Oman - A sukuk shortage and housing shortage

As Islamic banks and windows enter Oman's housing finance market, they have the opportunity to use the shortage of Omani sukuk to benefit the entire market without creating too much risk for the government.  For example, with a government guarantee, the risk should be covered by the originators through fees in exchange and limits on the eligible mortgages to ensure it can be targeted specifically at the segments of the market where supply is the most lagging of demand.

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Securtization, financial engineering and regulation

In my last post, I advocated for greater securitization in Islamic finance and I think it is a good way to expand the sukuk marketplace.  However, like all other things in finance, it should come with constraints and limitations because of the global capital standards under Bassel 2 and Basel 3.  However, those capital standards (applied to Islamic financial institutions by AAOIFI) still give the off-balance-sheet nature of those transactions preferential treatment and so it is especially important to make sure the Shari'ah standards can be applied to avoid Subprime (v.Islamic).

It is very clear to anyone watching the industry that it is mostly run by people with conventional financial experience a cadre of lawyers experienced in financial engineering to manipulate international capital standards to their own benefit.  The industry also operates to a large degree in emerging and frontier markets whose regulators may not be as well equipped as in developed markets (an admittedly low benchmark).

In "developed" markets, financial products engineered so that regulations become ineffective and the possibility for financial engineering to make regulation ineffective in emerging and frontier markets is even greater.  The only offsetting factor is Shari'ah scholars who should impose a degree of conservatism into the structuring process.  However, at this point, any challenge they raise to Shari'ah standards becomes an intellectual challenge to the lawyers and financiers to "overcome" much like they undid the prudential regulations in the developed world.

As cynical as this post is becoming, this is not meant as a diatribe against the possibility for Shari'ah-compliant securitizations.  It is more of a warning to watch out for the cynical manipulation of Islamic financial products to create a new "shadow banking" industry.  There is no widespread use of Islamic finance to evade the capital (or other) rules (sorry, conspiratorialists).

However, there are 'bad actors' in every industry and when one is exposed as Gulf Finance House was by Reuters, we know there are many more lurking in the shadows, either having evaded detection or those that are not yet big enough to merit attention.

All this gloom and doom should not obscure the efforts of thousands of people in the Islamic finance industry who are working hard with the best of intentions to create a financial system that is Shari'ah-compliant (even if there is continual debate about what that means).  It should serve, however, as a warning that not everyone in the industry has these pure motives and so regulations need to anticipate the next attempt to operate outside of bounds.

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.

Late payment penalties, liquidity management, creating secondary markets in sukuk

An article in Arab News discusses the issue of a fee charged by an Islamic financial institution for late payments. In May, Bank Negara Malaysia's Shari'ah Advisory Council said that charging a fee in case of late payment is allowable and separated out the cases where the bank can and cannot keep it and recognize it as income. In the case where the fee is charged as a fine or penalty (gharamah), it must be donated to charity and not recognized as income. Where the fee is for compensation (ta'widh) for actual loss by the Islamic bank, it can be kept and recognized as income. While the distinction is clear between the two concepts, it seems likely to be difficult to distinguish in practice. Perhaps it might be a better practice for Islamic banks that use this to treat everything as ta'widh until the actual costs of collections are met and only then be able to treat any fees as allowable income. However, it is unlikely that such a solution could be approved because it would not be possible to provide ex ante certainty in the contracts between the bank and its customers. Whether this is used or not, it could allow Islamic banks to increase the total fees to Islamic banking customers, which would make the products less competitive and probably result in a slower growth rate for Islamic banking. It would also complicate the Shari'ah audits because it would require that the fees be reviewed to determine whether the bank has basis for compensation if it used the principle of ta'widh.

A fantasstic article from Islamic Business & Finance discusses the challenges facing Islamic finance in developing short-term liquidity management products, despite their importance. The article specifically looks at the UAE commodity murbaha Islamic CDs, the idea of Shari'ah-compliant repo transactions and an electronic wakala/murabaha platform.

