IMF report, UAE Islamic banks, tawarruq attracts criticism, effects of the Dubai World debt agreement

The IMF released a study in August 2010 that provided an interesting analysis of what drove growth in Islamic banking from 1992 to 2006. The main finding of the study was that oil prices (which created a significant inflow of liquidity into the GCC, which is a major region for Islamic banking) had the largest effect. One interesting specification they used included both the price of oil and a dummy variable to measure the effect of 9/11 (to see whether growth was higher after 9/11, all other things being equal) and found that it did on its own, but when the effects of the oil price were included, the impact of 9/11 became insignificant. This suggests that the rise in oil prices in the 2000s was much more impactful on the growth of Islamic banking than 9/11. The argument for the impact of 9/11 was that following the attacks, many funds that were invested in the West were repatriated to (mostly) the GCC.

The head of Shari'ah at the Islamic Development Bank, Sheikh Mohammed Mukhtar Al Salami, says that tawarruq is 'usury' and therefore is 'haram'. His argument is that the transaction is "being carried out by Islamic banks as mere concealed usury operations as they are done not only at one place but at two place", reiterating an argument made by the Fiqh Council of the OIC. The OIC Fiqh Council's argument differentiated between classical tawarruq and organized tawarruq. In a tawarruq transaction a bank sells a metal of a client with deferred repayment (cost-plus-profit) and then the client sells the metal to get cash. In an organized tawarruq (also called reverse murabaha), the bank facilitates the sale of the the metal in the spot market (although the metal brokers used on each side of the transaction are different). Tawarruq is a commonly used product by Islamic financial institutions and greater Shari'ah risk around the product highlights the need for short-term liquidity management tools for institutions and new products for consumers, as tawarruq attracts more criticism.

Several articles describe the effect of the Dubai World debt agreement on other sukuk. Bloomberg reports that it is unlikely to lead to a 'massive' rally according to the CEO of Mashreq Capital in Dubai. Another Bloomberg article notes that the Dubai World agreement has failed to benefit Tamweel sukuk. Tamweel is a troubled Islamic mortgage company in Dubai that may be merged with Amlak Finance, another Islamic mortgage company, with assistance from the Dubai government. The Dubai World agreement could move the spotlight onto Nakheel, which has paid its trade creditors in cash and sukuk and has also repaid 2 of its 3 sukuk with assistance from the Dubai Financial Stability Fund. The Dubai World deal does raise an issue with Nakheel: the first two sukuk were repaid at par whereas Dubai World creditors accepted a writedown of principal and an extended maturity. The next key date for Nakheel is January 16, 2011 when the Nakheel Development 2 sukuk (the final one) is scheduled to mature. Will investors be forced to take a haircut or will the DFSF step in again to ensure repayment at par? It is too early to tell.

Profits in UAE-based Islamic banks fell 17% in the first half of 2010 compared with the same period in 2009. This is somewhat expected as the impacts of the financial crisis hit this region slightly later than in other parts of the world. However, despite the fall in profits, analysts believe the banks have not provisioned enough for non-performing loans, particularly in real estate in construction, the two sectors hit hardest.

Takaful continues to grow, but it is several years behind the growth in Islamic finance. Prudential BSN Takaful, a joint venture between Prudential PLC and Bank Simpanan Nasional Bhd in Malaysia, is launching three new takaful plans. An African Reinsurance company African Re, is launching a retakaful subsidiary with a wide focus on Africa, the Middle East and Asia. The Bahraini takaful compay t'azur recently announced a retakaful agreement with Hannover Re, a large conventional reinsurance company. Retakfaul is the Shari'ah-compliant version of reinsurance and has been very limited in availability. The Sri Lankan takaful firm Amana Takaful says that its operations are hampered by a lack of enough Shari'ah-compliant investments. If the takaful plan were managed like a conventional insurance pool, it would invest most of its assets into sukuk. However, the sukuk market has not been large enough to support the needs of takaful companies as well as other Islamic investors and unless there is significant growth in sukuk, takaful companies will have difficulties. They could invest in other assets: real estate, equities, commodities. However, all of these are more volatile than fixed income and it will probably not end well if a significant proportion of takaful fund assets were invested in these asset classes if there were a repeat of the financial crisis or even a less severe recession. It also makes it more difficult for the managers of the takaful funds to project its long term assets and ensure they match with expectations about its long term liabilities.

Other News

• The Javelin JETS Dow Jones Islamic International Index Fund, the first US-based Islamic ETF, will close. The company cites limited investor interest "through the marketing channels typically used by ETFs" according to Javelin's president Brint Firth.
  
• Mapletree Industrial Trust, a Shari'ah-compliant REIT, is raising $800 million in an IPO in Singapore.
  
