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Shabnam Mokhtar ∗ I. INTRODUCTION Tranche is a French word which means: class, section, series, portion, slice, partition, or part of something. Tranching is done through subordination, which refers to “the process of prioritizing the order in which losses are allocated to the various layers of bonds” (Mason, 2008). Investment banks use tranching extensively in structured finance to appeal to different sections of investors. It allows different investors to enjoy different risk levels and returns, although they have claims on the same pool of assets. For example, let’s say there are three tranches in an ABS deal: AAA, BBB and an equity tranche. For payments of profit, AAA would get paid first, followed by BBB and then the equity tranche. On the contrary, in cases of losses, the equity tranche will absorb the losses first, followed by the BBB investors and finally, if any losses remain, then only it will go to the AAA investors. This, in a nutshell, is how tranching works. That’s why the equity tranche is usually named the first-loss position, because they are the ones that will first absorb any losses first. Tranching is done to achieve a cheaper cost of funding on average. As we can see from the above illustration, the AAA investors bear very little risk because their position is cushioned by the equity tranche and the BBB (mezzanine) tranche. Thus they will be paid a lower return compared to the other two tranches; whereas, since the equity tranche bears the higher risk, they will obtain the highest return. By having these varying classes of investors and varying returns, the originator can arrange, on average, funding at a cheaper cost.
Shabnam Mokhtar is an Associate Researcher at ISRA. She can be contacted at email@example.com.
ISRA International Journal of Islamic Finance • Vol. 2 • Issue 1 • 2010
while ABS investors depend solely on the quality of the asset. To achieve this we conducted case-studies analysis of the asset-backed ÎukËk2 in the market. This research note summarizes the findings from the casestudies analysis. 2010) for a detailed definition of asset-based and assetbacked ÎukËk. Simply put. how it works. 162 ISRA International Journal of Islamic Finance • Vol. Refer to (Dusuki & Mokhtar.compliant ABS in the global market: Caravan Sukuk (Hanco). In concluding the empirical findings. East Cameron. Return to ABS holders relies on income generated from the underlying asset. Excluding Malaysia. 2 • Issue 1 • 2010 . while buyers of corporate bonds are generally unsecured creditors of the issuer. this is not the case for asset-backed ÎukËk. in this research we would like to provide empirical evidence on how tranching is done in the Islamic space. 2010. only 15 ÎukËk (5%) were junior or subordinated ÎukËk (Securities Commision Malaysia. Corporate-bond holders rely on the overall strength of the company. Out of these. The ÎukËk market has issued both asset-based ÎukËk (equivalent to the general obligation bond) and the asset-backed ÎukËk (equivalent to the ABS). there have only been four SharÊÑah. its benefits and its disadvantages. These 1 2 3 Asset-backed securities (ABS) are alternatives to corporate bonds issued in the conventional market for providing liquidity to the originator. SUMMARY OF EMPIRICAL FINDINGS A. to explore and examine SharÊÑah issues in the operation of tranching. An Overview of Tranching Practice in the ØukËk Market 306 ÎukËk had been issued in the Malaysian asset-based3 ÎukËk space as of 6th April. we identified possible SharÊÑah issues that we will analyze in the second part of the project. II. ii. to date. to fully comprehend the exact mechanics of tranching. Tamweel and Sorouh Sukuk (Sun Finance). to evaluate tranching’s application in current Islamic ABS1 and examine the SharÊÑah issues. there have been seven SharÊÑah-compliant ABS issued. n.d).A Diagnosis of Tranching in Light of SharÊÑah Principles The specific objectives of the research are as follows: i. While assetbased ÎukËk have witnessed tremendous growth in the Islamic space. iii. In Malaysia.
no specific SharÊÑah construct was discussed. On the other hand. 11. 4. B. Two deals (Am Islamic and OCBC) did not mention tanÉzul explicitly but used implied tanÉzul. this clause will provide evidence of tranching (if any).Shabnam Mokhtar ÎukËk were subordinated in terms of right to payment and right to collateral (if any) to the senior ÎukËk. i. three utilized tranching while one did not.e. highlighted in grey) do not have any senior ÎukËk accompanying them. Out of the seven ÎukËk in the asset-backed ÎukËk space in Malaysia. none of the junior ÎukËk used an ijÉrah structure. These ÎukËk (Deal Nos. This is one of the mechanisms used to achieve prioritization of the senior class because the junior class waive their right to payment and collateral. istiÎnÉÑ and murÉbaÍah) or mushÉrakah (among investors). Out of the four deals in the global asset-backed ÎukËk space. five deals utilized tranching while two did not. the ranking or priority of payment to ÎukËk-holders. with the exception of PINS Capital (Deal No. 2 • Issue 1 • 2010 163 . as it was stated that the 4 5 A clause in the ÎukËk term sheet that defines the status of the ÎukËk-holders.. in which the junior ÎukËk was issued based on murÉbaÍah while the senior ÎukËk was based on ijÉrah. 8). it will state which class of investors have priority compared to the subordinated ÎukËk-holders. Tranching in Asset-Based ØukËk: Malaysia Table 1 summarizes the information on junior or subordinated ÎukËk issued in the asset-based ÎukËk space in Malaysia. ISRA International Journal of Islamic Finance • Vol. In addition. we can observe that out of the 15 deals. 14 and 15. If we look into the ÎukËk structures. Another almost universal feature of corporate issuances is that the junior ÎukËk uses the same underlying structure as the senior structure. If there is subordination. tranching is present). although the status clause4 shows that the senior would have priority over the junior ÎukËk (i. In other words. TanÉzul literally means ‘waiver’. all corporate issuances feature the pairing of a junior ÎukËk with a senior ÎukËk. The findings show that a majority of the deals (13 deals) did not mention tanÉzul at all. All were either sale-based (BBA. If we look much closer into tranching practices in the asset-based ÎukËk. We then conducted a search to see if tanÉzul5 was used in achieving the prioritization. four ÎukËk were actually issued by banks to raise subordinated debt for their capital purposes.e.
