There have been a lot of articles sitting in my feed reader and I won't have time to write more in depth on the topics, but here are the links with quick summaries.
Size of Islamic finance industry
The City UK released its latest annual report on the Islamic finance industry showing the industry has $1.3 trillion in assets. I hope to have more detail on this in another post when I have time to read it.
The Malaysian Islamic finance banking industry reached 22.4% of the country's total at the end of 2011. Despite only having 15% of the outstanding USD-denominated sukuk issuance, it has one of the best developed (i.e. liquid) sukuk market, based on a lot of domestic MYR-denominated sukuk, but still showing that size isn't everything.
Shari'ah standards
A conference participant suggests that investors and advisors should do their own Shari'ah research instead of waiting on a Shari'ah board to provide a fatwa. Not much chance of happening, but interesting to see new perspectives.
Goldman Sachs
Reuters gives the latest update on the Goldman Sachs murabaha sukuk which has attracted a lot of criticism, saying that the Shari'ah advisors have signed off and the ball is in Goldman's court. I offered my perspective on the trading issue with a murabaha sukuk in an earlier post.
IIFM-ISDA
The ISDA press release is available here for the new Mubadalatul Arbaah master agreement.
Australia
The National Bank of Australia is considering a $500 million sukuk issuance, the first from the land down under, as Islamic finance begins to develop in the country.
Hong Kong
HK returns to its work on attracting Islamic finance. Despite expressing a desire to become an Islamic finance and sukuk hub, Hong Kong has not progressed far with the only issue coming from RMB500 million ($79 million) sukuk from Khazanah.
Indonesia
The Indonesian government issued its first 4 series of project-based sukuk, although only the 30 year sukuk received bids accepted by the government. Out of a 2.18 trillion rupiah ($237 million) in total bids, only 355 billion rupiah ($38 million) was accepted, all for the PBS0004 issue due 2037.
Microfinance
A microfinance product that offers a deposit product and interest-free loan program rolled into one. When will Islamic finance get behind Islamic microfinance in a big way?
Thursday, March 29, 2012
Wednesday, March 28, 2012
Islamic derivatives
While writing the post yesterday on the new profit rate swap master agreement (mubadalatul arbaah), I explained the reasons why I think the master agreement can help make a difference in developing Islamic finance and providing a product that can help 'real economic activity' by providing certainty in financing costs for companies that have floating rate financing.
However, there is an issue with Islamic derivatives in general that has been raised multiple times about the participation of 'speculators' versus those participants who are involved in 'legitimate hedging transactions'. This is a tricky issue, and one that is very hard to even define (since what transaction doesn't involve some elements of speculation.
In the context of derivatives, there will likely be some profit to be made and in general, it will be a profit that, if you view the transaction in the abstract will be gain for one party at the expense of the other. This is generally viewed as akin to gambling (maysir) in Islamic finance because the gains from one party will come at the expense of the other.
In the profit-rate swap example, viewing the transaction in the abstract misses some key elements that differentiates a profit-rate swap from others (such as, for example, a credit default swap). In a profit-rate swap, assume that the company has a two-year $100 million floating rate ijara, with a floating rate starting at 5% annual rate, which is set at the end of year 1. The ijara is structured so the cash flows are:
T=0: Company sells assets worth $100 million to the financier, which it will rent with rental payments adjusting, but beginning at $2 million a year (benchmarked to an interest rate that starts at 5%). The first payment is made.
T=1: Company pays rent benchmarked to an interest rate
T=2: Company pays repurchases the asset for $100 million
At T=0, the company enters into a profit-rate swap to exchange the rent in T=1 for cashflows of $2 million at T=1 for a floating rate based on the same benchmark with a spread (through two separate commodity murabaha). At T=1, the murabaha are paid, with the company paying $2 million and the counterparty paying $100 million * (R+e), where e is the spread paid.
Looking just at the transaction, no net payments are made when the benchmark rate is (5-e)%. If the benchmark rate is higher than (5-e)%, then the company makes the difference between the rate and (5-e)%. If the rate is lower, than the swap counterparty makes the difference between (5-e)% and the benchmark rate.
For the transaction alone, the components of the transactions are common. There is an ijara and, separately, the company enters into two murabaha with another party. However, the murabaha transactions result in the outcome of a win-lose scenario. An increase in the reference rate benefits the swap counterparty, while a decrease benefits the company, in equal amounts. The criticism of this transaction is that it is not financing any 'real economic activity', and also that the counterparty is merely speculating on the direction of the reference rate (the company is hedging its exposure to changes in the reference rates, which would be viewed as legitimate hedging activity).
There would be in most cases, a clear economic benefit of the transaction because the company would be able to lock in the cost of financing the asset it purchased. Armed with the certainty of its costs, the company wouldn't have to incorporate the uncertainty around its financing costs in its financial planning, and could devote the resources that might be held back in case the rate increased to expand its business. The counterparty would assume the risk of changes in the reference rate (in expectation of a lower rate or to hedge itself against its own fixed rate liabilities (most financial counterparties would be likely able to show enough fixed rate liabilities to justify its participation on the grounds that it is hedging, even if it were speculating).
As I mentioned, the fact that the contract is executed on an OTC basis adds some risk that the counterparty cannot meet its obligation, which would moot some of the benefits to both parties of resources freed up by hedging its profit-rate exposure. There won't be many issues with whether the parties are legitimately hedging (it is probably easy enough for the Islamic financial institution to speculate while being able to at least nominally show that it is hedging some exposure on its balance sheet). However, it will be difficult to convince the doubters of profit-rate swaps that the transaction adds value overall and is different from a transaction like a CDS.
Most arguments in support of the profit-rate swap assume that Islamic finance institutions are involved in liquidity transformation, just like conventional banks, but using Shari'ah-compliant contracts. The criticism of Islamic derivatives are mainly (but not entirely) from people who believe that Islamic financial institutions should be based entirely on profit-sharing contracts. It is difficult to offer a counter-argument, because a pure profit-sharing bank would not need to worry about liquidity constraints because it would not transform short-term liabilities into long-term assets (rather, it would, but it could pass off any losses directly to depositors).
This is how a typical mutual fund works (the fund manager acts as a mudarib or wakeel), but it is not how Islamic banks work. If an Islamic financial institution is working in a bank-like role (taking deposits and making loans) in an environment where pricing is based on interest rates (because the Islamic bank is competing with conventional bank), then there will be a role for instruments like a profit-rate swap. Arguments against profit-rate swaps are mostly shifting the discussion into a theory versus practice argument. At this point it usually turns into a discussion where people from two different perspectives are talking past one another.
