Sukuk ALIM - RAM Ratings report

RAM Ratings in Malaysia has a fantastic overview (registration required) of the Sukuk al-Amanah Li al-Istithmar (ALIM) that was issued recently by Cagamas (the national mortgage corporation) working with Al Rajhi Bank. The sukuk structure is unique in Malaysia in that it was specifically created to be acceptable under Shari'ah standards in both Malaysia and the GCC. It is also the first I have seen that uses an auction to redeem the sukuk certificates rather than a wa'ad (purchase undertaking), which is used in most other cases. The AAOIFI rules that prohibited purchase undertakings at par for mudaraba and musharaka sukuk limited the issuance of those types of sukuk in the intervening two years.

The Sukuk ALIM structure is very similar to the sukuk al-istithmar structure used by the Islamic Development Bank. The sukuk certificates are issued and are used to purchase a basket of contracts. In the case of the sukuk ALIM, the SPV purchases home finance contracts (ijara and 'debt-based' like murabaha). The portfolio of contracts are set up so that there are more than 50% in the ijara contracts where ownership of the underlying asset is transferred to sukuk investors. AAOIFI rules require that at least 33% of contracts transfer real ownership of an asset (rather than just ownership of a receivable) in order for the contracts to be tradable. The Islamic Development Bank's first istithmar sukuk used this threshold, but subsequent sukuk raised the level to 50%.

Any cash remaining that is not used to purchase assets (either ijara or debt-based) is invested in commodity murabaha transactions with Cagamas through the Bursa Suq al-Sila' platform (with Al Rajhi as the commodity agent). This essentially provides income on surplus cash for the sukuk investors.

The redemption of the sukuk is also unique. Instead of a wa'ad (purchase undertaking), the assets held by investors are auctioned to third parties or Cagamas with a minimum acceptable bid of the principal and final profit payment. This has the benefit for investors that if the auction is conducted at a time when the assets value is higher than par, the investors could receive a higher redemption value than if it were a bond. They are not likely to face a loss. If there are no outside bids for the assets, Cagamas can also bid on the assets and would likely make a bid of at least the minimum amount (Cagamas' largest shareholder, with 20%, is the Malaysian Central Bank, Bank Negara). This is reflected in the credit rating on the sukuk, which is the same as Cagamas' other unsecured debt.

The auction method is interesting because it provides a way to make the final redemption price based on the market value of the assets at maturity. However, it is not really a risk-sharing arrangement because there is limited potential for loss if the asset value falls because Cagamas will be unlikely (at least as unlikely as for the sovereign) to withhold a minimum offer on the assets at maturity. However, that is generally the current state of sukuk; they will incorporate limited profit-sharing, but not to the point at which the sukuk has risks that differ from an unsecured bond.

The sukuk ALIM does add a new dimension into the sukuk market because of the incorporation of an auction and there may be additional potential for this to become more widely used--particularly in securitizations. However, it is unlikely to become universally used because many sukuk are issued using an asset that the issuer would not want to part with if its value rose during the term of the sukuk issued. A business that used its headquarter building is unlikely to want to risk having to pay more than the face value of the sukuk in order to maintain owenership of its headquarters. In those cases it is likely that the purchase undertaking (which is permitted in an ijara sukuk) is likely to remain common in many situations. However, it will be interesting to see how the sukuk ALIM is received in the market and how it performs when the first redemption occurs.

Indonesia sukuk, rules on forward currency transactions, ISRA to set up Shari'ah scholar org

Indonesia sold sukuk through a private placement for 336 billion rupiah ($37.45 million). There was an indication that the government would move away from the auction method towards private placements after several auctions where the yields demanded by investors were higher than the Ministry of Finance was willing to expect. The higher yields versus conventional bonds were attributed to lower liquidity in secondary markets for sukuk compared to conventional bonds in Indonesia, something that is common in other countries as well. The current issue is non-tradable sukuk with a yield of 7.3% maturing in 2014.

The Shari'ah Advisory Council of Bank Negara Malaysia, the country's central bank, ruled that no payment can be made in exchange for a forward currency transaction used for hedging (based on a binding promise, wa'ad). The basis for the ruling was that the upfront fee would turn the transaction into a bilateral wa'ad, which is viewed as a contract, which is not permissible. The unilateral (binding) promise is viewed as acceptable because it is a promise made without compensation. The issue of bilateral wa'ad also emerged as a stumbling block in the IIFM report on sukuk repo transactions.

