A Diagnosis of Tranching in Light of Sharah Principles

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, lets 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. Thats 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 shabnam@isra.my.

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A Diagnosis of Tranching in Light of Sharah Principles

The specific objectives of the research are as follows: i. to fully comprehend the exact mechanics of tranching, how it works, its benefits and its disadvantages; ii. to explore and examine Sharah issues in the operation of tranching; iii. to evaluate tranchings application in current Islamic ABS1 and examine the Sharah issues. Simply put, in this research we would like to provide empirical evidence on how tranching is done in the Islamic space. To achieve this we conducted case-studies analysis of the asset-backed ukk2 in the market. In concluding the empirical findings, we identified possible Sharah issues that we will analyze in the second part of the project. This research note summarizes the findings from the casestudies analysis. II. SUMMARY OF EMPIRICAL FINDINGS A. An Overview of Tranching Practice in the ukk Market 306 ukk had been issued in the Malaysian asset-based3 ukk space as of 6th April, 2010. Out of these, only 15 ukk (5%) were junior or subordinated ukk (Securities Commision Malaysia, n.d). These

Asset-backed securities (ABS) are alternatives to corporate bonds issued in the conventional market for providing liquidity to the originator. Return to ABS holders relies on income generated from the underlying asset, while buyers of corporate bonds are generally unsecured creditors of the issuer. Corporate-bond holders rely on the overall strength of the company, while ABS investors depend solely on the quality of the asset. The ukk market has issued both asset-based ukk (equivalent to the general obligation bond) and the asset-backed ukk (equivalent to the ABS). While assetbased ukk have witnessed tremendous growth in the Islamic space, this is not the case for asset-backed ukk. Excluding Malaysia, there have only been four Sharah- compliant ABS in the global market: Caravan Sukuk (Hanco), East Cameron, Tamweel and Sorouh Sukuk (Sun Finance). In Malaysia, to date, there have been seven Sharah-compliant ABS issued. Refer to (Dusuki & Mokhtar, 2010) for a detailed definition of asset-based and assetbacked ukk.

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ukk were subordinated in terms of right to payment and right to collateral (if any) to the senior ukk. Out of the seven ukk in the asset-backed ukk space in Malaysia, five deals utilized tranching while two did not. Out of the four deals in the global asset-backed ukk space, three utilized tranching while one did not. B. Tranching in Asset-Based ukk: Malaysia Table 1 summarizes the information on junior or subordinated ukk issued in the asset-based ukk space in Malaysia. If we look much closer into tranching practices in the asset-based ukk, we can observe that out of the 15 deals, four ukk were actually issued by banks to raise subordinated debt for their capital purposes. These ukk (Deal Nos. 4, 11, 14 and 15, highlighted in grey) do not have any senior ukk accompanying them. On the other hand, all corporate issuances feature the pairing of a junior ukk with a senior ukk. Another almost universal feature of corporate issuances is that the junior ukk uses the same underlying structure as the senior structure, with the exception of PINS Capital (Deal No. 8), in which the junior ukk was issued based on murbaah while the senior ukk was based on ijrah. If we look into the ukk structures, none of the junior ukk used an ijrah structure. All were either sale-based (BBA, istin and murbaah) or mushrakah (among investors). In addition, although the status clause4 shows that the senior would have priority over the junior ukk (i.e. tranching is present), no specific Sharah construct was discussed. We then conducted a search to see if tanzul5 was used in achieving the prioritization. The findings show that a majority of the deals (13 deals) did not mention tanzul at all. Two deals (Am Islamic and OCBC) did not mention tanzul explicitly but used implied tanzul, as it was stated that the

A clause in the ukk term sheet that defines the status of the ukk-holders, i.e., the ranking or priority of payment to ukk-holders. If there is subordination, it will state which class of investors have priority compared to the subordinated ukk-holders. In other words, this clause will provide evidence of tranching (if any). Tanzul literally means waiver. 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.