16) 164 ISRA International Journal of Islamic Finance • Vol. 2 • Issue 1 • 2010 . Table 1: Tranching Practices in Asset-Based ØukËk in Malaysia No. however. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Date of Issuance 30/1/2004 Issuer Glomac Berhad Underlying Contract BBA BBA BBA Issue Size RM60 RM250 RM148 RM1. it was for the incentive fee clause by which the investors would agree to waive their right to any profit beyond the expected profit.500 RM230 RM20 RM10 RM10 RM8 TanÉzul NO NO NO NO NO NO NO NO NO NO NO Senior structure (if any) BBA BBA murÉbaÍah NA istiÎnÉÑ murÉbaÍah murÉbaÍah ijÉrah murÉbaÍah murÉbaÍah NA mushÉrakah mushÉrakah NA NA Pantai 27/10/2003 New Expressway Sdn Bhd Trans Kota 23/10/2002 Lingkaran Sdn Bhd 15/5/2006 23/6/2008 7/10/2008 30/5/2008 15/6/2007 27/7/2006 26/5/2006 25/9/2009 MRCB Southern Link Berhad Serrisa Sinar Berhad DHTI Capital Sdn Bhd PINS Capital Sdn Bhd Malayan Banking Bhd BBA istiÎnÉÑ murÉbaÍah murÉbaÍah murÉbaÍah Cellular Structures Sdn murÉbaÍah Bhd Tele-Flow Capital Sdn murÉbaÍah RM10 Bhd mushÉrakah CIMB Islamic Bank (among RM2000 Berhad investors) GSM Sdn 28/12/2007 Binariang Bhd 30/4/2007 Nucleus Avenue (M) Berhad 21/12/2006 AmIslamic Bank 24/11/2006 OCBC Bank mushÉrakah (among RM3016.89 NO investors) mushÉrakah (among RM1700 NO investors) mushÉrakah Agree (among RM400 up-front investors) (p.A Diagnosis of Tranching in Light of SharÊÑah Principles buyers of the ÎukËk agree to waive their rights of payment to more senior instruments. AmIslamic mentioned tanÉzul in the term sheet. 7) Waive its No info RM200 right (p.
Note that in the example highlighted below. Usually. Table 2 summarizes the tranching practices in the asset-backed ÎukËk space (both Malaysia and Global). Thus Class C will stand last in line of payment. It utilized two different securities (ÎukËk and RPS) to achieve the prioritization. There were eight deals that had this prioritization. 2 • Issue 1 • 2010 165 .Shabnam Mokhtar C. The waterfall column in Table 2 identifies if there was prioritization or not. the returns (both Class A and B) will be paid first before the principal (of Class A and B) is paid. This in turn means if the cash flow is not sufficient to pay all the classes. the asset-backed ÎukËk deals utilized much more intense tranching. the most junior classes will absorb the losses (by not being paid) up to their investment amount. The remaining seven deals that had different prioritization used multi-classes.e. When an event of default has occurred. Tranching in Asset-Backed ØukËk Compared to asset-based ÎukËk. Instead it was held by the originator (which is a common practice). In other words. If the column says “different priority” it means that the tranche that had a higher rating (AAA for example) would be paid first. prior to any event of default. the losses are not shared on a pari passu basis. Box 1 shows a common waterfall (i. prior to a lower-rated class. prioritization structure) used in a multi-class ÎukËk. which used tranching of only two classes (senior and junior). Hanco was the only deal that used two classes (similar to asset-based ÎukËk). Class C was the equity class and it was not issued to third-party investors. The classes range from two to 14 classes. ISRA International Journal of Islamic Finance • Vol. Refer to the “classes” column in Table 2 for details. the return and principal of Class A will be paid first before the return and principal of the next class in line is paid.
