Over the past two years, the Islamic securitization market has grown dramatically, although its growth faces serious roadblocks if the legal issues surrounding how to achieve a true sale are not clarified.
The main hindrance goes back to the combination of the overregulation by scholars, the grey areas within the Shariah framework and the absence of a recognized and accepted central body in the Gulf Cooperation Council (GCC) region to sign off on securitization structures.
One of the most debated topics in Islamic finance continues to be tranching and its acceptability by the different Shariah schools and scholars. The risks shared by different tranches in terms of losses, sequential payment of cash flows, etc., are different, as would be the coupon attached to the respective tranches.
Iad Boustany, general manager at BSEC, compiled deal cases that have been deemed Shariah compliant where the concept of tranching was implicit. He said that scholars have provided mixed views on the ability to give different investors differentiated rights over the same underlying asset. "From our perspective, we have seen many compliant deals where the explicit tranching was put to question by scholars, and in essence, the development of the market all goes back to tranching," he said.
Debashis Dey, partner and head of capital markets and structured finance at Clifford Chance's Middle East practice, said that many Islamic scholars already think securitization fits neatly with Shariah principles. "Presently, there are solutions that at least two scholars deem would be acceptable, but they have yet to sign off on the deals," he said. "One previous solution is to have investors agree on certain contractual arrangements between them."
Dey added that many corporate issuers of Sukuk, or Islamic bonds, are being encouraged to move closer to the securitization model. The difference is that current corporate Sukuk do not place full asset risk with investors while most securitizations do, a principle that Shariah equates with true ownership.
Farmida Bi, who this week joined Norton Rose as a partner in the firm's Islamic capital markets practice, agreed that one of the biggest challenges for the market has been structuring deals around the issue of tranching. Bi worked on the Dubai-based Tamweel deal when she was at Denton Wilde Sapte. The transaction successfully dealt with the tranching issue whereby the junior noteholders agreed to be paid after the senior noteholders were paid, using a trust structure. "If investors knowingly agree that they are subordinated, then tranching can be achieved," Bi said.
Tamweel securitized a book of dirham-denominated Ijara contracts. In order to follow Shariah, the transaction included residential leases rather than mortgage loans in the asset pool. Because the assets were denominated in dirhams while the notes were denominated in U.S. dollars, currency swap arrangements appropriate for Shariah-compliant institutions had to be used.
Hussein Hamid Hassan, who is chairman of Fatwa and Shariah Supervisory Board and Dubai Islamic Bank, United Arab Emirates (UAE), and who is one of the world's leading Shariah scholars, issued the fatwa on the Tamweel deal. "Dr. Hussein is keen to promote the development of Islamic finance for the greater good of Islam," Bi said.
Looking for Consistency
Creating a global standard for Sukuk, specifically on how these deals can be designed, could help the market develop further. One of the key reasons behind the success of the Malaysian market, for example, has been the central body at the central bank acting as a Shariah counsel.
Boustany said vetting the product at a similar localized point would create liquidity and cut the endless debate on whether the product is and will be compliant between banks. "There are similarities between different transactions, and what has already been approved or where something similar has been done should be easier to get approved, but the varying schools of thought mean that deals often get held up," he said.
Over the last year, Bi said that there seems to have been a greater cautiousness on the part of some scholars in approving transactions. This change comes on the back of a critique delivered by Mufti Taqi Usmani, a leading Shariah scholar who questioned the increasing use of Musharaka and Mudaraba structures and the irregularities in these structures that are approved as Shariah complaint.
Musharaka means a partnership that involves the placing of capital with another person and sharing the risk and reward. The difference between Musharaka arrangements and normal banking is that one can set any kind of profit sharing ratio, although losses must be proportionate to the amount invested.
Mudaraba refers to an investment made on an issuer's behalf by a more skilled person. It essentially creates a contract between two parties: one who provides the funds and the other who provides the expertise and agrees to the division of any profits made in advance. These instruments are more flexible and basically function as loss sharing arrangements similar to a conventional structured bond.
Issuers of these structures, said Mufti Taqi Usmani, have spent a good deal of time making them competitive with the conventional bonds to make them more acceptable to both Islamic and conventional markets. The justification, according to issuers, is that international ratings agencies will not grant the desired investor-grade ratings unless these mechanisms are used to guarantee the return of principal to investors and to distribute profits from capital at specified rates. Without these mechanisms, it would not be possible to market Sukuk widely.
Bi said that there needs to be more debate on how to successfully incorporate the Shariah standards into structured finance techniques. "What we achieved with Tamweel I think is that we successfully dealt with tranching, but other ideas have also been put forward that could in fact also work," she said.
One such alternative is creating a series of SPVs that would hold separate assets and issue different classes of notes so that each class of noteholders would be the only beneficiaries of the trust created by that SPV over its assets, thus overcoming the issue of subordination within a particular trust created by an individual SPV.
