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A LEGAL APPROACH
A LEGAL APPROACH
Haluk Gurulkan, LL.M. Finance
Istanbul October 2010
M.This study has been prepared by the attorney of our Law Firm. . Frankfurt am Main. as an LL. Esq. Haluk Gurulkan. thesis and presented to to the Institute For Law and Finance at Johann Wolfgang Goethe University.
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5 Asset-backing 1.2.1 Murabaha 1.3 Main Transaction Types 1.2.6 Salam 1.3.1 What is Islamic Finance? 1.1 Ban on Interest (riba) 184.108.40.206 Ethical investments that enhance society 1.3.2 Ban on transactions and products with excessive uncertainty (gharar-maisir) (gharar-maisir) 1.ISLAMIC SECURITIZATION CONTENTS ABBREVATIONS INTRODUCTION 1 ISLAMIC FINANCE 1.3.7 Istisna 5 6 6 7 7 8 10 11 13 14 16 1 3 3 4 .3.2.3 Principle of risk and profit sharing 1.3 Musharaka 1.2 The basic principles 1.2 Mudaraba 220.127.116.11 Diminishing Musharaka 1.5 Ijara 1.2.
1.1.4 The ability to help in capital adequacy requirements 18.104.22.168.1 Motivation for the Originator 2.4.6 The ability to match the assets and liabilities 22.214.171.124.5 The opportunity to achieve off-balance financing 126.96.36.199.3 Structure of Securitization 2.ISLAMIC SECURITIZATION 2 SECURITIZATION 188.8.131.52 Motivation for Securitization 2.1.7 The ability to reduce credit concentration 2.8 The opportunity for arbitrage by repackaging 2.3 The ability to manage corporate risk 184.108.40.206 Credit Rating 220.127.116.11 Motivation for the Investors 20 21 23 25 26 27 32 33 ii 34 34 34 35 35 36 36 36 36 37 37 .4.2 Special Purpose Vehicle 2.3.2 The ability to diversify funding sources 2.5 Profit Extraction 2.3.1 What is Securitization? 2.4.1 True Sale 2.3 Credit Enhancement 2.2 History of Securitization 2.1 The potential for reducing costs 2.
3.2 Mudaraba (or Muqarada) Sukuk 3.5.3 Credit Rating Issues 3.1 According to asset types 2.3.4 Benchmarking Issues 3.3.ISLAMIC SECURITIZATION 2.7 Hybrid Sukuk 18.104.22.168.1.3 Sukuk 3.1 Types of Sukuk 3.3.2 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues 3.6 Securitization and the recent credit crunch 38 38 38 39 40 41 42 3 ISLAMIC SECURITIZATION 3.1 What is Islamic Securitization? 3.1.5 Asset-backed & Future Flows Securitization Structures 2.4 True sale & Synthetic Securitization Structures 22.214.171.124 Musharaka Sukuk 126.96.36.199.2 Structure of Islamic Securitization 3.1.6 Istisna Sukuk 3.1 Ijara Sukuk 3.5 Different Classifications of Securitization 188.8.131.52.5 Salam Sukuk 3.1.5 Recent Sukuk Defaults 69 iii 71 73 74 46 47 51 54 54 57 59 61 64 66 68 .1.3.4 Murabaha Sukuk 3.3 Pass through & Pay through Securitization Structures 2.2 According to SPV types 2.3.5.
5 A Case study: Sorouh Securitization CONCLUSION BIBLIOGRAPHY WEB PAGES 76 80 84 86 95 .4 The Use of Derivatives in Islamic securitization 3.ISLAMIC SECURITIZATION 3.
ISLAMIC SECURITIZATION ABBREVIATIONS AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions ABS Asset-Backed Securities AED United Arab Emirates Dirham AIG American International Group. ARM Adjustable Rate Mortgages BIB Bahrain Islamic Bank BMA Bahrain Monetary Agency CAGR Compound Annual Growth Rate CDO Collateralized Debt Obligations ECP East Cameron Partners EIBOR Emirates Inter-bank Offered Rate IDB Islamic Development Bank IFSB Islamic Financial Services Board IIRA International Islamic Rating Agency LIBOR London Inter-bank Offered Rate MBS Mortgage-Backed Securities MENA Middle East & North Africa NINA No Income No Assets NIVA No Income Verified Assets PLS Profit-and-loss-sharing OC Offering Circular OIC Organization of the Islamic Conference ORRI Overriding Royalty Interest OTC Over-the-counter ROE Return on Equity SIVA Stated Income Verified Assets . Inc.
ISLAMIC SECURITIZATION SLR Statutory Liquidity Requirement SPC Special Purpose Company SPE Special Purpose Entity SPV Special Purpose Vehicle STS Solidarity Trust Services UAE United Arab Emirates .
an Arabic term that is often translated into “Islamic Law”. banking. p. Islamic Banking Remarks. including religion. the Ottomans introduced western-style banking to the Islamic world to finance their expenditures. 12. the roots of which in turn are derived from the: (1) Qur’an. 2 The concepts that underlie Islamic finance derive from Islamic law or the Sharia. The development of Islamic Finance in the UK: the Government’s perspective.com/islamicfinance/article. 10 December 2008.hm-treasury. 201 3 Mayer Brown LLP. (3) Ijma. being the holy book of Islam (notably less than 3 percent of the Qur’an is legal in nature). the majority found those practices to be violations of Islamic prohibitions against usury (Arabic term: riba. economics. Vol. Michael. The rapidly growing market of Islamic Finance requires the knowledge of Shariacompliant structures for finance transactions. This resentment continued through the European colonial period. as opposed to the modern identification of usury with exorbitant interest). 3 In the late 19th Century. While some Islamic jurists approved of modern banking practices. Obviously. Law and Business Review of the Americas. which are the binding authority of Prophet Muhammad’s dicta and decisions. and in some parts of the Muslim world.pdf 2 Silva. available at http://www.7. or “consensus” of the community of scholars. business and law. (2) Sunna. However Sharia is perhaps best characterized as moral guidance or a set of principles governing all aspects of the day-to-day activities of Muslims. 1 Sharia provides guidelines for aspects of Muslim life. equivalent to the Hebrew ribit. Islamic revival played a central role in the intellectual and social foundations of indeHM Treasury. our main aim is to give the basic principles of Islamic Finance. which lasted into the mid-20th Century. or analogical deductions and reasoning.asp?id=7813&nid=12368 1 .uk/d/islamic_finance101208. Spring 2006. available at http://www.1 What is Islamic Finance? Islamic Finance is based on Sharia.ISLAMIC SECURITIZATION INTRODUCTION 1 ISLAMIC FINANCE In this part. 2. one should first understand the basics of Islamic Finance in order to have a better understanding of Islamic Securitization as the structures of the latter have to comply with the basic rules of Islamic Finance and are constructed on the main transaction types of Islamic Finance. White Paper – Islamic Finance. 1.gov. and interpreted in its classical Biblical sense of any interest charge on loans. p. p. (4) Qiyas. politics. 15 September 2009.mayerbrown. Issue 2.
particularly through the issuance of Sukuk (Islamic bonds). To many intellectual founders of the movement. Asia. 8 Although in the past local banks in the Middle East and Malaysia held a monopoly on Islamic finance. a number of non-Muslim institutions have begun to offer Sharia-compliant services. 9.cfm?story_id=14859353 4 . and El-Gamal. Vol. 41 8 Economist article. Mansour. Overview of Islamic Finance. Others have suggested that the growth in the sector could be far higher. political independence was to be supplemented with economic independence. BNP Paribas. with an average annual growth of 15 per cent. Ishaq. (The development of Islamic finance in the UK: the Government's perspective. Office of International Affairs. The Journal of Risk Finance. 4.economist. 6 The ratings agency Standard & Poor’s has forecasted that the industry could potentially control up to $4 trillion of assets. This contrasts with $190 trillion in global assets that are currently under management. p. 3 5 As a result of these efforts. the first Islamic financial institution was a mutual savings bank formed in the Egyptian town of Mit Ghamar in 1963. available at http://www. There are about 300 Islamic financial institutions across 70 countries. No. Barclays Capital. Ahmad (1952). 7 As of 2009. Occasional Paper No. as Muslims account for 20 per cent of the global population yet currently only hold approximately 1 per cent of global financial assets. Citigroup. June 2006. 5 The huge influx of petrodollars from the late 1970s provided a strong impetus to the development of several Islamic banks in the Middle East. In recent years it has emerged as the fastest-growing segment of global finance due to consistently high oil prices in international markets and other favorable sociopolitical factors. Other Muslim countries established their own Islamic financial institutions over time. Al-Arabi (1966). It has been estimated that Islamic banking will have a market value of $4 trillion by 2010. 8) 7 Khan. holding capital investments worth $500-800 billion. Deutsche Bank. 2008. Siddiqi (1967) and Al-Sadr (1974) made significant contributions to the evolution of the Islamic banking model. p. Bhatti.3 billion Muslims worldwide within the next eight to ten years. it is likely that Islamic finance will become an increasingly important component of the international financial system. Whatever the case. M. 6 It is expected to capture about 40-50 per cent of the total savings of 1.com/world/europe/displaystory. 4 The conceptual development of Islamic banking gained momentum after the mid-1940s.1. Mahmoud Amin. through the definition of an Islamic economic system. Islamic banking has made steady progress over recent decades. The major Western banks currently engaged in this practice include HSBC. Europe and North America. Development in Islamic Banking: a financial risk-allocation approach. Islamic scholars such as Qureshi (1946). p.ISLAMIC SECURITIZATION pendence movements of the mid-20th Century. Maududi (1961). December 2008. it is estimated that over $822 billion worldwide Sharia-compliant assets are managed according to the Economist. M. Uzair (1955). It is flourishing in Africa.
not covered by a corresponding increase in labor. and it is discussed often in the Hadith 11.3 9 .1 Ban on Interest (riba 10) Any level of interest is considered to be usurious and is prohibited. A Basic Guide to Contemporary Islamic Banking and Finance. wheat for wheat. p. Islamic Finance in a Global Context: Opportunities and Challenges." This fundamental prohibition is "unequivocal. Strom. The Qur’an proclaims: "Allah 12 hath permitted trade and forbidden usury. Theodore. the one who pays it. and salt for salt. Chicago Journal of International Law. p. Texas International Law Journal. hand to hand.ISLAMIC SECURITIZATION Standard Charter. 13 Richardson. 9 1. Winter 2007. barley for barley. like for like. 385-386 10 Riba means and includes any increase over and above the principal amount payable in a contract obligation. Fall 2006. p. and the one who documents it 13 and he defined riba as “Gold for gold. commodity.2 The basic principles Major principles of Sharia that are applicable to finance and that differ from conventional finance are: 1.” 14 Sometimes it is misunderstood that only a high rate of interest is prohibited and any normal charge on loans or debts does not come under the purview of prohibition. Much of the proliferation of Islamic banking practices appears to have taken the form of non-Muslim banks opening Sharia-compliant "windows" or branches in the Middle East. Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field." and the Qu'ran and early Islamic writings clearly consider riba a very serious offense: The Messenger of Allah cursed the one who devours riba. a number of large law firms have Islamic business departments or units. risk or expertise. Steven. Frederic. The Qur’an contains almost a dozen references to this fundamental prohibition against interest. It is argued that a loan Karasik. 12 Allah is the standard Arabic word for God. silver for silver. June 2000. Similarly. Christopher F. Wehrey. 125 14 El-Gamal.2. Mahmoud. Rice University. the one who witnesses it. in equal amounts. dates for dates. Moody's estimates that over $200 billion individual assets lie in these Muslim "windows". and any increase is riba.. 11 Hadith are narrations originating from the words and deeds of the prophet Mohammad.
by failing or neglecting to define any of the essential pillars of contract relating to the consideration or measure of the object. “rate” is a relative term and any rate will. 3. the argument is not tenable as per the tenets of the Qur’an. Intrinsically. 127 16 15 . The key element of gharar is uncertainty. Unlike riba (which is an absolute prohibition) some level of risk remains a fundamental aspect of commercial life and risk allocation a necessary component of Islamic finance.. The Qur’an says: “If you repent. then you have your principal only”. Edition. Understanding Islamic Finance. which entails exploitation. supra. any addition over the amount of debt per se is prohibited. John Wiley & Sons. It is added that modern banking interest cannot be termed “riba” as the rate of interest is not excessive or exploitative. uncertainty in contractual terms and conditions is not allowed. 16 While riba is condemned in the Holy Qur’an. the limitation on gharar is related to the Islamic prohibition on gambling (maisir).ISLAMIC SECURITIZATION involves riba only if it carries the condition of doubling and redoubling. although minor uncertainties can be permitted when there is some necessity. double and redouble the principal. Believers have been ordered to give up whatever amount of riba is outstanding. However. Muhammad. the parties undertake a risk which is not indispensable for Ayub.2. over time. In a general context. p. Further. Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field. any addition chargeable to the principal amount is riba. 50 Richardson. condemnation of gharar is supported by Hadith. 15 1. 2008. and for that matter a trade transaction culminating in a debt contract. irrespective of the rate. the unanimous view of the jurists held that. speculative trading and transactions meeting exceeding limitations are considered gharar. and the word “riba” refers only to usurious loans on which an excessive rate of interest is charged by the creditors. p. In business terms. The Qur’an makes it very clear that in a loan transaction. only disproportionate risk. hence. in any transaction. Inc. gharar means to undertake a venture blindly without sufficient knowledge or to undertake an excessively risky transaction.2 Ban on transactions and products with excessive uncertainty (gharar-maisir) In principle.
Islam supports the view that Muslims do not act as nominal creditors in any investment. Mohammed. Ahmad.3 Principle of risk and profit sharing In Islamic finance.page 19 Al-Jarhi.. World Scientific Publishing Co. 18 1. available at http://www. 17 20 Venardos. Ben. Ltd. 51 17 . In other words.. Latifa M. Islamic Finance: An Introduction. Where the distinction between general commercial risk and speculation is not clear the commercial substance of a transaction will be analyzed. Inc. This is an equity-based system of financing. Angelo M. p. Speculative trades where there is little or no certainty as to the outcome.. Islamic Banking and Finance: Fundamentals and Contemporary Issues. Kabir. Islamic Research and Training Institute and Universiti Brunei Darussalam. such as currency market speculation or investment in derivatives. Unlike interest-based financing.. forms of speculation which are regarded as akin to gambling are prohibited. Mervyn K. Edward Elgar Publishing..claytonutz. then their money would also be lost. such as lotteries and betting on races. Whilst distinct concepts.2. Islamic Banking & Finance in South-East Asia. but are actual partners in the business. they deserve to be rewarded since this profit would have been impossible without their investment and. Mabid Ali. Islamic Banking and Finance: Philosophical Underpinnings. Ed. 2005. there is no guaranteed rate of return. Selected Papers from Conference in Brunei.39 18 Sandstad. 23 June 2009. Lewis. Profit-and-loss-sharing (PLS) financing is a form of partnership where partners share profits and losses on the basis of their capital share and effort.com/publications/newsletters/banking_and_financial_services_insights/20090623/islamic _finance_an_introduction. 19 Parties of a financial transaction must share both the associated risks and profits. Pte. 5-7 January 2004. Ausaf. This kind of risk was deemed unacceptable and tantamount to speculation because of its inherent uncertainty. Islamic Critique of Conventional Financing. those who finance investment share a good part of the risk with those who carry out actual investment activities.ISLAMIC SECURITIZATION them. p. 20 Algaoud. While general commercial risk is permissible. 2007. Lewis. Handbook of Islamic Banking. Speculative transactions with these characteristics are therefore prohibited. if the investment were to make a loss. there is some degree of overlap between gharar and maisir.. Its Development and Future. M. p. Strom. Salman Syed. 17 The prohibition of maisir covers gambling and other games of chance. where the justification for the PLS-financier’s share in profit rests on their effort and the risk that they carry. ed. furthermore. Hagbarth. by Ali. would not be permitted. Banking and Financial Services Insight. Mervyn K. by Hassan.
110 22 Karasik. alcoholic beverages. p. Strom. pork and pork products is prohibited. Wehrey. the sale and trading of commodities such as wine or alcoholic products. Innovative Financial Securities in the Middle East: Surmounting the Ban on Interest in Islamic Law. Even though Sharia prohibits payment or receipt of any interest on loans of money. is that the investor's return must be tied to the performance of the underlying asset. and contracts involving such commodities are void on the grounds of their illegality. Miami Business Law Review 107.2. supra. pork consumption. pornography and prostitution. Islamic investments must be socially responsible. 22 In essence. U. 382 23 Ayub. Generally inappropriate business activities include gambling and casino games. supra. For equity investments in stocks. Islam discourages investment in companies with high debt levels. and financial services dependent on payment of interest (riba). Islamic Finance in a Global Context: Opportunities and Challenges. Certain industries are viewed as inappropriate activities. although such ownership may be only indirectly beneficial in nature.ISLAMIC SECURITIZATION Islamic scholars prefer that investors obtain some form of ownership or participating interest in the underlying asset. The key. weapons/defense. not encourage activities considered sinful from an Islamic point of view. it instead shares the profits from its endeavors with the investors. Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field. p. For example. 135 24 Richardson. 24 Berschadsky. pp. Ariel. p. Because the "borrower" cannot pay interest. 2001. supra. 23 The investments should also be done in a financially sound manner. 126-127 21 . however.4 Ethical investments that enhance society Financing must be for a worthwhile cause. and the level of actual participation is often passive. 21 1. Understanding Islamic Finance. with each bearing some of the risk that the underlying assets could underperform. Islamic law permits and actually encourages the allocation of risks and rewards and sharing in the resulting profits or losses. the prohibition includes investments in companies with heavy debt (an extension of the proscription of riba and gharar).
Islam does not recognize money as a subject-matter of trade. Payments are made in installments. The word murabaha derives from the Arabic word ‘ribh’. Kluwer Law International. unlike conventional financial institutions. 26 In financing. Edward Elgar Publishing Limited. there is no room for making profit through the exchange of these units inter se. An Introduction to Islamic Finance. but also as a guaranteed profit margin.3. 2009. financing in Islam is always based on illiquid assets which create real assets and inventories. hence prohibited. 25 1.2. meaning profit. p. 2002. except in some special cases. Profit is generated when something having intrinsic utility is sold for money or when different currencies are exchanged. but also at a later date or in installments. either on a deferred basis or through 25 Usmani.1 Murabaha The most popular Islamic financial instrument is murabaha. The mark-up can be seen as a payment for the services provided by the intermediary. which includes a profit component. pp. The profit earned through dealing in money (of the same currency) or the papers representing them is interest. Hans.ISLAMIC SECURITIZATION 1. Therefore. Mufti Muhammad Taqi. Money has no intrinsic utility. that is. one for another. Payment may take place immediately.3 Main Transaction Types 1. stipulating that one party buys a good for its own account and sells it to the other party at the original price plus a mark-up. Each unit of money is 100% equal to another unit of the same denomination. 57 . Islamic Finance Principles and Practice. identifiable underlying asset”.5 Asset-backing Each financial transaction must be tied to “tangible. 1415 26 Visser. murabaha is used as a form of a sales contract in which the financial institution or investors buy an asset and then later sell it to the "borrower" at a marked-up price. it is only a medium of exchange. A murabaha contract is a trade contract. a cost-plus or mark-up contract. therefore.