The International Shari'ah Research Academy for Islamic Finance (ISRA) may set up an international body for Shari'ah scholars with the hope of creating a (self-)regulatory organization for Shari'ah scholars. Currently, there is no international body that regulates Shari'ah scholars, although the procedures for Shari'ah-compliance are standardized through AAOIFI and the IFSB. I think it is a good effort, but I agree with Muneer Khan, head of Islamic finance at the law firm Simmons & Simmons, who is quoted saying that "It's very difficult to set up an international body which actually has the power to effect these changes [...] It all depends on voluntary cooperation. A lot of work would have to take place behind the scenes to get regulators to sign up".

The editor of Arabian Business, Damian Reilly, wrote an opinion piece in the paper about Moody's recent downgrading of Bahrain's rating from A2 to A3. He says that, despite Moody's claim that the ratings downgrade was based on its budget deficits and dependence on higher oil prices of $80 to balance its budget, it was based on Moody's view that the outlook for Islamic banking in 2011 was diminished. The Moody's analysis also cited the size of Bahrain's banking sector--much of which is Islamic banks--that has assets of three times the country's GDP. Mr. Reilly counters that the large size of Islamic banking as a share of the country's banking sector--and that industry's better performance in the financial crisis--suggests that Moody's is becoming more cautious on Islamic banking. In my opinion, his point avoids the real detriment that a global recession can have on an Islamic banking system. Even if the Islamic banking system performs better than conventional banks, the government would find it hard to support the banking industry if things became worse. The budget deficit is currently 7.3% of GDP (expressed another way, 2.4% of total banking assets) and even a small requirement for cash from the government by the banking industry would have a disproportionally large share of the country's GDP and also a large increase in the budget deficit, which could make the country's creditors uneasy.

JP Morgan estimates that the tradable sukuk paid to Nakheel's creditors for 60 percent of what they were owed (with the remaining 40 percent paid in cash) are worth about 60% of their value if they made all principal and periodic payments. The estimates of their fair value is based on Nakheel being able to pay "almost all" coupon payments but JP Morgan doubts Nakheel's ability to repay the principal in 2015. The five-year sukuk have a coupon of 10% per year. The terms of Nakheel's payment to trade creditors was higher than their offer to debt holders of Dubai World, who extended maturities of debt with a 1% yield. The holders of Nakheel's 2009 and 2010 sukuk received redemption in full with funds from the Dubai Financial Stability Fund and the 2011 sukuk are expected to be repaid in full from the same source.

Other News

• The Islamic Development Bank's $3.5 billion sukuk program securities will be listed in Kuala Lumpur and London. So far $1.1 billion has been issued and another $1 billion will be issued by year end in 5-, 7-, and 10-year sukuk. This is separate from the RM1 billion sukuk that was listed on Bursa Malaysia yesterday.
  
• The bill to put sukuk on equal footing with conventional bonds in the tax code in South Korea has been held up by the (unfounded) concern that it could lead to money laundering and financing of terrorist groups. This is unfortunately not an isolated case where unfounded fears hamper the growth of Islamic finance.
  
• The East Asian region lead the Dow Jones Islamic Indices in August according to a report from Dow Jones.
  
• Affin Bank has applied for the first Islamic bank license in China, according to an article in Business Times. The Ningxia Hui Autonomous Region was working in 2009 to develop a pilot Islamic financial services institution in northwest China.
  
• Indonesian bank BNI Syariah wants to partner with foreign investors to expand its Islamic banking business.
  
• Another article discusses the dichotomy between the GCC and Malaysia in the state of their Islamic finance sectors, primarily new sukuk issuance.
  
• The CEO of the Qatar Exchange, Andre Went, says it is drafting new rules to cover trading in bonds and sukuk. Trading was expected to begin in September, but Mr. Went did not say when trading would begin.
  

Wednesday bullets

• The Islamic Development Bank plans to sell $1 billion in sukuk to fund development projects. It also listed its RM1 billion sukuk medium-term note program on Bursa Malaysia under the exempt regime, which means it will not trade or be quoted on the exchange.
  
• Returns on sovereign sukuk are beating returns on corporate sukuk for the first time since May.
  
• CIMB Islamic expects $25 billion in sukuk issuance in 2010 compared with $20 billion in 2009. Bloomberg updated its list of sukuk sales.
  
• Abu Dhabi Islamic Bank signed a $300 million loan facility with Al-Jaber Energy Services.
  
• Dubai says it has no plans to request a rating from a rating agency or issue bonds. It currently has open a $2.5 billion Islamic medium-term note program and a $4 billion plan for conventional bonds.
  

