Tuesday, December 08, 2009

Should Islamic finance move away from unsecured debt?

One of the areas that has preoccupied me when thinking about the Nakheel sukuk and the lessons it presents for the rest of the Islamic finance industry is whether the idea of an unsecured sukuk even makes sense. In many ways, it is an easy uncomplicated change to the typical ijara (for example) sukuk structure. An asset is sold to an SPV (essentially being securitized in the process) that has issued sukuk certificates to raise the purchase price. It is then leased to the issuer over the maturity of the sukuk. However, at maturity (or in a default), the issuer must repurchase the asset under a ‘purchase undertaking’.

This raises several questions for me, especially with respects to the Nakheel sukuk. However, first returning to sukuk in general, AAOIFI ruled in March 2008 that repurchase at par is not acceptable in mudaraba and musharaka where the issuer ‘buys out’ the investor from the partnership at a predetermined level equal to the redemption value of the certificates. However, they also upheld the use of repurchase agreements at the redemption value for ijara. The AAOIFI ruling (pdf)states that “It is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to undertake to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase”. However, “It is permissible for a lessee in a Sukuk al-Ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he [lessee] is not also a partner, Mudarib or investment agent.”

I do not claim to make an argument on this point based on what is and is not permissible or Shari’ah-compliant. I have no basis to argue that the structure used in an unsecured sukuk is or is not Shari’ah-compliant. The issue for me is that seems logical for the investors in a mudaraba sukuk or musharaka sukuk to be forced to share in a profit shortfall. However, it also seems that the same logic should apply to an ijara sukuk. If the value of the asset sold to the SPV declines significantly (like DWF South and Crescent Lands, the two properties backing the Nakheel sukuk), then the repurchase agreement should not be fixed at par if the company defaults on the sukuk.

Granted, if this were the case, there would be far fewer investors (particularly those looking for alternative investments that closely resemble bonds) interested in sukuk and the growth (or regrowth) in the sukuk market would be significantly stunted. However, it would provide at least a format for how a resolution of a default would occur. There would be some discount to the repurchase agreement (a haircut) reflecting the diminished market value of the asset backing the sukuk. This could be any number that is agreed upon in a default. In the event that there was no default and the asset remained at relatively the same valuation as it started, there would be little or no change to the price at which the asset were repurchased.

Returning to the case of a default, the SPV (on behalf of the investors in the sukuk) should have the right to take possession of the asset backing the sukuk and either hold onto it or liquidate it to recover some of the initial investment (it should be secured rather than unsecured). The expected recovery value from taking possession of the assets and selling them (likely into a distressed market environment or at a fire sale price) would provide a floor for the negotiation of the haircut that investors would take. It would also provide a way for the creditors to be secured against total loss (like what may happen to investors in the Saad Group’s Golden Belt 1 sukuk). It would also provide a way for a default to be resolved that does not place the entire liability upon the issuer if the assets turned out to be less than what they were initially worth.

In the case of the Nakheel sukuk, the asset was valued at $4.2 billion based on the development plan for the land that backed the sukuk and also on assumptions about the timeframe for that development (there was a discount rate used for future value to bring it back to a present value). The land itself was not worth $4.2 billion had there not been plans to develop it into the Dubai Waterfront. Perhaps in this case, the ijara structure may not have been appropriate because there was not a physical asset that was worth the price it was sold for at the issue of the sukuk.

It may have been more appropriately structured as a musharaka with contributions of cash from investors and contribution from the land by Nakheel. Then the profits that flowed to the investors could have been based upon the actual realization of profit. However, it would not have been that simple. The sukuk, if it were a musharaka sukuk, would probably have been structured so that the musharaka SPV (owned jointly by the investor SPV and Nakheel) would lease parcels of the contributed land to sub-developers who would then pay lease payments sufficient to make regular payments to the investors and then, upon completion, the developed properties would be sold by the musharaka SPV to redeem investors.

That is just one somewhat hastily constructed example of an alternate structure that could avoid the unsecured nature of the Nakheel sukuk and provide a different risk-return profile for investors who would be joint owners in the land. It would have done nothing to clear up the big problems facing investors, which is the enforceability of contracts and claims to the underlying land (through English and Dubai courts) in Dubai.

That caveat in mind, the lesson that I think should come out of the Nakheel sukuk in particular but unsecured sukuk in general, is that the use of an asset to structure a sukuk with a purchase undertaking to make it into an unsecured obligation of the issuer contains an element of cognitive dissonance . What is the point in using an asset in a structure if it does not actually come into play if events don’t happen as intended.

This question raises more intriguing questions about other more common Islamic finance products that have attracted criticisms of their own , specifically commodity murabaha and tawarruq. These have come under fire from some scholars and critics within the industry because the use of an underlying asset never enters into any real economic activity. One does not enter into a commodity murabaha with platinum with the intention of taking physical possession of the platinum. It is used as a non-currency commodity to structure what amounts to an unsecured loan.

I don’t have an answer; both commodity murabaha and unsecured sukuk are a significant part of the Islamic financial industry and will probably continue to be significant. However, as the industry takes the lessons from the recent defaults, this would be one area where there should be a significant amount of consideration in whether the Islamic finance industry continues its current trajectory or shifts towards a combination of secured debt and quasi-equity products that would match the rhetoric used by the industry better than the current slate of products that relies heavily on structuring unsecured debts.


Anonymous said...

Thanks for the post, very useful.

A am not familiar with Islamic finance, but I have read that Ijara Sukuk should be based on the lease of real assets. In the case of the Nakheel Sukuk Dec-09 the Crescent Lands did not actually exist at the time of issuance, these where lands that were to be reclaimed from the sea in the future. I understand that only partial works have been undertaken on the Crescent Lands, so there really is no "asset" for the Sukuk holders to claim (they can claim DWF South, but that is only part of the security they were promised).

How did the Sharia board get comfortable with the above at the time of issuance?

Blake Goud said...

I don't think you are correct in your assessment of the lands on which it was built. From what I can tell, the land was waterfront property at the Jebel Ali Palm, as well as some land nearby on the south side of Sheikh Zayed Road.

I went and looked up the area on Google Maps and it is indeed pretty vacant desert: Map of Jebel Ali Palm and Waterfront area

Anonymous said...

Thanks Blake.

I keep my position on the Crescent Lands. I have had a look at the OC and the Jones Lang Lasalle valuation at the end states:

"The subject property includes Dubai Waterfront Islands and Dubai Waterfront South, comprising a total area of 6,296 hectares"

"The proposed Dubai Waterfront Islands is a series of manmade islands designed to reflect the shape of Palm Jebel Ali's crescent, and located along the maritime border with Abu Dhabi. These islands are planned to accomodate low density developments and are connected to the mainland by a series of bridges".

This link is to the Waterfront masterplan, you can see the "crescent" that was planned:


Again, this is a Sukuk backed in part by "manmade" islands that did not exist at the time of Sukuk issuance, nor do they exist now. A puzzle for me, either under conventional finance securitisation or Islamic finance.