• Indonesia plans to issue sukuk and global bonds in the first half of 2011. The government reduced its sukuk issuance in 2010 when deficits came in lower than expected. Several of the sukuk auctions failed during 2010 because investors demanded a higher yield than conventional bonds to account for the lower liquidity of sukuk compared to bonds.
  
• The development of Islamic banking in India is still not possible and the Indian Centre for Islamic Finance has approached the Reseve Bank of India, the central bank, and asked it to allow a few banks in Mumbai to open Islamic windows on a pilot basis before it considers any regulatory changes.
  

Nakheel repays its sukuk, FT Special Report

The Nakheel restructuring discussions continue as Nakheel repays the Nakheel Development 3 sukuk for $980 million (Thursday) with assistance from the Dubai Financial Support Fund. The trade creditors of Nakheel are close to approving the deal which would pay them 40% in cash with the remainder in a "publicly traded security with a 10 percent per annum return". Previous reporting said the security would be a sukuk, which is not mentioned in the latest news. AFP reports that 50% of trade creditors have agreed to the plan; 65% approval is needed for it to be approved. One interesting piece of information contained in the article that I had not seen explicitly mentioned was that upon the approval of a restructuring plan, Nakheel would no longer be part of Dubai World and would instead be owned directly by the government of Dubai. The repayment of the Nakheel sukuk is described as a part of the debt restructuring plan for Dubai World.

The Dubai World debt restructuring is an extremely complex process with many different stakeholders with different goals. However, it appears that there has been differential treatment of various parties without regards to their seniority (excepting the initial Nakheel Development sukuk). The first Nakheel sukuk provided sukuk investors with a mortgage over the underlying (undeveloped) properties, but the trade creditors, investors in Nakheel Development 2 and 3 sukuk and the other debt holders are all unsecured creditors of either Dubai World or one of its subsidiaries. In general, a restructuring should (in my opinion) treat all unsecured creditors equally if the debt restructuring for all entities (with the exception of excluded business like DP World) is done at once. In the current deal, all investors are theoretically being repaid at par but sukuk holders receive their payment upon the scheduled maturity dates while trade creditors receive 40% cash payment with the remainder paid in the form of a tradable security and other creditors have maturities extended with a 1% interest rate being offered.

There are good reasons for some of these developments--the Dubai government recognizes that trade creditors receiving cash on their claims (at least on a portion) will help the local economy. Paying sukuk holders on the near-term maturity will avoid default. However, it is troubling for the Islamic finance industry as a whole because it could create a perception problem for the industry. In general, the products used in Islamic finance are created to mimic conventional bonds, but their robustness in cases of default is unproven. A default by Dubai World on sukuk could have ripple effects because it was viewed (incorrectly) as a quasi-sovereign issue. However, on-time repayment of the sukuk while other creditors see the maturity extended and the interest rate dropped could make companies less likely to consider sukuk.

The rationale is somewhat convoluted, but I will try to explain it. A company that uses both conventional and Islamic forms of debt finance brings a conventional unsecured, senior bond to the market. Before that bond matures, the company issues an unsecured, senior sukuk (equal in seniority with the conventional bond) to diversify its funding sources that makes up a relatively small share of the company's total debt. When the time comes to roll over the conventional bonds, the investors balk at the debt pointing to Dubai World and asking "If you run into trouble, will the sukuk certificateholders have de facto seniority over the bond holders? Will they be repaid while we wait for a debt resolution?". The prospects for the issuance of sukuk by a conventionally financed company to create investor concerns among conventional bondholders could make such a company think twice about issuing the sukuk in the first place. This would deprive the Islamic finance industry and sukuk markets of a large group of potential issuers and will slow the growth of a portion of the industry, but not just investment banks who work on the sukuk issuers. Takaful companies, for example, will see the shortage of sukuk accentuated if potential issuers do not issue sukuk for this reason.

The Financial Times has a special report on Islamic finance. Rather than try to summarize each article, I will just list the articles and recommend them all:

• "Derivatives: 'In need of robust architecture'"
  
• "Rich potential in emerging markets"
  
• "Products: Industry 'strays too far from its roots'
  
• "Hedge funds: Industry once more at centre of attention"
  
• "Malaysia: Ahead of the game in local contest
  
• "Sukuk: Sustained recovery expected in second half of the year"
  

Other News

• Differences in interpretation and the lack of enforcement powers by standardization bodies like AAOIFI could be hindering the Islamic financial industry's growth.
  
• Bahraini Islamic investment bank Elaf Bank was appointed to arrange sukuk for two Indonesian companies.
  
• Dubai Islamic Bank approved a wakala agreement with the Ministry of Finance. The wakala agreement converts a $1 billion deposit by the government that was part of efforts to shore up local banks in the wake of the debt troubles at Dubai World.
  
• An article in the UK looks at Islamic ETFs from iShares available in the UK.
  

