Islamic Development Bank sukuk, Nakheel update, BNM releases SPR1 on murabaha, Takaful in the U.S.

The descriptions of the Moody's Aaa rating given to the $1.5 billion sukuk provide some details about the way they are structured, a hybrid structure combining the investments made by the bank to governments and companies. The hybrid sukuk combines "ijara assets, murabaha contracts, istisna'a contracts and Islamic Development Bank investments in equity and sukuk certificates". The sukuk represent ownership of the pool of assets which are serviced by the Islamic Development Bank. Profits are paid during the term of the sukuk and the sukuk assets are repurchased upon maturity. One interesting part of the sukuk is that their profit payments appear to be fixed during the term of the sukuk and the SPV issuing the sukuk is given a noninterest-bearing line of credit with the Islamic Development Bank to make up any shortfall in periodic payments. Given the structure of the sukuk in which most of the assets are likely to be ijara, murabaha, istisna'a and sukuk, the profit payments should be relatively predictable. The line of credit makes the sukuk equivalent to senior unsecured debt of the IsDB.

Two large holders of Nakheel's sukuk which matures in December 2009 belive that there will be no restructuring and that the sukuk will be repaid in full upon maturity. Meanwhile Nakheel is apparently selling liquid assets at a steep discount to raise cash to repay the sukuk. The National reports that Nakheel has sold its stake in Australia's Mirvac for 80% less than it paid in 2007.

Bank Negara Malaysia, the Malaysian central bank, released its guidance on the Shari'ah-compliance requirements for murabaha (Shariah Parameter Reference 1) to encourage standardization and is working on similar SPRs for ijara, mudaraba, musharaka, istisna'a and wadi'ah.

Takaful is now available in the U.S. from a subsidiary of now-government-owned AIG that is available through exclusive broker Zayan Takaful. So far the takaful is available in 13 states although only a few hundred people have signed up. The article also has an interesting discussion about differences in opinion about the need for takaful and the acceptability of it in its current form.

Other News

• Al-Arabiya has an article profiling Shari'ah scholar Sheikh Nizam Yaquby.
  
• Sime Darby, a Malaysian conglomerate, is reported to be planning to raise RM4 billion ($1.14 billion) by issuing a sukuk.
  
• Islamic banks grew assets during 2008 compared with 2007.
  
• CNN has a story about the growing demand for Islamic finance education in the wake of the credit crisis which gives a pretty decent summary of how the industry was affected by the credit crisis.
  
• A list of the top Shari'ah scholars and some of the institutions on whose boards they sit.
  
• Islamic indices have underperformed during the past month.
  

Gulf Finance House/Macquarie Joint Venture, Other News

Gulf Finance House and Macquarie signed a Memorandum of Understanding to establish a joint venture Islamic financial services platform. Macquarie may invest up to $100 million in the joint-venture and there are reports that it will be structured as a convertible murabaha and will be launched in the beginning of 2010. There is also a story from Australia that has a slightly different perspective from Macquarie's end.

Other News

• Korea will exempt foreign holders of sukuk issued by local firms from taxes on the periodic payments.
  Gulf Air used an ijara financing for eight new airplanes.
  
• Lahem al Nasser at Asharq Alawsat offers his perspective on the recent Moody's report on Islamic banks.
  
• Dubai Silicon Oasis received a AED300 million ($82 million) investment from Abu Dhabi Commercial Bank structured as a mudaraba.
  

Malaysian standardized commodity murabaha deposits, GCC sukuk issuance 2009H1, Nakheel sukuk update

Malaysian Islamic banking groups approved a Corporate Murabaha Master Agreement which will standardize the deposit murabaha agreement where an Islamic bank deposits funds that are used by the depositor to purchase a commodity and resell it to the bank with deferred repayment on a cost-plus basis. It standardizes a reverse murabaha agreement that is similar to a reverse tawarruq product. The agreement is seen as a beneficial innovation in Islamic money markets by the Association of Islamic Banking Institutions Malaysia (AIBIM) which secured the approval. Reuters reports the product will be similar to the Islamic interbank money markets already in operation. IIFM, an industry body in the GCC estimates that commodity murabaha accounts for $100 billion in annual activity.