Islamic finance lagging in private equity; sukuk for the Saudi mortgage market

An article cites Hussein Hassan, the head of Middle east structuring at Deutsche Bank pointing out that Islamic banks avoid private equity despite its similarity with the partnership approach in Islamic finance contracts like mudaraba. This is attributed to the use of high levels of debt in private equity, the financing of haram industries and the asset-liability mismatch in Islamic banks which limits their ability to invest in longer-term projects. Lahem Al-Nasser covers a similar topic when he chides Islamic banks for financing more "traditional" projects over projects which are new and untested. He says this bias is based on the management having experience in conventional banking who believe that "Islamic banking is nothing more than a marketing instrument to make profit" and they "lack the incentive to push for creativity and innovation".

The VP and MENA business manager for corporate trust at BNY Mellon Corporate Trust in Dubai suggests that "sukuk would be the best way to mortgage homes in a Shari'ah-compliant fashion" using an asset-backed structure. I would tend to agree because so long as most of the mortgages are tradable (i.e. not based on murabaha), they could be securitized in a way similar to the Islamic Development Bank's sukuk al-istithmar. In the istithmar sukuk, the underlying assets are other financing contracts (in the case of the IDB sukuk, they are murabaha, istisna'a and ijara). The sukuk is tradable so long as the proportion of ijara contracts (by value) is more than one-half of the total assets. The reason for this is that murabaha and istisna'a contracts create a debt obligation (the financier holds a receivable for future payment), whereas an ijara contract provides the financier with ownership of an asset.

Kazakhstan is planning to issue $500 million in sovereign sukuk, in part to try and make the country the "Islamic finance hub" for the former Soviet Union. The government of Abu Dhabi-owned Al Hilal Bank opened the first Islamic bank in the country earlier this year. The CEO of the Kazakhstan branch of Al Hilal Bank, Prasad Abraham, tempers the expectation saying that issuance could start at just $200 million this year but rising to as much as $3 billion per year by 2015. The sukuk is replacing a cancelled $750 million Eurobond, which Bruce Gaston, the CEO of Skybridge Finance, says will cost the government up to 150 basis points m more compared to the Eurobond.

Other News

• Kuwait Finance House Research estimates that global sukuk issuance in 2010 will reach $30 billion. The first half issuance was $16.5 billion.
  
• Al Baraka Banking Group plans to raise $200 million through its first sukuk issuance by the end of 2010. Al Baraka also signed a non-exclusive memorandum of understanding with the Islamic Corporation for the Development of the Private Sector (ICD). ICD is part of the Islamic Development Bank group.
  
• Gulf Finance House is planning to increase its capital by $300 million but did not specify how it plans to raise that capital.
  
• Dubai may issue debt in 2010, but it is "not under pressure to do anything".
  
• Bahrain Financial Harbour raised $240 million through a 7-year ijara facility to repay debt.
  
• The Al Rajhi Bank-Cagamas cooperation may only be the first effort to bridge the divide--particularly in Shari'ah standards--between the GCC and Malaysia. While much of the news concerns the Shari'ah standards, there are other areas where harmonization of standards becomes difficult. Megat Hizaini Hassan, the head of Islamic banking & finance at Zaid Ibrahim, is quoted saying: "In the Middle East, in certain jurisdictions [Islamic finance] is not even regulated so how can you harmonise?".
  

Thursday bullets

• The first Sukuk ALim was issued by Cagamas for RM1 billion ($317 million) with a yield of 3.48% and a three-year tenor. 43% of the issuance was subscribed by overseas investors including one-third from the Gulf. The structure was jointly created with the Malaysian unit of Al Rajhi Bank to conform to both Malaysian and GCC Shari'ah-compliance standards. It was 2.7 times oversubscribed.
  
• An article in Reuters discusses the push to close the gap between Malaysia and the GCC in Islamic finance.
  
• Sukuk yields have continued to fall in the face of uncertainty about the global economy, with yields falling to lower levels in Malaysia versus the GCC.
  
• Afghanistan is planning to issue Islamic banking licenses for three Islamic banks, the first in the country.
  
• Gulf Finance House said it had recorded a net loss in the first half of 2010 of $47.7 million compared to $92.1 million in the same period during 2009. Reuters calculated that the second quarter net loss was $39.9 million compared with a loss of $54.4 million in the second quarter of 2009. As part of its restructuring plan it reduced its assets from $2.7 billion at the end of 2009Q2 to $1.4 billion at the end of 2010Q2.
  
• Barclays Capital began offering Islamic repos during the past couple weeks. The structure was not discussed in the Bloomberg article.
  
• The Islamic Bank of Britain's shareholders approved the capital injection from Qatar International Islamic Bank of GBP20 million ($31 million).
  
• Kuveyt Turk issued a $100 million, 3-year sukuk, the first in the country. The government issued "revenue-indexed bonds" that are similar to sukuk in early 2009.
  