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buyers of the ukk agree to waive their rights of payment to more senior instruments. AmIslamic mentioned tanzul in the term sheet; however, it was for the incentive fee clause by which the investors would agree to waive their right to any profit beyond the expected profit.
Table 1: Tranching Practices in Asset-Based ukk in Malaysia
No. 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 RM1,500 RM230 RM20 RM10 RM10 RM8 Tanzul NO NO NO NO NO NO NO NO NO NO NO Senior structure (if any) BBA BBA murbaah NA istin murbaah murbaah ijrah murbaah murbaah NA mushrakah mushrakah 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 istin murbaah murbaah murbaah

Cellular Structures Sdn murbaah Bhd

Tele-Flow Capital Sdn murbaah RM10 Bhd mushrakah 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

mushrakah (among RM3016.89 NO investors) mushrakah (among RM1700 NO investors) mushrakah Agree (among RM400 up-front investors) (p. 7) Waive its No info RM200 right (p. 16)

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C. Tranching in Asset-Backed ukk Compared to asset-based ukk, which used tranching of only two classes (senior and junior), the asset-backed ukk deals utilized much more intense tranching. Table 2 summarizes the tranching practices in the asset-backed ukk space (both Malaysia and Global). The waterfall column in Table 2 identifies if there was prioritization or not. 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 a lower-rated class. This in turn means if the cash flow is not sufficient to pay all the classes, the most junior classes will absorb the losses (by not being paid) up to their investment amount. In other words, the losses are not shared on a pari passu basis. There were eight deals that had this prioritization. The classes range from two to 14 classes. Hanco was the only deal that used two classes (similar to asset-based ukk). It utilized two different securities (ukk and RPS) to achieve the prioritization. The remaining seven deals that had different prioritization used multi-classes. Refer to the classes column in Table 2 for details. Box 1 shows a common waterfall (i.e. prioritization structure) used in a multi-class ukk. Usually, prior to any event of default, the returns (both Class A and B) will be paid first before the principal (of Class A and B) is paid. Note that in the example highlighted below, Class C was the equity class and it was not issued to third-party investors. Instead it was held by the originator (which is a common practice). Thus Class C will stand last in line of payment. When an event of default has occurred, the return and principal of Class A will be paid first before the return and principal of the next class in line is paid.

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Pre-EOD Waterfall

Post-EOD Waterfall

Box 1: Prioritization in ABS Plantation

(Source: ABS Plantation Term Sheet, pp. 24-25 and pp. 27-28)

Three deals (Cagamas MBS, Musharakah One Capital and East Cameronall based on mushrakah) did not use tranching on losses. Cagamas MBS Musharakah and Musharakah One Capital had different tranches; all the classes had the same rating. What differentiated the classes were the maturities. However, if there are any losses, all the outstanding classes would have to share the losses pari passu. In other words, every class will share the losses according to their capital contribution. No one class will be paid in full if there are losses. This is known as time tranching. Refer Box 2 for the information on the tranches in Musharakah One, for example.
Box 2: Time Tranching in Musharakah One ukk
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, pp. 20 and 22)

Finally, we also sieved through the term sheet to see if tanzul was explicitly mentioned. Similar to the findings in asset-based ukk, none of the dealsexcept for Tamweelmentioned tanzul at all. Tamweel only used implied tanzul, as it was mentioned that the

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different classes are free to waive or dispose their right.6 Menara ABS and Sorouh discussed how prioritization was achieved. Menara ABS used eight lease agreements to represent the eight classes of the ukk-holders. Sorouh used a muswamah 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. Other deals did not clearly discuss how prioritization was achieved.
Table 2: Tranching Practices in Asset-Backed ukk
of No Date Issuance 1 8/9/2005 Issuer ABS Plantation Asset Underlying Contract BBA/ijrah Classes A, B, C (multi-rated) Waterfall Different priority Tanzul NO