Rushdi Siddiqui has another interesting article in Gulf News, this one covering the issue of where is the hub of Shari'ah transactions, which quickly morphs into the discussion of the lack of a hub. One point that he makes, which I agree with and have made before on this blog, is the lack of secondary markets for sukuk. He takes it one step further adding that even where there are secondary markets for sukuk, they are not deep enough or liquid enough to provide much information. He suggests that the Islamic finance industry needs to 'institutionalize' and 'internationalize' itself, primarily by moving from bilateral price discovery through over the counter (OTC) trading to "multiple price discovery". As much as the effort towards creating secondary market platforms for sukuk will help lay the groundwork for this in the future, it is impossible until there is enough supply to sate the demands of hold-to-maturity investors and leave enough exchange-listed sukuk that can be traded in secondary markets to develop meaningful liquidity that provides more information than bilateral trades in illiquid markets can.

Other News

• Sorouh raised $640 million in conventional and Islamic debt, of which $400 million (AED1.47 billion) will be used to redeem the remainder of the sukuk issued in 2008 which I described about a month ago in a blog post. At the time, there was AED1.5 billion remaining of the AED4 billion securitization sukuk.
  
• Malaysia's central bank, Bank Negara, issued its fourth Shari'ah Parameter Reference which covers musharaka. The previous SPRs covered ijara, murabaha, and mudaraba. The bank also issued a concept paper on takaful.
  
• Bloomberg compares the performance of Shari'ah-compliant equity indices with sukuk indices. Equities have lagged sukuk in the past 2 quarters due to an agreement to restructure $23.5 billion of debt by Dubai World and its creditors.
  
• Japanese firm Nomura Holdings plans to issue a $100 million sukuk in Malaysia, the first Japanese company to do so.
  
• The proposed Islamic Bank of Thailand THB5 billion ($154.5 million) is likely to be issued in the second half of 2010 depending on market conditions. The sukuk will have a 5 to 7 year maturity.
  
• Deutsche Bank's Shari'ah-compliant platform is investing in a foreign exchange strategy, based on "investor demand" according to the managing partner of the advisory firm which will create the strategy using a structured note. Deutsche Bank previously created the controversial Total Return Swap structure that allowed investors to receive a return benchmarked to a group of conventional hedge funds.
  
• Singaporean REIT company Mapletree Investments is launching an Islamic REIT whose IPO may be up to $713 million (S$1 billion). The REIT will be marketed in the GCC by Arcapita.
  

Sun Finance sukuk and Islamic securitizations

I took a good look at the Sun Finance (Sorouh) sukuk documents which were issued at the beginning of the intensification of the financial crisis (late 2008). The sukkuk was a sukuk-al-mudaraba and was issued after the AAOIFI guidance on sukuk, meaning it could not stipulate repurchase at par, which was included through the purchase undertaking not specifically referencing the repurchase price for the portion of sukuk repurchased under the amortization schedule. The sukuk, despite the challenging environment for the global economy and the securitization market, has been successful so far and none of the three rated tranches have been downgraded despite a collapse in the securitization markets.

In the transaction, Sorouh Real Estate ('Sorouh') was seeking to securitize receivables from plot sales to sub-developers in two of its developments, Shams-Reem Island and Saraya. The proceeds of the sukuk were used to fund the mudaraba and those were used by the mudarib, Sorough Abu Dhabi Real Estate LLC ('SPV'), an SPV set up as a distinct entity from Sorouh, to purchase the full title to the underlying plots from Sorouh. The SPV provides the sukuk certificate holders with a beneficial ownership of the plots, while the SPV executed a 'true sale' of the assets from Sorouh. A portion of the sukuk proceeds were placed in various reserve accounts to make up any shortfall in profit payments (Liquidity Reserve), to fund expenses of the SPV (Senior Expense Fund) and to finance the construction of infrastructure on the plots (Infrastructure Fund). The profit sharing ratio between the mudarib (SPV) and rabb ul-mal (sukuk certificateholders) was 1% and 99%, respectively.

The receivables from the sub-developers (all 109 plots were sold by Sorouh to sub-developers before the sukuk was issued) will be paid to the SPV and used make periodic payments on the sukuk. The remainder will be paid to the mudarib (the SPV) as an incentive payment. This amount will then be used to repurchase a portion of the beneficial interest held by the sukuk holders (described in the offering documents as a 'constructive dissolution'). This leads to payment of both the profit on the sukuk assets as well as a principal redemption. The interest rate risk (the payments to sukuk holders of all tranches is based on EIBOR plus a spread) from changes in the benchmark is hedged by the SPV in a separate transaction where it acts in its own capacity and not as the mudarib. At some point, if the sub-developers continue to make payments or the plots are resold in case of sub-developer bankruptcy, the entire beneficial interest held by the sukuk holders will have been extinguished and the SPV will retain the right to the remaining payments.