There are two different things to consider, which are entirely different, when considering profit-rate swaps:
Where I stand is that Islamic banking does operate in a regulatory environment that was designed for conventional banking and that providing a standardized way for Islamic banks to hedge against profit-rate risk will lead to a more stable banking system (counterparty issues still unresolved) and will provide a benefit to the non-financial who enter into profit-rate swaps to fix their costs as a part of their financial planning.
However, there is an issue with Islamic derivatives in general that has been raised multiple times about the participation of 'speculators' versus those participants who are involved in 'legitimate hedging transactions'. This is a tricky issue, and one that is very hard to even define (since what transaction doesn't involve some elements of speculation.
In the context of derivatives, there will likely be some profit to be made and in general, it will be a profit that, if you view the transaction in the abstract will be gain for one party at the expense of the other. This is generally viewed as akin to gambling (maysir) in Islamic finance because the gains from one party will come at the expense of the other.
In the profit-rate swap example, viewing the transaction in the abstract misses some key elements that differentiates a profit-rate swap from others (such as, for example, a credit default swap). In a profit-rate swap, assume that the company has a two-year $100 million floating rate ijara, with a floating rate starting at 5% annual rate, which is set at the end of year 1. The ijara is structured so the cash flows are:
T=0: Company sells assets worth $100 million to the financier, which it will rent with rental payments adjusting, but beginning at $2 million a year (benchmarked to an interest rate that starts at 5%). The first payment is made.
T=1: Company pays rent benchmarked to an interest rate
T=2: Company pays repurchases the asset for $100 million
At T=0, the company enters into a profit-rate swap to exchange the rent in T=1 for cashflows of $2 million at T=1 for a floating rate based on the same benchmark with a spread (through two separate commodity murabaha). At T=1, the murabaha are paid, with the company paying $2 million and the counterparty paying $100 million * (R+e), where e is the spread paid.
Looking just at the transaction, no net payments are made when the benchmark rate is (5-e)%. If the benchmark rate is higher than (5-e)%, then the company makes the difference between the rate and (5-e)%. If the rate is lower, than the swap counterparty makes the difference between (5-e)% and the benchmark rate.
For the transaction alone, the components of the transactions are common. There is an ijara and, separately, the company enters into two murabaha with another party. However, the murabaha transactions result in the outcome of a win-lose scenario. An increase in the reference rate benefits the swap counterparty, while a decrease benefits the company, in equal amounts. The criticism of this transaction is that it is not financing any 'real economic activity', and also that the counterparty is merely speculating on the direction of the reference rate (the company is hedging its exposure to changes in the reference rates, which would be viewed as legitimate hedging activity).
There would be in most cases, a clear economic benefit of the transaction because the company would be able to lock in the cost of financing the asset it purchased. Armed with the certainty of its costs, the company wouldn't have to incorporate the uncertainty around its financing costs in its financial planning, and could devote the resources that might be held back in case the rate increased to expand its business. The counterparty would assume the risk of changes in the reference rate (in expectation of a lower rate or to hedge itself against its own fixed rate liabilities (most financial counterparties would be likely able to show enough fixed rate liabilities to justify its participation on the grounds that it is hedging, even if it were speculating).
As I mentioned, the fact that the contract is executed on an OTC basis adds some risk that the counterparty cannot meet its obligation, which would moot some of the benefits to both parties of resources freed up by hedging its profit-rate exposure. There won't be many issues with whether the parties are legitimately hedging (it is probably easy enough for the Islamic financial institution to speculate while being able to at least nominally show that it is hedging some exposure on its balance sheet). However, it will be difficult to convince the doubters of profit-rate swaps that the transaction adds value overall and is different from a transaction like a CDS.
Most arguments in support of the profit-rate swap assume that Islamic finance institutions are involved in liquidity transformation, just like conventional banks, but using Shari'ah-compliant contracts. The criticism of Islamic derivatives are mainly (but not entirely) from people who believe that Islamic financial institutions should be based entirely on profit-sharing contracts. It is difficult to offer a counter-argument, because a pure profit-sharing bank would not need to worry about liquidity constraints because it would not transform short-term liabilities into long-term assets (rather, it would, but it could pass off any losses directly to depositors).
This is how a typical mutual fund works (the fund manager acts as a mudarib or wakeel), but it is not how Islamic banks work. If an Islamic financial institution is working in a bank-like role (taking deposits and making loans) in an environment where pricing is based on interest rates (because the Islamic bank is competing with conventional bank), then there will be a role for instruments like a profit-rate swap. Arguments against profit-rate swaps are mostly shifting the discussion into a theory versus practice argument. At this point it usually turns into a discussion where people from two different perspectives are talking past one another.
There are two different things to consider, which are entirely different, when considering profit-rate swaps:
- Should Islamic financial institutions work within the regulatory system that exists today? Or should they try to change the regulatory environment to allow pure profit-and-loss sharing for Islamic banks?
- If Islamic banks work within the current banking regulations, should they be permitted to hedge their exposure to fluctuations in their profit rates which may be exposed to fluctuations determined by changes in interest rates? And does the profit rate swap contribute to an underlying economic activity?
Where I stand is that Islamic banking does operate in a regulatory environment that was designed for conventional banking and that providing a standardized way for Islamic banks to hedge against profit-rate risk will lead to a more stable banking system (counterparty issues still unresolved) and will provide a benefit to the non-financial who enter into profit-rate swaps to fix their costs as a part of their financial planning.
Tuesday, March 27, 2012
Profit rate swap master agreement
The International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA) announced their newest master agreement for a profit rate swap (mubadalatul arbaah). This is a good development in my opinion because it provides a lower cost way for Islamic financial participants to hedge against fluctuations in the interest rates that are used to determine the cost of Islamic financial products.
The idea of Islamic derivatives have been controversial because they are often viewed as instruments for speculation, which is viewed as not being in the spirit of Islamic finance. Speculation financed by Islamic financial products (e.g. in the Dubai real estate market before the crisis) somehow escapes the same level of scrutiny as derivatives. Other objections have focused on the synthetic nature of Islamic derivatives as being just copies of conventional products done in a way that is Shari'ah-compliant, and is somewhat condescendingly described as not being used to finance 'real economic activity'.
However, profit rate swaps are quite easily used for legitimate hedging transactions that doesn't necessarily shift risk from one party to another at least entirely (a criticism that could be more aptly pointed at talk of developing Islamic credit default swaps). Hedging is viewed as permissible, where speculation is viewed in a negative light (again with a somewhat double standard).
Take, for example, a situation where an Islamic bank financing a widget factory through a murabaha. The bank only offers the company a floating rate loan. However, the managers of the widget factory don't want to be exposed to the risk that the financing costs increase over the term of the murabaha because it could lead to additional cost that complicates their planning for the business.