Sukuk markets for new issuance in the first half of 2009 continue to be lackluster in the GCC with only $1.1 billion in sukuk issued and all but one of the new issues coming from the Bahraini government through its regular salam and ijara sukuk and a new $500 million longer-term ijara sukuk.

Nakheel and the government of Dubai could have saved up to $1 billion by buying back the sukuk instead of allowing it to mature at par with deferred lease payments in December. I describe this in greater detail in an article forthcoming in Business Islamica magazine.

Other News

• National Bank of Kuwait continues to expand its ownership in Boubyan Bank to increase its Islamic banking industry exposure.
  
• BIMB plans further innovation in its Islamic financial products.
  
• Nomura plans to expand its operations into Islamic finance to attract GCC-based liquidity.
  A RAM Holdings analyst predicts greater growth in the industry in response to the financial crisis although his rationale as quoted in media reports seem to ignore the impact of the financial crisis in exposing speculative bubbles in real estate in the GCC that has had significant negative impacts on Islamic financial institutions that were overexposed to the sector.
  
• The Filipino government is increasing the capital of the sole Islamic bank in the country, government owned Al-Amanah Islamic Investment Bank.
  

Nakheel sukuk maturity, Commodity Murabaha House, KFH in joint venture with US-based REIT

The first trading day of the Commodity Murabaha House arrived. The exchange, now called Bursa Suq Al-Sila', will initially transact only in Ringgit, but will eventually allow trading in other currencies. The trades are currently based on crude palm oil (using current month futures prices) that provide Islamic banks a way to meet short-term liquidity needs by purchasing palm oil with deferred cost-plus markup payment. The commodity can be sold in the spot market after delivery. While controversial for its similarities with interest-based lending, commodity murabaha is a common financial transaction used by Islamic banks to deal with short-term liquidity needs. In the first day of trading, RM200 million ($56.5 million) in commodity murabaha was executed by CIMB Islamic, which traded RM3 billion ($848 million) per month in 2008 and has traded RM6 billion ($1.696 billion) so far this year.

Kuwait Finance House has formed a joint-venture with US-based REIT UDR to purchase up to $450 million of class 'A' buildings. This is the first re-entry of KFH into the U.S. property markets since exiting prior to the financial crisis. The joint venture, KFH will contribute 70% and UDR will contribute 30%.

The National continues to provide the best coverage of the upcoming Nakheel sukuk maturity in December, first with an article about the danger should Nakheel be unable to pay on the maturity and another article about the rise in secondary market prices for Nakheel which may signal that Nakheel will be able to make repayment. Nakheel may be one of the beneficiaries of the Dubai government's bailout funded by its $20 billion in bond issues. Despite the higher prices in the secondary markets, Nakheel's sukuk carries a yield of around 60% at current prices according to data provided by Zawya. The initial lease payments were 6.345% and the sukuk holders receive half of the lease payments upon maturity according to the offering circular which I described in an earlier post.

Other News

• Dow Jones launched two new Islamic indices, Islamic GCC and Islamic MENA.
  
• The new CBB Sukuk al-Ijara (6 months maturity) was oversubscribed by 300% and yields 1.05%.
  
• Islamic finance is "better placed to take advantage of the improvement in the capacity factor of renewables - the percentage of time that a plant is operational" according to iQuantis Ltd.
  
• Malaysia's Artice IV consultation with the IMF included several mentions of the country's Islamic financial industry.
  