The unique feature of this sukuk is that it offered three different rated tranches, each with different priority rights and coupon amounts. The three tranches (A, B and C) had successively higher return (spread over 1 month EIBOR) of 200, 250 and 350 basis points, respectively. The three tranches were also accorded different priority for periodic payments with the A tranche senior to the B tranche which was senior to the C tranche. The way the seniority over periodic and principal payments was structured was using a musawama (cost-plus sale where only the final amount is agreed between the parties). At each periodic payment date, each class is paid 2.5 percent of the rabb ul-mal's profit allocaiton and the remainder of both profit and amortization payments are made according to seniority with a musawama between the tranches used to create a non-pari passu payment outcome.

The sukuk has performed well with payments passed on from sub-developers to the SPV and used to redeem the sukuk (see table below which reflects the amounts included on Sorouh's balance sheet, which does not break down the results for each tranche of the sukuk, nor does it provide a way to measure the performance of the sukuk as a whole). However, it does show that the carrying value of the debt on Sorouh's balance sheet has declined throughout the life so far of the sukuk as the cumulative payments made rises.

When the sukuk is viewed in more detail, the structure was clearly made to mirror a multi-tranche securitization deal and the fact that it is Shari'ah-compliant had limited impact on its performance. The use of a non-recourse securitization removes the issuer's financial strength from the picture so long as it is able to continue servicing the receivables (there was a back up servicer specified in the offering documents). The performance of the sukuk reflects the ability of the underlying plot sub-developers to continue paying installment payments on the plots (where the total value of the securitized assets provided overcollateralization for sukuk investors).

This type of sukuk, while in limited use so far, does not provide any additional security compared to a conventional securitization. The quality of the assets used in creating the securitization will ultimately determine its success or failure. However, the general conservative nature of (most) Islamic financial institutions' lending will make it less likely that future securitizations using this model would include questionable assets. Despite this caveat, securitizations could present an opportunity to create debt instruments for investors while also providing Islamic financial institutions with additional capital to expand their lending. Of course, as the subprime meltdown reiterated, if the quality of the securitized assets is poor, then the performance of the securitization is also likely to be poor. There is always the possibility for a securitization crash in Islamic finance if the standards used to evaluate recipients of future financing that is then securitized.

In a rapidly growing industry like Islamic finance, the ability to free up capital on bank balance sheets through securitization could provide a way for additional capital to be lent out while also broadening the number of sukuk for investors looking to Islamic finance. There is an additional potential: conventional investors looking for private-label securitizations will be hard pressed to find conventionally securitized mortgage-backed securities and they could provide additional capitla for Islamic mortgage companies that can demonstrate high lending standards. That would benefit those investors as well as the Islamic finance industry that, for example in the US has relied upon conventional securitization through Freddie Mac and Fannie Mae. Creating an Islamic securitization market for home finance could further expand Islamic finance in Western countries where it is currently limited.

The potential for Islamic securitization is nothing new. Back in 2007, Standard & Poor's released its approach to rating sukuk [1] and stated that:

"We expect that this type of sukuk [sukuk with no credit enhancement from the issuer] will become more popular in the foreseeable future in response to the huge number of projects in the planning stage, particularly in Gulf countries. Changes to regulation in the Gulf could give a boost to this type of sukuk. Banks and regulators in the Gulf are currently considering enhancing the legal framework surrounding mortgage financing for both commercial and residential properties. In the longer run, once sufficient mortgage loan volumes are booked on banks' balance sheets, Islamic securitization will become more attractive."

. The topic of Islamic securitizations was also raised by Andreas Jobst of the International Monetary Fund [2]. He wrote that:

"Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. [...] Islamic securitization transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. In its basic concept, originators would sell existing or future revenues from lease receivables (asset-based), 'sale-back profit' (debt-based) or private equity from a portfolio of Islamically acceptable assets to a special purpose vehicle (SPV),31 which refinances itself by issuing unsecured securities to market investors, who are the 'capital market corollary' to a singular lender in Islamic finance."