The manager of the company may then approach an investment company to lock in the financing costs, to make its finance costs predictable over the life of the murabaha. A fund approaches the company with the offer of a profit-rate swap that locks in the financing costs for the widget company through a profit-rate swap. The fund receives a stream of fixed rate payments in exchange for paying a floating rate, which it expects to benefit its investors.
The master agreement facilitates this process by lowering the costs compared to the participants having to custom build a profit-rate swap. Without the master agreement, there would be fewer transactions, which would make an impact on the 'real economy' because fewer companies would have the opportunity to fix their financing, and effectively shift the management of interest rate fluctuations to institutions that have a focus on managing those changes.
The one criticism I have of the profit rate swap is that it is an over the counter (OTC) swap. The benefits of the profit-rate swap come with the cost of counterparty risk by adding a third party into the original murabaha, which exposes the widget to the company that it will lose its fixed rate protection if the counterparty in the swap cannot fulfill the terms of the contract. However, creating an exchange for swaps is a whole different challenge that can (and probably will) wait for another day (likely well into the future).
The idea of Islamic derivatives have been controversial because they are often viewed as instruments for speculation, which is viewed as not being in the spirit of Islamic finance. Speculation financed by Islamic financial products (e.g. in the Dubai real estate market before the crisis) somehow escapes the same level of scrutiny as derivatives. Other objections have focused on the synthetic nature of Islamic derivatives as being just copies of conventional products done in a way that is Shari'ah-compliant, and is somewhat condescendingly described as not being used to finance 'real economic activity'.
However, profit rate swaps are quite easily used for legitimate hedging transactions that doesn't necessarily shift risk from one party to another at least entirely (a criticism that could be more aptly pointed at talk of developing Islamic credit default swaps). Hedging is viewed as permissible, where speculation is viewed in a negative light (again with a somewhat double standard).
Take, for example, a situation where an Islamic bank financing a widget factory through a murabaha. The bank only offers the company a floating rate loan. However, the managers of the widget factory don't want to be exposed to the risk that the financing costs increase over the term of the murabaha because it could lead to additional cost that complicates their planning for the business.
The manager of the company may then approach an investment company to lock in the financing costs, to make its finance costs predictable over the life of the murabaha. A fund approaches the company with the offer of a profit-rate swap that locks in the financing costs for the widget company through a profit-rate swap. The fund receives a stream of fixed rate payments in exchange for paying a floating rate, which it expects to benefit its investors.
The master agreement facilitates this process by lowering the costs compared to the participants having to custom build a profit-rate swap. Without the master agreement, there would be fewer transactions, which would make an impact on the 'real economy' because fewer companies would have the opportunity to fix their financing, and effectively shift the management of interest rate fluctuations to institutions that have a focus on managing those changes.
The one criticism I have of the profit rate swap is that it is an over the counter (OTC) swap. The benefits of the profit-rate swap come with the cost of counterparty risk by adding a third party into the original murabaha, which exposes the widget to the company that it will lose its fixed rate protection if the counterparty in the swap cannot fulfill the terms of the contract. However, creating an exchange for swaps is a whole different challenge that can (and probably will) wait for another day (likely well into the future).
Thursday, March 22, 2012
Arcapita bankruptcy - The benefits of the bankruptcy process
Arcapita is working through the bankruptcy filing and with their public statements to portray the hedge funds who bought the debt in the secondary markets as the bad guys who forced the company into a hastily prepared bankruptcy to 'protect' the company's other creditors. Arcapita's preferred method was to 'extend-and-pretend' the $1.1 billion syndicated murabaha facility for three years.
However, as Bloomberg notes, the hedge funds had their own concerns that Arcapita was paying unidentified consultants ($96.3 million so far this year) and had sold an asset to Qatar Islamic Bank, two weeks before the bankruptcy, which Bloomberg reported "has a relationship with Arcapita". For any creditor, the prospect that Arcapita could move funds around freely if it remained outside of bankruptcy (perhaps distributing it to other investors or moving it to countries where it would be harder to recover) is a legitimate concern.
I have seen arguments made that paint the hedge funds as the 'vultures' who bought the murabaha at a discount, pushing an otherwise healthy company into bankruptcy. However, it is impossible to know whether Arcapita is a healthy company because of the lack of transparency into their financials (the most recent statements available are for the quarter ending September 30, 2011), and they provide little transparency on the operating companies' financial situation.
As I mentioned in a post earlier this week, Arcapita reports on their own website that they have only one portfolio company that they bought after the financial crisis. That is J. Jill which they bought less than a year ago in a leveraged buyout. As I reported in the past year for The Islamic Globe, J. Jill's debt has been downgraded twice to Caa by Moody's (and CCC by Standard & Poor's) on concerns about high debt levels and that prospects for J. Jill to breach debt covenants. While J. Jill is one of the only company where there is some vision about the leverage levels of portfolio companies, it led investors to be concerned that Arcapita's investments (as reported on their balance sheet) might not be accurately valued.
If the assets were more significantly impaired than Arcapita has assumed in its financial statement, the equity Arcapita holds in the portfolio companies might be written down (e.g. if a company like J. Jill were taken over by its creditors, which could wipe out equityholders). Holders of the murabaha including the hedge funds might want to force greater disclosure of the true financial position of the portfolio companies, as well as Arcapita itself, and a more transparent outcome. This is where bankruptcy can work well, because it tries to find the most equitable solution for creditors, as well as providing a way for the business (if possible) to continue as a going concern.
At this point, it would be easy to jump to the conclusion about the financial state of Arcapita or the motives of the hedge funds who bought the debt at a discount. However, it makes more sense to wait until a fuller picture of the case emerges as Arcapita works through the bankruptcy process.
However, as Bloomberg notes, the hedge funds had their own concerns that Arcapita was paying unidentified consultants ($96.3 million so far this year) and had sold an asset to Qatar Islamic Bank, two weeks before the bankruptcy, which Bloomberg reported "has a relationship with Arcapita". For any creditor, the prospect that Arcapita could move funds around freely if it remained outside of bankruptcy (perhaps distributing it to other investors or moving it to countries where it would be harder to recover) is a legitimate concern.
I have seen arguments made that paint the hedge funds as the 'vultures' who bought the murabaha at a discount, pushing an otherwise healthy company into bankruptcy. However, it is impossible to know whether Arcapita is a healthy company because of the lack of transparency into their financials (the most recent statements available are for the quarter ending September 30, 2011), and they provide little transparency on the operating companies' financial situation.
As I mentioned in a post earlier this week, Arcapita reports on their own website that they have only one portfolio company that they bought after the financial crisis. That is J. Jill which they bought less than a year ago in a leveraged buyout. As I reported in the past year for The Islamic Globe, J. Jill's debt has been downgraded twice to Caa by Moody's (and CCC by Standard & Poor's) on concerns about high debt levels and that prospects for J. Jill to breach debt covenants. While J. Jill is one of the only company where there is some vision about the leverage levels of portfolio companies, it led investors to be concerned that Arcapita's investments (as reported on their balance sheet) might not be accurately valued.
