Thursday, June 03, 2010

Sun Finance sukuk and Islamic securitizations

I took a good look at the Sun Finance (Sorouh) sukuk documents which were issued at the beginning of the intensification of the financial crisis (late 2008). The sukkuk was a sukuk-al-mudaraba and was issued after the AAOIFI guidance on sukuk, meaning it could not stipulate repurchase at par, which was included through the purchase undertaking not specifically referencing the repurchase price for the portion of sukuk repurchased under the amortization schedule. The sukuk, despite the challenging environment for the global economy and the securitization market, has been successful so far and none of the three rated tranches have been downgraded despite a collapse in the securitization markets.

In the transaction, Sorouh Real Estate ('Sorouh') was seeking to securitize receivables from plot sales to sub-developers in two of its developments, Shams-Reem Island and Saraya. The proceeds of the sukuk were used to fund the mudaraba and those were used by the mudarib, Sorough Abu Dhabi Real Estate LLC ('SPV'), an SPV set up as a distinct entity from Sorouh, to purchase the full title to the underlying plots from Sorouh. The SPV provides the sukuk certificate holders with a beneficial ownership of the plots, while the SPV executed a 'true sale' of the assets from Sorouh. A portion of the sukuk proceeds were placed in various reserve accounts to make up any shortfall in profit payments (Liquidity Reserve), to fund expenses of the SPV (Senior Expense Fund) and to finance the construction of infrastructure on the plots (Infrastructure Fund). The profit sharing ratio between the mudarib (SPV) and rabb ul-mal (sukuk certificateholders) was 1% and 99%, respectively.

The receivables from the sub-developers (all 109 plots were sold by Sorouh to sub-developers before the sukuk was issued) will be paid to the SPV and used make periodic payments on the sukuk. The remainder will be paid to the mudarib (the SPV) as an incentive payment. This amount will then be used to repurchase a portion of the beneficial interest held by the sukuk holders (described in the offering documents as a 'constructive dissolution'). This leads to payment of both the profit on the sukuk assets as well as a principal redemption. The interest rate risk (the payments to sukuk holders of all tranches is based on EIBOR plus a spread) from changes in the benchmark is hedged by the SPV in a separate transaction where it acts in its own capacity and not as the mudarib. At some point, if the sub-developers continue to make payments or the plots are resold in case of sub-developer bankruptcy, the entire beneficial interest held by the sukuk holders will have been extinguished and the SPV will retain the right to the remaining payments.

The unique feature of this sukuk is that it offered three different rated tranches, each with different priority rights and coupon amounts. The three tranches (A, B and C) had successively higher return (spread over 1 month EIBOR) of 200, 250 and 350 basis points, respectively. The three tranches were also accorded different priority for periodic payments with the A tranche senior to the B tranche which was senior to the C tranche. The way the seniority over periodic and principal payments was structured was using a musawama (cost-plus sale where only the final amount is agreed between the parties). At each periodic payment date, each class is paid 2.5 percent of the rabb ul-mal's profit allocaiton and the remainder of both profit and amortization payments are made according to seniority with a musawama between the tranches used to create a non-pari passu payment outcome.

The sukuk has performed well with payments passed on from sub-developers to the SPV and used to redeem the sukuk (see table below which reflects the amounts included on Sorouh's balance sheet, which does not break down the results for each tranche of the sukuk, nor does it provide a way to measure the performance of the sukuk as a whole). However, it does show that the carrying value of the debt on Sorouh's balance sheet has declined throughout the life so far of the sukuk as the cumulative payments made rises.

When the sukuk is viewed in more detail, the structure was clearly made to mirror a multi-tranche securitization deal and the fact that it is Shari'ah-compliant had limited impact on its performance. The use of a non-recourse securitization removes the issuer's financial strength from the picture so long as it is able to continue servicing the receivables (there was a back up servicer specified in the offering documents). The performance of the sukuk reflects the ability of the underlying plot sub-developers to continue paying installment payments on the plots (where the total value of the securitized assets provided overcollateralization for sukuk investors).

This type of sukuk, while in limited use so far, does not provide any additional security compared to a conventional securitization. The quality of the assets used in creating the securitization will ultimately determine its success or failure. However, the general conservative nature of (most) Islamic financial institutions' lending will make it less likely that future securitizations using this model would include questionable assets. Despite this caveat, securitizations could present an opportunity to create debt instruments for investors while also providing Islamic financial institutions with additional capital to expand their lending. Of course, as the subprime meltdown reiterated, if the quality of the securitized assets is poor, then the performance of the securitization is also likely to be poor. There is always the possibility for a securitization crash in Islamic finance if the standards used to evaluate recipients of future financing that is then securitized.

In a rapidly growing industry like Islamic finance, the ability to free up capital on bank balance sheets through securitization could provide a way for additional capital to be lent out while also broadening the number of sukuk for investors looking to Islamic finance. There is an additional potential: conventional investors looking for private-label securitizations will be hard pressed to find conventionally securitized mortgage-backed securities and they could provide additional capitla for Islamic mortgage companies that can demonstrate high lending standards. That would benefit those investors as well as the Islamic finance industry that, for example in the US has relied upon conventional securitization through Freddie Mac and Fannie Mae. Creating an Islamic securitization market for home finance could further expand Islamic finance in Western countries where it is currently limited.

The potential for Islamic securitization is nothing new. Back in 2007, Standard & Poor's released its approach to rating sukuk [1] and stated that:
"We expect that this type of sukuk [sukuk with no credit enhancement from the issuer] will become more popular in the foreseeable future in response to the huge number of projects in the planning stage, particularly in Gulf countries. Changes to regulation in the Gulf could give a boost to this type of sukuk. Banks and regulators in the Gulf are currently considering enhancing the legal framework surrounding mortgage financing for both commercial and residential properties. In the longer run, once sufficient mortgage loan volumes are booked on banks' balance sheets, Islamic securitization will become more attractive."
. The topic of Islamic securitizations was also raised by Andreas Jobst of the International Monetary Fund [2]. He wrote that:
"Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. [...] Islamic securitization transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. In its basic concept, originators would sell existing or future revenues from lease receivables (asset-based), 'sale-back profit' (debt-based) or private equity from a portfolio of Islamically acceptable assets to a special purpose vehicle (SPV),31 which refinances itself by issuing unsecured securities to market investors, who are the 'capital market corollary' to a singular lender in Islamic finance."
However, those articles were written before the onset of the financial crisis that saw conventional markets for securitization nearly completely shut down. Investors may be more wary of securitizations than they were when interest rates were low and economies strong and anything providing higher yields was sought after. However, the Islamic finance industry may provide an opportunity for securitization to re-emerge with more secure backing and without the additional re-securitizations that were the main impetus for the collapse in the securitization markets. There still remain several obstacles to Islamic securitizations although the relatively successful outcome of sukuk like the Sun Finance (Sorouh) sukuk can provide an example for future securitizations that comply with the new AAOIFI rules on mudaraba sukuk.

[1] Standard & Poor's. 2007. "Standard & Poor's Approach To Rating Sukuk," September 17, 2007.
[2] Jobst, Andreas A. 2007. "The Economics of Islamic Finance and Securitization," Journal of Structured Finance, Volume 13, Number 1. (Working paper)

Sun Finance Sukuk Payments & Remaining Balance, 2008Q4 - 2010Q1
Cumulative Payments
Accrued Profit
AED 2,494,500
At Issue


All figures in AED '000.
Source: Company financial statements.

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