However, those articles were written before the onset of the financial crisis that saw conventional markets for securitization nearly completely shut down. Investors may be more wary of securitizations than they were when interest rates were low and economies strong and anything providing higher yields was sought after. However, the Islamic finance industry may provide an opportunity for securitization to re-emerge with more secure backing and without the additional re-securitizations that were the main impetus for the collapse in the securitization markets. There still remain several obstacles to Islamic securitizations although the relatively successful outcome of sukuk like the Sun Finance (Sorouh) sukuk can provide an example for future securitizations that comply with the new AAOIFI rules on mudaraba sukuk.

[1] Standard & Poor's. 2007. "Standard & Poor's Approach To Rating Sukuk," September 17, 2007.
[2] Jobst, Andreas A. 2007. "The Economics of Islamic Finance and Securitization," Journal of Structured Finance, Volume 13, Number 1. (Working paper)

Sun Finance Sukuk Payments & Remaining Balance, 2008Q4 - 2010Q1

Quarter	Cumulative Payments	Balance	Accrued Profit
2010Q1	AED 2,494,500	1,497,213	98,967
2009Q4	2,041,666	1,940,643	89,563
2009Q3	1,691,923	2,279,300	78,477
2009Q2	n/a	2,843,853	n/a
2009Q1	820,546	3,123,973	51,773
2008Q4	320,873	3,609,919	38,030
At Issue		4,016,000

All figures in AED '000.
Source: Company financial statements.

Should Islamic finance move towards asset-backed securitization?

Two lawyers with experience in Islamic finance, Debashis Dey and Stuart Ure, wrote an article in The National about the future of sukuk and in particular, they highlight one of the important features of sukuk which is often misunderstood:

"In the majority of unsecured sukuk transactions the investors ultimately have no direct recourse to the assets themselves. The repayment of their investment is dependent on the exercise of a purchase undertaking by the seller of the assets at maturity or upon default. Thus, as with a conventional bond, the investors take credit risk on the seller who has granted the purchase undertaking.

Although typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default."

This is one of the aspects of sukuk which I have criticized because it isolates the actual asset from the transaction and thus creates an unsecured debt that appears to be based on an asset. While this is clear in the offering documents, the amount of different articles that talk about Islamic finance as being more stable because it is based on real assets suggest that they have not read offering circulars of sukuk.

The solution, if the industry wants to make the rhetoric match the reality, in the eyes of these two lawyers (which I agree with) is:

"While Sharia principles seem harmonious with the nature of asset-backed securitisation, for securitisation to become more mainstream in the GCC, three prerequisites will be required: firstly, investors will need to demonstrate a commercial desire to take the risk (and reward) associated with the true sale of assets in an asset-backed structure, including the management of those assets in a default scenario; secondly, those companies seeking finance will need to demonstrate a desire to sell their assets (which will have accounting and shareholder equity implications); and thirdly, a robust legal framework will need to evolve as bankruptcy and asset-selling laws in many jurisdictions in the GCC remain opaque and militate against securitisation structures."

These three points are important and have not been the focus of the future of sukuk as much as they should be.

The prime example for a sukuk which does use an asset-backed securitization structure that has run into trouble (and therefore is instructive when compared with recent defaults of unsecured asset-based sukuk) is the East Cameron sukuk. This sukuk was a musharaka between the issuer SPV and an oil-and-gas exploration & production company. The asset was an overriding royalty interest (ORRI) and the two parties split the production from the musharaka assets (natural gas), which was then sold to make periodic payments and redeem the sukuk.

The transfer of the ORRI to the musharaka SPV was a true sale and this has been upheld in the bankruptcy court overseeing the reorganization of East Cameron Partners. According to documents filed in the bankruptcy court, the sukuk investors have provided debtor-in-possession financing to the company and a reorganization plan is expected to be submitted sometime in January 2010. However, for the discussion of ABS structures for sukuk, the idea of using a true sale rather than a sale of beneficial interest that is common in unsecured sukuk has shown to protect sukuk investors by giving them rights to the underlying asset that is insulated from the claims of other creditors.