If the assets were more significantly impaired than Arcapita has assumed in its financial statement, the equity Arcapita holds in the portfolio companies might be written down (e.g. if a company like J. Jill were taken over by its creditors, which could wipe out equityholders). Holders of the murabaha including the hedge funds might want to force greater disclosure of the true financial position of the portfolio companies, as well as Arcapita itself, and a more transparent outcome. This is where bankruptcy can work well, because it tries to find the most equitable solution for creditors, as well as providing a way for the business (if possible) to continue as a going concern.
At this point, it would be easy to jump to the conclusion about the financial state of Arcapita or the motives of the hedge funds who bought the debt at a discount. However, it makes more sense to wait until a fuller picture of the case emerges as Arcapita works through the bankruptcy process.
Monday, March 19, 2012
Arcapita bankruptcy
I am not too surprised by the Arcapita bankruptcy (the NY Times has a copy of the bankruptcy filing on their Deal Book blog, their other filings are available here). Their portfolio of investments was mainly from pre-financial crisis, with the lone exception being J. Jill.
They had $1.1 billion in a syndicated murabaha financing coming due at
the end of the month, and reported only $19 million in cash as of
September 30, 2011 despite many asset sales earlier in 2011.
I have written quite a bit about the troubles with J. Jill (which saw its debt ratings downgraded repeatedly) for The Islamic Globe, including in late February 2012. However, the problems with Arcapita were far deeper than just the troubles of J. Jill (the debt of the two is separate and one does not directly affect the others, apart from the potential cash infusion that would be required from Arcapita to stave off default by J. Jill if that happens).
The biggest problem for Arcapita is that it was unable to continue its business model (leveraged buy-outs and sales of its holdings at a profit) after the credit crisis hit. In the immediate wake of the credit crisis, potential buyers of its portfolio were likely unable to get their own debt financing. As the crisis dragged on, the holdings remaining on the Arcapita balance sheet (most of the holdings were in part sold off to their investors when deals were completed) were worth far less than they were purchased for.
Leverage works both ways. Arcapita (and other private equity companies) relied upon their holdings appreciating so that they could be sold off for more than they paid to buy, with the returns amplified by the leverage they employed, both on a portfolio company level and the holding company level (the more debt they had to support their balance sheet, the higher the returns to their equity holders. However, their business model imploded along with the business model of many private equity companies. It is impossible to speculate about whether they were disproportionately hurt compared to their rivals. Their headquarters building sitting alone on the location of a development at Bahrain Bay they began in 2005 which has still not been completed says more than any analysis of their balance sheet can.
The real question for creditors is whether the extend-and-pretend will succeed. If they extend the murabaha they are hoping that Arcapita's holdings can be sold for prices high enough to repay the company-level debt and return enough cash to Arcapita's coffers to repay the murabaha, so long as it is not turned into a fire sale. The situation is complicated by distressed debt funds owning between 15% and 25% of the murabaha by my best estimates (with the remainder split between around 60% original syndicate members and 20% who likely invested directly in the syndicated murabaha in 2007).
Arcapita blamed this minority as precipitating the bankruptcy filing, but perhaps these investors put a fair value on Arcapita's holdings, and they would not be able to repay the murabaha and continue on as a going concern afterwards, even if they were given additional time. The concept of bankruptcy and Islamic finance is not well established and one of the few relatively successful bankruptcies of an Islamic debt instrument was East Cameron. It was solved through a relatively ad hoc solution in a US bankruptcy court that saw some conventional funds work with Islamic investors to create a solution that allowed for the Islamic investors to potentially recover some of their investment, while remaining within their Shari'ah mandate.
From what I could see in the East Cameron filings and a post mortem from people I spoke with, the solution wasn't pretty (i.e. it wasn't solved along the exact lines drawn up in the contracts), but instead relied upon the focus of US bankruptcy courts of finding an equitable solution. Perhaps a similar resolution of the Arcapita bankruptcy through US courts could make the US a more recognized jurisdiction for Islamic finance. That, more than anything, would encourage more Islamic finance in the US.
A post script: I wasn't able to fit into the blog post the connection between current discussion of presidential candidate Mitt Romney's involvement in private equity with Bain Capital and the Arcapita bankruptcy, but they do have a strange overlap. Bain Capital has been heavily criticized for leading American Pad & Paper into bankruptcy in 2000. Three years later, the firm was bought by Arcapita.
I have written quite a bit about the troubles with J. Jill (which saw its debt ratings downgraded repeatedly) for The Islamic Globe, including in late February 2012. However, the problems with Arcapita were far deeper than just the troubles of J. Jill (the debt of the two is separate and one does not directly affect the others, apart from the potential cash infusion that would be required from Arcapita to stave off default by J. Jill if that happens).
The biggest problem for Arcapita is that it was unable to continue its business model (leveraged buy-outs and sales of its holdings at a profit) after the credit crisis hit. In the immediate wake of the credit crisis, potential buyers of its portfolio were likely unable to get their own debt financing. As the crisis dragged on, the holdings remaining on the Arcapita balance sheet (most of the holdings were in part sold off to their investors when deals were completed) were worth far less than they were purchased for.
Leverage works both ways. Arcapita (and other private equity companies) relied upon their holdings appreciating so that they could be sold off for more than they paid to buy, with the returns amplified by the leverage they employed, both on a portfolio company level and the holding company level (the more debt they had to support their balance sheet, the higher the returns to their equity holders. However, their business model imploded along with the business model of many private equity companies. It is impossible to speculate about whether they were disproportionately hurt compared to their rivals. Their headquarters building sitting alone on the location of a development at Bahrain Bay they began in 2005 which has still not been completed says more than any analysis of their balance sheet can.
The real question for creditors is whether the extend-and-pretend will succeed. If they extend the murabaha they are hoping that Arcapita's holdings can be sold for prices high enough to repay the company-level debt and return enough cash to Arcapita's coffers to repay the murabaha, so long as it is not turned into a fire sale. The situation is complicated by distressed debt funds owning between 15% and 25% of the murabaha by my best estimates (with the remainder split between around 60% original syndicate members and 20% who likely invested directly in the syndicated murabaha in 2007).
Arcapita blamed this minority as precipitating the bankruptcy filing, but perhaps these investors put a fair value on Arcapita's holdings, and they would not be able to repay the murabaha and continue on as a going concern afterwards, even if they were given additional time. The concept of bankruptcy and Islamic finance is not well established and one of the few relatively successful bankruptcies of an Islamic debt instrument was East Cameron. It was solved through a relatively ad hoc solution in a US bankruptcy court that saw some conventional funds work with Islamic investors to create a solution that allowed for the Islamic investors to potentially recover some of their investment, while remaining within their Shari'ah mandate.
