Wednesday, April 27, 2011

Islamic structured products...and more

Since posting has been light due to other commitments, there are a few things I haven't had a chance to write about. So I'm going to step outside the normal form and combine a few posts into one.

ADIB soft commodity note

An article describing the Abu Dhabi Islamic Bank soft commodity note struck my attention because I think it offers an example of a product that I view as problematic. This product is not problematic on its own--it offers exposure to an investment class that is otherwise hard to find in the Islamic space--but the complex structure these products use (and the high potential upside with capital protection) suggests hidden risks. Given the risk-return profile of the note, there has to be something else (which is present in most Islamic structured notes) that makes the product worth the bank's time (probably the high fees).

The structure is described as "provide[ing] an opportunity for investors to invest in this Murabaha based note, the profit of which is determined by the prices performance of cotton, corn and sugar." This structure is common for structured notes. The investor puts money with the bank which is invested in a murabaha (to provide the capital protection). The returns, which the bank says have a "maximum upside return of up to 18 per cent over 2 years with an annual payout", are usually generated using the wa'ad total return swap with an external counterparty (swapping the returns on the murabaha with the returns on an index of the commodity price). The investor is paid either the return on the index or their invested capital (likely less a fee).

There are plenty of products that offer returns and on which the institution offering the product earns a fee. That is how investing works. But the capital protected notes offer something that is too good to be true. Either you get your money back if the commodity prices fall or you get a return up to 18% according to the bank offering the product.

The key point with these types of products is to look at how the bank makes its money (and mitigates the risk of paying the return which is not generated by any profit-making activity, but by the behavior of an index). If the product were as simple as possible, you would appoint the bank as your agent under a wakala contract and they would buy the commodities on your behalf and you would profit if prices increased and face losses if they fell. However, this product offers the upside in prices (up to 18%) with no downside. If this structure were used, the bank would expect the prices to rise more than 18% in 2 years and would capture the upside where you would be on the hook for the downside.

But the product is structured to take away the downside risk from your investment. That means the bank is either able to hedge its downside risk on the commodity prices or foolishly expects that prices will keep rising (so it can capture the upside if it is greater than 18%). Banks are not in the business of speculating on commodity prices; they profit on the difference between their cost of funds and the returns on what they invest in (i.e. loans). That is where the wa'ad-murabaha structure comes in, which both adds risk to the investor and somewhat subverts the Shari'ah-compliance of these types of products (in my layman's opinion).

From the bank's perspective, they are borrowing funds with no guaranteed return (i.e. no direct cost to them) and receiving the fee charged for the product. They are paying the murabaha profits to another institution that takes the risk of rising prices (most likely a conventional bank). As long as the fee is larger than the murabaha profits (plus the profits that can be made using the funds in the interim, less the structuring fees), they make money on the transaction. The counterparty will hedge itself against the commodity price risk. For the counterparty, as long as the cost of hedging is lower than the murabaha profit, they make money.

The impact this has on the investor is that there are likely to be relatively high fees for these products and it adds a risk that is not apparent in its brief description. Specifically, the risk is counterparty risk with the bank and (for the bank) with its counterparty in the wa'ad total return swap. This risk is not unique to Islamic finance. For example, Exchange Traded Notes (ETNs) carry the same risk. They usually offer a return based on an underlying commodity index, but legally they are unsecured debt of the issuing institution.

Besides the hidden risks in these products (admittedly, these risks are minimal in normal times), they also raise questions about whether the structures are designed to work within the framework of Shari'ah-compliance or to avoid the restrictions of Shari'ah-compliance. I have moved further into the viewpoint that the replication of conventional products is fine because they serve real needs of the Muslim consumers of the product, but there is a limit and structured products are on the border between serving a need and creating the solution to a problem that is not apparent.

Exposure to commodity markets is difficult within the bounds of Shari'ah-compliance, but a structured product to offer that exposure seems unnecessarily complicated (although profitable for banks offering the product). Offering exposure to commodity markets through non-bank financial institutions seems like it would offer a simpler way to offer this type of exposure because bank regulation is not really suited towards taking or facilitating commodity risk so a bank-based product will try to turn it into a credit risk.

Dubai comeback

There are two pieces of news out of Dubai, both of which support an idea that rumors of its death have been greatly exaggerated. First, Nakheel is coming to a resolution on $11 billion in debts which need to be restructured. These debts include a $1.85 syndicated Islamic loan that will be extended seven years according to Reuters. The new development that I see in this is that Reuters reports that Nakheel "will eventually be separated from Dubai World to become a full government subsidiary". The main problem with Nakheel's sukuk was that (besides being subject to a standstill), they were viewed as being guaranteed by Dubai's government, despite only being guaranteed by Dubai World, a government-related entity.

With the support from Abu Dhabi through the Dubai Financial Stability Fund (which was used to pay off the 3 Nakheel sukuk), the Dubai government has returned from its pariah status in the credit markets and has been considering issuing a bond or sukuk in Malaysia.