Petronas sukuk 4th 144A compliant, Nakheel sukuk, Cagamas RMBS sukuk, RHB twarruq, resturcturing sukuk, diversity in Shari'ah views

The Petronas sukuk recently issued for $1.5 billion is another that complies with the U.S. Securities & Exchange Commission's 144A rules which makes it more accessible to investors in the United States. This would be the fourth sukuk that complies SEC Rule 144A after the Indonesian sovereign sukuk issed earlier this year. Another Malaysian issuer, Cagamas, listed MYR4 billion ($1.1 billion) of residential mortgage-backed sukuk structured as a musharaka.

A Reuters blog describes a meeting held by Thomson Reuters about whether the diversity of opinions among the Shari'ah scholars hampers the industry. I think this is an interesting discussion but the diversity of opinions, in my opinion, is a benefit for the industry because it keeps the industry working to meet the broad set of interpretations across the various geographies in which Islamic finance operates as well as providing a source for innovation to occur which can help the industry grow. That said, there are issues of standardization globally that, like any regulatory regime, hamper inter-regional development, but these are in my opinion outweighed by the benefits from a continuing discussion among Shari'ah scholars of the direction the industry should move.

RHB Islamic developed a tawarruq product based on telecommunication airtime as the underlying asset.

The National has a blog post on the Nakheel sukuk and in particular whether a restructuring is possible without jeapordizing the company's future access to the capital markets. It also covers the problems created by the Dubai government's implicit backing through a guarantee by Dubai World and compares this with the problems the U.S. government faced when Freddie Mac and Fannie Mae, two government-sponsored enterprises, ran into trouble and were at risk of failing. With the recent plans for the second tranche of the Dubai government's $20 billion bond issue which is reported to be used to support government-related entities like Nakheel and Dubai World, there may be a resolution to the specific problem posed by the maturity of Nakheel's $3.5 billion sukuk in December, but the greater issues raised will not be resolved as quickly. Back in May, I wrote my analysis of the Nakheel sukuk.

An article in Financier Worldwide discusses the particular difficulties of resolving restructuring/bankruptcies in the Middle East, particularly those involving Islamic financing structures.

Other News

• A writer in the New Straits Times discusses the potential for Islamic finance to play a role in re-establishing trust in the global financial system.
  
• Lahem Al-Nasser reviews the articles he has written about sukuk in Asharq Alawsat.
  
• Bangor University in Wales has seen significant uptake of its Masters courses in Islamic Banking & Finance and may offer an MBA with a focus on Islamic finance.
  
• An Islamic financial institution in India expands as the country's Islamic finance industry slowly grows.
  

Jadwa Investment report on Saudi sukuk market

Jadwa Investment recently released a short report on sukuk markets in Saudi Arabia (PDF) which contains some details about the new Tadawul sukuk market. While it is good at covering the specific topics it covers, there are two main areas where the report could have benefited from greater detail and analysis. First, the report contains a common factoid that is incorrect:

"The main difference between sukuk and bonds is that sukuk holders take direct ownership of an underlying asset or pool of assets, whereas a bond is purely the financial debt of the issuer."

As a few of the recent defaults of sukuk have demonstrated, the ability of sukuk investors to take posession of the assets they 'own' is limited by the legal structure established to make sukuk behave as much as possible like conventional debt. This is particularly true of 'asset-based' (in contrast to 'asset-backed') sukuk. In the former case, the returns are based on an asset and therefore behave as if the investor owned the asset, although in case of default the investors are merely able to compel the issuer to repurchase the sukuk at full value. Even in cases where sukuk are asset-backed, it is unclear whether the assets will end up being owned by the issuer SPV for disposition at current market prices to allow investors to recoup the principal of the sukuk. Instead, there may be a structure that 'sells' the assets to the issuer SPV but the Issuer SPV is limited to essentially exercising a re-sale provision where it can compel the issuing company to repurchase the assets at par (or perhaps following the controversy about repurchase clauses, at market prices).