• A fund manager in Guernsey, Argyll Investment Services, launched its World Shariah Funds PCC Ltd.
  
• Indonesia delayed its sovereign sukuk for up to $650 million until 2011 because of lower budget deficits. The country's central bank is reviewing whether to approve changes to rules that would allow Islamic banks to restructure loans that are current. Current rules restrict restructuring to loans that are non-performing.
  
• The chairman of the World Islamic Economic Forum Foundation, Musa Hitam, was on a global version of CNBC (video) talking about where Islamic finance stands today.
  
• A conference on Islamic finance in Jeddah will suggest that there be a database of "permanent fatwas". Presumably, this would include fatawa on the most common Islamic finance structures.
  

Islamic foreign exchange forward contracts; halal participation banking?

Malaysian scholar Shamsiah Mohamad, who is a member of the Securities Commission Shariah Advisory Council, said that muwa'adah is a valid contract for foreign exchange contracts. Muwa'adah is a mutual promise in forward foreign exchange contracts and has been ruled impremissible by AAOIFI. The trading of currencies in forward markets is viewed as prohibited because currencies (taking the analogy from trading of gold and silver, which were used as dinar and dirham coins) must be traded only in the spot market. The distinction made with muwa'adah by the scholar is that the forward trade is a promise, not a contract because "it is not a sale and purchase contract because specific words must be used to enter into a contract in Islam". The controversy emerges because AAOIFI has ruled that the transaction (the binding mutual promises) does represent a contract and therefore cannot be used for foreign exchange futures contracts. It is one more example that the fiqh surrounding financial matters is still evolving in many areas and--whether it leads to positive or negative outcomes for the industry--it does represent an area of uncertainty in Islamic finance.

Rushdi Siddiqui's latest article in Gulf News deals with whether Islamic banking needs a rebranding. I have heard him speak a number of times and he has articulated the need to move beyond the 'Islamic' brand and the use of Arabic names for contracts to become more 'familiar' or 'accessible'. In his article, he ends with a combination of two ideas for Islamic banking: 'Halal Participation Banking', which combines the idea of that which is halal (which has been successful in the food industry) with participation banking, the name for Islamic banking in Turkey. I think it will be difficult to change the description of Islamic banking as 'Islamic', but that should not deter anyone from trying. In particular, the use of "participation" as a descriptor of the Islamic banking system is a good one in my opinion because it represents a reminder that Islamic banking differentiates itself as one where 'risk sharing' is an important idea. It may be used in practice less often as many Islamic financial products have replicated conventional financial products, but it provides a more clear explanation of how Islamic finance is designed to differ from conventional finance. It is also a phrase which can more easily convey the difference (in theory) with conventional finance and can be more easily be grasped by non-Muslims who may agree with the ideas of Islamic finance without even realizing it because of the use of Arabic terms and the 'Islamic' or 'Shari'ah-compliant' label.

Other News

• South Africa has a proposal to modify its tax laws to place Islamic finance on equal footing with conventional footing by treating the profits in Islamic finance in a way equivalent with its treatment of interest in conventional transactions.
  
• The latest Central Bank of Bahrain Sukuk al-Ijara was oversubscribed 630% with BD63 million in subscriptions received for the BD10 million ($26.5 million) issue.
  
• Abu Dhabi Commercial Bank issued the first sukuk in its RM3.5 billion ($1.1 billion) sukuk program for RM500 million at 4.75%.
  
• Bloomberg has an article about the IIFM report on Islamic repos, which I discussed after it was released.
  
• An article describes the potential of Islamic finance in Russia and adds that state-controlled VTB Bank, which has had a sukuk in the pipeline for several years, will issue its sukuk for $200 million in the second half of the year, citing a Reuters report from April.
  
• Dubai's oldest Islamic bank, Dubai Islamic Bank, reported lower income in its second quarter financial report. It did not reveal its exposure to Dubai World. DIB owns 20% of Tamweel, the troubled Islamic mortgage company, and Deyaar, a Dubai-based property developer. Tamweel, which is in merger talks with Amlak Finance, another Islamic mortgage company in Dubai, reported positive income for the most recent quarter.
  
• A takaful provider, Dar Altakaful, launched a takaful policy for horse owners if their animal dies or becomes injured.
  
• An article in Bloomberg discusses the growth of Islamic investing in Malaysia with the entrant recently of international companies like Saturna Capital, the parent company of the Amana Funds in the U.S.
  
• Gulf Finance House is planning to raise additional capital--the second time in less than a year--and has delayed reporting its results.
  
• Ithmaar Bank reported its first results as an Islamic retail bank since its reorganization with its former subsidiary Shamil Bank.
  
