Tuesday, June 19, 2012

The potential for growth in Islamic mortgage-backed securities

The GCC does not have a well developed market for mortgage-backed securities, and with the exception of a number of MBS sukuk issued by Cagamas in Malaysia, Islamic finance has seen few MBS sukuk.  One notable exception was an MBS issued by Sorouh Real Estate, which I described in a blog post and which was later redeemed (which revealed a limitation for investors since the sukuk was redeemed by the issuer (scroll down to the July 18 newsletter) and not through pre-payment on the underlying assets).

However, with Tamweel considering the issue of $235 million in asset-backed MBS, there is a potential benefit for the sukuk market from more sukuk like this.  The estimated redemption date is 2046 according to Moody's who rated the MBS significantly higher than both Tamweel and its parent company, Dubai Islamic Bank. 

Before you start commenting on the post and suggesting that Islamic finance shouldn't use any of the products which played a part in the financial crisis, I want to offer a rebuttal.  The development of MBS was not at fault in the credit crisis by virtue of their structure.  In fact, they offer an asset-backed product which is demanded in the market (with potentially longer maturities for takaful and pension funds).  The role that MBS (in contrast to CDO and CDS) played in the crisis was more effect than cause: as home prices fell, many MBS lost value.  In addition, the MBS which lost the most value were those backed by bad mortgages that would not have been issued in earlier years. 

There are risks to MBS that aren't present in a sukuk.  For example, in the Sorouh MBS sukuk, the issuer could refinance and redeem the sukuk early, even before the underlying assets had paid out.  But that was more an issue of that structure that gave the issuer a call option on the portfolio but left the risk with the sukuk investors.  The structure of the Tamweel may not include a similar provision (I have not seen the documents for the Tamweel MBS sukuk). 

Apart from this redemption risk, there is also the risk that the underlying assets are redeemed earlier (introducing reinvestment risk, as the investor is paid out earlier than anticipated and may not be able to find another investment with a similar return).  

The benefit for the Islamic finance industry from more MBS issuance is that it can free up more funds for Islamic banks and mortgage lenders, while also offering additional sukuk to the market, potentially with longer maturities than most sukuk issance.  This will expand the capacity of Islamic banks to finance other projects and expand their scope, while also offering a more complete fixed income market, which has been so far dominated (particularly in the GCC in recent years) by sovereign issues.

The potential ability of MBS to attract higher credit ratings than their originators is a mixed benefit.  It is good, of course, to have a larger supply of highly rated sukuk to fill the portfolios of conservative investors like pension and takaful funds.  However, this benefit should always be carefully weighed against the potential to replicate the ills of the MBS market leading up to the crisis where ratings schemes were gamed by originators to get higher ratings so they could push out more and more issuance, the risk of which is largely transferred to investors.  

All in all, I think more MBS issuance should be a good thing for the Islamic finance industry and it can offer a way for investors to get Shari'ah-compliant fixed income investments.  There are risks to be sure and, given the recent financial crisis, there should be vigilance to ensure that the MBS markets are not flooded with MBS sukuk backed by low quality assets.  But if done correctly, it could be a boon to sukuk markets. 

2 comments:

rutran martin said...

The potential ability of MBS to attract higher credit ratings than their originators is a mixed benefit.

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