Dubai, Gulf Finance House, criticism of media descriptions of Islamic finance

Dubai and GFH
The worries over Greece has spilled back into Dubai with the credit default swaps rising to their highest levels since the Thanksgiving crisis over the maturing Nakheel sukuk. The money provided by Abu Dhabi to redeem the Nakheel sukuk will finance payments due until the end of April while Dubai World negotiates a standstill agreements but rumors have been spreading about a request for a standstill on all of Dubai World's debt for six months reported (but not confirmed) in al-Ittihad article.

In the wake of rising CDS premiums and concerns over Dubai World, the price of the Dubai sukuk has fallen significantly raising yields above 10%. It remains unclear about whether the problems with Dubai World will spill over into the Dubai government (which does not explicitly back Dubai World's debt).

The Dubai situation is not the only hotspot in Islamic finance in the Gulf recently. Gulf Finance House rolled over 1/3 of its maturing debt while paying off the remainder, which has brought attention to the offshore banking business (particularly investment banks) in Bahrain. The article above (from Reuters) notes that "most investment houses in Bahrain relied on booking upfront fees on money raised from investors for real estate projects and private equity projects, a market which collapsed following the end to a regional property boom late in 2008."

The terms on which GFH was able to postpone repayment of its entire maturing debt are costly with reports that the $100 million will cost the bank LIBOR+500 basis points plus an extension fee of 100 basis points. An analysis of the market situation for GFH is outside of the scope of what this blog covers, but there are questions about the Shari'ah-compliance of such an agreement.

Little is mentioned about the deal except that the new facility is a murabaha (replacing the old murabaha) and therefore I would imagine Shari'ah scholars signed off on the deal. The transaction itself is relatively unproblematic (if expensive). GFH received a financing facility from a group of investors which happened to be its previous creditors on a murabaha basis with an expensive profit for those investors.

However, the substance of the murabaha may be relatively common as a financing mechanism, the rolling over of debt and inclusion of an 'extension fee' seem problematic in my (untrained) eyes. I don't have the expertise in Shari'ah nor have I seen the documents for the deal, but this deal looks like an increase in the debt load on the $100 million in exchange for additional time for repayment.

However the deal was structured, this particular aspect seems to contradict at least the way that Islamic finance is supposed to operate. As I understand it, the prohibition of interest was at least in part a reaction to the exploitation caused by creditors rolling over debts in exchange for an increase in the amount owed to the creditors. I would hope that someone would come out and publicly explain how the deal was structured to avoid breaching the restrictions imposed by the Shari'ah.

General Islamic finance

The National newspaper has an article on the growth of Islamic finance that has some interesting comments from Michael McMillen, a partner at the U.S. law firm Fulbright & Jaworski. Commenting on the defaults, and the ongoing bankruptcy case of East Cameron Partners, he said "In my view, the impact is likely to be net positive. Thus far, the responses of involved parties provide grounds for optimism."

I think his assessment is correct, except for the impact on the investors in the sukuk. The default resolution process is one of the areas that has been a continuing source of uncertainty. One concern I have with the way Islamic finance is described in the article (not by Mr. McMillen) is the assertion that "Islamic banking is based on five pillars: no interest, no uncertain speculation, no financing of companies involved with goods and services deemed haram, such as weapons, pork and gambling, the sharing of profit and loss and the understanding that all financial transactions must be backed by tangible assets."

There are two points made here that I think are somewhat misleading. Islamic finance does not always involve a sharing of profit and loss. There are several commonly used transactions like murabaha and ijara where profit and loss are not shared.

In a murabaha, the transaction is a sale with a markup. The risk is placed on the debtor who must repay the cost plus profit regardless and if they do not do so, they are generally in default. The way it operates is that the bank operates as a wholesaler and the price they charge includes a markup. The financing feature of the transaction is that the buyer is offered deferred repayments. There is not interest charged on the deferred payments and the buyer must make these payments to remain current on the financing, just as if they were purchasing a good from another wholesaler.

The other statement I think is misleading is that "all financial transactions must be backed by tangible assets". This is also incorrect and does not give a clear picture of how many transactions are structured. To use a generic example, look at an asset-based ijara sukuk. In the standard transaction, the issuer sells the beneficial interest in an asset to an SPV which raises money from investors through a sukuk. The issuer then leases back the asset with a pre-determined rent payment (often benchmarked to an interest rate like LIBOR). At maturity, the issuer repurchases the asset at the sale price to allow the SPV to redeem the sukuk at par.

The transaction involves the sale of the asset, but the transaction is not 'backed' by the asset. If the issuer defaults, the investors can exercise a purchase undertaking granted by the issuer that forces the issuer to repurchase the asset at the par value (often this is the only option provided to the investors). The investors then become unsecured creditors of the issuer on par with all other unsecured creditors of the issuer. There is no additional protection granted by virtue of the asset being involved in the transaction, nor do the investors have recourse to the asset used in the transaction.

The descriptions provided by The National about Islamic finance that I have clarified are not unique to this article. I think that The National provides generally very good coverage of the Islamic finance industry and their articles are mostly very informative. However, this article falls into the 'simple explanation' trap that has most of the coverage of Islamic finance has fallen into.

There are far worse examples of poor description of how Islamic finance works in other news articles, but it is high time that the industry find a different 'simple explanation' that incorporates the essential features of how Islamic finance actually works so that there is not surprise when a situation arises like the Nakheel sukuk where people realize that Islamic finance is not always 'backed' by an asset. In fact, the Nakheel sukuk was different from the traditional ijara structure because investors were provided with recourse against the assets through the granting of a fully perfected mortgage over the assets that the sukuk was based on.

Other News

• Westpac Banking Corp, an Australian bank, is planning to announce an interbank product, most likely based on commodity murabaha, according to the Trade Minister Simon Crean.
  
• Columbia University held a symposium on Islamic finance with Umar Moghul and Taha Abdul-Basser, an Islamic finance lawyer and Shari'ah scholar, respectively.
  
• A college in Canada became the first in the country to offer an online course in Islamic finance.
  
• There will be a workshop on Islamic finance held in Libya by the Union of Arab Banks.