In more positive developments (rather than news about fixing old problems), Dubai Ports World's sukuk reached record low yields after it was upgraded to the lowest investment-grade rating. DP World has always appeared to be on more stable footing than Dubai, Inc. because of its role in global trade (where recovery from the severe recession was less in doubt than Dubai's recovery from its property boom and bust).

The combines effect of Nakheel restructuring and the DP World upgrade (and Bahrain's continuing turmoil) should support Dubai's ambitions to expand its prominence as a center of Islamic finance in the GCC region. This point will be contested in Saudi Arabia (which has a larger economy but which offers less availability to international investors) and Qatar (which is still working through the central bank's decision to prohibit conventional banks from offering Islamic banking products). Compared to the sentiment towards the end of 2009 when the Dubai World standstill was announced, the competitive situation facing Dubai is far more favorable.

Indonesia sukuk

Indonesia just sold $2.5 billion in 10-year dollar-denominated bonds at a yield of 4.875%, reflecting international interest in the country's debt. 49% of the debt was sold to US-based investors. The strong issuance reflects interest in strong emerging markets and the strengthening of the Indonesian Rupiah. The Indonesian Finance Ministry director of Islamic finance, Dahlan Siamat, told Bloomberg that the country is considering issuing dollar-denominated sukuk in the second half of 2011. While the growth in external debt issuances is positive (the total for 2010 as a whole was $3 billion), the issuance presents risks if the currency depreciates significantly like in 1997/1998.

Live blogging the Gulf News article about Gatehouse Bank

"competition has to be fair in the context of pricing and taxation [...] taxation rules [...] favoured financing through debt compared to equity, but in the aftermath of the financial crisis that exposed the weaknesses of excessive leverage there is a move to create a level playing field for equity funding and asset-backed financing which lies at the core of Islamic finance."

There is not really a market for equity finance within the Islamic finance industry (except for the equity finance that most of us know--common stock). Most banks including investment banks use debt-alternatives, which should be competitive with conventional debt, but for added structuring costs. The main obstacles are double-taxation of the ownership transfer in Islamic financial structures, which have been legislated in most Western countries (e.g. the UK).

"[Richard] Thomas [CEO of Gatehouse] said the recent decision by the Central Bank of Qatar not to allow conventional banks to offer Islamic financial services is a move in the right direction to create a level playing field for pure Islamic institutions to compete with conventional institutions."

I agree with some of the concerns of the central bank in terms of leakages between Islamic and conventional arms of banks that offer both. However, requiring conventional banks to close their Islamic windows creates a bad precedent that will discourage conventional banks from offering Islamic windows, which could offer competition. The commingling of assets cited by the central bank are Shari'ah issues and should be addressed by the Shari'ah boards. The central bank should, at most, force these units to be spun off into stand-alone subsidiaries with Islamic banking licenses from the central bank. Otherwise it just looks like a move to protect the banks in the local market.

"Thomas believes that Islamic banks will continue to have good growth prospects in the UK as long as their offerings do not imitate those of their conventional peers."

The replication of conventional products offers an alternative to consumers, but the financial needs remain the same. Trying to fit a square peg of equity-based products into the round hole of current regulations is impracticable. The Islamic Bank of Britain's problem (from my review of their financial statements) was that they could not find enough people to offer financing. This may be a reflection of rejection of products that replicate conventional products, but those types of products are relatively well accepted in other parts of the world (including the US). Perhaps it is a failure in its marketing strategy or the ability to offer a cost-competitive product.

Thomas: "We are now taking business from conventional banks because we have a different business model and are not part of that mega-debt culture. We have seen a pick-up in business mainly in corporate asset finance, real estate, also the trade-related business."

I hope they are able to take business from conventional banks, but it is not because Islamic finance as it operates now gives a non-debt alternative. There are plenty of non-debt (i.e. equity) alternatives available. Hopefully it is the case that the Shari'ah restrictions on the financing provides a more equitable relationship between financier and those receiving financing.

In the end, I do want to see Islamic finance thrive in the UK, but the signs so far are not great. The Islamic finance institutions there--not just Gatehouse, but all of them--need to recognize their limitations in terms of size and not try to compete with the established conventional banks. The Shari'ah-compliance requirements can be a part of the appeal if they give a superior product at a competitive price. However, just appealing to Islamic finance as the opposite of conventional debt won't do it. Most of the Islamic financial products replicate debt nearly perfectly in economic outcome and there are conventional alternatives to debt (e.g. equity financing). Islamic finance has to come up with some reason that it is better that doesn't rely upon mis-informing about how the industry actually works. Otherwise it won't succeed except in providing Shari'ah-compliant alternatives to conventional financial products to Muslims.

DIB fraud case

I don't know enough about the DIB fraud case that has been ongoing for several years, so I will present the link to an FT article with no other comment than it is likely to reflect badly on Dubai's judicial system for its unwillingness to offer bail to the defendants, one of whom was acquitted after serving 3 years in jail.

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