Dubai World update and more

In contrast with the 1% rate offered to debt holders by Nakheel, the company has offered trade creditors tradable sukuk with a 10% coupon. The distinction, as described in a Reuters article is that it will allow trade creditors to monetize the sukuk at a better price. However, this could also make debt holders reject the restructuring plan. The price trade creditors could receive from selling the sukuk would depend not only on the coupon, but on the perceived ability of Nakheel to make good on its obligations following the approval of the restructuring plan. Local banks are seeking better terms in the Dubai World restructuring plan.

Rushdi Siddiqui writes in Gulf News about the need for Islamic financial institutions to view public relations as an important part of business development to expand their appeal.

Other News

• A contributor to TwoCircles.net describes the potential for Islamic microfinance and laments the shortage of Islamic banks becoming involved with microfinance.
  
• The sukuk market is not expected to regain its growth until 2011-2012 according to analysts. 2010 is expected to be flat compared with 2009, where there was significant recovery after a multi-year low in 2008.
  
• The Saad Group has yet to reach an aggrement with the banks to whom it owes at least $6.5 billion.
  
• Without naming The Investment Dar, Lahem al-Nasser, writes a damning criticism of their challenge in the case surrounding the wakala agreement with Blom Bank in Asharq Alawsat calling their legal claims 'Machiavellian". Andrew Cunningham, the managing director of the Financial Services Volunteer Corps adds his thoughts in a Financial Times opinion piece.
  
• Islamic banks in Malaysia and the UK plan further cooperation to increase the number of cross-border transactions.
  

Dubai World debt restructuring and Islamic finance in a restructuring

The details of the Dubai World proposed restructuring plan are still not fully known. However, what is known is that Dubai will fund Dubai World with $9.5 billion, of which $8 billion will be provided to Nakheel under the proposed restructuring proposal described by the media. Of this, $4 billion will be used to restart projects at Nakheel and repay the maturing sukuk with a combined principal amount of $1.75 billion. To restart projects, smaller trade creditors would receive full payment and larger trade creditors would receive 40% payment in cash with the remainder paid with a tradable security that could be held for full repayment or sold to another party. One of the concessions by Dubai's government is that it will place itself lower than other creditors in receiving a return of the funds it has injected in Dubai World of $8.9 billion by the Dubai Financial Support Fund (DFSF) and will convert this into equity. The remaining Dubai World debt holders' fate is less clear although it is believed they will be repaid in full over a lengthened 5-8 year period at lower interest rates than the debt pays currently.

While the plan faces an uncertain fate because it must be approved by creditors, it does raise a question in my mind about the different treatment of Nakheel sukuk holders. Why would Dubai provide full repayment of the 2010 and 2011 Nakheel sukuk and not other debts? There is an Islamic facility for $1.2 billion for Limitless, the international property arm of Dubai World, that matures in March 2010 that was reported to be rolled over with the maturity extended and possibly also excluded from Dubai World negotiations. One of my first reactions to the Nakheel sukuk being repaid was that perhaps their Shari'ah-compliant nature meant that rolling them over by extending the maturity would have raised too many Shari'ah-compliance issues and therefore was repaid on schedule to avoid these constraints. However, the Limitless Islamic facility is not included in the restructuring proposal details that have been released and its size relative to the Nakheel sukuk is comparable.

However, without any additional information provided, I cannot speculate on the cause of the different treatment, but it is an interesting area to explore how a sukuk could have its maturity extended. In general, creditors are supposed to provide additional time for debtors to repay outstanding debts but cannot condition this extension of time upon a fee. However, many of the commonly used structures appear to be flexible enough to extend maturities of outstanding debts. For example, in an ijara, the rental period can be extended and the purchase undertaking amended to extend the date on which the creditor can compel purchase by the debtor. This would have the effect of lengthening the maturity of the ijara agreement. In a mudaraba or musharaka, the partnership can be extended but there would probably be issues with a fixed 'anticipated profit' on the mudaraba or musharaka without incorporating the new rules on these sukuk that would put some of the principal at risk if the underlying business cannot generate sufficient profits to repay principal plus anticipated profits.

A murabaha would be more difficult because after the sale of the good with a markup is already accomplished and the cashflows are a debt and extending the maturity with additional profit payments would probably not be allowed. However, the debt could be repaid with a new murabaha (e.g. commodity murabaha or tawarruq) that would effect the same thing as extending the debt with continuing interest payments. An istisna'a contract could be extended using the same commodity murabaha or tawarruq transaction.

However, does this extend too far beyond what Shari'ah scholars would permit as Shari'ah-compliant because they are moving away from providing financing alternatives into an area where they create the extension of a debt maturing in exchange for a fee? This is more than I can even speculate on because I am not a Shari'ah scholar, but it should provide the starting point for discussion on how Islamic finance could work within a debt restructuring.