From what I could see in the East Cameron filings and a post mortem from people I spoke with, the solution wasn't pretty (i.e. it wasn't solved along the exact lines drawn up in the contracts), but instead relied upon the focus of US bankruptcy courts of finding an equitable solution. Perhaps a similar resolution of the Arcapita bankruptcy through US courts could make the US a more recognized jurisdiction for Islamic finance. That, more than anything, would encourage more Islamic finance in the US.
A post script: I wasn't able to fit into the blog post the connection between current discussion of presidential candidate Mitt Romney's involvement in private equity with Bain Capital and the Arcapita bankruptcy, but they do have a strange overlap. Bain Capital has been heavily criticized for leading American Pad & Paper into bankruptcy in 2000. Three years later, the firm was bought by Arcapita.
Trading murabaha (Arcapita and Goldman Sachs)
There are a lot of areas where criticism has been directed at Goldman Sachs' murabaha sukuk, but one area can probably be dismissed: the listing of the sukuk on the Irish Stock Exchange. The concern is that the sukuk will be traded at values other than par, which is not allowed in most cases (outside of Malaysia where bay' al-dayn or debt trading is permitted).
The argument from Goldman Sachs is that the listing on the Irish Stock Exchange is for "tax mechanism purposes", not for trading according to a Shari'ah scholar quoted by EuroWeek. The prospectus states that the sukuk is not tradable except at par, but this is just a statement from the scholars, not a legally binding part of the prospectus. A spokesperson for the Irish Stock Exchange has also said it "would not be appropriate for an exchange to determine price in the market" (also from the EuroWeek article).
This makes sense, and while not desirable from a Shari'ah perspective, will inevitably be a concern whether or not the sukuk is listed. Arcapita's $1.1 billion murabaha (which the company was not able to roll-over leading the firm to file for Chapter 11 bankruptcy protection) would have contained a similar requirement around trading for Shari'ah-compliant investors, yet it traded a year ago at 76 cents on the dollar and other market data suggests it was trading between 50 and 60 cents a few months ago.
I am not making an argument on Shari'ah grounds here (I am utterly unqualified to make a judgement on such an issue), but on the mechanics of how Islamic finance interacts with the conventional financial system. There is no requirement that Islamic debt be subscribed only by Shari'ah-compliant investors, nor would that make sense. The issuer buys a commodity (or other tangible asset) from the investors at the cost plus a markup and agrees to make deferred payment for the asset. The Shari'ah board reviews the transaction to ensure it complies fully.
An Islamic financial institution which subscribes to the murabaha would hold the debt and could--if it chooses--sell it to another institution, but only at par (something its own Shari'ah board would oversee and sign off on). However, the other investors who are not required to be Shari'ah-compliant are freely able to trade that receivable to other conventional investors at whatever price they decide is fair (if they were to sell to an Islamic financial institution, the buyer's Shari'ah board would likely determine that the purchase must take place at par).
The murabaha issued to conventional investors is subject only to the law chosen that governs it (e.g. English or New York law is most common) and the post-sale transactions with non-Islamic investors would be governed by whatever securities laws apply to the buyers and sellers. It would be inappropriate and impossible to have Shari'ah scholars ruling on the transactions between two parties who do not subject themselves to remaining Shari'ah-compliant. Nor would transactions at prices besides par make the rest of the issued murabaha not Shari'ah-compliant.
Returning to the Goldman Sachs sukuk, there are other more pressing issues for potential Islamic investors than the tradability of the sukuk. For example, the use of proceeds and the ability of a non-Shari'ah-compliant institution to fund its non-compliant businesses using Islamic financial products.
The argument from Goldman Sachs is that the listing on the Irish Stock Exchange is for "tax mechanism purposes", not for trading according to a Shari'ah scholar quoted by EuroWeek. The prospectus states that the sukuk is not tradable except at par, but this is just a statement from the scholars, not a legally binding part of the prospectus. A spokesperson for the Irish Stock Exchange has also said it "would not be appropriate for an exchange to determine price in the market" (also from the EuroWeek article).
This makes sense, and while not desirable from a Shari'ah perspective, will inevitably be a concern whether or not the sukuk is listed. Arcapita's $1.1 billion murabaha (which the company was not able to roll-over leading the firm to file for Chapter 11 bankruptcy protection) would have contained a similar requirement around trading for Shari'ah-compliant investors, yet it traded a year ago at 76 cents on the dollar and other market data suggests it was trading between 50 and 60 cents a few months ago.
I am not making an argument on Shari'ah grounds here (I am utterly unqualified to make a judgement on such an issue), but on the mechanics of how Islamic finance interacts with the conventional financial system. There is no requirement that Islamic debt be subscribed only by Shari'ah-compliant investors, nor would that make sense. The issuer buys a commodity (or other tangible asset) from the investors at the cost plus a markup and agrees to make deferred payment for the asset. The Shari'ah board reviews the transaction to ensure it complies fully.
An Islamic financial institution which subscribes to the murabaha would hold the debt and could--if it chooses--sell it to another institution, but only at par (something its own Shari'ah board would oversee and sign off on). However, the other investors who are not required to be Shari'ah-compliant are freely able to trade that receivable to other conventional investors at whatever price they decide is fair (if they were to sell to an Islamic financial institution, the buyer's Shari'ah board would likely determine that the purchase must take place at par).
The murabaha issued to conventional investors is subject only to the law chosen that governs it (e.g. English or New York law is most common) and the post-sale transactions with non-Islamic investors would be governed by whatever securities laws apply to the buyers and sellers. It would be inappropriate and impossible to have Shari'ah scholars ruling on the transactions between two parties who do not subject themselves to remaining Shari'ah-compliant. Nor would transactions at prices besides par make the rest of the issued murabaha not Shari'ah-compliant.
Returning to the Goldman Sachs sukuk, there are other more pressing issues for potential Islamic investors than the tradability of the sukuk. For example, the use of proceeds and the ability of a non-Shari'ah-compliant institution to fund its non-compliant businesses using Islamic financial products.
Sunday, March 18, 2012
Egypt working on sukuk laws
In this week's newsletter (sign up on the right side of the blog), I discussed the Tunisian working group that was established to determine how the country will change its laws to facilitate Islamic finance generally and sukuk specifically. Egypt appears much farther down the road to having a sukuk law that will facilitate issuance.
As I mentioned with regards to Tunisia holds true in Egypt as well. The first sukuk will likely be sovereign issuance to finance large post-revolutionary budget deficits. However, in contrast with Tunisia, there are three Islamic banks (two of which have ties in the GCC) that can issue sukuk and more easily tap Gulf liquidity.