One of the defaults (actually a bankruptcy proceeding by the issuer) where the ownership of the assets by the issuer SPV may be established is the East Cameron Gas Company sukuk, the only sukuk issued by a U.S.-based company. In this case, the assets were an overriding royalty interest (ORRI) in an oil and gas lease on an offshore property off the coast of Louisiana. The sukuk documents specified a backup operator and a bankup off-taker that could serve to continue the production. This could lead to changes in how sukuk are structures to give investors greater ability to take possession of the assets on which the sukuk are based.

The second area where greater analysis would have been useful is the maturity of sukuk. The report mentions this in passages that imply that sukuk provide longer-term financing:

"Unlike conventional bank loans, companies have the ability to choose the term over which they want to borrow in a sukuk issue and there is an urgent need for more long-term financing options in the Kingdom. Most bank lending in the Kingdom is short-term and little is available beyond five years"

The unexplained part of this statement is that the secondary markets, both electronic and over-the-counter, in Saudi Arabia according to the report is composed entirely of sukuk with five-year maturities and this is largely also the case in other markets, although there are some shorter-term sukuk elsewhere. The market is nearly devoid of sukuk with short- and long-term maturities as found elsewhere in the conventional debt markets. This scarcity is the real area where the sukuk markets need to develop in order for Islamic debt markets to be a substitute for conventional debt markets.

Moody's report, takaful for sukuk, development of Islamic finance industry, tawarruq, AAOIFI stepping into Shari'ah-compliance

Moody's released a Special Comment about Islamic banks that highlights their relative stability despite their rapid growth because they are conservatively leveraged, have maintained generally high profit margins and retain significant liquidity. However, beneath this positive outlook, Moody's highlights some of the risks facing Islamic banks. For example, if they are not able to develop sufficient investment of their liquidity, an economic boom could leave them lagging. In part, Islamic banks are limited in their utilization of this liquidity because they lack long-term funding sources and therefore keep additional liquidity to meet shorter-term liquidity needs. The same day (yesterday), Moody's placed four UAE banks' ratings on review for possible downgrade including Dubai Islamic Bank.

The Islamic financial industry is developing outside of Muslim-majority countries but none have the regulatory framework as well developed to allow Islamic finance than the United Kingdom according to two articles looking at the West Midlands in England and Scotland. An article in The Lawyer has a good analysis of of the future of Islamic finance for the GCC and the prospects for the region to be outdone in some areas by non-Muslim majority countries if there is a sovereign sukuk from another region. Another article from Gulf News talks about Islamic asset management and the scarcity of Islamic money markets.

AAOIFI is going to review the Shari'ah-compliance of Islamic financial products to "homogenize the market" on a limited basis. It presents an interesting expansion of the role of AAOIFI which has been limited until now on establishing accounting standards for the industry but which I believe could be a significant development in bridging the gap between the Malaysian model of nation-wide Shari'ah boards and the GCC where each institution has its own Shari'ah board.

Sheikh Yusuf DeLorenzo added his support to tawarruq for its necessity for Islamic finance to function while adding that it should not be used as a financing instrument on its own and rather should be "a means to an end".

Takaful providers could offer sukuk insurance, according to a Reuters article. However, this raises some questions about how much Islamic finance should replicate conventional finance because a takaful policy on sukuk would essentially replicate the credit default swaps (CDS) that led to some problems in the conventional market during the credit crisis. However, the products do provide investors with an assurance they will not lose their entire investment in a sukuk should the issuer default. It would likely be a requirement that the insurance is only available to holders of sukuk and not available as a speculative tool as it has become for some investors with CDS.

Jadwa Investment has a report on sukuk.

Other News

• The Star in Malaysia has an interview with central bank governor Dr. Zeti Akhtar Aziz.
  
• The Malaysian central bank believes it is a good time for the government to issue sukuk.
  
• HSBC says that Indonesia could tap up to $4.75 billion by issuing sukuk.
  
• Saudi Arabian firm Zain Saudi Arabia closed a $2.5 billion murabaha financing facility, in part being used to roll over existing murabaha.
  