Kabir. 52 29 Mayer Brown LLP. Islamic Finance At a Glance. Lewis. Thus. Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field. Mervyn K. Edward Elgar Publishing. M.mayerbrown. 27 Some observers see this mode of Islamic finance to be very close to a conventional interestbased lending operation. ed. Inc.asp?id=4357&nid=12368 27 . Zaidi. Abbas. 130 28 Mirakhor.. 2007. seeking and purchasing the required goods at the best price) and the mark-up is not stipulated in terms of a time period. if the client fails to make a deferred payment on time. p. However.ISLAMIC SECURITIZATION upfront payment with deferred delivery. Iqbal.. Banking & Finance Newsletter. Also the bank owns the goods between the two sales. 28 A basic structure of a murabaha transaction is as follows: 29 Richardson. available at http://www. by Hassan.com/islamicfinance/article. p. March 2008. a major difference between murabaha and interest-based lending is that the mark-up in murabaha is for the services the bank provides (for example. Murabaha instruments usually supply only short-term financing. supra. Profit-and-loss sharing contracts in Islamic finance. which means it carries the associated risks. the mark-up does not increase from the agreed price owing to delay. Handbook of Islamic Banking.
supra . for which he will not be given any remuneration.2 Mudaraba Mudaraba is a special kind of partnership in which an investor or a group of investors provides capital to an agent or manager who has to trade with it. 30 Please see below for a basic structure of Mudaraba: 31 At the core of any Mudaraba contract. The loss of the agent (Mudarib) is by way of expended time and effort. Introduction to Islamic Finance. 320-321 Mayer Brown LLP. pp. there are four basic conditions between the mudarib and the rabb al-mal [capital provider(s)] as follows: 30 31 Ayub. There is no restriction on the number of persons giving funds for business or any restriction on the number of working partners. The loss means a shortfall in the capital or investment of the financier.ISLAMIC SECURITIZATION 1. Islamic Finance At a Glance.3. Profit cannot be in the form of a fixed amount or any percentage of the capital employed. supra. while the loss has to be borne exclusively by the investor. the profit is shared according to the pre-agreed proportion.
apart from his or her right to restrict possible fields of economic activity for the Mudaraba. The rabb al-mal cannot interfere in the day-to-day management of the Mudaraba. This gives an incentive to invest wisely and take an active interest in the investment. but losses are shared in exact proportion to the capital invested by each party. 33 32 El-Din. however. 2007.ISLAMIC SECURITIZATION Profit. which explains why the profit-sharing ratio is mutually agreed upon and may be different from the investment in the total capital. Seif I. Loss of capital can be guaranteed by the mudarib only when such loss proves to be the result of mismanagement or delinquency of the mudarib. Profits are shared between partners on a pre-agreed ratio.3. Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice. This provision.3 Musharaka This is often perceived to be the preferred Islamic mode of financing. 1-2. would have to be born entirely by capital providers as the mudarib only loses his/her effort. Zaidi. p. because it adheres most closely to the principle of profit and loss sharing. in case it arises. Profit-and-loss sharing contracts in Islamic finance. The mudarib has a ‘hand of trust’ (yad amana) in the management of Mudaraba capital. Partners contribute capital to a project and share its risks and rewards. like violating restricted fields of economic activity. 57-58 33 Mirakhor. Loss. Kyoto Bulletin of Islamic Area Studies. when realized. which means he would work to his best effort and. In Musharaka. therefore. or where such loss results from a breach of the contract. cannot guarantee capital or profit to rabb al-mal. pp. has to be made clear within the mudarib contract. all partners have the right but not the obligation to participate in the management of the project. Tag. supra. has to be shared between the two parties in accordance with a profitsharing ratio pre-stipulated at the time of the contract. Thus a financial institution provides a percentage of the capital needed by its customer with the understanding that the financial institution and customer will proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is consummated. 32 1. 51 .
except where one party deliberately gives up (waivers) this right to other parties. Many Islamic banks prefer to waiver their rights of Musharaka management to clients on the grounds that clients are more qualified to run their own businesses. None of the parties can be held liable to guarantee capital or profit to other parties.ISLAMIC SECURITIZATION Below is a basic structure of a Musharaka transaction: 34 We can sum up the special provisions in a Musharaka contract as follows: Partners of Musharaka all have the right to engage in the day-to-day management of the Musharaka capital. has to be shared by partners in proportion to their capital contributions (i. Profit. however. on pro-rata basis) unless otherwise agreed on reasonable ground. Loss. Islamic Finance At a Glance. In the context of Islamic banking. when realized. and no 34 Mayer Brown LLP. Profit (or loss) cannot be prioritized within the Musharaka contract.e. Only where mismanagement and delinquency are proved or where a breach of the Musharaka contract is committed. has to be strictly shared on pro-rata basis. it is possible for the client to get a proportionately bigger share of profit if the bank has already waivered its right in management to the client. supra . the party so charged may be held liable to guarantee capital contributions of the other parties. No party (or group of parties) can be preferred to others in terms of profit distribution or loss allocation.
2008. 337 37 Said. and one of the coowners undertakes to buy.3.4 Diminishing Musharaka The participatory contracts that may be more suitable for financing of fixed assets and present-day ongoing projects. Pervez. can be based on the concept of “Diminishing Musharaka”. Expenses incidental to ownership may be borne jointly by the co-owners in the proportion of their co-ownership. Seif I. 36 It is a variant of Musharaka. Islamic Alternatives to Conventional Finance. supra. 38 The chart below shows the basic structure of a diminishing Musharaka transaction: 39 El-Din. 37 The key features of the diminishing Musharaka are given below: Diminishing Musharaka is applied for the purchase of tangible assets. p. supra. in periodic installments. Losses. Islamic Alternatives to Conventional Finance. 19 35 . Islamic Finance: A Guide for International Business and Investment. Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice. Each periodic payment shall constitute a separate transaction of sale. By Habiba Anwar. the proportionate share of the other co-owner until the title to such tangible asset is completely transferred to the purchasing co-owner. p. p. particularly for financial intermediaries. Introduction to Islamic Finance. shall be borne by the co-owners in proportion of their respective investments. p. 18 38 Said. Tag. if any. Ed. in order to ensure that each agreement is a separate transaction. and a form of co-ownership in which two or more parties share the ownership of a tangible asset in an agreed proportion.ISLAMIC SECURITIZATION pre-fixed return can be promised to any. 58 36 Ayub. and Separate agreements/contracts shall be entered into at different times in such manner and in such sequence so that each agreement/contract is independent from the others. supra. The fact that all parties have to be treated on an equal footing (pari passu) underscores profit & loss sharing as the core concept of Musharaka. GMB Publishing. Proportionate shares of each co-owner must be known and defined in terms of investment.35 1.
for instance. 40 In the case of housing finance. p. Ben. auto financing. available at http://www. p. In Lariba’s home buying scheme. supra. for example. Introduction to Islamic Finance. home buyer and a financier jointly own a home and over time the financier’s share diminishes continuously as the home buyer’s share increases. the client leases the financier’s share in the property and agrees to buy that share over a period of up to 30 years. supra. 24 September 2009. Islamic Finance Principles and Practice.ISLAMIC SECURITIZATION Diminishing Musharaka can be easily used for the purpose of financing fixed assets by Islamic banks. 339 41 Visser. It includes house financing. however. factory/building financing and all other fixed asset financing. Often. 111 39 . In the UK.page 40 Ayub. plant and machinery financing. Banking and Financial Services Insight. diminishing Musharaka is combined with ijara. 41 Sandstad. Usually. the client buys the home as the financier’s agent from the vendor and registers it directly into their own name.claytonutz. Introduction to Islamic Finance – Part II. HSBC Amanah only transfers ownership at the end of the agreed period.com/publications/newsletters/banking_and_financial_services_insights/20090924/introdu ction_to_islamic_finance-part_ii.
ISLAMIC SECURITIZATION 1. or for the effort or work proposed to be expended. available at http://minaretcapital. According to the jurists. Introduction to Islamic Finance. riding/work animals. which is rent in the case of hiring assets or things and wages in the case of hiring people. Introduction to Islamic Finance. tailor. p. jewelry. Minaret Capital. etc. 44 42 43 Ayub. While the latter involves employing the services of a person for a wage. wages or rent. residences. 279 Common Islamic financing structures. supra. it is the transfer of usufruct for a consideration. etc. clothes. vehicles. the subject matter giving usufruct can be divided into two types: property or assets. shops. ijara is a contract of a known and proposed usufruct of specified assets for a specified time period against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken.3. In other words. supra.com/structure. like houses. p. and labor.html 44 Ayub. the former relates to usufruct of any asset or property that is transferred to another person in exchange for rent. 42 The structure below illustrates how an ijara structure works: 43 For the purpose of ijara. like the work of an engineer.5 Ijara In Islamic law. carpenter. etc.. 280 . ijara is the sale of usufruct of any commodity in exchange of ujra. doctor. and covers houses.
It is essentially a forward agreement where delivery occurs at a future date in exchange for spot payment of price. 52 El-Gamal. called salam meaning “prepayment. and rent should be preagreed to avoid speculation.ISLAMIC SECURITIZATION When we look at its usage in the Islamic financing practice. aircrafts or cars. salam was originally designed as a financing mechanism for small farmers and traders.” This contract was primarily used for financing agricultural production. ijara is a contract under which a bank buys and leases out an asset or equipment required by its client for a rental fee. the bank purchases a building.46 A salam is deferred delivery contract. Responsibility for maintenance/insurance rests with the lessor. the bank) who is responsible for its maintenance. existence of some property as the object of sale is generally a condition for contract validity. Zaidi. the lessor has the right to renegotiate the terms of the lease payment at agreed intervals. which means that it assumes the risk of ownership. equipment or an entire project and rents it to the client. the ownership of the asset remains with the lessor (that is. there are some notable exceptions that allow sales of non-existent objects. the lessee commits himself to buying the asset at the end of the rental period. Profit-and-loss sharing contracts in Islamic finance. which will eventually result in the lessee’s purchase of the physical asset from the lessor. p. the client) does not have the option to purchase the asset during or at the end of the lease term. the lessee (that is. ijara wa iqtina (hire-purchase). Under an ijara contract. at an agreed price.6 Salam In Islamic law. One of the most important exceptions is an ancient contract that predates Islam. 2006. Cambridge University Press. During a predetermined period. Economics and Practice. 81 . For example. Under this contract.3. like buildings. but with the latter’s agreement to make payments into an account. supra. Leased assets must have productive usages.. It basically mimics financial leasing practices of conventional finance. p. Mahmoud A. a trader in need of short-term funds sells merchandize to the 45 46 Mirakhor. Under a salam agreement. In ijara wa iqtina. Islamic Finance Law. However this objective may be achieved through a similar type of contract. This is to ensure that the rental remains in line with market leasing rates and the residual value of the leased asset. 45 1. Unlike earlier mechanisms of murabaha and ijara. However.
which is expressly prohibited by the Sharia rulings (any unpaid price represents a debt to the buyer and a debt to the seller for the value of such goods not paid for in advance). It receives full price of the merchandize on the spot that serves its financing need at present. 2005. Islamic Finance At a Glance. Since the spot price that the bank pays is pegged lower than the expected future price.ISLAMIC SECURITIZATION bank on a deferred delivery basis. King Abdulaziz University. in full. Islamic Research Center. pp. to the seller at the time of effecting the sale. At a pre-agreed future date. supra 47 . Islamic Financial Services. The bank sells the merchandize in the market at the prevailing price. it delivers the merchandize to the bank. 95-96 48 Mayer Brown LLP. the transaction should result in a profit for the bank. otherwise it will be tantamount to a sale of debt against debt. 47 A simple salam structure is presented below: 48 Some additional considerations in salam are as follows: The buyer should pay the price. Obaidullah Mohammed.
17 Visser. But there are respected scholars who disagree and accept salam contract for shares. 61 51 Visser. supra. 50 The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Islamic Alternatives to Conventional Finance. This means that gharar is involved. Its permissibility is based on the sunna. supra. p. under a salam contract.ISLAMIC SECURITIZATION The debt liability of the seller cannot be adjusted against the price for salam sale. in part or in full. but it differs in two important aspects from the usual forwards and futures. that became effective in January 2007. p. Second. It is necessary that the quality of the goods intended to be purchased is fully specified. p. Salam can be affected in only those goods that are normally available in the market and whose quality and quantity can be specified exactly. but the downside is that hedging also becomes more difficult. the full price of the product must be paid in advance. and In order to ensure that the seller shall deliver the goods on the agreed date. 49 Salam is a bit of an exception in the Islamic financial landscape. supra. as the underlying assets may change. has ruled against salam contract for shares in a standard. the bank can also ask the seller to furnish a security. Salam may be a forward contract. as forward contracts are not generally acceptable. leaving no ambiguity leading to dispute among the parties involved in the transaction. on the grounds that shares are all identical and readily available on the market. First. at maturity the buyer must take delivery of the good. 62 . The parties may fix any date for delivery with mutual consent. The reasoning appears to be that the shares cannot be described well enough for the future. The exact date and place of delivery must be specified in the salam contract. 51 49 50 Said. Islamic Finance Principles and Practice. Islamic Finance Principles and Practice. Muslim scholars argue that in this way speculative activities (maisir) are prevented. Sharia Standard 21. which may be in the form of a guarantee or in the form of a mortgage/hypothecation. You cannot sell what you do not own and possess.
Edward Elgar Publishing. roads and highways. In a financial transaction. Kabir. with asset delivery to be within a specified period of time. Islamic banks can undertake the construction of any project/asset and its sale for a deferred price. supra 52 . The sane does not need to manufacture or construct the asset itself. If the original sane causes another sane to manufacture or construct. M. supra. By way of a Parallel Istisna contract with subcontractors. Inc. The mustasne will be required to pay the purchase price of that asset if the asset is manufactured or constructed within the specified time period and meets the agreed-upon specifications. Islamic Finance At a Glance. by Hassan.7 Istisna An istisna is a type of contract in which a mustasne (a client requiring the manufacturing or construction of an asset) orders from a sane’ (manufacturer or constructor) an asset meeting certain specifications (the masnou).ISLAMIC SECURITIZATION 1.T. projects. the Banks or a special purpose Funding Company would be the original sane and would contract with another sane (the end sane) for the manufacture or construction of the asset. 404 54 Mayer Brown LLP. Handbook of Islamic Banking. Islamic Project Finance. ed. Mervyn K.. Michael J.. plant. p. bridges. 2007. 53 The figure below illustrates the structure of an istisna transaction: 54 McMillen. Lewis. and subcontract the actual construction to any specialized firms. it may locate the asset in the market and purchase it for delivery to the mustasne or it may cause another party to manufacture or construct the asset.. 206 53 Ayub.3. the original sane remains liable to the original mustasne for the delivery of the masnou. 52 Istisna can be used for providing the facility of financing the manufacture or construction of houses. Introduction to Islamic Finance. p.
financing high technology industries such as the aircraft industry.ISLAMIC SECURITIZATION The legality of istisna is accepted by the Sharia scholars because it does not contain any prohibition. Istisna is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture. As a financing mode it has been legalized on the basis of the principle of Istihsan (public interest). hospitals. supra. assemble or construct (or cause so to do) anything to be delivered at a future date. p. locomotive and shipbuilding industries. Istisna is a valid contract and a normal business practice. schools and universities. 56 55 56 Ibid. Introduction to Islamic Finance. p. 263 Ayub. 55 Potential areas that istisna structure can be used are as follows: financing the construction industry – apartment buildings. development of residential/commercial areas and housing finance schemes. It becomes an obligation of the manufacturer or the builder to deliver the asset with agreed specifications at the agreed period of time. 269 . it has always been a common practice in the world and also because of ease for human beings.
ISLAMIC SECURITIZATION The main difference between an istisna and a salam contract is that. . in istisna contracts. it should always be something that needs manufacturing while the subject of a salam contract may be either a natural product or a manufactured good.
ISLAMIC SECURITIZATION Chapter 2 SECURITIZATION .
ISLAMIC SECURITIZATION 2 SECURITIZATION As we did make a beginning with the basics of Islamic Finance. project finance. to meet this requirement. structured finance is a flexible financial engineering tool. techniques employed whenever the requirements of the originator or owner of an asset. its structure and main transaction types. a good working definition for structured finance may be the following: . Frank J. liquidity. Henry A. Even though there is no universal definition for structured finance. cannot be met by an existing. p. Thus. risk transfer. available at http://en.. 4 . the underlying commercial needs and its history. 57 one should better start with defining what structured finance is. be they concerned with funding. 2006. or other need. structured notes and leasing 59. we will be trying to explain conventional securitization. off-the-shelf product or instrument. . Thus. Davis.org/wiki/Securitization Fabozzi.1 What is Securitization? As securitization is a structured finance technique. 2. John Wiley & Sons. Inc. Introduction to Structured Finance. p. we also need to grasp the idea of conventional securitization in order to perfectly understand what Islamic Securitization is. 58 Even though this very definition of structured finance would include not only securitization but also structured credits. 1 59 Ibid..wikipedia. in this chapter. Moorad. Hence.. existing products and techniques must be engineered into a tailor-made product or process. So what is securitization then? 57 58 Article “Securitization” from Wikipedia. it obviously gives a number of clues in relation to securitization. New Jersey. . Choudhry.