• Bahrain Financial Harbour Holding Company repaid a $134 million sukuk.
  

DIFC Investments, Other News

JP Morgan said the government of Dubai may have to convert its $1 billion loan to DIFC Investments into equity, as well as make an equity investment in the company. The report also upgraded DIFC Investments' $1.2 billion mudaraba sukuk maturing in 2012 from "underweight" to "neutral" based on "improved asset coverage". Other analysts believe the rally--the sukuk rose in price to 79.15 (yielding more than 13%) --has gone to far in DIFC sukuk, as well as other Dubai-related sukuk.

Other News

• Gulf Finance House was able to roll over $100 million in debts for two years, with an option to extend it by another year.
  
• Standard Chartered is expanding its Islamic finance business. The bank recently launched a product that will allow for hedging against fluctuations in commodity prices.
  
• Bloomberg has a list of upcoming sukuk. Many new sukuk are coming from Asia including Hong Kong and Singapore, although regulatory challenges remain.
  
• The Houston Chronicle interviews Monem Salam on the Amana Funds.
  
• Moody's placed Dar Al-Arkan's credit rating (and the rating on its sukuk) on review for possible downgrade.
  
• Islamic finance has become as closely watched as celebrities, according to Lahem Al-Nasser.
  

GCC sukuk markets slow to recover, new AAOIFI rules on Shari'ah scholars may be coming

The headline is promising: "GCC bond and sukuk market bounce-back in Q2". The article--which reflects data from National Commercial Bank in Saudi Arabia--continues to show data that supports continued weakness in sukuk markets in the GCC (particularly compared to Asia). After a rosy headline of a bounce-back, the press release describes that "the primary sukuk market also picked up, lead by sovereign issuances, and reached a total value of $3.4bn, a significant rise over the same period last year." (emphasis added) This type of comparison--regardless of the data being reported--is relatively easy to make at the current time because one year ago, the global economy was just exiting a severe financial crisis. Reading further, "Sovereign sukuk issuance totaled $1.5bn during the quarter, whereas activity proved much more lackluster in the corporate sukuk space with the notable exception of a landmark issue by Saudi Electric Company". (emphasis added). The press release quantifies this weakness. There were eight sukuk issues from the GCC region in the second quarter of 2010, seven of which ($1.5 billion worth) were issued by sovereigns (Qatar and Bahrain), which leaves only the Saudi Electric Company sukuk from the corporate space (making up the $1.9 billion remainder). The details of the press release confirm that the market for sukuk--at least in the GCC--is still open primarily to governments. The corporate sector has not returned in the wake of the credit crisis, which saw defaults by Saad and Algosaibi, The Investment Dar, International Investment Group and the near-default of Nakheel increase uncertainty about sukuk. I would expect the third quarter sukuk issuance to be similarly slim, but it will be interesting to see what deals currently in the pipeline are brought to market after Ramadan.

Bloomberg is reporting that the Secretary General of AAOIFI, Mohamad Nedal Alchaar, said that the body is considering placing rules on Shari'ah scholars to minimize potential conflicts of interest. The rules may limit the number of boards on which a scholar may sit and may also limit the scholar's ability to have investments in those institutions as well. It will be interesting to see whether there is push back, both from scholars, but especially from Islamic financial institutions. My expectation is that the financial institutions--particularly the mid-size ones--will complain (in some cases validly) that the limitation on Shari'ah scholar's participation on multiple boards will harm them because there is a shortage of well known scholars and the multi-national financial institutions will be able to draw the most recognizable scholars. This is probably a valid concern (depending on how low the bar is set as far as the maximum number of boards each scholar can sit on). In the longer-term, it will be beneficial by helping younger scholars become more well recognized, but there will be a cost in the interim where the mid-sized institutions that have thus far been able to have well regarded Shari'ah boards may get priced out of their services by multinational banks. But until there is a firm proposal on the table from AAOIFI, this is just speculation.

Other News

• Falling yields on sukuk issued by Malaysia and Indonesia may be the result of their rising currencies against the US dollar which has attracted foreign investors, reports Bloomberg.
  
• Cagamas issued RM230 million ($72.8 million) in three-year, variable rate commodity murabaha sukuk.
  
• There is a good article in Arab News about a conference held at the George Washington Law School. The conference featured Frank Vogel, Yusuf DeLorenzo, Umar Moghul, Aamir Rehman and Ibrahim Warde.
  
• Deutsche Bank's Saudi-joint-venture Deutsche Gulf Finance launched its Islamic mortgage product that offers home financing for up to 30 years, according to a press release.
  