Box 2: Time Tranching in Musharakah One ØukËk Series (RM) 1 (115m) 2 (115m) 3 (115m) 4 (115m) 5 (107m) Rating AAA AAA AAA AAA AAA Maturity (year) 1 2 3 4 5 Source: Musharakah One Term Sheet. for example. However. 2 • Issue 1 • 2010 . Similar to the findings in asset-based ÎukËk.A Diagnosis of Tranching in Light of SharÊÑah Principles Pre-EOD Waterfall Post-EOD Waterfall Box 1: Prioritization in ABS Plantation (Source: ABS Plantation Term Sheet. all the classes had the same rating. No one class will be paid in full if there are losses. Cagamas MBS Musharakah and Musharakah One Capital had different tranches. This is known as time tranching. Musharakah One Capital and East Cameron–all based on mushÉrakah) did not use tranching on losses. we also sieved through the term sheet to see if tanÉzul was explicitly mentioned. Tamweel only used “implied” tanÉzul. In other words. as it was mentioned that the 166 ISRA International Journal of Islamic Finance • Vol. What differentiated the classes were the maturities. none of the deals–except for Tamweel–mentioned tanÉzul at all. if there are any losses. Refer Box 2 for the information on the tranches in Musharakah One. 20 and 22) Finally. pp. all the outstanding classes would have to share the losses pari passu. 27-28) Three deals (Cagamas MBS. pp. 24-25 and pp. every class will share the losses according to their capital contribution.
C. Different D. C and Subordinated (multi-rated) 6 tranches with one rating (time tranche) 5 series with one rating (time tranche) One class of ÎukËk (no tranching) Different priority No priority (time tranche) NO 8 Aug-08 NO NO tanÉzul for incentive fee. C.6 Menara ABS and Sorouh discussed how prioritization was achieved.2). B. C (multi-rated) ÎukËk & RPS7 A. 38 of Tamweel Offering Circular (Clause 2. Table 2: Tranching Practices in Asset-Backed ØukËk of No Date Issuance 1 8/9/2005 Issuer ABS Plantation Asset Underlying Contract BBA/ijÉrah Classes A. Other deals did not clearly discuss how prioritization was achieved. RPS is a redeemable participating share subscribed by Hanco (the originator). ISRA International Journal of Islamic Finance • Vol. D (multi-rated) Different priority Different priority Different priority Different priority NO 3 4 15/1/2008 15/2/2004 Menara ABS Caravan I (Hanco) Tamweel ijÉrah ijÉrah NO NO Implied tanÉzul (agree to dispose/waive right) NO 5 Jul-07 ijÉrah 6 28/6/2006 Dura Palms Golden Crop Return Sun Finance (Sorouh) Cagamas MBS Musyarakah One Capital East Cameron ijÉrah ijÉrah/ mushÉrakah muÌÉrabah 7 22/11/2005 ÎukËk (5 tranches. 9 8/8/2005 mushÉrakah 10 4/4/2005 mushÉrakah No priority (time NO tranche) No tranching NO 11 Jul-06 mushÉrakah 6 7 Refer to p. Different multi-rated) & priority mushÉrakah A.Shabnam Mokhtar different classes are free to waive or dispose their right. B1B3. Menara ABS used eight lease agreements to represent the eight classes of the ÎukËk-holders. B. B. 2 • Issue 1 • 2010 167 . D (multi-rated) A. B.1. C (multi-rated) Waterfall Different priority TanÉzul NO 2 8/5/2007 ABS Logistic ijÉrah A1-A10. C. E priority (multi-rated) A1-A4. B. not tranching. Sorouh used a musÉwamah arrangement to neutralize the requirement that the senior class must pay back anything due to the junior classes because of the non-pari-passu loss-sharing.
the following are some possible SharÊÑah issues that require further analysis: i. can the losses be shared differently? Can one investor have priority of claim compared to another in the SharÊÑah? As we can see from the above findings. Is the requirement to share losses on a pari passu basis applicable to wakÉlah as well? iii. etc. What is the relationship between the SPV and the investors? Is it related to the “name of the ÎukËk” or is it actually mushÉrakah/muÌÉrabah/ wakÉlah? ii.) affect the permissibility of prioritization in investment? One should keep in mind that these structures explain the relationship between the SPV and the originator. mushÉrakah. To conclude. can we use the concept of ÑadÉlah (justice) to allow such prioritization? vi. Do different types of underlying structures (murÉbaÍah. Since the lower-rated classes enjoy a higher return. From the illustration on how tranching works above. Can we use promise to make tanÉzul as a way out to allow prioritization? vii. POSSIBLE SHARÔÑAH ISSUES IN TRANCHING First and foremost. Do tanÉzul of right and tanÉzul of liabilities have the same ruling? v. 2 • Issue 1 • 2010 .A Diagnosis of Tranching in Light of SharÊÑah Principles III. very few deals actually provide this information. 168 ISRA International Journal of Islamic Finance • Vol. we can readily observe the main SharÊÑah stumbling block. ijÉrah. Does having different sale/lease/mushÉrakah agreements for different classes of investors solve the SharÊÑah stumbling block on prioritization of investors? iv. there is a need to enhance transparency on how prioritization is achieved and what SharÊÑah constructs are used to justify such prioritization. one needs to look into the effects the ÎukËk market will face if tranching is not allowed. Shall the SharÊÑah scholars find ways out (makhÉrij) to allow tranching or should the scholars drive the market to meet the requirement of the SharÊÑah? In analyzing this. If all the investors have a claim on the same pool of assets.
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