As the Islamic finance market develops, it is expected that more and more guidelines will emerge and that the new structures that will come to the market will conform to those guidelines. Nathalie Esnault, managing director at Calyon, said there have been some recent developments with the Accounting and Auditing Organization for Islamic Financial Institutions publishing new guidelines on Sukuk. In particular, AAOIFI has criticized the repurchase option of the issuer present in a number of structures.
The International Swaps and Derivatives Association and the Bahrain-based International Islamic Financial Market have also been working toward a Shariah-compliant master solution. If it doesn't come in the near future, Dey said that Islamic securitization structures will just try and move the hedge outside the ABS structure in order to get a deal done.
The issue of tranching is just one element that is stalling the market. Boustany said that another roadblock for the development of Islamic securitizations has been the market's over-liquidity.
In the GCC region, banks are flush with cash and the current high level of liquidity means that many originators will continue to have access to alternative sources of funding, and at the moment these banks don't have a pressing need to enter into a complicated process like securitization.
But two things will converge that will tighten the access to certain types of financing. "For one, people are becoming more discriminating on whether a borrower needs a rating or not," Dey said. "Some borrowers can't achieve a rating, so choosing securitization would allow them to get a rating on the assets themselves," he said.
"Secondly, many banks in the GCC region are approaching the central bank's limit of certain concentration lending, for example in real estate. It means that these banks may no longer be allowed to lend across certain asset classes, and credit will become more expensive."
If these banks can't lend via the traditional route, they will turn to the securitization market as an alternative to push their regulatory balance sheet out. Originators of corporate Sukuk would also have to opt for securitization if lenders are struggling to provide either the maturity profile of the repayment that the originator requires (the securitization market offers longer maturities than bank funding) or the size of the funding required (banks are increasingly unable to meet the deals' large sizes, even on a club basis, except for the very best credits), explained Dey.
Boustany said that larger players who hold a long-term strategic view and who are also looking to build a footprint in the capital market might consider securitization, but for the most part originators are still looking for longer-term financing on cheaper terms.
Another hindrance to the development of the market has been the inability to include any form of receivables (except leasing). Securitizations are mainly receivable based. For Sukuk, you need to have compliant collateral such as leasing revenues, future flows or real assets. It cannot be a receivable. However, this has not been the case in Malaysia, Boustany said.
The overall state of the market has also had a hand in holding back further developments on the securitization side. "Since many of the end investors of Islamic securitization transactions are conventional and many of the arranging banks are conventional institutions, they have also been affected by the credit crunch," Bi said. "Islamic financing is an emerging market product, and we have to be aware that these aren't seasoned assets. They haven't been tested in adverse market conditions."
As an emerging market with a legal system not designed to deal with securitization, the biggest challenge is to get the right legal opinion to get the right rating. On the rating agency side, Dey said that the concept of Islamic securitization is still new and for analysts it's been a learning experience.
Clifford Chance was working on a deal last year that was near completion when the credit crisis erupted. The deal was deemed Shariah compliant by the scholar but collapsed as a result of the 2007 summer market turbulence. "It was a real shame because the scholar, banks and rating agency completely agreed that the structuring worked," Dey said.
It's likely that the Islamic securitization market will not see significant deal volume come through in the short term. Instead, Bi said that a number of clients seem to be focusing on related activities like warehousing instead of looking to launch large deals.
Dey said that to date Clifford Chance's focus has been largely on corporate Sukuk, but that the firm has also worked on conventional securitizations. The latest was the DEWA transaction. DEWA has issued approximately 2 billion ($3.16 billion) in over two issues. The first came at the height of the credit crisis last year, and the latest came last May. It's considered one of the largest securitizations in the Gulf. "We are also looking at possibly structuring a Shariah-compliant Saudi securitization, but the progress has been slow and it will take some time because there is a lot of diligence that must be done," he said. "But in the UAE, these types of deals are certainly doable and we've come quite far with scholars to make sure all the elements are covered."
Turning to New Ground
One interesting development has come not within the Middle East but in Western Europe, where there is increased awareness of the potential for Islamic compliant funding to be an additional source of liquidity.
"There is some potential for deals to emerge in Western Europe on the back of the recent surge in Shariah-compliant bank financings such as the Chelsea barracks deal," said Laurence Garside, a partner in the London capital markets practice at Norton Rose.
The U.K. Treasury recently said it was committed to selling government bonds that conform to Islamic law. Over the past year, there has been significant Islamic finance activity in London, and there is increasing interest in France, Germany and Denmark, Bi said, adding, "It's not just European corporates; we are beginning to see interest from private equity funds that need cash to finance their investment activities and are interested in accessing investors in the Gulf using Islamically compliant structures."
The same issues regarding tranching would apply in this case, but provided that Shariah-compliant assets can be identified to securitize, doing a deal in a Western European jurisdiction in an established asset class is likely to be more straightforward in a number of ways than in a Gulf or other emerging market jurisdiction.
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