Of course, this case occurred in the U.S. where the legal system is more developed in terms of understanding and resolving claims regarding asset-backed securitizations than in other jurisdictions where sukuk are issued. The ability to take this example and generalize to sukuk issued elsewhere is, therefore, limited. However, lack of generality does not make it a useless exercise.

Other News

• The UK has proposed changes that would put corporate sukuk issuance on equal footing with conventional bond issuance by removing them from regulation as collective investment schemes. A Reuters blogger, Cecilia Valente, says that there continue to be discussions about a sovereign sukuk from the UK government, although she ascribes the renewed focus as a reaction to moves by the French to promote their own ambitions of being a Western hub for Islamic finance.
  
• The Accounting and Auditing Organization for Islamic Financial Institutions released updated standards for the Islamic financial institutions.
  
• Thomson Retuers launched a risk management system for Islamic banks.
  
• The Islamic Development Bank is increasing the size of its medium-term note program, which will allow it to issue more sukuk to fund its activities.
  
• Bahrain-based Al Baraka is considering acquiring a large minority stake in Bank Muamalat, an Islamic bank in Malaysia.
  
• A report on microfinance in Afghanistan includes a suggestion that microfinance institutions offer Islamic microfinance based on client demand, although they note that it will be unclear if it will be demanded if it is more expensive than conventional microfinancial products.
  
• The Secretary General of the Franco-Arab Chamber of Commerce believes France will become a large part of the Islamic finance industry.
  
• Reliance Capital is entering Islamic finance through a Malaysian subsidiary, Reliance Asset Management.
  
• Forbes magazine provides a profile of Nicholas Kaiser, the head of the Amana Funds' parent company Saturna Capital.
  
• Indonesia priced its retail sukuk offering at 8.7%.
  

Islamic securitization, other news

A lawyer from Patton Boggs has an article in Islamic Finance News about the requirements for Shari'ah-compliant securitization to develop in the Middle East. Securitization markets across the world have been restricted following the credit crisis, but the securitization if done in a Shari'ah-compliant way would allow Islamic banks to increase the diversification of their assets and would free up capital for additional financing.

Other News

• The Islamic Development Bank's $1.5 billion sukuk program and the first issue of $850 million in sukuk received a AAA rating from Fitch's and Standard & Poor's and a Aaa rating from Moody's Investor Services.
  
• Malaysian ports operator Pelabuhan Tanjung Pelepaas plans to raise MYR1.5 billion ($441 million) from sukuk issues with a maturity of up to 10 years.
  
• Standard & Poor's will be responsible for maintaining and calculating the National Bank of Abu Dhabi's NBAD UAE Listed Islamic Index.
  
• The fate of Islamic mortgage firms Amlak and Tamweel continues to be discussed as a UAE state panel oversees their restructuring.
  
• Swiss Re received approval to launch a retakaful unit in Malaysia. The takaful industry has been growing, but there is a shortage of retakaful firms forcing many takaful providers to use conventional reinsurance.
  
• France sees Islamic finance as a potential way to deal with the credit crunch, although Islamic finance is not immune from similar crises that began in the U.S. in 2007.
  

Sukuk defaults attracting wider attention

In addition to an article about sukuk defaults in the Wall Street Journal, there are a number of pieces of news about sukuk. The Wall Street Journal article focuses on the defaults and provides some updates about the bankruptcy case that were not available when I wrote an article for Islamic Business & Finance about the bankruptcy in March. Where the case was left when I wrote the article that an announcement was expected on whether the sale of the overriding royalty interest (ORRI) in the East Cameron fields would be judged a true sale which would have protected sukukholders' interests from other creditors' claims. East Cameron claimed that the ORRI was not actually transferred to the SPV, Louisiana Offshore Holdings, and thus the loan was just secured by the ORRI.

As I mentioned in the article, a law professor I spoke to familiar with US bankruptcy laws and its effect on securitizations (which involve similar true sales), absent unusual circumstances, the sale would be judged a true sale. So far the judge has agreed with sukukholders' claims that the transfer of the ORRI to the SPV was in fact a 'true sale' saying that "holders invested in the sukuk certificates in reliance of the characterization of the transfer of the royalty interest as a true sale". If this ruling is finalized, the prospects for sukukholders will be strengthened and, more importantly for the industry, there will be a case history in US courts that supports the legal basis for many types of sukuk that rely on sales of assets to SPVs. With respect to sukukholders who will probably end up losing money they invested in the sukuk, the East Cameron Bankruptcy could provide impetus for new issues of sukuk by US-based companies shut out of the conventional financial markets in the wake of the credit crisis.