• A Malaysian expressway company is planning to issue new sukuk to redeem their outstanding sukuk because the tolls will be insufficient to cover the first repayments later this year.
  
• Indonesia sold 2.855 trillion rupiah($319 million) in 4-year sukuk to the government's Islamic Haj Fund. The planned global sukuk sale was cancelled because the deficit is smaller than expected and the government had trouble attracting investors at yields it would accept. The illiquidity of the sukuk were cited as the reason for higher yields.
  
• Qatar Islamic Bank (which owns Asian Finance Bank in Malaysia) is reportedly searching for a partner to expand into Indonesia. There have been quite a few Malaysian Islamic banks that recently announced interest in or completed acquisitions to enter the Indonesian market.
  

Thursday bullets

• The head of Shari'ah and CEO of IIMF believe that greater transaction document standardization, like the Master Agreement on Treasury Placement released by IIFM, will benefit the industry.
  
• There are a number of articles on Khazanah's S$1.5 billion ($1.1 billion) sukuk, including from Bloomberg, AsiaOne News and and Reuters.
  
• The Deputy Governor of the Central Bank of Malaysia gave a speech at the 21st Conference of Presidents of Law Associations of Asia on Islamic finance. The full text is available as a pdf.
  
• Al Rajhi Investment and Banking Corporation Malaysia Bhd, a subsidiary of the Saudi Islamic bank Al Rajhi Bank joined the Bursa Suq Al-Sila', the commodity murabaha/tawarruq platform in Malaysia.
  
• An article offers a few details about the Family Bank Bahrain, an Islamic microfinance institution that is working with the Grameen Trust.
  
• An article published by Zawya, written by three lawyers at King & Spalding, covers the different trends in how Islamic financial products are taxed.
  
• BMB Islamic released its Global Islamic Finance Report 2010, which in addition to describing the industry's growth also acknowledges that there is a shortage of authentic data on the size, growth and performance of the institutions making up the industry.
  
• The Maldive's Monetary Authority issued the first Islamic banking license to Maldives Islamic Bank Pvt. Ltd.
  
• Bloomberg has another article about the potential for growth in sukuk issuance from Asia while the GCC primary markets are at their slowest pace since 2005.
  
• A commenter for the Guardian Michael Tomasky takes a look at Islamic finance and realizes that the hyperbolic charges leveled against it are ridiculous on further examination.
  
• An Islamic brokerage, Makaseb Islamic Financial Services, in Abu Dhabi is closing.
  
• Malaysian companies Axiata Group Bhd and Malaysia Airports Holding Bhd are planning RM4.2 billion ($1.3 billion) in 7-10 year sukuk and RM3.1 billion ($981 million) in sukuk of unspecified tenor, respectively. The bulk of the Axiata sukuk will be sold to the Employees Provident Fund.
  

IIFM Repo Report

In my weekly newsletter (subscription form on the left side of the screen) for the past week, I wrote about the idea of Shari'ah-compliant repos before I had a chance to read the IIFM report. As such, I focused mostly on the criticism I could foresee about the effort. As I mentioned, I think that the repo product is important enough to overcome the objections of replicating conventional products because the lack of similar products to repos limits Islamic banks' liquidity management by forcing them to hold excess cash which provides no return. The other side of the coin is that without Shari'ah-compliant short-term liquidity management instruments, it makes Islamic banks potentially more susceptible to large depositor withdrawals forcing a firesale of assets in an otherwise solvennt institution.

In the newsletter, I wrote:

"I have not yet had time to read over the IIFM report on Shari'ah-compliant repurchase agreements (repos). However, I am sure it will be viewed negatively in some respects with an argument made that the repos are just another example of Islamic finance replicating conventional financial products. The argument is valid in some respects. In a repo transaction one party borrows money by selling a debt with an agreement to repurchase at a higher cost at some specified point in the future. The transactions are generally short maturity debts, even if the underlying bond being sold and repurchase is of longer maturity (usually Treasuries or some other highly liquid investment).

By that definition, there would seem to be several issues that are worked around that would make a repurchase agreement not Shari'ah-compliant. There is trading in debt, interest payments, and a forward contract on a debt at a specified price; all of which would make a traditional repo agreement not Shari'ah-compliant. The new structuring will likely replicate the outcome through a different Shari'ah-compliant structure. In the past with other transactions, that usually leads to criticism."

"The criticisms usually neglect the difficulty of developing an alternative to conventional finance working within a financial, legal and regulatory system that was developed with only the conventional financial system in mind. As such, it is hard to create an industry that competes with conventional finance and works within the financial system and so replication of conventional products--while not necessarily desirable long-term--do provide the Islamic financial industry with a starting point and as it develops further there will be changes that seek to improve it."