This instrument has existed Dictionary of Banking and Finance. which generate cash flows. 61 The institution owning the cash flow generating assets is commonly known as the originator. p. Oxford. a securitization structure may be much more complex than the main concept explained in our brief definition. 2005. These notes are backed by the cash flows from the original assets. Corporate Bonds and Structured Financial Products. to another company that has been specifically set up for the purpose. The other company mentioned in this explanation which purchases the cash flow generating assets is known as the Special Purpose Vehicle (SPV) which is also known as Special Purpose Company (SPC) or Special Purpose Entity (SPE). and the issuing of notes by this second company. Securitization generally refers to the sale of assets. 319 Choudry. 2.ISLAMIC SECURITIZATION Securitization may be very briefly defined as the process of making a loan or mortgage into a tradable security by issuing a bill of exchange or other negotiable paper in place of it. 60 Without any doubt. 61 60 . although the two are not the same. this brief definition needs a detailed clarification in order to make the quite complicated structure of securitization understandable for the reader. p. from the institution that owns them. let us now move on with the history of securitization. Elsevier Butterworth-Heinemann. in Europe a form of mortgage funding has existed for many years that has remarkable similarities to the present form of securitization. 2004. London. Moorad. After a basic explanation of what securitization is 63. 62 The SPV shall hold the assets purchased from the originator as collateral for the securities issued and sold to the investors. Edition. 297 62 For the purposes of this study.2 History of Securitization Even though the modern securitization practices appeared at the beginning of 1970s in the US. A & C Black Publishers Ltd. the concept Special Purpose Vehicle and the abbreviation SPV shall be used. We will be explaining the concept in detail in the sections regarding the structure of securitization and types of securitization. Besides. 3. 63 There are different kinds of ways to structure a securitization transaction which may vary considerably between each other.
as well as other financial intermediaries sensing a market opportunity. and structured the cash flows from the underlying loans. businesses substituted private credit enhancements. Comptroller of the Currency Administrators of National Banks. In 1985. auto loans were a good match for The Pfandbrief (plural: Pfandbriefe) is a mostly triple-A rated German bank debenture which has become the blueprint of many covered bond models in Europe and beyond. 109 66 Article “Historical view of securitization”. Vinod. Likewise. 1997.org/EN/banks/historysecuritization. Edition. A pool of assets second only to mortgages in volume. they improved thirdparty and structural enhancements. and sometimes by debt. on home loans. 67 But after World War II. banks were essentially portfolio lenders.ISLAMIC SECURITIZATION in Denmark for more than 200 years. the German “pfandbrief” 64 instrument has a long history and is even alive today. 2006. sought ways of increasing the sources of mortgage funding. available at http://www. The Pfandbrief is collateralized by long-term assets such as property mortgages or public sector loans as stipulated in the Pfandbrief Act. investment bankers eventually developed an investment vehicle that isolated defined mortgage pools. they held loans until they matured or were paid off. Securitization The Financial Instrument of the Future. 2 68 Ibid 64 . 66 For decades before that. Banks. securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. shortly thereafter. which was a direct obligation of the bank (rather than a claim on specific assets). depository institutions simply could not keep pace with the rising demand for housing credit. 65 The modern form of asset securitization began with the structured financing of mortgage pools in the United States in the 1970s.banque-credit. To attract investors. 65 Kothari. loan originators quickly realized the process was readily transferable to other types of loans as well. John Wiley & Sons (Asia) Pte Ltd. the American department of housing and urban development completes the first true securitization. These loans were funded principally by deposits. p. 68 To facilitate the securitization of non-mortgage assets. p. 2. First.html 67 Comptroller’s Handbook. Asset Securitization. In February 1970. Although it took several years to develop efficient mortgage securitization structures. they over-collateralized pools of assets. segmented the credit risk.
we will be going a step further than our definition section above and capture all the important features of a transaction.org/wiki/Securitization Ibid 71 Kothari. before going into the elements of a securitization deal. and their long statistical histories of performance gave investors confidence. approximately 75 per cent of which have originated from the US. Insurance-backed transaction (such as the ones implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government. supra. We will talk about that later in the section 2.69 Securitization only reached Europe in late 80's. let us try to make a summary of a securitization transaction in order to see the phases of it or how a transaction is structured: 69 70 Article “Securitization” from Wikipedia. such as UK Mortgage Master Trusts (concept imported from the US Credit Cards). 70 Securitization industry became a trillion dollar industry within a few decades. 2. Securitization The Financial Instrument of the Future. executed by Philippe Tapernoux).wikipedia.6 regarding securitization and the financial crisis. their maturities. considerably shorter than those of mortgages. p. In other words.3 Structure of Securitization In this section we will try to deeply examine how a securitization transaction is structured. available at http://en. made the timing of cash flows more predictable. 112 . 71 This rapid growth experienced a very harsh decline when the housing bubble in the US burst and the markets went into the worst financial crisis after the Great Depression of 1929. This technology only really took off in the late 90's or early 2000. thanks to the innovative structures implemented across the asset classes.ISLAMIC SECURITIZATION structured finance. when the first securitizations of mortgages appeared in the UK. Now.
An originator of (usually) high quality receivables, such as home mortgage loans and consumer credit receivables, sells the receivables to a specially formed company (SPV) in return for a purchase price payable immediately on sale. The SPV finances the purchase price of the receivables by borrowing from banks or by a conventional bond or note issue to sophisticated investors (“funding loan”). The SPV grants security to investors over the receivables to secure the borrowing. The SPV authorizes the originator as the “servicer” to collect the receivables on behalf of the SPV which uses them to pay principal and interest on the funding loan (investing the proceeds in the meantime). The SPV pays a servicing fee to the servicer. The SPV is usually a thinly-capitalized single-purpose company whose shares are held by somebody other than the originator, e.g. charitable trustees, so that the SPV is not a subsidiary which must be consolidated on the originator’s balance sheet. In order to ensure that the receivables are sufficient to repay the investors on time, there may be various forms of “credit enhancement”, e.g. a third party may give a guarantee to the SPV or the originator may agree to make a subordinated loan to the SPV. The loan by the investors, e.g. loan notes, is often rated by a rating agency. Usually the loan has a higher rating than would be obtainable for a direct loan to the originator. The SPV pays surplus income from the receivables, which is not needed to repay the funding loan, to the originator so that the originator takes the profit. The SPV may pay this profit to the originator as servicing fees or other means. 72
Below is a figure 73 which perfectly complements our summary:
Wood, Philip R., Title Finance, Derivatives, Securitisations, Set-off and Netting, Sweet&Maxwell, 4. Edition, 2001, pp.41-42 73 Fabozzi, Frank J., Davis, Henry A., Choudhry, Moorad, Introduction to Structured Finance, supra, p. 70
The originator is the key concept in a securitization structure. The originator is the legal (or even real) person that starts the whole process by deciding to securitize its cash flow generating assets. Who or what can be an originator or in other terms can securitize its assets?
An originator can be any legal person as well as real persons that have cash flow generating assets. Quite interestingly David Bowie, James Brown, the Isley Brothers, and Rod Stewart used securitization to obtain funding from their future music royalties. The first was David Bowie who in 1997 used securitization to raise $55 million backed by the current and future revenues of his first 25 music albums (287 songs) recorded prior to 1990. 74 The legal persons that use securitization may be financial institutions, large corporates, quasi-government agencies and even local governments and municipalities. 75
As the example regarding the music royalties may give a clue, all assets can be securitized so long as they are associated with cash flow. 76 The securitization market in the United States and
Fabozzi, Frank J., Kothari, Vinod, Introduction to Securitization, John Wiley & Sons, Inc., 2008, p. 15 Jobst, Andreas A., Asset Securitisation as a Risk Management and Funding Tool: What Does it Hold in Store for SMES? February 14, 2005, p.2, available at SSRN: http://ssrn.com/abstract=700262 76 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization
Western Europe is dominated by a number of asset classes: residential mortgage receivables, commercial mortgage receivables, credit card receivables, auto loans, consumer loans, trade receivables and uncontracted future cash flows (such as toll receipts). However the type of assets that can be securitized continues to expand (some of the key innovators in Western Europe have been governments). In principle, any assets or entitlements representing future (predictable) cash flows can be securitized to the extent that they can be effectively transferred to the SPV through a true sale (or to the extent that the Originator is considered to be “bankruptcy remote”). These may, for instance, include tax revenues or utilities payments. 77
2.3.1 True Sale
It is imperative that once the sale and transfer of the assets to the SPV has been effected, it cannot be challenged, voided or otherwise reversed in an insolvency of the Originator or otherwise. This concept is referred to as true sale. Whether a transaction constitutes a true sale under the applicable law (notably, whether it will be recognized as such by the competent court in the Originator’s insolvency) must be established through a legal analysis of the transaction. 78
If it is subsequently determined in a bankruptcy proceeding that the so-called sale by the originator was merely a nomenclature or a camouflage, then a bankruptcy judge can rule that the assets were never sold and were merely pledged as collateral for a financing. In that case, in the event of a bankruptcy filing by the originator, the bankruptcy judge can have the assets of the SPV treated as part of the assets of the originator. This would defeat the purpose of setting up the SPV. Typically, a true sale opinion letter by a law firm is sought to provide additional comfort to the parties in the transaction. 79
In order to qualify for a true sale treatment, generally, a transaction must meet the following criteria:
IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, p.2, available at http://www.ifc.org/ifcext/eca.nsf/AttachmentsByTitle/Securitization1A%2B904/$FILE/Securitization1A%2B9-04.pdf 78 Ibid 79 Fabozzi, Kothari, Introduction to Securitization, supra, p. 9
Inc. Therefore. Ed. and those assets are either beneficially held by the investors or collateralize the securities of the vehicle. This is what makes a special purpose vehicle bankruptcy-remote. Securitization The Financial Instrument of the Future. An SPV is a company that is created solely for a particular financial transaction or series of transactions. supra. A general purpose. is not fit to hold securitized assets as such a company might have other assets and other liabilities. by. It does so because creation of marketable securities is not possible without a conduit or vehicle that will house the assets transferred by the originator and create securities based on such assets. and/or incur liabilities. it might incur expenses. A special purpose vehicle is a legal entity. but a substantive non-entity. 80 2. 75 81 Article “SPV”. there is nothing left in the vehicle for anyone to have an interest in. a vehicle is required to serve as an intermediary between the originator and the investors. Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities.ISLAMIC SECURITIZATION Legal isolation from the seller (transferred assets put “presumptively beyond the reach of the transferor and its creditors”).3. 83 Hayre.2 Special Purpose Vehicle The originator intending to securitize its assets needs to establish a Special Purpose Vehicle (SPV). The new owner of the assets has the right to pledge or to exchange the assets (or the beneficial interests in the assets if the new owner is a qualifying (SPV).uk/spvspe/ 82 Kothari. and might go bankrupt. By its very nature. such as a trust. and The seller doesn’t have the right to buy the assets back. available at http://moneyterms. John Wiley & Sons. p. a special purpose vehicle is a legal shell with only the specific assets transferred by the originator. It may sometimes be something other than a company. 15-16 83 Ibid. pp.co. thereby destroying the transaction. 2001. or operating company. p. Lakhbir.. 81 So the originator establishes an SPV in order to use it for a particular financial transaction or series of transactions. 16 80 . each of which might interfere with the exclusivity of rights over the assets that the transaction intends to give to the investors. 82 If an operating company holds the assets.
3. August 14-18. 3. available at http://www. 228 84 . 3. 84 For tax reasons. 2006. Nevis. This increases the likelihood that the investors Akamatsu. Frequent issuers under US and UK law use master trust structures.slideshare." meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. the originator knows the borrowers and vice versa. Furthermore. the SPV is mostly established in a tax-friendly jurisdiction such as Luxembourg. Noritaka. collective investment fund or established under special law but only if those laws are SPV-enabling. The SPV cannot be consolidated with the originator for tax. It can take the form of limited partnership.net/financedude/role-of-special-purpose-vehicles-is-abs-market 85 Choudry. 2006. limited liability company. 85 2. p. Edition. Master trusts have been used by Mortgage-Backed Securities (MBS) and credit-card Asset-Backed Securities (ABS) originators. Cayman Islands. etc. Role of Special Purpose Vehicles in ABS Market.ISLAMIC SECURITIZATION As a result of the aforementioned. independent management or employees. Notes are then issued out of the asset pool based on investor demand. p. Under such schemes. So it makes perfect sense for the originator to go on administering the portfolio of the assets. the originator transfers assets to the master trust SPV. trust. etc. which allow multiple securitizations to be issued from the same SPV. the originator has an expertise in the area as it is mainly dealing with that type of business. accounting or legal purpose as that will effect its bankruptcy-remote position. corporation. in order to avoid the transfer or municipality taxes. An Introduction to Bond Markets. an SPV is a legal entity functioning as a conduit with no physical presence.3 Credit Enhancement Unlike conventional corporate bonds which are unsecured. securities generated in a securitization deal are "credit enhanced. The World Bank China. John Wiley & Sons. Obviously. Moorad.
Introduction to Securitization. so that one bond class provides credit enhancement to the other bond classes. supra. 89 To sum up. Whatever is available from the income of the transaction (after meeting senior expenses) to meet losses on the assets is credit-enhancing excess spread. over-collateralization. If the weighted average funding cost is 5. and (3) the payments made to the bond classes (which is based on the weighted average funding cost).5%. excess spread is the funds remaining after expenses such as principal and interest payments. Finally. supra. Originator-provided credit enhancement refers to credit support where a part of the credit risk of the asset pool is assumed by the originator/seller.5%− 1. (2) structural. p. supra. 86 88 Kothari. third-party credit enhancement refers to the assumption of credit risk by parties other than the originator and the other bond classes in the structure. and can be used when SPV expenses are greater than its income. Securitization The Financial Instrument of the Future. cash collateral. available at http://en.5% − 5%). assume a pool of loans that has a weighted average note rate of 9. 88 More specifically.wikipedia. and (3) third-party provided. etc. Introduction to Securitization.ISLAMIC SECURITIZATION will receive cash flows to which they are entitled. pp. 86-87 .0%. 87 The originator-provided credit enhancement mechanisms include excess spread. 86 The mechanisms for credit enhancement can be classified into three categories: (1) originator-provided. p. as well as other fees have been paid-off are accumulated. then the excess spread is 3% (9. (2) senior servicing fees. Kothari. 213 89 Fabozzi. Kothari. Structural credit enhancement refers to the redistribution of credit risks among the bond classes comprising the structure. 86 87 Article “Securitization” from Wikipedia. For example. the excess spread is equal to the interest paid by the asset pool (which is based on the note rate of the obligors in the asset pool) reduced by (1) the expenses of the transaction such as trustee fees. The advantage of retaining the exc ess spread is that it can be used to offset losses in future periods.org/wiki/Securitization Fabozzi. and thus causes the securities to have a higher credit rating than the originator.5% and the originator receives a servicing fee of 1.
mezzanine. Class B. and thus are rated differently.wikipedia. any balance in the cash collateral account is returned to the originator. 91 Let us move on with structural credit enhancement mechanisms. 92 As this is the very principle of structured finance –carving out securities with different risk/return attributes. 107 96 Article “Tranche” from Wikipedia. and both of them provide enhancement to Class A. available at http://en. The lower-rated notes usually have an element of over-collateralization and are thus capable of 90 91 Ibid.ISLAMIC SECURITIZATION Secondly. p. structural enhancement is crucial to a securitization transaction. 94 This mechanism. so it is called structured enhancement. p. 89 92 Ibid. Introduction to Structured Finance. The originator can also make a subordinated loan to the SPV which has the same cash collateral effect. supra.org/wiki/Tranche . As it is noted above. is known as the cash flow waterfall. At the termination of the transaction. 90 93 Kothari. or simply the waterfall. Choudhry. Securitization The Financial Instrument of the Future. p. 90 Over-collateralization is one of the most common forms of credit enhancement where the originator transfers an asset pool that has a market value that exceeds the amount paid by the SPV. The amount of the over-collateralization is a form of equity and is equal to the difference between the par value of the assets transferred and the price paid. Davis. p. 88 Ibid. 95 That structure is also known as Tranching. The figure below 96 is an illustration of how the waterfall structure in a securitization scenario works. and Class C. the originator can create a cash collateral account at the initiation of the transaction and the cash in that account is subject to withdrawal in the event of losses that exceed the amount provided by other forms of credit enhancement. the subordination of Class C provides a credit enhancement to Class B. in a securitization the issued notes are structured to reflect the specified risk areas of the asset pool. and junior (or subordinated) bond classes.93 When various classes of liabilities are issued with different priorities—such as Class A. The senior tranche is usually rated AAA. p. This credit enhancement comes from the structure of the liabilities. The most common form of credit enhancement for securitization transactions is the stratification of the bond classes into senior. supra. which is set down in the deal’s prospectus. 218 94 Ibid 95 Fabozzi.
supra.ISLAMIC SECURITIZATION absorbing losses. the bondholders would be in a position not to recover the principal outstanding for that loan. p. Choudhry. Pamela P. Financial Management and Investment Management. thereby absorbing the loss. Introduction to Structured Finance. 105 99 Fabozzi. Finance Capital Markets. to guarantee the performance of a certain amount of the collateral against defaults. 228 Fabozzi. 97 Finally. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator.. An Introduction to Bond Markets. for example. Inc. 433 98 97 . Frank J. a loan in the collateral pool goes into default and the underlying collateral is repossessed and then sold at a loss resulting in a partial payoff of the outstanding loan balance.. 2009. supra. It is often referred to as the first-loss piece. The most junior note is the lowest-rated or non-rated. an insurance provider will pay the difference between the loan payoff amount and the amount due to the bondholders. John Wiley & Sons.. 98 In this form of credit enhancement. an insurance provider agrees. Davis. 99 Choudry. p. because it is impacted by losses in the underlying asset pool first. p. If. for a fee. the third-party provided credit enhancements come in the form of third-party guarantees [such as a letter of credit (L/C) or a surety bond] that provide for first-loss protection against losses up to a specified amount. Drake. To provide protection to the bondholders.
102 At this point. John Wiley & Sons Ltd. 101 The most common credit derivative is the credit default swap. most securitization transactions contain some form of interest rate hedging and/or currency hedging to deal with currency risk and basis risk. Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. However when the bubble burst and the AIG was downgraded to AA. Inc. 2004. Credit derivatives were developed along the lines of other over-the-counter (OTC) derivatives but have found an excellent companion in securitization. supra. Elsevier Butterworth-Heinemann. to go almost bankrupt in the recent financial crisis. and this led AIG into a liquidity crisis. one of the biggest insurance agencies in the world. the parties to a securitization transaction are also under interest rate risk. we should note that this instrument was the main reason for American International Group. An Introduction to Credit Derivatives. It could only manage to survive with several Federal Reserve bailouts. 31 . Moorad. What AIG mainly doing was writing credit default swaps to back Collateralized Debt Obligations (CDO) which has been a very profitable business during the housing boom.org/wiki/American_International_Group 104 Deacon. p.16 103 Article “American International Group” from Wikipedia. Global Securitization and CDOs. p. An Introduction to Credit Derivatives. normally but not necessarily the originator of the credit asset. supra. with a protection buyer that pays a periodic fixed fee or a one-off premium to a protection seller. For that reason. John. Securitization The Financial Instrument of the Future. 100 The party that provides protection against such risk is called protection seller and the party that buys such protection. A payout under a credit derivative is triggered by a credit event associated with the credit derivative's reference asset or reference entity.ISLAMIC SECURITIZATION It is also possible to use derivatives as third party provided credit enhancement mechanisms. p.11 Kothari. 103 Apart from the credit risk. 25 102 Choudry. is called the protection buyer.wikipedia. This is a bilateral contract that provides protection on the par value of a specified reference asset. it was required to post additional collateral with its trading counter-parties. (AIG). in return for which the seller will make a payment on the occurrence of a specified credit event. 104 An interest rate swap can be used to alter the cash flow characteristics of the assets (liabilities) to match the characteristics of the 100 101 Choudry. 2004. p. available at http://en. credit swap or default swap. while talking about credit default swaps.