That being said, Egypt is unlikely to jump to the "hub of Islamic finance" that is expressed as a hope in some of the quotes in the article any time soon. There is still a challenging economic situation (as with any post-revolutionary country) and that will limit the appeal to international investors of any sukuk, sovereign or corporate. There are also domestic challenges since many people distrust Islamic finance due to failed investment funds in the 1980s that were supposedly Shari'ah-compliant.
However, it appears that there is not a movement to totally Islamize the banking system (as Sudan and Iran did, at least nominally), which is a positive. There may be support for that in some quarters, but it would be detrimental because the government (in particular) will have a continuing need for financing to cover budget deficits into the foreseeable future and cannot be too picky about where the financing will come from (i.e. conventional bonds or sukuk). Egypt has one of the more active government bond markets in the GCC. It does not have the same level of oil and gas reserves as many GCC countries do that let them pick and choose when and whether to issue debt (either conventional or Islamic).
However, given the need for funds from the government and the nascent Islamic banking sector, as well as the other areas of the economy, Egypt should not avoid facilitating Islamic finance. There is a sizable amount of liquidity in the GCC that can be tapped if the regulations and economic policies are done correctly. It should move to attract this financing without letting the work needed to do so distract the government from the most important job, which is to help the economy recover. Economic recovery (with some facilitative legislation in place) will do the most to attract investors' funds, something which would be necessary if the hopes for Egypt to become a hub for Islamic finance can even be discussed seriously.
As I mentioned with regards to Tunisia holds true in Egypt as well. The first sukuk will likely be sovereign issuance to finance large post-revolutionary budget deficits. However, in contrast with Tunisia, there are three Islamic banks (two of which have ties in the GCC) that can issue sukuk and more easily tap Gulf liquidity.
That being said, Egypt is unlikely to jump to the "hub of Islamic finance" that is expressed as a hope in some of the quotes in the article any time soon. There is still a challenging economic situation (as with any post-revolutionary country) and that will limit the appeal to international investors of any sukuk, sovereign or corporate. There are also domestic challenges since many people distrust Islamic finance due to failed investment funds in the 1980s that were supposedly Shari'ah-compliant.
However, it appears that there is not a movement to totally Islamize the banking system (as Sudan and Iran did, at least nominally), which is a positive. There may be support for that in some quarters, but it would be detrimental because the government (in particular) will have a continuing need for financing to cover budget deficits into the foreseeable future and cannot be too picky about where the financing will come from (i.e. conventional bonds or sukuk). Egypt has one of the more active government bond markets in the GCC. It does not have the same level of oil and gas reserves as many GCC countries do that let them pick and choose when and whether to issue debt (either conventional or Islamic).
However, given the need for funds from the government and the nascent Islamic banking sector, as well as the other areas of the economy, Egypt should not avoid facilitating Islamic finance. There is a sizable amount of liquidity in the GCC that can be tapped if the regulations and economic policies are done correctly. It should move to attract this financing without letting the work needed to do so distract the government from the most important job, which is to help the economy recover. Economic recovery (with some facilitative legislation in place) will do the most to attract investors' funds, something which would be necessary if the hopes for Egypt to become a hub for Islamic finance can even be discussed seriously.
Saturday, March 17, 2012
Khazanah sukuk
The first convertible sukuk in 2 years was issued by Khazanah Nasional at a yield to maturity of -0.5% and no periodic payments. The conversion premium into shares of Chinese retailer Parkson Retail Group) for the sukuk was 30%. Based on today's price of Parkson, was last time the conversion price was seen was at the beginning of 2011. The sukuk was 3.4 times oversubscribed and priced at the lower end of the expected range.
Khazanah has issed a few convertible sukuk to divest itself of several holdings including Telekom Malaysia and well as an exchangeable sukuk for PLUS, a company which operates highways in Malaysia (Khazanah also issued a renminbi-denominated sukuk last year). Both of those sukuk were issued pre-financial crisis (2006 and 2007, respectively). The pricing for the sukuk and the level of interest (from the oversubscription) indicates that the Malaysian sukuk market (at least those from companies connected to the government) continues to be robust.
Khazanah has issed a few convertible sukuk to divest itself of several holdings including Telekom Malaysia and well as an exchangeable sukuk for PLUS, a company which operates highways in Malaysia (Khazanah also issued a renminbi-denominated sukuk last year). Both of those sukuk were issued pre-financial crisis (2006 and 2007, respectively). The pricing for the sukuk and the level of interest (from the oversubscription) indicates that the Malaysian sukuk market (at least those from companies connected to the government) continues to be robust.
Wednesday, March 14, 2012
Could trade finance provide a place for murabaha in "authentic" Islamic finance?
The executive director of the Monetary Authority of Singapore, Tai Boon Leong, gave a speech at the Islamic Finance News Roadshow Singapore in which he suggested that Islamic banks become more involved in trade finance, noting the withdrawal of European banks due to the debt crisis. He said:
"Islamic finance players should however explore new growth areas which adhere to Shariah principles. One such possibility is trade finance. Globally, trade finance is facing funding pressures as European banks, who have been traditionally strong in this sector, continue to deleverage and adjust to the requirements of Basel III. Given Islamic finance’s emphasis on supporting tangible, real economic activities, trade finance is a business segment which fits well with Shariah principles and business model."
I am not extremely knowledgeable about trade finance (I am not a banker), but from what a few minutes of informal research, the forms of trade finance mostly revolve around factoring trade receivables (i.e. extending credit based on goods being transported internationally) and trade credit insurance. The roots of Islamic finance are based in trading, since many of the countries in the Middle East where Islam began were based on trading and much of the spread of Islam occurred along trade routes.
Murabaha has attracted a lot of criticism because of its similarity with conventional finance and also because it is being used to synthesize loans that mimic conventional loans. However, where applied to trade finance, the main points of criticism fall away. In a trade finance loan, the buyer in one country wants to sell goods to a seller in another but wants to get paid now and not bear the risk associated with dealing with a buyer in another country, as well as the time it will take to get paid. The seller does not want to pay in advance because it would be difficult to recover funds paid if the goods aren't delivered. A bank can serve as a trusted intermediary that takes the credit risk from the seller and facilitates the desire by the buyer to make payment on delivery.
The trade finance company can buy the good from the seller and take legal ownership of the good and then, at the same time, sell the asset to the buyer and transfer legal ownership of the good to the buyer, but with payment due in the future with a markup on the anticipated delivery date. The transfer of ownership shifts the risk of loss to the buyer, but removes the risk of fraud by the seller, and in return, the bank remains focused on the credit risk where banks are specialists.