"The argument that product replication is desirable is not clearer in my view than for the case of repos and other short-term liquidity management tools. These allow banks to invest more of their capital (rather than holding it in cash), which makes them more competitive with conventional financial institutions while also increasing the stability of Islamic financial institutions by increasing the liquidity of their balance sheet. So long as their counterparties in repo transactions believe they are solvent, they will be able to manage withdrawals of deposits without being forced into a firesale of their assets. There are always potential areas where problems can arise like the Lehman Brother's Repo 105, which manipulated the bank's assets to make it look more healthy than it was and this could become a problem with Islamic repos. However, as long as sufficient controls are put in place by regulators, the benefit from greater ability for banks to manage liquidity will outweigh the criticism of just another highly structured conventional product with a structure that makes it Shari'ah-compliant."

Having had a chance now to read the report, I think that my comments were correct. It could be viewed as an attempt to replicate repos in a Shari'ah-compliant structure, but the benefits from making short-term tools like Islamic repos available will ultimately benefit the Islamic financial industry. The report covers four concepts that were described and alludes to a fifth that is currently under discussion.

The first concept is a bilateral repo (I'aadat Al-Shira'a or 'IS'). It is the closest to a conventional repo. Two parties agree to a sale by one party in the spot market with a repurchase of an identical (although not necessarily the original) security at a later date at a set price. The set price (not dependent on the market price at the time of repurchase raised issues of riba with the Shari'ah considerations with the scholars they asked. The use of an identical (part of the same offering) rather than the original security was generally accepted as avoiding the problem of debt trading (bai' al-inah).

The second concept changed the purchase undertaking to a wa'd (unilateral undertaking to purchase or sell), but raised more Shari'ah issues that the authors said would be "difficult to overcome". As a result of the difficulties associated with bilateral repos ('IS'), the third concept abandoned the bilateral structure for a three-party structure, which is different from the conventional tri-party repo.

The three-party structure inserted a third party in between the two parties with a sale to the third party by the 'borrower' and a purchase from the third party by the 'lender'. There was also a purchase undertaking for a specified price between the 'borrower' and the 'lender' to return the securities for a pre-specified sale price at maturity of the repo agreement.

The issues in the three-party repo were covered more extensively than in bilateral repo, which suggests that the three-party repo is a more preferable model, at least from the perspective of the report's authors. There remain significant financial and accounting issues concerning margin calls, overcollateralization, accounting treatment of the repos. From a Shari'ah perspective, there are issues with the purchase undertaking, specifically whether it can be exercised by the lender (to force repurchase by the borrower) or whether it is a unilateral promise (wa'd) by the borrower to the lender.

In my opinion, the issues highlighted by the authors are valid and it will be difficult to create a three-party repo that has the substance of a repo transaction (and be acceptable to both parties, regulators and accounting bodies) while avoiding the pitfalls mentioned from the Shari'ah perspective. The sale and purchase transaction at the outset is in the spot markets and is probably acceptable (although if the transaction were overcollateralized, there might be issues). However, the purchase undertaking for securities raises issues that are much more difficult. If the purchase undertaking were unilateral (not binding on the borrower), then it would in essence be a call option, which would not be acceptable for the lender. If the values of the securities fell, the borrower would just abandon them to the lender (let the call expire) and the lender would be left with a loss. In the conventional setting, most repos are conducted using highly secure and highly liquid bonds (like US Treasuries) and the use of overcollateralization or haircuts can mitigate this risk to the lender (as can the enforceability of the repurchase agreement). However, these are not possible in the Islamic repo transaction.

The final concept outlined is one that is essentially a modified commodity murabaha transaction. As in a commodity murabaha transaction, the lender buys a commodity and sells it with deferred repayment to the borrower. Unlike a straight commodity murabaha, the repayment obligation is secured by the sukuk held by the borrower (and overcollateralized to cover fluctuations in the value of the collateral). If the repayment is made on schedule, the sukuk are not sold and is returned to the borrower. If there is a default, the lender takes possession of the sukuk and can sell them to recoup the unpaid repayment. There are a number of issues that were encountered in the three-party repo (margin maintenance, accounting treatment and Shari'ah issues) as well other issues as whether the securities held as collateral could be re-hypothecated (i.e. used by the bank holding the collateral in its own business).

The final concept uses the most similar structure to Islamic short-term liquidity management instruments used today, but if re-hypothecation were allowed, it would be the most 'replicated' product structure. The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products. With the three-party repo at least, there would be a purchase and sale of the securities and the obligation created by the wa'd (purchase undertaking) would be based on another purchase of securities, however difficult the Shari'ah and financial issues it presents are.