309 108 Ibid. floating rate cash flows based on the reference rate and margin owed to the covered classes of bonds.4 Credit Rating Rating is almost indispensable in the process of securitization. monthly payment characteristics. originated by an A-rated issuer. Essentially. Therefore. and more relevant in other jurisdictions. all that is required is to work out the level of credit enhancements or subordinated interest. it is quite possible to do so. 108 Even though it is often said that the rating of the originator is completely irrelevant for securitization transactions. the rating agencies are concerned with the quality of the underlying pool. 107 As securitization is a structured finance device. A generic or plain vanilla swap can be used to convert the monthly. All major international rating agencies are engaged in rating securitization transactions. and finally subprime issuers will have the highest credit enhancement (and additionally. 310 . fixed rate cash flows to monthly. prime issuers will have the lowest credit enhancement. 89 107 Kothari. p. The credit of the collateral 105 106 Fabozzi. For example. p. monthly payment loans but the bond classes that are supported by the collateral have floating rate. followed by nonprime issuers. 105 The credit enhancement is sized appropriately for the rating level to cover the expected pool losses during the life of securitization. Every securitization transaction has a potential to result in a given rating. p. For example. supra. often a monoline wrap). the investors are not concerned with the entity except for the quality of the originated portfolio. supra. 108 Hayre. if a AAA rating is targeted in an auto finance pool. Securitization The Financial Instrument of the Future. p. let us suppose a transaction has a pool of fixed rate. it should be noted that the rating of covered bonds depends on a composite view of the strength of the rating of the issuer and the rating of the collateral pool. supra. Introduction to Securitization. 106 2. Kothari.ISLAMIC SECURITIZATION liabilities (assets). The amount of credit enhancement will vary according to the expected pool losses and the historical volatility of the issuer’s losses.3. neither can be used solely – the issuer may be less relevant in jurisdictions with stronger insolvency ring-fencing. Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities.
an insurance company that was underwriting insurance on the pool of the assets. pp.com/2009/07/15/business/15calpers. Calpers Sues Over Ratings of Securities. In July. 72 112 Choudry. Introduction to Structured Finance. available at http://www. As rating agencies have long experience in rating securitization issues. An Introduction to Bond Markets. NY Times. they have developed a benchmark for different asset classes. supra. Securitization The Financial Instrument of the Future. 232 113 Wayne. Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. heavy utilization of credit enhancement or downgrade of a supporting rating – for example.nytimes. July 14. 109 Obviously the abilities of the originator as the servicer will have some effect on the cash flow from the originated assets. 2009. the corporation must assess the tradeoff between the additional cost of credit enhancing the bonds versus the reduction in funding cost by issuing a bond with a higher credit rating. 111 A change in rating for an Asset-Backed Security (ABS) or Mortgage-Backed Security (MBS) issue may be due to deterioration in performance of the collateral. 2009. clean and prior title to the securitized portfolio. the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies. Leslie.ISLAMIC SECURITIZATION pool may change with the ability to dynamically substitute the pool. The various credit enhancement mechanisms increase the costs associated with securitized borrowing via an asset-backed security. 113 109 110 Deacon. p. risks of set-off and prepayment. tax risks. solvency of the issuer. Mainly the most important rating agency concerns while giving a rating are the quality of the asset portfolio. 110 Why doesn’t a corporation always seek the highest credit rating (AAA) for the bonds backed by the collateral in a securitization transaction? The answer is that credit enhancement does not come without a cost. perfection of the legal structure. 112 Some recent lawsuits alone show the crucial role played by the rating agencies in securitization transactions. when it is seeking a higher rating. 310-313 111 Fabozzi. Choudhry.html?_r=3&scp=1&sq=calpers&st=cse . supra. p. Global Securitization and CDOs. So. etc. Davis. supra. 125 Kothari. supra. p.
1 Motivation for the Originator The rationale for securitization varies widely from company to company. obviously there are many reasons for the originators to undertake securitization deals and also for the investors to invest in the securities issued. 19 .3. it is time to look at the motives of the parties for securitization or what the reasons to undertake a securitization transaction and invest in the securities issued are. 2.4 Motivation for Securitization Even though the financial turmoil seen recently made many people think that securitization was one of the main reasons of the credit crunch. 2. In this part. available at http://www.hmrc. 114 Article “Securitization: other common features” from HM Revenue & Customs.ISLAMIC SECURITIZATION 2. It is then of the essence that any such surplus income should be returned to the originator. supra. 114 Now after scrutinizing the complex structure of securitization. at least in the good old times it was the case. it is expected that the SPV will receive more income than it needs from the securitized assets to meet its liabilities to the investors and its own nominal profit entitlement.uk/MANUALS/cfmmanual/CFM20050. p.gov.htm 115 Deacon.4.5 Profit Extraction In most securitizations. Global Securitization and CDOs. we will try to explain these motives for the parties to a securitization transaction. namely the originator and the investors. which is consistent with the securitization being essentially a method of funding rather than a sale of assets. 115 There is a bunch of reasons for different kind of originators to undertake securitization transactions and here we will try to explain the most important ones for most companies. from the Originator’s perspective.
p.4. supra. or has a low credit rating. supra. supra.2 The ability to diversify funding sources The ABS markets have their own investor base. or credit concerns on the originator. without disturbing existing lenders. 98 . p. available at http://en. Issuing in the ABS markets enables the originator to access this new base of investors and expand their current funding sources. or the amount of finance that can be raised. some or all of which may not be current investors in the business of the originator. whether due to unfamiliarity with the originator. 5 Article “Securitization” from Wikipedia. For an originator that is perceived as a bad credit risk.1 The potential for reducing costs The segregation of receivables from the insolvency risk of the originator will enable funds to be raised which are not linked to credit risk on the originator.1. Kothari.org/wiki/Securitization 118 Fabozzi. Introduction to Securitization. pension funds and the like may not be available for access. Global Securitization and CDOs. other than for investment in a securitization program. Moody's downgraded Ford Motor Credit's rating in January 2002. typical securitization investors such as insurance companies. The difference between BB debt and AAA debt can be multiple hundreds of basis points. Securitization The Financial Instrument of the Future. 5 120 Kothari. a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. it is meant that there is a source of capital that can be used to absorb losses incurred by the asset pool. 116 Let us give an example in order to show how that happens. 118 2.ISLAMIC SECURITIZATION 2. 15 119 Deacon. For example. 120 116 117 Ibid. 117 By credit enhancement.wikipedia.4. this should serve to improve the all-in cost of funds to the originator. asset managers. p. For many entities. continued to be rated AAA because of the strength of the underlying collateral and other credit enhancements. but senior automobile backed securities. Through securitization. p. 119 By doing so. issued by Ford Motor Credit in January 2002 and April 2002.1. securitization extends the pool of available funding sources to an entity by bringing in a new class of investors.
One of the very strong motivations for securitization is that it allows the financial entity to sell off some of its on-balance sheet assets. Securitization The Financial Instrument of the Future. 76 . p. 101 124 Kothari. 125 121 122 Fabozzi. while the loans taken by the lenders have a variable rate.4. securitization can be used as a corporate risk management tool. supra. p. supra. 100 125 Fabozzi. 121 Once assets have been securitized.ISLAMIC SECURITIZATION 2. Choudhry. and thus remove them from the balance sheet and reduce the amount of capital required for regulatory purposes 124 which again can lead to cost savings or allows the bank to allocate capital to other. Securitization The Financial Instrument of the Future. Introduction to Securitization.1. as mortgages for instance carry a fixed rate of return. supra. When the mortgages are securitized. if the bank does not retain a first-loss capital piece (the most junior of the issued notes). p. the lenders are also subject to the interest rate risk. it is removed entirely.4 The ability to help in capital adequacy requirements Capital adequacy requirements relate to the minimum regulatory capital for financial intermediaries. 123 2.1. supra. Kothari. the originator completely avoids the price risk as the entire interest rate or prepayment risk inherent in the pool is transferred to capital markets. 17 Choudry.4. 224 123 Kothari. perhaps more profitable. Introduction to Structured Finance. Davis. p. An Introduction to Bond Markets. the credit risk exposure on these assets for the originating bank is reduced considerably and. p. 122 Before securitizing the assets.3 The ability to manage corporate risk The credit risk and the interest rate risk of assets that have been securitized are no longer risks faced by the originator/seller. businesses. Thus. supra.
19 Kothari. p.5 The opportunity to achieve off-balance financing Most securitizations transfer assets and liabilities off the balance sheet. Securitization The Financial Instrument of the Future.7 The ability to reduce credit concentration Securitization has also been used by many entities for reducing credit concentration. supra. Mismatch spells either higher risk or cost.org/wiki/Securitization 129 Kothari. 101 . implies risk. Kothari. It refers to the maturity mismatch between assets and liabilities. securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis. available at http://en.1. thereby reducing the amount of the originator’s on-balance sheet leverage.4.8 The opportunity for arbitrage by repackaging Securitization has also been used by a number of banks and financial professionals for arbitraging purposes: Buying up assets from the market at higher spreads. Concentration either sectoral or geographical. 127 Depending on the structure chosen. supra.1. 98 128 Article “Securitization” from Wikipedia. accumulating them.6 The ability to match the assets and liabilities Asset liability mismatch is a serious issue for financial intermediaries such as banks and financial companies. Introduction to Securitization.4. p. supra. 126 127 Fabozzi. 128 2.ISLAMIC SECURITIZATION 2. 126 2. The off-balance-sheet financing can help improve the securitizer’s return on equity (ROE) and other key financial ratios. 129 184.108.40.206. Securitization by transferring on a nonrecourse basis exposure by an entity has the effect of transferring risk to capital markets.wikipedia.1. Securitization The Financial Instrument of the Future. p. and so intermediaries try to strike a near perfect match between maturities of assets and liabilities.
100 pooled assets. Thus. Investors are not affected by any of the risks that beset the originator. securitized instruments are devices of asset-based finance.4. rather than investing $100 million in an AA-rated corporate bond and be exposed to “event risk” associated with the issuer. supra. 133 That is why hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities. First of all. available at http://en. giving a net arbitrage profit to the repackager. Introduction to Structured Finance. p. investors can again exposure to. This is because investors perceive asset-backed securities as possessing a number of benefits.wikipedia.org/wiki/Securitization . securitization investments are far safer than investing directly in the debt or equity of the originator. For example. often diversified and reasonably credit-enhanced. 79 132 Kothari.org/wiki/Securitization 135 Choudhry. Davis.ISLAMIC SECURITIZATION providing or organizing enhancements and securitizing them.2 Motivation for the Investors Investor interest in the ABS market has been considerable from its inception. 102 133 Fabozzi.134 Obviously securitization gives the investors the opportunity to access sectors that are otherwise not open to them 135 and potentially earn a higher rate of return (on a risk-adjusted basis). p. supra.wikipedia. Choudhry. 136 130 131 Ibid Fabozzi. p. Investors have a direct claim over a portfolio of assets. 131 Now let us try to explain what advantages securitization ensures to the investors. available at http://en. Introduction to Structured Finance. 130 2. These pooled assets clearly have lower concentration risk. An Introduction to Bond Markets. These transactions are sometimes called repackaging transactions. 79 134 Article “Securitization” from Wikipedia. 132 A holding in an ABS also diversifies an investor’s risk exposure. Securitization The Financial Instrument of the Future. for instance. p. 224 136 Article “Securitization” from Wikipedia. supra. supra. Davis. Choudhry.
However the type of assets that can be securitized continues to expand. supra.1 According to asset types One actually needs to answer the question “What can be securitized?” in order to see different securitization structures according to asset types. auto loans. However. These conduits are typically administered by commercial or investment banks and are able to achieve a transaction cost economy of scale by IFC Technical Working Group on Securitization in Russia. their transaction costs can be high. 137 2. 31 137 . In principle. When we look at the practice we see that the most common assets that have traditionally been securitized are residential mortgage receivables. consumer loans. because one-off structures are created for a particular transaction.2 138 Schwarcz.5. credit card receivables. they can rarely achieve the transaction cost economies of scale realized by multiseller securitization conduits. commercial mortgage receivables. Securitization Key Legal and Regulatory Issues. 2004. We mentioned before that cash flow generating assets can be securitized.ISLAMIC SECURITIZATION 2. Steven L. The objective of this so-called one-off securitization is to provide the originator with significant flexibility to customize the securitization in terms of its particular structure and the types of capital market securities issued. p. the SPV is created specifically for the particular originator and the particular transaction. p. trade receivables and uncontracted future cashflows. for instance. International Financial Law Review.5 Different Classifications of Securitization 2. The Alchemy of Asset Securitization. May 1995.5. 138 A multiseller securitization conduit offers originators the opportunity to minimize their transaction costs by utilizing a common SPV. include tax revenues or utilities payments.2 According to SPV types In most securitization structures. any assets or entitlements representing future (predictable) cash flows can be securitized to the extent that they can be effectively transferred to the SPV through a true sale (or to the extent that the Originator is considered to be “bankruptcy remote”). These may.
Under the pay-through structure. John Wiley & Sons Inc. the assets are typically held by a limited purpose vehicle that issues debt collateralized by the assets. 143 In a pay-through securitization structure. Alternatively the potential risk caused by originator’s bankruptcy can be mitigated by special arrangement so called “compartment” stated in special securitization law. 139 Although multiseller structure can minimize the transaction cost by achieving economy of scale. p. p. 2. after deducting fees and expenses.vinodkothari.20-21 141 Available at http://www. pp. Accounting and Disclosure Rules. supra. they have simply invested in a Ibid. the issued debt instrument is a borrowing instrument. it has higher risk of getting involved with bankruptcy claims when single originator goes bankruptcy. Edition. multiseller SPV is often used in transactions with investment grades. Stephen G. 140 2. 7 143 Ryan. 196 140 139 .5.htm 142 IFC Technical Working Group on Securitization in Russia. as are there in the actual receivables.M. It can adversely affect legal existence of the multiseller SPV. Shegzhe. Like a pass-through. Investors in a pay-through bond are not direct owners of the underlying assets. and subject to the same fluctuations. 2007. Thus. True Sale Securitization in Germany and China. That is to say. In other words. 141 This is done by selling direct participations in the pool of assets. Principal and interest collected on the assets are “passed through” to the security holders.ISLAMIC SECURITIZATION allowing multiple originators to sell receivables to a single pre-existing SPV. the SPV is typically dissolved. Securitization Key Legal and Regulatory Issues. or rather.3 Pass through & Pay through Securitization Structures A pass through securitization structure refers to the securitization structure where the SPV makes payments. the debt service is met by cash flow “paid through” to investors out of the pledged collateral. Johann Wolfgang Goethe University. passes payments to the investors. 2004. LL. not participation. a pass-through certificate represents an ownership interest in the underlying assets and thus in the resulting cash flow. p. like the Securitization Law issued in March 2004 in Luxembourg. the seller acts primarily as a servicer. 2004. Finance thesis. 142 When substantially all the payments are collected and disbursed. 32 Wang. amount collected every month is passed through to investors.com/glossary/Passthro. because those originators are less likely to go bankrupt. Financial Instruments & Institutions.. on the same periods. Institute for Law and Finance (ILF)..
supra. 37 146 Wang.5. For accounting purpose. if the assets in question are synthetic rather than really transferred and securitized. The basis of a synthetic securitization IFC Technical Working Group on Securitization in Russia. 144 2. inter alia. 146 As asset securitization converts assets into securities. Securitization Key Legal and Regulatory Issues. a true sale securitization allows an originator to take the securitized assets off its balance sheet. 2004. 23 144 . Thus pay-through securities may be structured so that asset cash flows can be reconfigured to support forms of debt unlike those of the underlying assets. a securitization transaction will usually attempt to effect a ‘‘true sale’’ under the relevant legal regime relating to the receivables – terminology used to describe a sale of the receivables being securitized in a manner which ensures their isolation from the bankruptcy or insolvency of the originator. this is a synthetic securitization. Global Securitization and CDOs. p. where a position of risk and return emulating an actual asset or exposure is created by a derivatives transaction. 7 145 Deacon. In order to ensure that this treatment is available. supra. p. thus improving its leverage. 145 Obviously this will increase the rating for the securities and consequently the financing cost will be lower than it would otherwise be. Other objectives a true sale securitization can achieve are. into separate payment streams. The synthetic technology comes from the world of derivatives. Therefore. supra. transferring of credit risks. the issuing entity can manipulate the cash flows. p.4 True sale & Synthetic Securitization Structures One of the key aspects of ensuring the marketability of the relevant debt securities or bank debt that will fund the securitization is to enable the relevant rating agencies to analyze the credit risk of the relevant receivables free and clear of the credit risk of the entity that originated the receivables in question – such that the deal is delinked from the credit of the originator. access to capital markets and influencing balance sheet. True Sale Securitization in Germany and China.ISLAMIC SECURITIZATION bond backed by some assets.
147 A synthetic securitization securitizes a debt portfolio synthetically. 149 2. future flows is close to corporate funding in that there needs to be a performance on the assets or infrastructure to see the cash flow with which the securities will be paid. a business. As an example. 24-26 . we will see that. In a synthetic transaction.5 Asset-backed & Future Flows Securitization Structures While traditional asset-backed transaction relate to assets that exist.cash and transfer. supra. both are missing. . 525 149 Wang. an infrastructure. not actually. the transaction includes two key features. There is a source. Securitization The Financial Instrument of the Future. synthetic securitizations however mainly function as an efficient technique to hedge credit risks. nor does he transfer any assets. from which the asset will arise. 524 Ibid. in other words. 148 If we basically look at the main differences between the true sale and synthetic structures. future flows transactions relate to assets expected to exist. the main function of true sale securitizations is to get cheaper funding. p. In a true sale securitization structure. business or infrastructure in question will have to be worked upon to generate the income. True Sale Securitization in Germany and China. On the other hand. the originator does not raise any cash. an SPV is a must in true sale securitizations but not a necessity in synthetic securitizations. supra.5. p. while a synthetic securitization is an on-balance sheet financing tool. The source.ISLAMIC SECURITIZATION is a derivative or a risk transfer transaction and the purpose is to synthetically replicate actual transfer of assets. with the originator raising cash and making a transfer. an electricity company 147 148 Kothari. the income has not been originated and set apart such that repayment of the securities is a self-liquidating exercise. a true sale securitization is an off-balance sheet financing mechanism.
judgments. residential house prices and those financial instruments that depended on them. Confidence had been fragile before this point: but when it became clear that the U. John Wiley & Sons.6 Securitization and the recent credit crunch Before going into detail. The second stage began when the institutions that had mortgage risk suffered losses. The Credit Crunch was visibly underway. 154 Chapra. 154 Without a surprise. but the financial system was still functioning well. or high loan-to-value ratios. Securitization The Financial Instrument of the Future. less incentive to undertake careful underwriting. David. they had less capital as it had been eroded by their losses. p. Kothari. 152 Mortgage originators passed the entire risk of default to the ultimate purchaser of the loan security. Mortgage and Credit Markets. Forum Speech delivered at Eighth Harvard University Forum on Islamic Finance. or an airlines company securitizing air ticket sales is doing a future flows securitization transaction. high debt-burden ratios. that caused a housing boom. p. Umer. The Rise and Fall of the U. authorities would permit large institutions to fail. low credit scores. p 475 Murphy. This eroded confidence. CRC Press. This lasted from mid 2006 to mid 2007: during this period. it was entirely lost. James R. 150 2. let us first look at the chronological history of the financial turmoil seen recently. 2009.. Inc. Innovation and Authenticity in Islamic Finance. or bankruptcies.. The third stage of the Crunch began in September 2008 with the failure of Lehman Brothers.S.S. April 19-20. Consequently loan volume gained greater priority over loan quality and the amount of lending to subprime borrowers 153 increased. The first stage of the credit crunch involved U. 2009. it was clear that trouble was ahead. 153 153 The term subprime generally refers to borrowers who do not qualify for prime interest rates because they exhibit one or more of the following characteristics: weakened credit histories typically characterized by payment delinquencies. 6 151 150 . supra. Unraveling the Credit Crunch. M. 151 The broad industry shift from an originate-to-hold model (in which a lender initiates and then keeps loans in its own portfolio) to an originate-to-distribute model relies on the ability to sell mortgage-backed securities (MBS) to investors. Taylor & Francis Group LLC. 5-6 152 Barth. previous charge-offs. Firms found it harder to raise money. 2008. therefore. and by early 2008 a general contraction of lending had begun. and they were worried about the credit quality of many of their borrowers.ISLAMIC SECURITIZATION securitizing electricity revenues. Hence they made fewer loans. They had. pp.S.