The transaction offers value to both buyer and seller, and facilitates the exchange of a real asset that is in demand (in contrast to many murabaha which use an asset only to facilitate the extension of credit). Perhaps it is too boring of a transaction to attract much attention and it already occurs with regularity, but with the controversies around some murabaha transactions like the Goldman Sachs sukuk, it would be to the industry's benefit if transactions like this were mentioned as demonstrating the usefulness of murabaha to counter the widely held idea that most murabaha transactions are done as a way of replicating a conventional financial institution, and do not involve buying and selling an asset that is actually demanded. It is, instead, a transaction that would facilitate the economic activity between a buyer and seller that they would not (unless they turned to conventional finance) be willing to undertake without the Islamic bank.
"Islamic finance players should however explore new growth areas which adhere to Shariah principles. One such possibility is trade finance. Globally, trade finance is facing funding pressures as European banks, who have been traditionally strong in this sector, continue to deleverage and adjust to the requirements of Basel III. Given Islamic finance’s emphasis on supporting tangible, real economic activities, trade finance is a business segment which fits well with Shariah principles and business model."
I am not extremely knowledgeable about trade finance (I am not a banker), but from what a few minutes of informal research, the forms of trade finance mostly revolve around factoring trade receivables (i.e. extending credit based on goods being transported internationally) and trade credit insurance. The roots of Islamic finance are based in trading, since many of the countries in the Middle East where Islam began were based on trading and much of the spread of Islam occurred along trade routes.
Murabaha has attracted a lot of criticism because of its similarity with conventional finance and also because it is being used to synthesize loans that mimic conventional loans. However, where applied to trade finance, the main points of criticism fall away. In a trade finance loan, the buyer in one country wants to sell goods to a seller in another but wants to get paid now and not bear the risk associated with dealing with a buyer in another country, as well as the time it will take to get paid. The seller does not want to pay in advance because it would be difficult to recover funds paid if the goods aren't delivered. A bank can serve as a trusted intermediary that takes the credit risk from the seller and facilitates the desire by the buyer to make payment on delivery.
The trade finance company can buy the good from the seller and take legal ownership of the good and then, at the same time, sell the asset to the buyer and transfer legal ownership of the good to the buyer, but with payment due in the future with a markup on the anticipated delivery date. The transfer of ownership shifts the risk of loss to the buyer, but removes the risk of fraud by the seller, and in return, the bank remains focused on the credit risk where banks are specialists.
The transaction offers value to both buyer and seller, and facilitates the exchange of a real asset that is in demand (in contrast to many murabaha which use an asset only to facilitate the extension of credit). Perhaps it is too boring of a transaction to attract much attention and it already occurs with regularity, but with the controversies around some murabaha transactions like the Goldman Sachs sukuk, it would be to the industry's benefit if transactions like this were mentioned as demonstrating the usefulness of murabaha to counter the widely held idea that most murabaha transactions are done as a way of replicating a conventional financial institution, and do not involve buying and selling an asset that is actually demanded. It is, instead, a transaction that would facilitate the economic activity between a buyer and seller that they would not (unless they turned to conventional finance) be willing to undertake without the Islamic bank.
Transparency vs the OCIS-SC closed-door forum
The Oxford Center for Islamic Studies and Malaysia's Securities Commission held a closed-door forum on "Solutions for Liquidity Management" earlier this week. While I have no problem with a closed door meeting, I am a bit mystified trying to read the SC press release to figure out what they were talking about (there is no press release that I could find from the OCIS). I am not sure why a press release was issued that contains few details that would be useful to people following the industry.
There were really only 2 paragraphs of substance:
Transparency is a good thing. While it does not have to be universal--it shouldn't always be--press releases that say little about closed-door forums is not particularly useful for anyone involved. For example, I will never get the time back the time I spent trying to squeeze water from the rock that this press release.
There were really only 2 paragraphs of substance:
"While sukuk issuances have generally been successful in terms of primary subscription, "the lack of secondary trading - due perhaps to the scarcity of supply; lack of infrastructure; trading mechanisms that are not globally accepted; or unresolved issues over valuations - have all led to investors holding on to the "buy-and-hold‟ attitude of the instruments until maturity" observed HRH Raja Nazrin."I have discussed the liquidity challenges in sukuk secondary markets many times. I think that all of the reasons cited are valid, but I think the most problematic for investors is the lack of supply, so that it becomes hard to replace a sukuk sold in the secondary market with another (either in the primary or secondary market). There has to have been some interesting discussion in the forum on the differences in liquidity between Malaysia and the GCC (and beyond) that would not be too sensitive to release to the public, that could have offered as the basis for constructive discussion around what can be done to help the secondary markets develop. Alas, there was nothing beyond the well known issues for the sukuk markets. The press release continues a bit later discussing a bill in Malaysia being developed by the SC to expand the investment opportunities for funds.
""This bill will pave the way for Shariah funds to directly invest into income generating assets and businesses. The bill also proposes the creation of business trusts, a trust vehicle, to accommodate the ownership of businesses or assets, giving investors direct exposure to the real economy. More importantly, these initiatives are consistent with maqasid al shariah. This bill has strong roots in the exchange of visionary ideas and perspectives from the inaugural SC-OCIS Roundtable of 2010" added Tan Sri Zarinah."Here, the release is a bit more forthcoming suggesting the idea to allow more direct ownership of businesses through trusts, that give investors "direct exposure to the real economy". However, this does not appear--from the discussion in the press release--to be a new idea. Islamic funds already have direct exposure to the real economy through equity ownership in businesses, or through debt-based sukuk that use of trusts (SPVs), both of which are also "consistent with maqasid al shariah". A more direct discussion of the bill and how it differs from what is already in existence would help spur discussion, again without revealing any of the sensitive discussions that happened behind closed doors.
Transparency is a good thing. While it does not have to be universal--it shouldn't always be--press releases that say little about closed-door forums is not particularly useful for anyone involved. For example, I will never get the time back the time I spent trying to squeeze water from the rock that this press release.
Friday, March 09, 2012
More on the prospects for green sukuk
Last week, I wrote a post on the impact of green sukuk being used to reduce carbon emissions in the GCC (which would lead to more crude exports to countries that use oil more efficiently in terms of units of GDP per barrel). The Climate Bonds Initiative, an investor-focused non-profit, which is working with the Clean Energy Business Council of the Middle East and North Africa and the Gulf Bond & Sukuk Association, has a Green Sukuk Working Group,that says its aim is "to channel market expertise to develop best practices and promote the issuance of sukuks for the financing of climate change investments and projects, such as renewable energy projects".
While I want to see some solid progress made, not just a press release, I am encouraged by the working group because renewable energy projects are areas where the Islamic finance industry (and the sukuk market, which acts almost as its public face) can differentiate themselves from most of conventional finance. One thing I would hope for the Working Group is that it makes documents relating to the meetings publicly available. As a non-profit, it would benefit the mission of the working group if ideas that originate within the working group were copied by Islamic financial institutions. Hopefully they will provide the maximum amount of transparency possible.