• Yasaar Human Capital believes hiring in the Islamic finance industry will pick up after Ramadan.
  
• A lawyer experienced in Islamic finance has moved to a Polish law firm and hopes to use this experience in Poland. There has been little Islamic finance activity in Poland save for a deal by the Qatar Investment Authority to buy two shipyards.
  

Sukuk issuer quality, M&A, JAFZ downgraded

One of the areas of the Islamic finance industry that has been noticeable recently is the dearth of sukuk from non-high-quality issuers. This is particularly noteworthy in the GCC where a large supply of sovereign issues has not been followed by a comparable level of corporate issues. This trend was noted at a conference in Malaysia. The reasons commonly cited focus mostly on the pricing of sukuk and many even from sovereign issuers have priced considerably higher than they did prior to the financial crisis. With a pipeline of sukuk estimated to be $45 billion, a real recovery in the sukuk market should not be measured by the aggregate value of all sukuk, but by the ratio of sovereign versus corporate issuers.

Another area where the Islamic finance industry has yet to see much activity is in merger and acquisition activity between Islamic financial institutions. This is due to several factors, described well in the Yasaar Media Islamic Investment Banking 2009 report I summarized recently, but according to most industry participants there are simply too many Islamic banks and a majority of them are small. M&A activity could expand Islamic banks' balance sheets which would enable them to provide financing to more big projects as well as achieve greater diversification. in this light, it is noteworthy that Malaysian-based Bank Islam is reported to be 'actively seeking' a merger partner.

Jebel Ali Free Zone was downgraded by Moody's over concern about what support the Dubai government will provide to government-related entities. Jebel Ali Free Zone is a part of Dubai World. The downgrade puts a new light on the issue of valuation or illiquidity for the JAFZ Sukuk when looking at secondary market prices. Back in early February, I wrote a blog post on my blog at Zawya when the secondary market price was 66 . While the price has rebounded some to 77, that is still well below par and suggests that some price discovery may have been in fact occuring in sukuk secondary markets.

Other News

• Dow Jones Islamic Market Indexes named Tariq Al-Rifai, the founder of Failaka Advisors, to head its Islamic Index family following the departure of Rushdi Siddiqui last year to head Reuters' Islamic finance division.
  
• Gatehouse Bank combined two business units--its asset management and capital markets divisions--in the UK under new management to 'create an even stronger business' according to a company press release.
  
• Mayfair Wealth Management launched a Shari'ah-compliant UAE-focused distressed property fund and hope to raise $50 million.
  
• A UAE-based law firm Agha & Shamshi became likely the first Shari'ah-compliant law firm.
  
• South African fund manager has run into problems launching its planned Islamic equity funds, following the departure of its sole Islamic fund manager who remains as an external manager of their sole Islamic equity fund.
  

Islamic Investment Banking 2009 report

The Yasaar Media report, Islamic Investment Banking 2009 (available free from Yasaar Media as a PDF), provides a thorough review of the history and current state of Islamic investment banking. Below, I provide a basic summary of a few areas that I found the most interesting. It is not a comprehensive summary of the report and the areas that I highlight are very limited by what I took from them. I would strongly suggest a read through this interesting, detailed and timely report.

The premise from which the report begins is that although Islamic finance has experienced a rapid burst of growth during the past decade, not all areas of Islamic finance are experiencing the same pace of growth, particularly following the credit crisis which caused a global economic crisis. In the specific area covered by the Yasaar Media report—Islamic investment banking—there has been a significant reduction in the growth rate in 2008 and thus far into 2009. The areas in which this has been most pronounced is in private equity and sukuk issuance. One reason for this shrinkage is that on the whole, Islamic financial institutions, particularly investment banks, were too concentrated, both by industry (primarily real estate) and geographically (significant focus on the GCC region). The real estate sector in the GCC provided Islamic investment banks with a high rate of return relative to other areas and also provided an asset on which the financing could be based. This gravy train of high and stable returns ended when the global economic downturn led to the bursting of what had become a large bubble in parts of the GCC.