The qualification guidelines kept getting looser in order to produce more mortgages and more securities. Thomas. Thus. that were granted to borrowers with weak credit record and often require less documentation. they were responsible for more than 50 percent of all mortgage loan losses in 2007. increasing home owner equity enabled mortgage associations to waive part of delinquent interest payments in exchange for an increase in nominal value of the mortgage or to renegotiate the mortgage. 156 Weber. dissertation. Basically. Then.S. The lender no longer required proof of employment. rising delinquency and foreclosure rates in the US subprime mortgage market triggered a severe financial crisis which spread around the world. These loans offer fixed initial interest rates at a fairly low level. dollars globally.S. foreclosures and the supply of homes for sale increased. thus. 157 Throughout the time. rising real estate prices and. which further lowered homeowners' equity. This led to the creation of NINA. borrowers face a significant payment shock after the interest reset which increases the probability of delinquencies. the stated income. major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Total losses are estimated in the trillions of U. only account for about 15 percent of all outstanding US mortgages. housing market. In previous years. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy.118 157 Article “Subprime Mortgage Crisis” from Wikipedia. This placed downward pressure on housing prices. Although subprime mortgages 155.e.org/wiki/Subprime_mortgage_crisis 155 . 2008. the no income. available at http://en. i. Consequently. The decline in mortgage payments also reduced the value of MBS.wikipedia. NINA is an abbreviation of No Income No Assets. default rates increased. But during 2007 the trend in real estate prices has reversed in many regions of the United States leading to “negative equity" of many borrowers. verified assets (SIVA) loans came out. which eroded the net worth and financial health of banks. p. MBS is a financial innovation which enabled institutions and investors around the world to invest in the U. How to react to the Subprime Crisis? . Proof of income was no longer needed. verified assets (NIVA) loans came out.The Impact of an Interest Rate Freeze on Residential Mortgage Backed Securities. the mortgage qualification guidelines became looser and looser. Four Essays on Debt Securitization and Entrepreneurial Finance.ISLAMIC SECURITIZATION Starting in mid 2007. NINA loans are official loan products and let you borrow money without having to prove or even state any owned assets. PhD. All that was required for a mortgage was a credit score. Borrowers just needed to "state" it and show that they had money in the bank. At first. Borrowers just needed to show proof of money in their bank accounts. 156 As more borrowers stopped paying their mortgage payments. which are replaced by higher rates linked to an interest rate index after two or three years. Most of the subprime losses were caused by high foreclosure rates on hybrid adjustable rate mortgages (ARM). to real estate values that are lower than their outstanding debt. University of Konstanz. As housing prices declined.
clear rules of the game are needed that help achieve transparency. Mortgage and Credit Markets. and are still outstanding. But to make securitization work. 158 The rating process for subprime mortgage bonds was also marked by a fundamental conflict: Agencies received fees from the very issuers who requested the ratings—and almost everything wound up as AAA. Susan M. Securitization: Cause or Remedy of the Financial Crisis?. 2000. if we give them the tools to do so. Pavlov. there should be some changes in order to ensure a healthier financial system as immune as possible from the potential problems. However. 2008.S. AAA-rated securities accounted for 29 to 45 percent of all rated fixed-income securities that were issued between January 1.. August 27. As of November 5. not the traditional securitization process itself. Securitization has become an essential component of consumer finance and of housing finance in particular. Andrey D. It is very important to realize that it is only the speculative. 1462895. assure against counterparty risk and data provision to inform trading. Markets can price and expose risk. The advantages of slicing. 2009.ISLAMIC SECURITIZATION Rating agencies played a crucial role in the crisis as they provide information about the quality of such securities. Georgetown Law and Economics Research Paper No. 16 159 158 . p.. and Wachter. and bank regulatory authorities assign favorable capital treatment to bonds rated AAA. Adam J. The Rise and Fall of the U. 2008. and September 30. A more transparent system in all stages may be taken as a starting point. one should not blame securitization itself for all the financial turmoil seen. 157 Ibid 160 Levitin. Securities were “sliced and diced” precisely to obtain these high ratings. p. dicing and repacking risks as well as all the other advantages explained above are simply too great to be sacrificed. 159 Obviously. supra. 160 Barth. Investors have long assumed that a security with a AAA rating is of the highest credit quality (therefore it usually offers a relatively low yield) which obviously appeared to be a false judgment. over-leveraged excesses that have crept into securitization created recently that have contributed to the financial meltdown.
ISLAMIC SECURITIZATION Chapter 3 ISLAMIC SECURITIZATION .
which are typical conventionally securitized assets. Client Note.. Vol. The Economics of Islamic Finance and Securitization. 162 Since most Islamic financial products are based on the concept of asset backing. the underlying asset pool or portfolio of receivables in a securitization should. in essence. 428 163 Jobst. p. Contractual Enforceability Issues: Sukuk and Capital Markets Development. Islamic Finance: Sharia. Transfer of registered title is not necessary. match one of the accepted Islamic financing schemes. 163 So basically Islamic securitization can follow the principles of conventional securitization. Winter 2007. For a structure to comply with Sharia. Journal of Structured Finance. University of Chicago. 161 It involves asset transfers from an originator into a trust or similar SPV with Sukuk issuance by that SPV and payments on the Sukuk derived from the payments received in respect of those transferred assets. Mohammad Saad and Tanega. rather a collection of ownership rights that would allow the investors to perform duties related to ownership (if desired) or rights granting access (subject to notice) over the asset would be sufficient to satisfy Sharia. as they are interest-bearing loans. p. 2007. 2004. now it is time to scrutinize Islamic Securitization.T. Chicago Journal of International Law. 3. Joseph Atangan.1 What is Islamic Securitization? Islamic securitization can be basically defined as a legal structure which satisfies the requirements of Islamic Finance and replicates the economic purpose of a traditional asset-backed securitization structure whereby the rights over receivables are transferred from the owneroriginator to a special purpose vehicle (SPV/Issuer). we will start with definition. No. the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. which in turn issues notes that are sold to investors. Islamic Securitisation: Part I . some degree of ownership must be transferred to the investor. As we did in the former two chapters. Journal of International Banking Law and Regulation. Michael J. May 2007. Vol. 22. For instance.ISLAMIC SECURITIZATION 3 ISLAMIC SECURITIZATION After explaining the basics of Islamic Finance and Securitization. Issue 6. Andreas A. p.1. However. conventional mortgages and credit cards.. Sukuk & Securitisation. 164 Lahlou. do not comply with Sharia. 13. 15 164 Lovells LLP.13 161 . 295 162 McMillen. p.Accommodating the Disingenuous Narrative. Sweet & Maxwell.
we will also try to put the differences between the conventional and Islamic securitization structures and by doing so. Farmida (Norton Rose). Sharia compliant securitisations. but for now. Fajr Capital.ISLAMIC SECURITIZATION Investors participate in profits and losses generated by the assets placed in the securitization pool 165 as Islamic Finance rules prohibit interest-based financing. but not on the basis of interest. Luxembourg Stock Exchange Press Release. 3. 166 So Islamic Securitization is the creation of securities (or Sukuk 167) that: evidence ownership of a pool of tangible assets or a pool of tangible and intangible assets. Rafe. Islamic Finance Securitisation in Luxembourg. 168 Haneef. 168 After a brief definition. p. we may very briefly refer Sukuk as Islamic trust certificates or more generally Islamic bonds. but they could be banking or Bi. investors are allowed to support or invest on the basis of partnership.2 Structure of Islamic Securitization Various parties are involved in an Islamic Securitization transaction. that generates cash flow plus any rights or other facilities designed to assure the servicing or timely distribution of proceeds to the security holders. While talking about the structure. 4 November 2008. Vassiliyan (Loyens & Loeff). either fixed or revolving. 2008 167 We will examine Sukuk deeply in the coming sections. who sells its assets to the SPV and uses the realized funds. we will be seeking the answer of the question why there is a need for “Islamic” securitization while we already have quite improved securitization structures. July 2008. we now would like to move on with the structure of Islamic Securitization. and by their terms convert into cash within a finite time period. Originators are mostly governments or big corporations. Islamic Finance and Real Estate Forum. Asset-backed Sukuk and Asset-based Sukuk: A Primer. p.3 165 . March 13.3 166 Zanev. Key players in various issues are: The originator or the issuer of Sukuk.
3. These services are provided by syndicates of Islamic banks and big multinational banks operating Islamic windows. The Duality of the Saudi Legal System and its Implications on Securitisations. Amr Daoud. 11.1.3. The Ijara Sukuk represent equity interest in the SPV. in the assets.e.ISLAMIC SECURITIZATION non-banking Islamic financial institutions. the SPV sells the assets back to the originator (i. 393 The Sukuk issue made by Saxony-Anhalt will be explained in detail in the sub-section 3. leasing bonds) to investors. The SPV raises financing to purchase the assets by issuing Ijara Sukuk 171 (i. No.e.1 Types of Sukuk. Islamic banks and non-bank financial institutions and individuals who subscribe to securities issued by the SPV. Subscribers of Sukuk – mostly central banks. supra. The Company Lawyer. 170 would resemble the following scenario: The originator of the assets (e. p. Introduction to Islamic Finance. A widely used Islamic securitization structure. 171 We will explain Ijara Sukuk in sub-section 3.1. It purchases assets from the originator and funds the purchase price by issuing Sukuk.3. for a consideration or a commission. which should match the SPV’s obligations under the Ijara Sukuk. the owner of office buildings) sells the assets to an SPV. The issuers may delegate. and in turn. 346 . the process of arranging the issue. The seller makes periodic lease payments to the SPV.1 Ijara Sukuk. Investment banks – as issue agents for underwriting. which also illustrates the exact same structure with the Sukuk issue made by the German state of Saxony-Anhalt in 2004. The amount should cover any liabilities owed by the SPV under the Ijara Sukuk. At maturity. 169 This list shows us the fact that an Islamic securitization structure perfectly mimics a conventional securitization in relation to the parties involved. p. The SPV leases the assets back to the seller/originator. Sometimes. 172 Marar.1 Ijara Sukuk under the section 3. November 2006. The SPV – an entity set up specifically for the securitization process and managing the issue. lead managing and book-making services for Sukuk against any agreed-upon fee or commission. Volume 27. the SPV is also referred to as the issuer.g. The amount raised by issuing the Sukuk is equal to the purchase price. lessee or previous seller/owner of the assets). 172 169 170 Ayub.
which includes the configuration of credit enhancement (and other forms of credit and liquidity support) and the form of ownership conveyance. supra. the implementation of Islamic securitization requires a two-stage “fundamental” verification process.com/newsletter/issue%201/Sukuk%20101. 175 Available at http://www. Global Securitisation and Structured Finance 2007. 16 174 173 . p.ISLAMIC SECURITIZATION The figure 173 below illustrates how an Islamic securitization structure based on ijara basically works: The cash flow produced is similar to any bond. Michael J.middleeastbusinessforum. 2007. Dechert LLP. McMillen. p. Islamic Securitisation. and (ii) the transaction structure. The Economics of Islamic Finance and Securitization. 224 175 Jobst. 174 Unlike conventional securitization.html Kamalpour. Abradat. which assesses the Sharia compliance of (i) the type of assets in the underlying reference portfolio and the generation of investment returns. The lease payments are similar to coupons and the repurchase proceeds paid at the end of the term constitute the principal.
). the relationship between an underlying obligor and the originator should fall within one of the usual accepted Islamic financing schemes (Murabaha. p. in certain cases. For example.ISLAMIC SECURITIZATION Securitization under Islamic law bars interest income and must be structured in a way that rewards investors for their direct exposure to business risk. one should know that while equity in contrast to interest-bearing bonds appears to be a permissible financial asset that can form part of the pool.g.. In general. which entitle them to receive both pre-determined interest and the repayment of the principal amount. Lewis. cars etc. 178 For Islamic institutions. Legal Guide 2006. 2007. aircraft. ed. Handbook of Islamic Banking. Istisna. such as alcohol. Mudaraba.. of housing. In the case of a Sharia auto finance securitization. by Hassan. Edward Elgar Publishing. Mervyn K. 2006. Red Money Publishing. Kabir. Ijara. the underlying finance contract must be structured in accordance with Murabaha or Ijara principles. Note holders would typically hold (secured) contingent claims on the performance of securitized assets. opposite of “halal”. etc. i. 176 Apart from that.). p. the underlying assets must be Sharia compliant mortgages (usually structured around Ijara – the typical Islamic mortgage structure – or Istisna – mortgages concerning properties under construction).e. which originated in non-Islamic economies. investors receive a share of profits commensurate to the risk they take on in lieu of pre-determined interest. Kuala Lumpur. equipment. invariably involves interest-bearing debt. However conventional securitization. underlying assets that can be securitized include lease financing (e.193 179 Islamic Finance News. Inc. 14 180 Ibid 177 176 . when structuring a Sharia compliant mortgage securitization. Murabaha receivables (provided that the Murabaha receivables comprise less than 50% of any asset pool). such equity must not represent ownership of an institution dealing with interest or manufacture of haram 177 items. 178 Obaidullah. 179 The number of applicable structures to Islamic securitization is also limited comparing to conventional securitization. M. equity ownership (in Sharia compliant assets) and. Securitization in Islam. 180 Ibid Non-permissible according to Islamic law. (gambling) or pork.. Mohammed. household items.
Geneva. such as the active management of designated asset portfolio due to greater control over asset status. tranche subordination of conventional securitization can be replicated by a lease buy-back (ijara) transaction under Sharia law. 182 So Islamic institutions should be very selective in using credit enhancement methods. Islamic Securitisation: Practical Aspects. the Islamic framework provides for short-term (…) interest free loans. While the sale of conventional receivables is a sale of debts. Bushan K. while liquidity enhancement could be provided by independent financial institutions in the conventional framework. Islamic Finance and Securitization: Man-Made Tale or Reality. Islamic securitization offers the same economic benefits conventional structured finance purports to generate. supra. supra. p. one should be careful in relation to credit enhancement mechanisms while structuring a permissible securitization transaction according to Sharia. 185 To sum up. Securitization in Islam. The Duality of the Saudi Legal System and its Implications on Securitisations. 181 Finally. securitization in Islamic Finance is better referred to as “monetization” of the underlying assets. November 1. this comes dangerously close to riba and is rightly frowned upon by Sharia scholars. July 8-9 1998. 183 So Islamic law does not rule out the use of credit enhancement per se as long as it is optional for investors and does not change the overall character of the transaction. 2007. For instance. Thus. When credit enhancement is for a fee that is related to the quantum of facility. irrespective of religious conditions. Mohammed. 7 184 Jomadar. Securitization in Islam. the structure to be used must transfer a minimum level of ownership in the assets before Sharia scholars can be satisfied and approve the issuance. enhanced Ibid Obaidullah. the sale of Sukuk is a sale of shares of an asset. this is possible in Islamic securitization only when there is no financial reward for the provider. p. p. 12 185 Obaidullah. Presentation for World Conference on Islamic Banking. 184 Like credit enhancement. liquidity enhancement too comes under a cloud in the Islamic framework. 194 186 Marar. While this is easily achieved in an interest-based scenario. Credit enhancement is an integral part of conventional securitization process.. 186 However. Islamic Law and Law of the Muslim World Paper No. pp. supra. p. (as) using some of them may change the character of the transaction. Mohammed. 8-18. 346-347 182 181 .ISLAMIC SECURITIZATION It should also be noted that to comply with Sharia principles for a traditional Sukuk issuance. 194 183 Abdi Dualeh. Suleiman.
the business or activity cannot engage in prohibited business activities). services. 428-429 188 187 . when Malaysia issued a government-backed Sukuk. projects. Sukuk are defined as certificates of equal value put to use as common shares and rights in tangible assets. the AAOIFI standard stipulates that Sukuk must demonstrate: Jobst. i. Sukuk. usufructs. No. 190 The Accounting and Auditing Organization for Islamic Financial Institutions ("AAOIFI") has issued the Standard for Investment Sukuk. pp. and the underlying transactional structures (such as the underlying leases). and bonds. supra.. Understanding Islamic Finance. and services or as equity in a project or investment activity. we will look at the securities created within the processes of Islamic securitization. supra. notes. March 2008. 191 To sum up. Contractual Enforceability Issues: Sukuk and Capital Markets Development. Islamic Economic Studies.e. meaning certificate of investment or simply certificates) 189 are certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset. Vol. 3. 2007. 1. 19 Richardson. Andreas A. must be Sharia-compliant (for example. 392 190 Islamic Financial Services Board. or Sanadat. usufructs. It emphasizes that Sukuk are not debts of the issuer. the first of its kind. 187 At this stage. 92 191 McMillen. Sukuk may not be issued on a pool of receivables. they are fractional or proportional interests in underlying assets. as well as the isolation of certain assets in order to make them self-financing at a fair market rate. Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field. p.ISLAMIC SECURITIZATION asset-liability management and term structure transformation. Derivatives in Islamic Finance. Further. the underlying business or activity. p. 15. or investment activities. 131 189 Ayub. p.3 Sukuk Sukuk is a recently-developed Islamic investment product that first appeared in 2002. The AAOIFI Sukuk Standard carefully distinguishes Sukuk from equity. Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of Islamic Money Markets. 188 Sukuk (the plural of the word Sak. Under the AAOIFI Sukuk Standard. p. supra.
193 Below figure illustrates the huge success achieved within a very short period of time until the end of 2008 when the whole financial system was already in the recent turmoil: Lahlou. Mohieddine. Issue 7. Sweet & Maxwell. December 2008. Sukuk structures became the most successful innovation of short history of Islamic finance. allowable under Sharia] in nature and be being utilized as part of a Halal activity. 192 Without a doubt. Takaful and Sukuk: A Symbiotic Relationship. Volume 22. 367 193 Kronfol. and not simply comprise interest. Tanega.5 billion at the end of 2000 to over $118 billion at the end of the third quarter of 2008. the Sukuk must be backed by real underlying assets and these assets must be Halal [that is. p. Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative.ISLAMIC SECURITIZATION that any income arising must derive from the underlying activities for which the funding has been used. and there must be full transparency as to rights and obligations of all parties. 53 192 . Mohamed Saad. Globally. Journal of International Banking Law and Regulation. June 2007. Middle East Insurance Review. p. Joseph. growing at a compound annual growth rate (CAGR) of 32% since 2000. Sukuk issuance has increased from $7.
It is important to note that – contrary to popular perception – whilst a securitization can be achieved via Sukuk, most Sukuk that have been issued to date are not securitizations. 194 The creation of Islamic financial securities can be done in two distinct ways:
Direct structuring of securities; and The process of asset securitization.
Direct structuring involves the initial issuance of securities, and the funds raised will be used to fund certain assets/projects with the client company. The profits generated from these assets/ projects are then distributed amongst security holders. 195
Most Sukuk offerings to date have been of the bond type (direct structuring), and the ultimate credit in most of those bond offerings has been a sovereign entity. There have been very few, if any, true asset securitizations, largely because of the inability to obtain ratings from major international rating firms (ratings have been obtained for the sovereign bond issuances based upon the rating of the sovereign credit). 196
3.3.1 Types of Sukuk
Until now there have been 14 different types of Sukuk structures most common ones of which are Sukuk al-Ijara, Sukuk al-Istisna, Sukuk al-Murabaha, Sukuk al-Musharaka and Sukuk alMudaraba. 197 The list of 14 different types of Sukuk is not an exhaustive list since other forms of Sukuk can be issued such as by copyright owners, so continuing innovation in this field is expected. 198
Here, we will try to explain the most common Sukuk structures.