While I want to see some solid progress made, not just a press release, I am encouraged by the working group because renewable energy projects are areas where the Islamic finance industry (and the sukuk market, which acts almost as its public face) can differentiate themselves from most of conventional finance. One thing I would hope for the Working Group is that it makes documents relating to the meetings publicly available. As a non-profit, it would benefit the mission of the working group if ideas that originate within the working group were copied by Islamic financial institutions. Hopefully they will provide the maximum amount of transparency possible.
Wednesday, March 07, 2012
Dana Gas sukuk news analysis (update)
In a news analysis I wrote for The Islamic Globe about the Dana Gas sukuk, I wrote about the focus by investors on the ability of Dana Gas to turn receivables into cash in Egypt. I wrote: "Fortunately for Dana Gas, its production in Kurdistan through the Pearl Petroleum Co., of which it owns 40%, has continued to grow, although there is a problem collecting receivables there as well, albeit less severe than in Egypt. " However, new developments in Iraq may put the Kurdistan projects at risk. The central government of Iraq has long maintained that oil deals with the Kurdistan Regional Government are invalid and the government has not been shy about making life difficult for companies that do deals directly with the regional government, even oil majors like ExxonMobil. Exxon has not made a final decision about whether to abide by the central government's wishes or continue with its agreement with the regional government, but its decision could provide clarity on whether the Iraqi government is able to overturn existing contracts signed with the regional government. For Dana Gas, this clarity could be a positive, or another source of uncertainty about its ability to continue growing its production in Iraq, that provides a bright spot amidst continued uncertainties in Egypt.
Regulating Shari'ah scholars
The Director of Supervision of the Dubai Financial Services Authority David Gray questioned why there was not regulation for Shari'ah scholars in line with regulation of other areas of Islamic finance. He contrasts the lack of regulation of Shari'ah scholars with lawyers and accountants, who also provide advice to Islamic financial institutions.
I think he has an excellent point. It is not enough to just work on the faith that Shari'ah scholars will always act as objective parties, because they are human just like the rest of us. There have been few times when Shari'ah scholars have been directly implicated in a financial scandal, but that doesn't mean it cannot happen, and further that no regulation should be put in place to police potential violations of basic ethical guidelines about conflict of interest and confidentiality.
The guidelines need not lead to a central Shari'ah body like Malaysia has. They can focus on conflicts of interest caused by serving on many boards simultaneously, as well as providing an enforcement mechanism to discipline scholars, for example, if they disclose confidential information. These ideas are not meant to suggest there is a current problem, although there has long been concern that Shari'ah scholars may in some cases be faced with a conflict of interest, but why wait until there is a scandal that could damage the image of the industry. Much better to try and avoid an incident ahead of time.
I think he has an excellent point. It is not enough to just work on the faith that Shari'ah scholars will always act as objective parties, because they are human just like the rest of us. There have been few times when Shari'ah scholars have been directly implicated in a financial scandal, but that doesn't mean it cannot happen, and further that no regulation should be put in place to police potential violations of basic ethical guidelines about conflict of interest and confidentiality.
The guidelines need not lead to a central Shari'ah body like Malaysia has. They can focus on conflicts of interest caused by serving on many boards simultaneously, as well as providing an enforcement mechanism to discipline scholars, for example, if they disclose confidential information. These ideas are not meant to suggest there is a current problem, although there has long been concern that Shari'ah scholars may in some cases be faced with a conflict of interest, but why wait until there is a scandal that could damage the image of the industry. Much better to try and avoid an incident ahead of time.
Sunday, March 04, 2012
How much more expensive are sukuk than conventional bonds?
The main article from this week's newsletter, which I am posting again as a PDF (though future issues will only appear on the website with a lag, so you should subscribe on the right hand of the blog) deals with the costs of sukuk. There are also other short articles which I am not posting up on the blog.
One of the running debates in the Islamic finance industry is the issue of cost of Shari’ah-compliant products versus conventional products. Whether it is an Islamic mortgage, Islamic structured product or a sukuk, the conventional wisdom is that there is a premium associated with Islamic finance (which I discussed last December in a blog post).However, a story from Bloomberg, quoting the VP at SJS Markets Ltd., Samer Mardini, puts a figure on this premium: 120 basis points or 1.2%. The estimate from Marini estimates the coupon required to sell 5-year sukuk at 5.5%, significantly higher than the yield on conventional bonds of the same maturity according to Bloomberg.Perhaps this also puts some context behind the UK Treasury’s decision to again decide sukuk don’t offer value for the cost. In an era where debt levels are rising and there is heightened attention paid to the sustainability of debt, few Western sovereign issuers are going to opt for a more expensive option, especially if the spread over convention debt exceeds 100bps.The question then follows: where is the spread coming from and is there a way to reduce it? The answer to the first question, is two-fold. Many people would immediately point to the additional legal and financial structuring fees, and this is a contributing factor, but I think that investors demanding extra yield is probably a more significant factor.I place a lot of responsibility at the feet of the secondary markets and the lack of development of liquid markets for the additional cost. This was attributed as the cause of several Indonesian sukuk auctions back in 2010, despite the rapid growth in the economy of Indonesia. Due to illiquidity in secondary markets, investors demanded a spread of 50bps over conventional bonds, which are more liquid. The article linked above quotes a fixed income analyst at Mandiri Sekuritas: “The main problem in sukuk auctions is liquidity”.The liquidity issue is a difficult one to resolve, but changing conditions in sukuk primary markets (where sukuk issuance has surpassed pre-crisis levels) may indicate that at least one piece is fitting into the puzzle: supply. If there is sufficient supply of new issues, then investors may be more willing to part with the sukuk in their portfolio because they know they can replace it with a different sukuk, deepening liquidity in secondary markets.While this does provide some hope, there are still other obstacles blocking the path to a narrower spread between conventional bonds and sukuk. Even if one excludes the legal costs for structuring a sukuk, it will still be more costly for investors because each sukuk is different and the prospective purchasers will have to spend more time reviewing the structure, rather than focusing on whether the issuer is risky or not.There are likely to be cases where a custom sukuk is the only way to go, but there will be many more instances where it will just add cost and complexity to the issuer and to the purchaser. I like the idea that was proposed for IIFM and Hawkamah of creating a template for an ijara sukuk. IIFM has experience in the past creating standardized contracts (some of which have been more successful than others), and ijara sukuk are probably the most common structure for issuers.There is no guarantee that either a template for an ijara sukuk, nor a more liquid secondary market would lower spreads to zero, but better to tread down these paths and see if it makes an impact than to keep marching forward down the current path.
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