None of the four proposed methods are perfect and as I described in my newsletter, that was likely from the outset. However, by providing an overview that describes the benefits and the limitations and Shari'ah-compliance issues involved with each, I think that the authors of the IIFM report have done a great service. Not only were the issues laid out, they were done so publicly. While it may receive criticism as being an exercise in replication of a conventional product for the Islamic financial industry, this degree of transparency can only serve to start debate about what alternative structures could be used. For example, would it be more worthwhile for other central banks to follow the lead of the Central Bank of Bahrain and begin issuing short-term (non-tradable) securities like the sukuk al-salam? Is the Malaysian example instructive (it is probably a non-starter on Shari'ah grounds in the GCC)? However, now that four suggestions have been laid out, the burden is on the critics to propose a solution that addresses the need by the Islamic banking industry, moves away from commodity murabaha and wakala and offers a better solution than has been proposed. With the level of talent working in Islamic finance and a shared desire to create a better liquidity management tool for the Islamic financial industry, I believe this is just the first step on the road to a solution to the problem at hand.

Islamic Bank of Britain raises GBP20 million; sukuk markets send mixed signals

There are a number of articles on the Islamic Bank of Britain's raise of GBP20 million at 1 pence per share. The most detailed is from Ovum. There are a couple other articles. Mushtak Parker wonders whether the capital raise "addresses the bank's fundamental shortcomings". At the end of 2009, the bank had 546 million shares issued and outstanding so the 2 billion shares issued in the offering represent significant dilution for existing shareholders and will require approval of the bank's existing shareholders. From a cursory look at the annual report, the increase in the loss in 2009 compared with 2008 was due to a sharp decline in the profits on the bank's assets, despite an increase in the bank's deposits. As the company describes it: "In addition, those customer deposits that have not been used to fund asset growth produced lower returns due to declining yields in the Islamic inter-bank markets affecting the Company's margin."

In short, the balance sheet expanded with the deposit base increasing although those extra deposits were largely placed with other banks in commodity murabaha and wakala agreements (many of whom are based outside of the UK). This is the wrong direction for a bank, particularly an Islamic bank that is supposed to be focused primarily on pure intermediation: mobilizing profit-sharing deposits to finance businesses. Instead, the bank has been able to attract the deposits but has not found enough demand for those funds (or was constrained by capital requirements that would have required more capital based on their risk weighting on the asset side of the balance sheet). There was growth in home purchase plans (Islamic mortgages) from GBP7 million to 33 million, which does provide one good sign for the bank, but as described below, the reliance on Islamic inter-bank markets as a destination for the bank's assets remains high.

If the bank is focused on attracting deposits (GBP186 million in 2009 compared with 153 million in 2008) that it cannot use in a way that attracts a higher rate of return, it is not working the way it needs to be a profitable institution. As the deposits grew, the commodity murabaha and wakala with other banks increased from GBP152 million to 156 million out of total assets that were GBP207 million in 2009 compared to 181 million in 2008. This is a retail bank where around three-quarters of the assets are lent to other banks. I agree with Mushtak Parker; this is a temporary solution to the bank's needs to offset losses and it remains to be seen whether the bank can address its limited ability to find credit-worthy borrowers to finance. [NOTE: As described in the disclaimer on this blog, nothing contained here should be considered investment advice or an offer to buy or sell any security mentioned]

Sukuk yield premiums in the GCC are widening as conventional yields are falling. Another article points to the best month for sukuk since March with yields on some sukuk falling. The discrepancy is probably due to the selection of sukuk; the latter article primarily focusing on Asian sukuk like the Malaysian sovereign and Petronas sukuk. The planned $1 billion sukuk that was reported to be part of a joint venture financing between Saudi Aramco and Total has been abandoned because of market conditions. A Bloomberg article has another take on the Saudi sukuk market, pointing to the likelihood that issuance of sukuk from the kingdom will double in 2010 compared to 2009 and lead the GCC region. Taking these four articles together suggests that investors remain hesitant to invest in GCC-based sukuk after the Dubai debt crisis despite significantly different economic conditions across the countries of the GCC. At the same time, Malaysian sukuk remain attractive to investors.

Other News

• AAOIFI released two new accounting standards. One which covers sukuk, shares and similar instruments breaks down the accounting treatment based on whether it more closely resembles debt or equity. The other standard provides institutions adopting AAOIFI standards for the first time with a starting point.
  
• Sameer Abdi of Ernst & Young was on CNBC talking about the E&Y report on Islamic fund management. I posted a few links when the report was released in May.
  
• Arab News provides a short article on the IIFM report on a potential Islamic repurchase agreements (repos).