Islamic Finance News, Legal Guide 2006, supra, p. 13 Mannan, Mansour, Islamic Capital Markets, Islamic Finance: A Guide for International Business and Investment, ed. by Habiba Anwar, GMB Publishing, 2008, p. 105 196 McMillen, Michael J.T., Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, p. 428 197 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Sharia Standards No. 17, May 2003, pp. 4-6 198 Lahlou, Tanega, Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative, supra, p. 368
220.127.116.11 Ijara Sukuk
Ijara (lease) is a contract according to which a party purchases and leases out equipment required by the client for periodic rental payment. The duration of the rental and the amount payable are agreed in advance, and ownership of the asset remains with the lessor. 199
If a lessor, after executing an Ijara contract, wishes to recover his cost of purchase of the asset to get liquidity or for the purpose of profit, he can sell the leased asset wholly or partly, either to one party or to a number of individuals. The purchase of proportion of the asset can be evidenced by issuing certificates, which may be called Ijara certificates or Sukuk. The certificates must represent ownership of the pro rata undivided parts of the asset with all related rights and obligations. Hence, Ijara Sukuk are the securities representing ownership of well-defined and known assets tied up to a lease contract, rental of which is the return payable to the Sukuk holders. 200
Let us have a look how the ijara Sukuk structure works: A single or a group of assets that are admissible for ijara contract are selected. The originator creates an SPV with separate independent legal personality to whom it sells the asset(s) with the understanding that the originator will lease back the asset(s) from the SPV. Rent is negotiated and a term specific lease contract is signed. The SPV then securitizes its assets by issuing ijara Sukuk for sale to investors. These are certificates of equal value representing undivided shares in ownership of tangible assets. The Sukuk sale proceeds provide funds to SPV to pay for the asset(s) purchased from the originator. A rent-pass-through structure is adopted by the SPV to pass on the rents collected from the originator-cum-lessee to Sukuk holders. These returns along with low risk and exit possibility through secondary market (liquidity) constitute the incentives for investors to buy Sukuk. At the expiry (or termination) of the lease deed the flow of rents would stop and ownership of the asset pool would be with the Sukukholders as a group. The Sukuk contract embeds a put option to the Sukuk-holders that the originator is ready to buy the Sukuk at their face value on maturity or dissolution date. 201
Mannan, Islamic Capital Markets, supra, p. 107 Ayub, Introduction to Islamic Finance, supra, pp. 400-401 201 Ali, Salman Syed, Islamic Capital Markets Products: Developments and Challenges, Islamic Development Bank Group Islamic Research and Training Institute, Occasional Paper No. 9, 2005, pp.30-31
The figure below well explains the concept of an ijara Sukuk transaction: 202
As it was mentioned before, the Sukuk issue by German State of Saxony Anhalt in 2004 was an ijara Sukuk structure. In this issue, the underlying transactions involves a certain number specified buildings owned by the Ministry of Finance. Certificates worth €100 million were issued by an SPV incorporated in the Netherlands was to get around the municipality tax in Germany. By doing so, the Sukuk remains competitive with regards to municipality tax which would not apply to a conventional bond. Under a 100 year Head Lease Agreement, Saxoy Anhalt, acting through the Ministry of Finance, leases properties to the SPV in consideration of receiving an amount equal to the Sukuk issue as a one-time advance head-lease rental. The SPV then enters into a sub-lease agreement where it subleases the properties back to the Ministry of Finance for a period of five years. The certificates held by the investors represent a pro-rata interest in the operating rights acquired by SPV under the headlease. Under the sub-lease, the State has a direct obligation to pay lease rentals at periodic intervals which are passed on to the Sukuk holders as coupon payments. The last lease rental will include the principal amount extended under the sub-lease. This five year certificate with a coupon payment of EURIBOR (flat) was co-managed by both Citigroup and the Kuwait Finance House. The Sukuk was fully subscribed with 60 % of the issue going to investors in Bahrain and the United Arab Emirates, while the other 40 % to investors in Europe, particularly Germany and France. 203 Like other German state
Jobst, The Economics of Islamic Finance and Securitization, supra, p. 21 Alkhan, Rashid Khalid, Islamic Securitization A Revolution in the Banking Industry, Miracle Graphics Co., 2006, p. 66
A Proposal for International Standards. Ijara certificates can be negotiated and traded freely in the market and can serve as an instrument easily convertible into cash. Robert Schuman Centre for Advanced Studies Policy Papers No. with an additional listing in Bahrain to attract Gulf investors. Tanega. depending upon the quality. 403 207 Ibid. A deciding factor in this regard is whether the Sukuk create any debt obligations or they represent an ownership stake in the underlying assets or project. the certificate will not be tradable. 206 Sukuk representing tangible assets or usufruct of such assets can be traded in the secondary market. Islamic Securitisation: Part II . 408 204 . p. 207 Wilson. in the former case. p. Islamic Finance in Europe. Introduction to Islamic Finance. 5 205 Lahlou. risk and profitability of the securitized assets. 2007/2. 204 The figure below shows the Saxony-Anhalt Sukuk structure: 205 Unlike some other Sukuk types. p. p. supra. supra. Legal Guidelines and Structures. while in the latter case. Rodney. 370 206 Ayub. it will be negotiable/tradable.ISLAMIC SECURITIZATION debt instruments the Sukuk was listed in Luxembourg.
com. 209 The figure below illustrates how Mudaraba Sukuk structure works: 210 This structure is of interest to originators who do not have assets that they can easily make available for an ijara Sukuk or Musharaka Sukuk. These types of Sukuk play a vital role in the process of development financing. because these are related to the profitability of the projects. supra.ISLAMIC SECURITIZATION 3.3.1. 108 Ayub. if any. p. 208 Mudaraba or Muqarada (Muqarada has the same meaning as that of Mudaraba) Sukuk or deeds can be instrumental in enhancing public participation in investment activities in any economy. Introduction to Islamic Finance.modarabas. These are certificates that represent projects or activities managed on the Mudaraba principle by appointing any of the partners or any other person as Mudarib for management of the business.pk/Sukuk. 398 210 Available at http://www.2 Mudaraba (or Muqarada) Sukuk Mudaraba means an agreement between two parties according to which one of the two parties provides the capital (capital provider) for the other (mudarib) to work with on the condition that the profit is to be shared between them according to a pre-agreed ratio. but which needs finance for additional business 208 209 Mannan. supra. The certificate holders own the assets of the Mudaraba and the agreed upon share of the profits belongs to the owners of capital and they bear the loss. As regards the relationship between the parties to the issue. p. subscribers are the owners of the capital and the realized funds are the Mudaraba capital. the issuer of Mudaraba certificates is the Mudarib. Islamic Capital Markets.php .
The funds mobilized would be the variable capital (class B share) of any bank to be marketed regionally through the selling of the issued Mudaraba Sukuk. p. Introduction to Islamic Finance. Zaidi. Profit-and-loss sharing contracts in Islamic finance. 399 214 Mirakhor. 108-109 213 Ayub. 55 211 . GMB Publishing. and Upon completion. 213 Mudaraba Sukuk may be issued by an existing company (which acts as mudarib) to investors (who act as partners. purchases the assets of the project from the issuer. 2008. 211 Steps involved in the structure: The Sukuk issuer enters into a Mudaraba agreement with the project manager (mudarib) for construction/commissioning of a project. the proceeds of which are given to the mudarib. by Habiba Anwar. 212 Islamic Financial Institutions can offer Mudaraba Sukuk or certificates to the investors who would subscribe and participate in the investment transactions. 214 de Belder. in its capacity as obligator. The profits from this separate activity are split according to an agreed percentage amongst the certificate holders. 95-96 212 Mannan.ISLAMIC SECURITIZATION investments or activities. Islamic Finance: A Guide for International Business and Investment. Richard T. ed. pp. which can be separated for accounting purposes from the company’s general activities.. supra. A mudarib can also be paid an incentive fee. the mudarib. Invesment Banking. Islamic Capital Markets. or rab al-mal) for the purpose of financing a specific project or activity. and often stipulates that a specific percentage of the mudarib’s profit share is paid periodically to the Sukuk holders to withdraw their investment in stages. The contract may provide for future retirement of the Sukuk at the then market price. The SPV issues Sukuk to raise funds. The mudarib undertakes the project and collects regular profit payments from the activity for onward distribution to investors. p. It is critical for Sharia compliance that the mudarib is entitled to a share in the profits rather than a flat fee. pp. supra. supra.
216 In securitizing a Musharaka arrangement. but losses are shared in exact proportion to the capital invested by each party. supra. Salman. Zaidi. Proceeds from the transaction were used to fund Aldar’s ambitious real estate development programme with Aldar acting as the mudarib. Islamic Banking Hub Bahrain Newsletter. 109 Mirakhor. The issuer of the Mannan. issued a 4. Almost all of the criteria applied to a Mudaraba Sukuk are also applicable to the Musharaka Sukuk. which represents his proportionate ownership in the assets of the venture or project for which financing is being raised.3. also provided an undertaking to purchase the assets of the Mudaraba should the Sukuk certificate holders not convert their holdings into Aldar’s shares by the maturity date (2011). partners contribute capital to a project and share its risks and rewards. Thus a financial institution provides a percentage of the capital needed by its customer with the understanding that the financial institution and customer will proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is consummated. let us have a look at an example of Sukuk al-Mudaraba: Aldar Properties PJSC. October 2003.ISLAMIC SECURITIZATION At this point. supra. p. 52 217 Akbar. an Abu Dhabi real estate development company. The only major difference is that the intermediary will be a partner of the group of subscribers or the Musharaka Sukuk holders in much the same way as the owners of a joint stock company. Profits are shared between partners on a pre-agreed ratio. p. Profit-and-loss sharing contracts in Islamic finance. 215 3. Islamic Banking & Takaful Task Force. Subsequent to the acquisition of substantial non-liquid assets. 217 Musharaka Sukuk which are based on an underlying Musharaka contract are quite similar to mudaraba Sukuk. but in the Mudaraba Sukuk the capital is from just one party. 4 216 215 . p. these Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market.75-year Sukuk convertible into its ordinary shares. Islamic Capital Markets. every subscriber can be given a participation certificate. in its corporate capacity. Aldar. Islamic Securitization from a practitioner’s Perspective.1.3 Musharaka Sukuk In a Musharaka transaction.
This structure is viable when the Musharaka party can use its in-kind contribution for a profit-generating venture. The Musharaka party will make an in-kind contribution to the Musharaka (usually including some tangible assets). Zaidi. the subscribers are the partners in the Musharaka contract. 219 The figure below is an illustration of how Musharaka Sukuk structure works: 220 218 219 Mirakhor. Profit-and-loss sharing contracts in Islamic finance.ISLAMIC SECURITIZATION certificate is the inviter to a partnership in a specific project or activity. The issuer will make a funding contribution to the Musharaka from funds it raises from the Sukuk issue. The issuer and the Musharaka party also enter into a purchase undertaking pursuant to which the issuer can require the Musharaka party to purchase a set amount of units on set dates during the term of the Sukuk. McMillen. Islamic Securitisation. 56 Kamalpour. p. 218 In the structure shown below. p. the parties’ respective interests in the Musharaka are represented by contractual units held by each party. The amounts received are distributed to the Sukuk holders in accordance with a set formula. and the realized funds are the contributions of the subscribers in the Musharaka capital. supra. The issuer will receive profit distributions from the Musharaka and proceeds from sales of the units to the Musharaka party. supra. 225 220 Ibid . The certificate holders own the assets of partnership and share the profits and losses.
p. 110 . supra. these Musharaka certificates can be treated as negotiable instruments. supra.4 Murabaha Sukuk Murabaha Sukuk are issued on the basis of murabaha sale for short-term and medium-term financing.3. p. 222 An example of Sukuk al-Musharaka is as follows: Emirates. In addition. 221 The Musharaka structure is considered more equitable and also safer for the investors than the Mudaraba structure. not only profit-sharing. the term murabaha refers to sale of goods at a price covering the 221 222 Ayub. Whenever there is a combination of liquid and non-liquid assets. as it involves both profit-and-loss-sharing between the fund manager and the Sukuk holders. Profit earned by the Musharaka is shared according to an agreed ratio. The Musharaka. was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport which was ultimately leased to Emirates. subject to the condition that the portfolio of Musharaka comprises non-liquid assets valuing more than 50 %. it can be sold and purchased for an amount greater than the amount of liquid assets in the combination or in the pool. Dubai’s national airline. As mentioned earlier. issued a $550 million Sukuk transaction for seven years. in the form of lease returns. 400 Ibid 223 Mannan. Certificates based on Musharaka/Mudaraba can be bought and sold in the secondary market. or joint venture. Loss is shared on a pro rata basis. Emirates then purchased the leased assets on maturity of the transaction. Profit. The deal was a structured on a Musharaka basis. generated from the Musharaka were used to pay the periodic distribution on the trust certificates.ISLAMIC SECURITIZATION After the project is started.1. 223 3. Introduction to Islamic Finance. Musharaka Sukuk holders will have added comfort and security from the cushion provided by the manager’s participation in the Musharaka capital. Islamic Capital Markets.
meaning that its assignment also has to be at face value. 56 Abdel-Khaleq. The financing of a project costing $50 million could be mobilized on an understanding with the would-be ultimate owner that the final price of the project would be $70 million. This is because the sale of a document representing money is akin to the trading of monies. such a receivable can be traded freely for purposes of Sharia. Transfer of this paper to a third party must be at par value and subject to the rules of Hawala 226. which is prohibited under the rules of riba. Winter 2007. trading will be allowed even if the non-liquid assets are more than 10% of its total worth. Zaidi. However. For this purpose.224 A commonly accepted view among Sharia scholars in a number of Islamic jurisdictions is that murabaha debt cannot be securitized. Profit-and-loss sharing contracts in Islamic finance. it is possible in this mode to seek additional financiers. Christopher F. The various financiers may share the $20 million murabaha profit in proportion to their financial contributions to the operation. the prevailing view among Malaysian scholars (in contrast to Sharia advisers in more conservative jurisdictions) is that so long as the underlying receivable is connected to a true trade transaction or to a commercial transfer of a nonmonetary interest. the pool of the assets should consist of Ijara or other fixed assets valuing more than 50% of its total worth. if the Hanafi 227 view is adopted.ISLAMIC SECURITIZATION purchase price plus a margin of profit agreed upon by both parties concerned.. as when money owed by a debtor to a creditor is paid by a person who owes the debtor money. Richardson. That paper represents a debt receivable by the seller. Introduction to Islamic Finance. Hawala transactions are usually based on trust and leave no written record. 412 226 Hawala is a system for remitting money. The purchaser on credit in a Murabaha transaction signs a note or paper to evidence his indebtedness towards the seller. Ayman H.. 405 225 224 . 228 Ayub. may issue negotiable certificates subject to certain conditions. Chicago Journal of International Law. supra. p. p. New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings. However. in which a financial obligation between two parties is settled by transferring it to a third party. 227 The Hanafi School is one of the four Madhhab (schools of law) in jurisprudence (Fiqh) within Sunni Islam. including Murabaha. A mixed portfolio consisting of a number of transactions. supra. The advantage of this mode of financing is that. p. thus making Sukuk backed by pools of murabaha debt impermissible. 225 However. 228 Mirakhor. it is generally accepted that a pool of receivables consisting of only Murabaha receivables cannot be securitized for creating negotiable Sukuk to be traded in the secondary market. if the required commodity in the murabaha is too expensive for an individual or a banking institution to buy from its own resources. which would be repaid in equal installments over five years. primarily in Islamic societies.
5. SPV collects funds from investors.ISLAMIC SECURITIZATION Now. let us see how a direct murabaha Sukuk structure works: 1. 3. SPV issues securities to investors. SPV pays to Vendor for purchase of Assets. an SPV is created for the purpose. . Company as agent of SPV takes delivery of Assets. 4. Company seeks advice from Investment Bank regarding issue of securities. Company purchases Assets from SPV on deferred payment basis and makes payment of installments to SPV. 6. 2.
It is presumed that the SPV will be maintaining a sufficient amount of inventory or fixed assets. 406 232 Ibid. 232 Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in lieu of a promise to deliver a commodity at a future date. supra. i. Salam Sukuk are certificates of equal value issued for the sake of mobilizing capital that is paid in advance in the shape of the price of the commodity to be delivered later. p. making its Sukuk negotiable. p. Salam sale is attractive to the seller. therefore. and to the buyer.5 Salam Sukuk As we noted earlier. 230 Obaidullah. p.C (Bahrain) issued five-year multicurrency Murabaha-backed Sukuk in 2005 with a five-year bullet maturity. SPV passes them on to investors after deducting mudarib share/wakala 229 fee for itself. 231 3. As Murabaha may yield a fixed return. 161 231 Ayub. while the subscribers are the buyers of that commodity. 403 229 . Introduction to Islamic Finance.S. The SPV will have full recourse to Arcapita and. 230 The following constitutes a practical example how a negotiable murabaha Sukuk can be created: Arcapita Bank B. The seller of the Salam commodity issues the certificates. whose cash flow is enhanced in advance. as the Salam price is normally lower than the prevailing spot price.1.ISLAMIC SECURITIZATION 7.e. The proceeds of the Sukuk are used for sale and purchase of assets via a series of commodity Murabaha transactions.3. the Sukuk holders have been offered a return equivalent to three-month LIBOR + 175 bps. All standard Sharia requirements that apply to salam contract also apply Wakala is a trust contract whereby money can be placed with an Islamic institution which then pays a return based on the assets on its balance sheet. Islamic Financial Services. the Sukuk are a freely transferable instrument on the basis of a mechanism approved by Arcapita’s Sharia supervisory board. supra. they are the owners of the commodity when delivered. It is essentially a forward agreement where delivery occurs at a future date in exchange for spot payment of price. a salam is deferred delivery contract.
p. the commodity and then to sell it for the profit of the Sukuk holders. Islamic Financial Services. This third party may be one of the prospective customers of the company. The unilateral promise is binding on this customer. The Salam proceeds are passed onto the obligator who sells commodity on forward basis SPV receives the commodities from the obligator Obligator. full payment by the buyer at the time of effecting the sale. 164 Nisar. Shariq. Such Sukuk obviously involve market risk as the price of the underlying asset may go down instead of moving up in future. Since the SPV representing investors need not participate in the market.com/article/8/1/546 235 Obaidullah. 234 The market risk or price risk for the investors can be mitigated if a third party makes a unilateral promise to buy the commodity at a predetermined price at a future time period. available at http://www. to the holders of Sukuk. as is the case with recent issue of Sukuk-al-salam by the Bahrain Monetary Agency (BMA). on behalf of the end-Sukuk holders. it assumes the role of seller to the third party customer at the specified future date. on behalf of Sukuk holders. date and place of delivery of the asset and the like. Salam certificates are issued to investors and SPV receives Sukuk proceeds. such as. fungibility or standardized nature of underlying asset.ISLAMIC SECURITIZATION to salam Sukuk. 233 The steps involved in Salam Sukuk transaction may be summarized as follows: SPV signs an undertaking with an obligator to source both commodities and buyers. Sukuk holders receive the commodity sale proceeds. The difference between the purchase price and the sale price is the profit to the SPV and hence. sells the commodities for a profit. 164 . The SPV is able to realize a higher predetermined price without participating in the market.financeinislam. Islamic Bonds (Sukuk): Its Introduction and Application. clear enumeration of quantity. 235 233 234 Obaidullah. Once the rights resulting from the promise are transferred to the SPV. The risk mitigation can some times come through sovereign guarantees. At the same time the SPV can appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. it would be insulated from price risk. p. supra. The obligator contracts to buy. quality. supra. Islamic Financial Services.
