it difficult to incorporate foreign exchange sways into Islamic capital market transactions. But market participants are investing time and resources to solve this issue and others. The International Swaps and Derivatives Association (Isda) has recently created a Middle Eastern working group to ascertain the views of Shariah scholars and market participants in this area, with the goal of producing a Shariah-compliant master agreement.
There are many Shariah-compliant securitization opportunities across the Muslim world. Many of the jurisdictions in the Muslim world are currently enjoying an economic boom (in part caused by the high price of oil) and the favourable economic standing of many of these jurisdictions ensures that these sovereigns are capable of supporting an investment grade rating. With this and the growing investor demand for Shariah-compliant products in mind, it is likely that this market will offer significant potential during the course of the next year.
Securitization opportunities in the Muslim World
Saudi Arabia
It is expected that 2005 will witness considerable growth in the Saudi Arabian capital market. The legislature recently enacted the Saudi Arabian Capital Markets Act to promote the issue and sale of debt securities. At present there is a total prohibition on the issue of debt securities by a Saudi Arabian corporate and the sale of securities in Saudi Arabia is prohibited by anyone other than a regulated banking institution. But such a restrictive legal framework has not prohibited the market from developing - the Caravan I transaction (a Shariah-compliant vehicle finance securitization) was launched last year.
Judging by the Islamic structured financings that have recently emanated from Saudi Arabia over the past year (most notably the $1.2 bn Eti-salaat financing) and the considerable interest that new legislation has generated, the domestic securitization market in Saudi Arabia is expected to quickly develop.
United Arab Emirates
The real estate market in the UAE (particularly in Dubai) has grown at one of the fastest rates across the world over the last couple of years. Barclays Capital arranged a securitisation transaction earlier this year that was backed by payments under real estate finance arrangements and long-term leases in respect of properties located on one of the Dubai Palm developments. Although this transaction was fully collateralized it was aimed to kick-start the market. Once investors and market participants become comfortable with local laws, there is nothing to prevent true securitizations in Dubai in the near future. With the current trend in Dubai to convert existing conventional residential mortgages into Shariah-compliant mortgages, it is thought by many that a Shariah securitization of this asset class is due soon.
Kuwait
Attempts have been made to structure a securitization transaction in respect of Kuwaiti assets, but so far the Kuwaiti regulator has blocked such attempts. However, to date the Kuwaiti regulator has only been asked to consider purely domestic transactions. It is possible that the regulator's approach may differ if the transaction structure incorporates an off-shore Issuer. Again, there is plenty of potential in this market and it is probably that some of the first securitization transactions in Kuwait will either be linked to commercial property or auto-finance contracts.
Qatar
Over the past year Qatar has seen tremendous growth in its Islamic finance industry. Most of these funds have been invested in Shariah-compliant project finance transactions (mainly in the oil and gas sector). It is expected that the funding provided by both Islamic and conventional banks for these transactions will require refinancing (these transactions by virtue of their sheer size are a significant drain on bank liquidity) and may be refinanced through a Shariah-compliant securitization.
Indonesia
The Muslim world is not limited to the Middle East. Indonesia is the most populous Muslim country in the world. Islamic financing is taking root in this market and the first cross-border Islamic financing transaction was structured last year for Pertamina (the state oil and gas company). Judging by the rapid development of the Islamic consumer finance industry (auto-finance and micro finance in particular) in Indonesia and the vast natural resources reserves that exist, it is possible that a Shariah securitization of either of these two asset classes may be structured soon.
Malaysia
Arguably the most active Islamic finance market in the world is Malaysia. Malaysian Islamic bankers have invested plenty of resources developing the Islamic capital markets. Recently, Time Engineering issued a RM556m ($150m) five tranche Shariah-compliant securitization. This offering was considered a true securitization under Malaysian guidelines and is backed by payments due from the Malaysian government to the originator under contracts to supply teaching equipment and training to state schools. In addition, Camagas (a Malaysian government-controlled secondary mortgage company) launched a Shariah-compliant mortgage securitization that was arranged by HSBC Amanah. These transactions are not one-offs - it is reported that there are a number of Shariah securitization transactions in the pipeline.
In the early phase of the development of the Islamic capital markets it was thought that certain Islamic financing techniques considered permissible by the Malaysian Shariah scholars would not be acceptable to the Middle Eastern Shariah scholars (Islamic jurisprudence is divided into four main schools of thought and the school of thought that is prevalent in the Middle East differs from that in Malaysia). But recently there seems to be a convergence of opinions between the Malaysian and Middle Eastern scholars in respect of certain concepts that are particularly relevant for the further development of the Islamic capital markets. It is hoped that the growth of the Malaysian Shariah-compliant securitization market will prove a catalyst for the growth of the Middle Eastern market.
What is Islamic finance?
Islamic finance is not tied to any particular jurisdiction and can take place anywhere in the world where there are Muslims who wish to engage in a financing transaction in a manner consistent with Shariah (Islamic law).
One of the fundamental principles governing Islamic financing is that the receipt of interest is prohibited. This is categorically stated in the Qur’an:
‘Those who devour Riba (interest) will not stand except as stands one whom the devil hath driven to madness by (his) touch)’.
It is this one verse of the Qur’an and the teachings of the Prophet Mohammed that define the principles and limits of the Islamic finance industry. The basic principals of this sector are:
Interest (Riba) – in an investment environment, Riba is interpreted as any return on money that is pre-determined in an amount and therefore includes modern day interest-based financing. Islamic principles allow instead for the replacement of interest by a return that is dependent upon profitability of the underlying investment. Modern day scholars have also encouraged asset-backed finance where the return to the financier is linked either to the provision of an asset to the client or to the acquisition of an asset from the client. In essence Islamic finance promotes financing structures that link the earning of returns and the assumption of risk.
Uncertainty (gharar) – there is a prohibition on the sale of items whose existence or characteristics are uncertain, and upon contractual terms that are ambiguous or unclear. This may result in certain contracts containing obligations to insure another or to grant an option to purchase may be unacceptable.
Gambling (maisir) – may apply to dealing in futures and options to the extent that they are speculative.
Prohibited items (haram) – there is a blanket prohibition on any activity that involves the provision of pork, alcohol and certain illicit activities. Nevertheless, views differ on borderline cases such as hotel and aircraft in which, for example, alcohol may be served.
The role of a Shariah board in an Islamic finance transaction
Although the beginnings of this industry can be traced to one verse in the Qu’ran, the interpretation of this verse and the teaching of the Prophet Mohammed on this subject are far from clear. To prevent each potential individual investor in an Islamic financing transaction from forming its own view as to the structure's compliance with Shariah, it is usual for the institution arranging the financing to appoint a committee made up of senior officers and religious scholars (mufti) which evaluate whether certain transactions conform to Shariah. There are a handful of well regarded Shariah scholars and a fatwa, signed by one or more such individuals, will ensure that the market does not test the Shariah compliance of the transaction structure.
This article originally appeared in International Financial Law Review.