One of the first areas tackled by the report is the significant overlap between private equity and the Islamic concept of mudaraba. While this is familiar to one who thinks on the subject, the Yasaar Media report takes the comparison one step further in light of the financial situation of the day. In conventional private equity, there is significant reliance on high levels of debt that would not be possible in an Islamic private equity transaction. In the wake of the financial crisis, ‘deleveraging’ is the word of the day and therefore the more equity-based Islamic private equity transaction could be viewed by investors as well as the recipients of the investment as a preferable means of raising private capital.

The next area where the report focuses is probably one of the smallest parts of the Islamic financial industry—venture capital. Because the Islamic venture capital industry is not developed in any size, the report provides a broad focus on what it will take for an Islamic venture capital industry to emerge and highlights the role the Malaysian government is playing to develop the industry. In the course of describing the similarities between venture capital and Islamic principles that support profit-and-loss sharing, the Yasaar Media report raises the interesting dimension of how the profit-and-loss sharing ratio should be determined to remain Shari’ah-compliant. For a sector that has been largely overlooked, this leads one to recognize how even areas that seem quite natural for Islamic finance have more complex issues of Shari’ah-compliance that have yet to be resolved.

Mergers and acquisitions, another area covered, is on with particular relevance in the current financial environment where smaller institutions may be squeezed in ways that larger rivals are not. It has been the conventional wisdom that the UAE and other parts of the GCC are ‘over-banked’ for years. However, there are difficulties caused by several factors that may limit the actual merger and acquisition activity within the Islamic financial industry. As the report states, many of the M&A activity that is possible because of depressed valuations would be desirable from an industry-wide perspective may run into regulatory hurdles or simply the problem that the banks are not ‘for sale’.

Unlike many of the areas of Islamic investment banking that have been severely hit by the financial and economic crisis of the last year, Islamic syndicated lending has been one of the first to recover and although it is on pace to fall year-on-year, its supply has recovered quite a bit more substantially than, say, the sukuk market. As mentioned above, the counterpoint to the relatively quick recovery is the rethinking that has to occur about the desirability of using real estate as a large part of an investment bank’s investment portfolio.

The section on capital markets was one that provided thorough cover of the issues facing, in particular, sukuk following questions from Sheikh Taqi Usmani about the Shari’ah-compliance of the mudaraba and musharaka sukuk which was followed by a steep drop in issuance due to the credit crisis. These problems were complicated by the default or bankruptcies of several issuers which leaves the market for new sukuk somewhat in limbo. Although a reduction of the stress facing capital markets has led Indonesia and several GCC countries to resume sovereign issues, the supply of new corporate sukuk issues remains constricted by pricing and uncertainty about default resolution.

Following on a discussion of capital markets is a detailed overview of the situation Islamic banks face in terms of liquidity management as well as the avenues that are currently being used. More than most areas of Islamic finance, the types of liquidity management tools are incredibly varied. This reflects the rather underdeveloped state of this area of Islamic finance despite its premier importance to Islamic financial institutions. This will be a continued area of stress for Islamic bankers until there is something more uniform that is able to meet the demand in a way that is both comparable in ease to conventional inter-bank lending as well as broadly accepted as Shari’ah-compliant.

The report finishes with a summary of Islamic trade finance, a quietly important area of Islamic finance that, despite the lack of attention it receives compared to sukuk and liquidity management, provides significant value to the non-financial businesses that use it. It seems a relatively good area to conclude the report since it is the area that is most important for non-financial businesses and, unlike many areas of conventional finance, this is the ultimate raison d’etre of Islamic finance.

I have written a forthcoming report for Yasaar Media on Islamic finance in North America, which will also be available on the Yasaar Media website. To receive reports as they are released, you can email media@yasaar.org with the subject line ‘Please send me your research reports immediately on publication’.