The Bahrain government sells aluminum to Bahrain Islamic Bank (BIB). 114 Ayub. 403-404 238 In our email correspondence with Prof.” He defines Sharia Arbitrage as “using legal devices. supra. 165 240 Ayub. Dr.1. aiming to provide Islamic banks liquidity management tools. as per the contract. Available at http://www. he referred to this Sukuk structure as “It is one of many forms of what I call "Sharia Arbitrage.3." which is the mode of operation in today's so-called Islamic finance. Islamic Financial Services. p. Introduction to Islamic Finance. p.ft. Islamic Finance Law. 236 The BMA. BIB appoints the government its agent to market the aluminum at the time of delivery through its channels of distribution. supra. developed Salam-based securities with LIBOR-related three-month tenures used by Islamic banks for maintaining statutory liquidity requirement (SLR). The most prolific issuer of salam bonds to date has been the Bahrain Monetary Agency. a highly respected Islamic Finance expert and chairman of Department of Economics in Rice University. pp.ISLAMIC SECURITIZATION A number of bond structures could be synthesized from the salam contract. in June 2001.com/reports/islamicfinance2007 239 Obaidullah. which has been nominated to represent the other banks wishing to participate in the Salam contract. 240 3. Mahmoud El-Gamal.6 Istisna Sukuk We already mentioned that istisna is a contractual agreement for manufacturing goods. secondary market trading of Salam Sukuk is considered impermissible on the grounds that the certificates represent a share in the Salam debt. 237 The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price. Introduction to Islamic Finance. allowing cash payment in advance and future delivery or a future payment and future delivery of the goods manufactured. often employing special-purpose vehicles. El-Gamal. 239 So far. 238 This means that the securities have the characteristics of short-term government treasury bills. Economics and Practice. restructuring interest-bearing debt and collecting interest in the form of rent or price mark-up” in his article “Incoherent pietism and Sharia arbitrage” published in Islamic Finance 2007 Report of Financial Times. which will provide a return to Al Salam security holders equivalent returns to those available through other conventional short-term money market instruments. At the same time. Houston. supra. 404 237 236 . p. supra. in which case they are subject to the rules of debt trading. The government undertakes to supply a specified amount of aluminum on the basis of Salam at a future date.
Mervyn K. Sharia precludes sale of these debt certificates to a third party at any price other than the face value of such certificates. Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future project. Islamic Capital Markets. Property/project is leased or sold to the end buyer. 165 243 Mannan. p.. In that case it will generate fixed return securities. p. M. Islamic Financial Services. 241 Under such a scheme the SPV representing investors becomes seller-contractormanufacturer of an asset to a buyer (say. 243 Khan. supra. the government) and uses back-to-back istisna for creation of the facility. a building or bridge) will generate. the SPV takes upon itself the legal responsibility of getting the facilities constructed. In other words. Title to assets is transferred to the SPV.. Edward Elgar Publishing. and The returns are distributed among the Sukuk holders. ed. generating variable-return securities. or it can be securitized on the basis of variable income (such as a toll tax on the bridge). 294 242 Obaidullah. These Sukuk may have different maturities to match the installment plan that has been agreed upon by the two parties. 111 241 .ISLAMIC SECURITIZATION Istisna contracts can be securitized to raise funds on the basis of the rental income that the asset (for example. 242 Steps involved in the structure: The SPV issues Sukuk certificates to raise funds for the project. p. and sub-contracts the work to manufacturers/contractors. by Hassan. Kabir. 2007. They represent buyer’s debt and hence. Fahim. Lewis. M. supra. The end buyer pays monthly installments to the SPV. Inc. Handbook of Islamic Banking. Islamic methods for government borrowing and monetary management. The deferred price that the buyer will pay may be in the form of Sukuk that are an evidence of indebtedness whose total facevalue exactly equals the total deferred price.
3. 111-112 .ISLAMIC SECURITIZATION The prohibition of riba precludes the sale of these debt certificates to a third party at any price other than their face value.hybrid or mixed asset Sukuk . such certificates. 244 An example of Sukuk al-istisna is as follows: The Durrat Al Bahrain. p. 245 3. as Murabaha and Istisna contracts cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. The Sukuk was structured to provide quarterly returns with an overall tenure of five years and an option for early redemption. a more diversified Sukuk . supra. cannot have a secondary market. Later. The proceeds of the issue (cash) were used by the issuer to finance the reclamation of the land and the development of base infrastructure through multiple project finance (istisna) agreements. During the istisna period. a $1 billion world-class residential and leisure destination situated in the Kingdom of Bahrain. Islamic Capital Markets.1. the istisna receivable (amounts held as cash) was only subject to trading at par value. pp. issued the Durrat Sukuk to finance the reclamation and infrastructure for the initial stage of the project. the Sukuk became tradable. supra. which may be cashed only on maturity.7 Hybrid Sukuk Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors. As the works carried out under each istisna were completed by the contractor and delivered to the issuer. the issuer gives notice to the project company under a Master Ijara Agreement to lease such infrastructure on the basis of a lease to own transaction. In a hybrid Sukuk. 405 Mannan. However.emerged in the market. they can be transferred at face value to a third party. Therefore. the underlying pool of assets can comprise of Istisna. Introduction to Islamic Finance. 111 246 Ibid. upon completion of the istisna period and when lease agreements were put in place. 246 244 245 Ayub. Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. p. As noted above.
p. SPV issues certificates of participation to the Sukuk holders and receive funds. If. Certificates would be redeemed at 100% of their principal value. at all times during the period. and IDB. net of expenses of the trust. the proportion of assets evidenced by Ijara contracts fell below 25 %. by virtue of its separate undertaking. a dissolution event would occur. particularly suitable for investment banks and development finance institutes. p. would be used to give a periodic return to the certificate holders. comprise Ijara assets. Principal amounts of Sukuk would be reinvested in Ijara and Musharaka contracts to form a part of Sukuk assets. 248 The modus operandi of issuing mixed portfolio Sukuk is an effective tool for converting nonmarketable and illiquid assets to negotiable instruments having a secondary market. Islamic finance originator purchases these assets from the SPV over an agreed period of time. 406 249 Ibid. supra. Most of the assets (over 50 %) would. Investors receive fixed payment of return on the assets. In the case of any early dissolution event. the redemption would be according to adjustment. 247 A prominent example of such mixed portfolio Sukuk are Islamic Development Bank’s (IDB) Solidarity Trust Sukuk for $ 400 million issued in 2003. Each certificate represented an undivided beneficial ownership in trust assets and ranked pari passu with other trust certificates. Solidarity Trust Services (STS) served as trustee to issue the fixed-rate trust certificates that were issued to purchase a portfolio of Sukuk assets comprising Ijara. Murabaha and Istisna contracts originated by the IDB. keeping in mind the return accumulation period.ISLAMIC SECURITIZATION Steps involved in a hybrid Sukuk structure are as follows: Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV. The funds are used by the Islamic finance originator. 407 . p. 112 Ayub. 249 247 248 Ibid. Profit on Sukuk assets. would be obliged to purchase all of the assets owned by the trustee pursuant to the terms of the “purchase undertaking deed”. Introduction to Islamic Finance. at any time.
we have reviewed various methods of creating fixed income debt securities based on the classical Islamic contracts of murabaha. salam-based instruments seem to be too restrictive in scope. supra. for instance. Ijara seems to offer maximum flexibility in terms of negotiability. Not all forms meet with universal approval of Islamic jurists. and Malikis 252 deem it admissible only under very strict conditions. Does this involve riba or is it a claim on a fraction of a very stable stream of profits? Opinions differ. This may make sense in the case of large investments. Issue No. In the same way. while murabaha is useful for financing trade. 65 Obaidullah. Murabaha however. 251 3. lease claims are securitized and sold to the public in the form of Sukuk. musharaka. 254 Visser. 253 El-Gamal. issued a $3. consider it haram.392. for example. Islamic Finance Principles and Practice. Dubai Ports. management of price risk etc.2 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues A Sukuk flotation can be seen as a securitization of assets. Istisna-based instruments are quite useful for financing large infrastructure projects. mudaraba. If. 95 251 250 .6 254 Dudley. One development is the convertible Sukuk. ijara-based instruments are free from all these constraints. or Sukuk. A Basic Guide to Contemporary Islamic Banking and Finance. ijara. 165-166 252 Hanafi. involves sale of debt or receivables and hence suffer from the restrictions on their negotiability. Islamic Financial Services. supra. which can be exchanged for equity. Euromoney. by contrast. Such securitization took off on a large scale in Malaysia after the Shafi School ruled it halal. 250 So. 253 The division goes so deep that Bahraini Islamic banks refuse to trade with Malaysian Islamic banks. the buyer receives a financial instrument that pays a fixed income and carries a low risk. Of all these. supra. A secondary market in this instrument is almost ruled out. such as infrastructure projects or large industrial complexes. Shafi.5 billion pre-IPO convertible Sukuk in January 2006. pp. p. Islamic Banks tap a Rich New Business. Nigel. salam and istisna that are free from riba. p. Compared to these. p. financiers are free to devise other varieties.ISLAMIC SECURITIZATION This list of Sukuk forms is not exhaustive. Musharaka participations can be securitized by issuing negotiable certificates. And hence Sukuk-al-ijara are expected to play a significant role in development of an Islamic debt market. Maliki and Hanbali are the four “Madhhab”s (schools of law) in jurisprudence within Sunni Islam. Hanafis and most Hanbalis.3. December 2001.
as long as the lessee is not also an investment partner. to agree to purchase the assets for their net value. partner. or investment agent to agree to purchase assets from Sukuk holders or from whoever represents them for a nominal value of those assets at the time the Sukuk are extinguished at the end of their tenors. It is permissible. It is not permissible for tradable Sukuk to represent either revenue streams or debt except in the case of a trading or financial entity that is selling all of its assets. in accordance with Sharia rules of Partnership and modern partnerships. however. or a partner. regardless of whether the manager acts as an investment manager.ISLAMIC SECURITIZATION However in relation to Sukuk. however. The fatwa basically claimed that 80-85 % of the Sukuk issued until then is not Sharia-compliant and recommended six principles in order to reach permissible structures. the real earthquake was created by the fatwa (religious opinion concerning Islamic law issued by an Islamic scholar) issued by the AAOIFI in February 2008. in real assets. or for a price agreed to at the time of their purchase. or fair market value. It is permissible. to establish a reserve for the purpose of covering such shortfalls to the extent possible. to undertake to offer loans to Sukuk holders when actual earnings fall short of expected earnings. or a portfolio which includes a standing financial obligation such that debt was incurred indirectly. Sharia supervisory boards must not consider their responsibility to be over when they issue a fatwa on the structure of Sukuk. that may be possessed and disposed of legally and in accordance with the Sharia. on condition that the same be mentioned in the prospectus. or an investment agent. or agent. The manager of a Sukuk issuance must establish the transfer of ownership of such assets in its books. with all of the rights and obligations that accompany ownership. It is not permissible for the manager of Sukuk. or market value. they must review all contracts and documentation . whether tangible or usufructs or services. incidental to a physical asset or a usufruct. Rather. and on the subject of Guarantees. It is not permissible for the investment manager. investment manager. and must not retain them as its own assets. It is permissible for the lessee in a Sukuk Al-Ijara to agree to purchase the leased assets when the Sukuk are extinguished for their nominal value. The recommendations of AAOIFI’s Sharia Committee are: Tradable Sukuk must represent ownership for Sukuk holders.
supra. it is difficult to obtain ratings from major international rating agencies on transactions that are dependent.ISLAMIC SECURITIZATION related to the actual transaction.aaoifi.com/aaoifi_sb_Sukuk_Feb2008_Eng.3 Credit Rating Issues If Sukuk are to achieve their macroeconomic and microeconomic benefits. but is an organization based in Bahrain in which leading Sharia scholars participate in order to resolve issues and try and reach agreed settled positions. upon laws in most jurisdictions within the Islamic economic sphere.wordpress. such Sukuk will have to be rated by international rating agencies. it is essential that asset securitization Sukuk be issued and traded on a large scale. as well as in jurisdictions in which the Sharia is incorporated to some extent in the secular law of the land ("Sharia-incorporated jurisdictions"). including true sales of assets and various bankruptcy law matters. 255 However.3. There are general issues as to whether and to what extent the Sharia or Sharia-compliant transactions can be enforced in jurisdictions in which the Sharia is not incorporated to any extent in the secular law of the land ("purely secular jurisdictions"). at any level. 256 The immediate reaction of some bankers has been that the recommendations may put a dampener on the issuance of future Sukuk because of these extra ‘constraints’ and thus affect their future tradability. 257 3. The main legal impediments relate to the inability to obtain satisfactory legal opinions with respect to a range of enforceability issues.com/2008/05/21/aaoifi-Sharia-councils-proposals-for-amendments-incontemporary-Sukuk-issues/ 258 McMillen. and then oversee the ways that these are implemented in order to be certain that the operation complies at every stage with Sharia guidelines. 258 The original declaration of AAOIFI in relation to amendments in contemporary Sukuk issues is available at http://www.pdf 256 AAOIFI is not a statutory industry-wide body. 431-432 255 . At present. pp. To achieve widespread issuance and trading. Available at http://islamicfinancenews. 257 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues. May 2008. AAOIFI recommendations do not have the force of law and it remains to be seen how the industry will react to it. however. Contractual Enforceability Issues: Sukuk and Capital Markets Development.
p. we see that generally the credit rating is directly linked to the credit rating of the originator. 20 February 2009. It will also assess the compliance with the Sharia of financial instruments as well as their issuers.) We therefore have assigned them ratings equivalent to those on their guarantors and view them as ranking pari passu with the senior unsecured obligations of guarantors. regional governments. the shortfalls of judicial systems in the countries of Sukuk issuances. rating agencies’ interpretations on the transaction structures. p. and financial institutions.” 260 Obviously this means that.ISLAMIC SECURITIZATION When we look at the ratings given to Sukuk structures. supranationals. The International Islamic Rating Agency (IIRA). Let us read from the Standard & Poor’s’ Islamic Finance Outlook 2009 Edition: “To date. usually by a parent or original owner of the underlying collateral and the guarantor provides Sharia-compliant shortfall amounts in case the issuing vehicle (usually a special-purpose entity or SPE) cannot make payment. there are many reasons for that: On the one hand. Most Sukuk we rate benefit from full external guarantees. on the other. fiduciary risk and creditworthiness. Standard & Poor’s has assigned ratings to 23 Sukuk issued by sovereigns. supra. is a step in the right direction to overcome the latter of the aforementioned issues. Islamic Finance Law. a very important benefit of securitization does not really work for Islamic structures. Economics and Practice. Without any doubt. It will have a Sharia board 259 260 Standard & Poor’s. 108 . Islamic Finance Outlook 2009. corporations. which has been established in Bahrain. for now. the Sukuk rating is linked directly to that of its sovereign issuer: “The ratings of the Certificates will be based primarily on the credit rating of Qatar. It will perform a number of functions including the rating of all public and private issuers of credit instruments with respect to their financial strength. falling in the first category (where there is an irrevocable third-party guarantee.” 259 The Offering Circular (OC) of Qatar Global Sukuk issuance is a fine example showing the said rating agency’s approach: On page 9 of the OC. 30 El-Gamal.
Mervyn K.3.. IMF Working Paper 07/237. Edward Elgar Publishing. Challenges facing the Islamic financial industry. p. 261 3. Umer. Christopher F. ed. p. Lewis. Kabir.. Inc. 412-413 261 . 263 Chapra. M. thus. While this is true in a number of ways. Eurobonds: Is There a Difference in Value-at-Risk?.. The difference is the utilization of different mechanisms and finance techniques.4 Benchmarking Issues In most Sukuk structures. Selim and Raei.ISLAMIC SECURITIZATION of its own to advise it on Sharia issues. pp. Ayman H. It will. Faezeh. Winter 2007. 331 262 Cakir. New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings. it is important to note that an Islamic investment product is a factor of both utilizing specific mechanisms and respecting the fact that the form by which investments are made is as important under Sharia as the substance. Richardson. Chicago Journal of International Law. M.. the variable rent is calculated by reference to a conventional interest rate such as LIBOR (London Inter-bank Offer rate) as the table below proves: 262 An argument often heard from investment bankers is that Sharia requirements achieve the same end result that conventional investment or finance products would achieve in a number of situations. by Hassan. complement the work of the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in setting standards for adequate disclosure. 2007.3 263 Abdel-Khaleq. October 2007. Handbook of Islamic Banking. Sukuk vs.
on the one hand. For instance. therefore. On the other hand. given their high activity in the real estate sector compared to conventional banks.ISLAMIC SECURITIZATION Mohammad Ayub makes the following interpretation on the issue: “The question arises whether any interest rate benchmark like LIBOR can be agreed as the benchmark for rental. This is not the correct viewpoint. we may conclude with the fact that the better position is that the reference to an interest rate is acceptable based on the Sharia grounds of necessity or public need because. According to a minority of the scholars. at present. 57 266 de Belder. because as long as the basic requirements of Sharia are being complied with. there is no viable Sharia compliant alternative.. 284 Visser. 266 3. Introduction to Islamic Finance. with such benchmarks the transaction becomes similar to an interest-based transaction and. they have not been completely insulated from the recent economic and financial shocks. supra. Investment Banking. supra. supra. 264 265 Ayub. Richard T. the Islamic financial industry is considered by many to be less risky because financial transactions are backed by physical assets. any benchmark can be used to price sale or lease transactions. and more generally for pricing Islamic financial instruments. be it with some lack of enthusiasm. p. 265 Saying that.3. is widely accepted by Sharia scholars. is not permissible. Islamic Finance Principles and Practice.5 Recent Sukuk Defaults As Islamic banks operate within the global financial system. p. 95 . Benchmarking the transaction’s pricing to an interest-based rate does not render it Haram.” 264 The use of interest rates as benchmarks for determining mark-ups. Islamic banks may be more vulnerable to fluctuations in the mortgage market. p.