8/5/2007

ABS Logistic ijrah

A1-A10, B, C, Different D, E priority (multi-rated) A1-A4, B1B3, C (multi-rated) ukk & RPS7 A, B, C, D (multi-rated) A, B, C, 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

ijrah ijrah

NO NO Implied tanzul (agree to dispose/waive right) NO

Jul-07

ijrah

28/6/2006

Dura Palms Golden Crop Return Sun Finance (Sorouh) Cagamas MBS Musyarakah One Capital East Cameron

ijrah ijrah/ mushrakah murabah

22/11/2005

ukk (5 tranches, Different multi-rated) & priority mushrakah A, B, C and Subordinated (multi-rated) 6 tranches with one rating (time tranche) 5 series with one rating (time tranche) One class of ukk (no tranching) Different priority No priority (time tranche)

NO

Aug-08

NO NO tanzul for incentive fee, not tranching.

8/8/2005

mushrakah

10

4/4/2005

mushrakah

No priority (time NO tranche) No tranching NO

11

Jul-06

mushrakah

6 7

Refer to p. 38 of Tamweel Offering Circular (Clause 2.1.2). RPS is a redeemable participating share subscribed by Hanco (the originator).

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III. POSSIBLE SHARAH ISSUES IN TRANCHING First and foremost, there is a need to enhance transparency on how prioritization is achieved and what Sharah constructs are used to justify such prioritization. From the illustration on how tranching works above, we can readily observe the main Sharah stumbling block. If all the investors have a claim on the same pool of assets, can the losses be shared differently? Can one investor have priority of claim compared to another in the Sharah? As we can see from the above findings, very few deals actually provide this information. To conclude, the following are some possible Sharah issues that require further analysis: i. Do different types of underlying structures (murbaah, ijrah, mushrakah, etc.) affect the permissibility of prioritization in investment? One should keep in mind that these structures explain the relationship between the SPV and the originator. What is the relationship between the SPV and the investors? Is it related to the name of the ukk or is it actually mushrakah/murabah/ waklah? ii. Is the requirement to share losses on a pari passu basis applicable to waklah as well? iii. Does having different sale/lease/mushrakah agreements for different classes of investors solve the Sharah stumbling block on prioritization of investors? iv. Do tanzul of right and tanzul of liabilities have the same ruling? v. Since the lower-rated classes enjoy a higher return, can we use the concept of adlah (justice) to allow such prioritization? vi. Can we use promise to make tanzul as a way out to allow prioritization? vii. Shall the Sharah scholars find ways out (makhrij) to allow tranching or should the scholars drive the market to meet the requirement of the Sharah? In analyzing this, one needs to look into the effects the ukk market will face if tranching is not allowed.

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References
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Mason, S. (2008). The Basics Of Credit Enhancement in Securitization. New York: Standard & Poors. Menara ABS. (2008, January 15th). RM1100 million Menara ABS Sukuk Ijarah PTC. Retrieved May 15th, 2009, from Securities Commission Malaysia: www. sc.com.my Musharakah One Capital. (2005, April 4th). RM2500 Musharakah One Capital Sukuk Musharakah PTC. Retrieved May 15th, 2009, from Securities Commission Malaysia: www.sc.com.my Padhi, R. (2005). An Empirical Study of Subordination Levels in Commercial Mortgage Backed Securities. Cambridge: MIT. Securities Commision Malaysia. (n.d.). Bond Market. Retrieved April 6th, 2010, from Securities Commision Malaysia: http://www.sc.com.my/SC/search_principle. asp?stype=P&skey=2 Sun Finance. (2008, August). AED5020 million Sun Finance Sukuk Mudarabah Offering Circular. Retrieved August 5th, 2009, from IFIS Sukuk Database: http://www.securities.com/ifis/ Tamweel. (2007, July). US$200million Tamweel Offering Circular. Retrieved August 5th, 2009, from IFIS Sukuk Database: http://www.securities.com/ifis/ Whetten, M., & Adelson, M. (2004). Tranching Credit Risk: Examples with CDOs and the iTraxx Index. New York: Nomura Fixed Income Research.

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