271 Despite the black clouds on the Islamic securitization. future prospects still seem bright. June 16. A court in Louisiana is deciding what rights. July 2009. and East Cameron Partners in the US have all defaulted on Islamic bonds since the financial crisis erupted. Saad. if any.euromoney. Sukuk forecast to ride rough patch. Shayerah. said in May 2009 it had defaulted on a $100 million Sukuk issued in 2005 and registered in Bahrain and became the first Middle Eastern company to default on Islamic bonds. Wall Street Journal.ISLAMIC SECURITIZATION The recent slowdown in real estate activity in the Gulf economies raises concerns about some Islamic banks’ financial positions. Dominic. 3 268 Fidler. 269 These defaults follow last autumn’s (2008) bankruptcy of Texas-based East Cameron Gas Company.ft. available at http://online. Defaults Pose Latest Snag In Islamic-Bond Market.com/cms/s/0/ed243650-47da-11df-b998-00144feab49a. Congressional Research Service. Euromoney Magazine. Stephen.html 270 Ibid 271 Wigglesworth. available at http://www. which issued a $167 million Islamic securitization in 2006. the noteholders have. Islamic Finance: Sukuk market on trial as Islamic bonds default. Kuwait’s The Investment Dar.com/article/SB124510859262816907. Even though Islamic Finance has been shown as a potential cure for the crisis by Ilias. Investment Dar. 267 The Islamic finance industry is undergoing a big test as defaults and restructurings appear in the Sukuk market for the first time. a Kuwaiti investment company that owns a 50% stake in luxury-car maker Aston Martin Lagonda Ltd. Robin. Islamic Finance: Overview and Policy Concerns. 268 In June 2009.html 267 . p. These defaults are taken by the market as a natural result of the hardest crash since the Great Depression of 1929. 270 Dubai managed to avoid defaulting on a $4bn Sukuk held by developer Nakheel in December – thanks to a loan from Abu Dhabi – but Saad Group in Saudi Arabia. 14 April 2010. There is uncertainty as to whether the issuer of the notes is bankruptcy remote and whether a true sale of the assets took place. there was a default on a $650 million Islamic bond launched in 2007 by an offshore vehicle linked to Maan Al Sanea’s troubled Saudi group.com/Article/2245562/ChannelPage/0/AssetCategory/14/Islamicfinance-Sukuk-market-on-trial-as-Islamic-bonds-default. 2009.html 269 O’Neill. February 2009.wsj. Financial Times. available at http://www.
who were increasingly buying Sukuk as a way to diversify. There’s a degree of nervousness about defaults in the Sukuk market but that is outweighed by the bullishness demonstrated by the new Sukuk deals currently being done and those likely to come to the market in the course of this year (2009). Thus. May 6. in a report recently predicted that Islamic bond sales in 2010 could exceed last year’s $24bn as global regulatory and legislative initiatives. will return to the market. partner at law firm Clifford Chance in Dubai. Lorenzo. Vatican Says Islamic Finance May Help Western Banks in Crisis. Islamic finance can not be crisis-proof alone while the whole financial system in the world is suffering more than ever. 3 275 Wigglesworth. David Oakley of Financial Times says “It is also hoped that non-Muslim European investors. deputy chief executive of HSBC Amanah. Islamic Finance: Sukuk market on trial as Islamic bonds default. and there remains underlying demand from local investors.” 274 Moody’s. probably equal to or better than last year. “The underlying reasons being that there are still a lot of infrastructure investments to come for which some of the financing will probably be raised through Sukuk.” 275 Totaro. available at http://www.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy 273 O’Neill. supra 272 . Dominic. March 4. Moody’s argued. the credit rating agency. Century. investment banking is becoming a subject in history books. before the credit crisis. He points out that the $750 million Bahrain sovereign Sukuk last month (June 2009) had an order book of $2 billion.ISLAMIC SECURITIZATION Vatican. Most sales will come in the second half of this year (2010) as the global economic recovery gathers pace and boosts investor risk appetite and corporate profits. western buyers sometimes accounted for more than 80% of Sukuk investors. Credit Freeze victim shows signs of a thaw. while in February (2009) Indonesia’s $650 million sovereign Sukuk had an order book of $3 billion. thousands of highly educated finance (and financial law) experts are losing their jobs. p. 2009. and a possible Dubai World restructuring settlement.bloomberg." says Qudeer Latif. “I think we will have a good Sukuk year in 2010. 272 the whole financial system in the world is so much linked as of the first decade of the 21. David. Sukuk forecast to ride rough patch. etc. however. North Africa and Asia accounted for 70% of the buyers of the Bahrain Sukuk. Even so. 273 Again. In 2007. one of the bookrunners tells Euromoney that the Middle East. supra 274 Oakley. Islamic Finance Financial Times Special Report. boost issuance. 2009.” says Razi Fakih.
p. 279 Thomas.com/AOWeb/binaries/47753. Euromoney Books. M. Second. 278 Specialist derivatives practitioners are now facing both an exciting opportunity and an interesting challenge.ISLAMIC SECURITIZATION 3. four main difficulties arise with respect to compatibility with Sharia law. Structuring Islamic Finance Transactions. Priya. 7 October 2008. Allen & Overy Article. we need to note some important qualifiers. ed. Sukuk cannot avoid being competitive if they are to operate in traditional financial markets.Sc. However. gharar. Ali Arsalan. 63 278 Tredgett. Bryan. 2005. the positive aspects of derivative markets can be beneficial for developing capital markets if replicated in the emerging markets. Abdelkader. 2004. Risk Management and Derivatives.PDF 276 . in International Banking thesis. 184 277 Tariq.4 The Use of Derivatives in Islamic securitization Islamic finance is still struggling to determine whether or not it has a parallel approach to western risk management. Islamic Derivatives Case study: A cross currency swap. First.com/AOWeb/binaries/45568. it shall be noted that the prohibition of interest and gharar does not close the room for financial engineering in compliance with the Sharia. Available at http://www.pdf 279 Uberoi. Allen & Overy LLP Article. Nick. Stella. Third.allenovery. Evans. by Thomas. Abdelkader. 18 June 2008. Loughborough University. Structured systemic Islamic financial products require structured innovation within Sharia confines. Kraty. 276 The non-existence of interest rates in Islamic finance apparently makes the need for derivative instruments redundant in Islamic markets. p. Managing Financial Risks of Sukuk Structures. Profit Rate Swap. namely the Sharia prohibitions on riba. Cox. Richard. namely to produce products which provide parties with the unquestioned benefits of conventional derivatives (particularly with respect to effective hedging and general risk management) whilst also adhering to and respecting the core tenets of Sharia.allenovery. maisir and debt exchange. 277 When structuring derivatives products. Available at http://www.
1. and that options trading like other varieties of trade is permissible. exercising it over a period of time or charging a fee for it. 282 Thomas. it relies on structural arrangements of asset transfer between borrowers and lenders to emulate traditional interest-bearing financial contracts. 283 Notwithstanding the religious constraints and legal uncertainty surrounding the enforceability of investor interest under Islamic jurisprudence. 280 Perhaps the most important derivatives question made after an examination of the substance of the contract is whether it serves a public benefit or maslahah 281 to such an overriding degree that it may be transacted. he noted that. 185 283 Jobst. supra. Risk Management and Derivatives. 26 284 Ibid. Derivatives in Islamic Finance. Islamic scholars from the time of the Prophet Muhammad have agreed that the public good outweighs the break from generally accepted contractual forms. p. it is simply an extension of the basic liberty that the Qur’an has granted. mortgages. With that in mind. April-June 1999. 1. 282 It is now agreed that there is nothing inherently objectionable in granting an option. p. supra. 28 281 Maslahah means that an underlying process may have some problematic issues or prospectively harmful elements from a Sharia perspective. p. vice president of Moody’s recently authored a report in relation to derivatives in Islamic Finance and in his report. No. Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration. and derivatives known in conventional finance. 2 280 . International Journal of Islamic Financial Services. p. “If employed with care. Vol. Islamic finance can synthesize close equivalents to equity. To this end. Obiyathulla Ismath.ISLAMIC SECURITIZATION Aside from a narrow focus on the contractual framework. strong opposition to derivatives seems to be inherited from a pathology of religious interpretation that turns a blind eye to the fact that derivatives are a new phenomenon in an Islamic context. but the good achieved by its application outweighs harm. 284 Anouar Hassoune. In the case of salam and istisna. derivatives can Bacha. Islamic scholars must take into consideration the potential “welfare loss” when deciding on the permissibility of derivative instruments. and as such.
2010. futures and options may be compatible with Islamic law if they (i) are employed to address genuine hedging demand on asset performance associated with direct ownership interest. thereby making them more competitive as well as appealing to customers.ISLAMIC SECURITIZATION enhance efficiency in Islamic Financial Institutions through risk mitigation. mainly because of the possibility of speculation (or deficient hedging need) and the absence of entrepreneurial investment violate of the tenets of distributive justice and equal risk sharing subject to religious restrictions on the sale and purchase of debt contracts as well as profit taking without real economic activity and asset transfer. However. (ii) disavow mutual deferment without actual asset transfer. In a sense.pakistanchronicle. available at http://www. If circumstances dictate that he will not buy the commodity then the seller keeps the deposit. Several schools of thought are in the impression that the uncertainty arising from the use of the contract amounts to gharar and is thus unfair on the seller. The contract affords the buyer of a good to make a deposit whereby if he decides to buy the specified product in the future he will pay the difference between the full price and the deposit.com/content/moody%E2%80%99s-sees-huge-global-potential-islamic-bankingindustry 286 Jobst. supra. Derivatives in Islamic Finance. Sharia-compliant derivatives would also maintain risk sharing between contract parties by forgoing the zero-sum proposition of many conventional derivative transactions in favor of win-win situations from changes in the value of the underlying asset. and (iii) eschew avertable uncertainty (gharar) as prohibited sinful activity (haram) in a bid to create an equitable system of distributive justice in consideration of public interest. Pakistan Chronicle. two practices forbidden under Sharia. the arboun contract ostensibly replicates the functions of a conventional call option. The permissibility of the contract within Islamic doctrines is debated and much of debate is with regards to historical records of the use of the contract during the time of the Prophet Muhammad.” 285 In principle. 286 The closest approximation to a conventional option contract within Islamic finance is the arboun contract. p. the de facto application of many derivative contracts is still objectionable. On the other hand. The applicability of the contract is particular to the condition that commodity in question is 285 Moody’s sees huge global potential for Islamic banking industry. 28 . other schools of thought uphold the contract citing inaccuracies in the historical records of its alleged reproach. April 7. their application in Islamic finance is highly controversial for reasons of speculation and uncertainty. However.
Derivatives in Islamic Finance. Sharia compliance of the transaction is established by the uncertainty of cash flows from the asset performance of permissible real economic activity with identified and direct investor participation. 287 The first Islamic securitization transaction in the U. and an “issuer SPV”. which funds the asset purchase by issuing investment trust certificates (Sukuk notes). pursuant to the following provisions: (i) the purchase of overriding royalty interest (ORRI) from the originator for $113. supra. p. The commodity price hedge as part of the funding agreement to protect investor interest is remarkable in the context of Islamic finance. investors have recourse to the underlying assets and can force the sale of the cash flow generating assets. Secondly. the uncertainty involved in the contract is tantamount to gharar making it invalid within the sphere of Sharia. demonstrates the Sharia-compliant use of derivatives in structured finance. While deferrals are possible. According to the Organization of the Islamic Conference (OIC) Academy. (ii) the payment of the development plan for $38. 22 289 Ibid . in the default event. Its two-tier securitization structure consists of a “purchaser SPV” (incorporated in Delaware). raised $165. since it confers true commercial value (rather than speculative interest). Texas. The relationship between both SPVs is governed by a “funding agreement”. Managing Financial Risks of Sukuk Structures. 64-65 Jobst. Firstly. The hedge constitutes a Sharia-compliant obligation. which is passed on to the Sukuk note holders. In July 2006.28 million. the option contract amounts to investing in something intangible. an option contract is not tradable. 288 Overall. According to Sharia. (iii) the funding of the reserve account with an initial balance of $9. an independent oil and gas exploration and production company based in Houston.5 million. East Cameron Partners (ECP).05 million in a specific hedge agreement with an outside party.S. which acquires the underlying assets. the arboun cannot be used for generic commodities which hinder its possibility to fully replicate the functions of conventional option contracts that are on unspecified underlying assets.67 million from the issuance of a Sukuk al-Musharaka backed by natural oil and gas royalties. The funding agreement aims at materializing the contribution of the “issuer SPV” (as a musharek) and (ii) conveying to the “issuer SPV” a certain risk and reward profile.84 million. which does not imply the payment or receipt of any interest guarantee. pp.ISLAMIC SECURITIZATION specified and unique to the contract. which includes periodic funding repayments and the transfer of net profits. registered in the Cayman Islands. 289 287 288 Tariq. and (iv) the acquisition of natural gas put options for $4. supra.
9 billion). sells them to individual developers. and b) Saraya ($290 million. thereby affected by the credit crunch. Apart from that. Freshfields Bruckhaus Deringer LLP and Bedell Cristin Jersey Partnership acted as legal counsels for different parties in the transaction. we used the related reports and media releases of Clifford Chance LLP. 291 While preparing the case study. One should remember that East Cameron Partners Sukuk defaulted during the harshest days of the recent financial crisis and the conflict is before an American court at the moment. that purchases the plots and.1 billion). 2009. The decision of the court in relation to enforceability may potentially affect the future Sukuk structures. some.ISLAMIC SECURITIZATION However. a 170-hectare development and $3. with limited liability) securitization is to allow Sorouh Real Estate PJSC (hereinafter referred to as Sorouh) to monetize future cash flows for from the sale of real estate plots to property developers. there are three principle parties involved in this transaction: Sorouh. 290 3.1 billion 292 residential project on Al Reem Island. and the total issue was AED4 Billion ($1. Citigroup. Standard & Poor’s and the Economist as well as Sorouh Real Estate PJSC’s ADX Financial Report dated June 30. Abu Dhabi Commercial Bank. and Sun Finance (Issuer) that issues the AlMudaraba Al-Muqayyada certificates to investors. Freshfields Bruckhaus Deringer LLP. one should note that the legal risk from Islamic jurisprudence could affect the legal enforceability of the funding arrangement and the asset control of investors. Moody’s. First Gulf Bank. mixed-use) development in Abu Dhabi's central business district. 290 . a project developer that sells the plots. mostly Middle Eastern sources claim that the project is worth actually AED25 billion ($6. National Bank of Abu Dhabi. 292 Despite the conservative assessment of the Economist. Afridi & Angell. our main tool was the Offering Circular of the deal. in turn. Noor Islamic Bank took part in the transaction as joint bookrunners while Clifford Chance LLP. In essence. the Channel Islands. Sorouh applied the proceeds of the monetization toward funding the utility infrastructure for two of its flagship real estate developments: a) Shams Abu Dhabi. The transaction was closed in August 2008. Sorouh Abu Dhabi Real Estate LLC (Propco).5 A Case study: Sorouh Securitization 291 The purpose of the Sun Finance Limited (incorporated in Jersey.
ownership of the land incrementally shifts to the developers.ISLAMIC SECURITIZATION Sorouh securitization comprises three classes of notes rated by Moody’s and Standard & Poor’s. Propco releases the relevant plot to the developer. p. If plots are not sold or purchase prices not achieved. . The below table 293 shows the relevant profit rates 294 and ratings from the said agencies as well as some other details accordingly: The transaction is capitalized by Sun Finance applying the certificate proceeds toward a mudareb (investor of capital). effectively a partner in the mudareb. In turn. The certificate proceeds amount to the Issuer’s beneficial interest in the mudareb. and puts the purchase price toward the investors’ (that is. 293 294 The table is taken from the Offering Circular (OC) of Sorouh securitization. Propco purchase undertaking is backed solely by the sale proceeds from the real estate plots. buys the plots from Sorouh. Propco. sells them to the developers. effectively making the Sun Finance transaction a non-recourse Sukuk. trust certificate holders’) returns and funding for the infrastructure works. As payments from the developers come in through plot sales. The Issuer’s ability to service the certificates lies ultimately in the ability of Propco to sell and be paid for the plots. Propco incrementally purchases the Issuer’s beneficial interest in the Mudaraba (trust) as it receives funds from plot sales. 2 EIBOR is the abbreviation for Emirates Interbank Offered Rate. The significance of this feature is that the credit quality of Sorouh is effectively not an issue once the sale of the plots to Propco is completed. Propco will likely not be in a position to meet is obligations under the purchase undertaking. thereby amortizing the certificates. When a plot sale payment is received.
Such interest is not the same as outright legal ownership though. the issuer is entitled to instruct the independent director to force a sale of the assets held by Propco. 9 . While the Issuer has a fixed and floating charge under U. there is a degree of legal and country risk in each transaction. there is some question as to whether such charge would be enforceable in the UAE where the assets are located. p. The structure features both senior and subordinated certificates. law over the assets of Propco. who would then own 100% of Propco. the remaining 1% being held by an independent director. In the event of a payment default by Sorouh. transaction documentation indicates that the 99% share would be transferred to the independent director. In summary. It benefits from a fatwa to the effect that it's Sharia-compliant. Below is a structure diagram of the Sorouh securitization transaction: 295 295 The diagram is taken from the Offering Circular (OC) of Sorouh securitization.ISLAMIC SECURITIZATION Propco is 99%-owned by the chairman and managing director of Sorouh.K. Investors do not have security as much as they hold a beneficial ownership interest in the mudareb. in the event of the insolvency of Sorouh. As noted above.
a director at Citi says “In contrast to past full-recourse deals. including Sharia compliant tranches and representing one of the few fully distributed asset backed transactions since the advent of the "credit crunch". but notably. It is also Abu Dhabi’s first ever local currency securitization deal. 1 December 2008.isr-e. marks the first asset-backed securitization out of Abu Dhabi. The transaction is also unique in many other ways. it was an incredible deal for many reasons. “Objectively speaking.com/story.asp?storycode=284065 297 Deal of the Year 2008 – Emerging Markets.” says Khalid Howladar.” Available at http://www. a senior analyst in the Middle East and Islamic structure finance group at Moody’s Investors Service. Sharia scholars have recently expressed concern over pure-recourse deals and as a consequence previously Sharia-compliant deals would no longer be compliant if proposed today.ISLAMIC SECURITIZATION It is the first ever securitization of installment sales receivables which was Sharia compliant.com/story.asp?storycode=284065 296 . apart from being the first ever securitization of this asset class. The Sukuk certificates which are asset backed by installment sales receivables from the sale by Sorouh of plots of land on the iconic Shams and Saraya Master Developments in Abu Dhabi have been awarded the highest credit rating to date for a non-sovereign instrument issued in the MENA (Middle East & North Africa) region. The transaction is also the world's largest Sharia compliant securitization 296 to date.isr-e. “I’ve never seen anything like it.” 297 Robin Ward. Available at http://www. Winner: Sun Finance. this transaction features partial recourse to the originator.
Obviously the aforementioned success will not come with ease. As the number of Islamic finance experts all around the world. interesting world of Islamic Securitization. Lack of expertise has always been an issue regarding the success of Islamic finance. We believe that the importance of these efforts is beyond having standardized structures. both Muslim and non-Muslim. We do believe that securitization in Islamic Finance will be the impulsive power of Islamic Finance in its challenge to become a player in the mainstream financing. That is why we believe that this problem is a matter of life and death. The lack of standardization may have an adverse effect on the spectacular up-going trend in the long run. This mere reality is making Islamic Finance and Securitization great partners. there is a huge risk of witnessing individual issuers simply mimicking conventional structures and calling the structures they created “Islamic”. As one may well argue. the “different interpretations of Islamic law” is a serious issue concerning the sound growth of Islamic Securitization as well as other structures of Islamic Finance. That is why Islamic financial institutions may benefit a lot from the liquidity and risk management features of securitization. The efforts of institutions like AAOIFI are very important regarding standardization as we mentioned their suggestions in relation to Sukuk issues echoed all around the world. is increasing in . This may cause Islamic Finance lose its nature and identity in the long run. This is almost a matter of life and death to Islamic Securitization and Islamic Finance in general.ISLAMIC SECURITIZATION CONCLUSION We tried to explain the quite complex and hence. We hope we at least managed to give a broad picture which may give the reader a basic understanding of this quite young branch of financing universe. Securitization which is in its essence a Sharia compliant structure perfectly fits with the needs of Islamic financial institutions that have traditionally accepted the model of originate-to-hold. Our point to this argument is that without universally accepted structures.
it is not possible to deny the contribution of the international law firms most of which have a quite deep and wide Islamic Finance expertise and practice. in fact. it is not impossible to beat these “potential” forecasts.O ----- . even the increases in these forecasts. Most of the innovative structures were created with the effort of the partners and associates of these firms working in the offices in the Middle East or other locations particularly London. Provided that the aforementioned efforts continue to exist (or even increase as one may suggest) and the recession fears ease. prove that there is. this issue is becoming less important gradually. There are many parameters which make us believe that the potential numbers seem to be quite modest.ISLAMIC SECURITIZATION multiples. Only time will tell… ----. much more potential than it is claimed at the moment. coming one after another. We gave some numbers in our thesis regarding the potential of Islamic finance which shows there is still a lot of way to go. Apart from the others. Obviously.
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