Reuters blogger Felix Salmon adds his take to the sukuk default story from the WSJ with some interesting comments about the difference between sukuk and conventional bonds:

"The first sukuk (Islamic bond) defaults have arrived, and no one has a clue how they’re going to shake out. Which might actually be a feature rather than a bug, going forwards.

Bondholders often have a large amount of complacency derived from the fact that an enormous amount of equity needs to be wiped out before they take any hit at all. And that complacency does the system no favors in the long term. If capital structures get muddied a little, and debt takes on more equity-like uncertainty — as seems to be the case in the sukuk market — then maybe investors will be more assiduous about examining underlying risks, rather than relying on capital structures to protect them."

Another sukuk, the Golden Belt 1 sukuk issued by the troubled Saudi firm Saad Group, will provide another test of how sukuk function in a reorganization as the company restructures its debts.

In addition to the ongoing sukuk default and restructuring, the issuance of new sukuk fell during the year to June 14 compared to the same period in 2008. The number of issued fell 21.5% from 88 to 69 while the total value of new sukuk issues fell from $9.35 billion to $8.46 billion, a decline of 9.4%. There is some good news in this release in that the average sukuk size increased year-over-year. One of the developments in 2008 was that the average size of each sukuk declined compared with previous years, most likely because of an absence of large sukuk like the $3.52 billion Nakheel sukuk which was issued in 2006.

Other News

• Following the launch of a bond and sukuk markeet on Tadawul, Shuaa Capital said it may structure and sell sukuk for Saudi firms.
  
• After reports came out that The Investment Dar had failed to block the National Bank of Kuwait's acquisition of a 19.2 percent stake in Islamic bank Boubyan Bank, it now appears that the sale has been temporarily blocked.
  
• Indonesia is increasing its planned sukuk issuance for 2009, although the spokesman from the Ministry of Finance declined to provide a number.
  
• Fawad Butt, the CEO of Chicago-based Islamic finance advisory firm working to launch an Islamic community bank in Chicago, is speaking at the World Affairs Council of Pittsburgh tomorrow.
  
• Following a difficult year for Islamic finance, Bahrain-based Seera Bank is optimistic about the industry's prospects following its receipt of an award for its acquisition of UK water treatment specialty company BWA.
  

(Late) Weekend Update

The Saudi government plans on starting a Fannie Mae-like institution to encourage the growth of sukuk and conventional bond markets. The counry is estimated to have a home ownership is 62% according to Ibrahim al-Assaf, the finance minister for the country, although some analysts estimate it at less than 1/2 this level. The development would provide a boost for Islamic banks by allowing them to remove assets from their balance sheet and also providing a large source of supply of sukuk to the market, which in turn could help provide Islamic banks with a better, more liquid investment to hold against short-term liabilities like deposits. However, the securitization into sukuk would have restrictions on the number of various types of Islamic mortgages. Although ijara mortgages are generally considered transferrable because they include ownership of an underlying assets, murabaha mortgages would not (except at par vale) because transfer represents the sale of cashflow from a loan, not an actual asset.

A Central Bank of Bahrain official, Abdul Rahman Al-Baker, executive director of financial supervision pointed out that as the industry crosses the $1.5 trillion mark (estimates of the size of the Islamic financial industry vary widely), it needs to broaden the customer base it addresses:

"In addition to adequate regulations there is a need for creating the necessary framework for investment instruments targeting small investors, medium size investors, as well as professional or high net-worth individuals, who would like to invest their funds in accordance with Shariah principles,"

HSBC Amanah is joining a growing number of companies launching sukuk funds with their HSBC Amanah Sukuk Fund that will be domiciled in Saudi Arabia. The fund is expected to hold about 12 to 14 companies' sukuk from the GCC region and have a 4-year maturity.

Banking officials in Iraq are looking at ways to encourage Islamic banks according to Central Bank advisor Mudher Kasim. The article describes the difficulty facing Islamic banks due to the regulation about banks investing in real estate and their mandatory capital reserves.

Advantage Consulting Company Managing Director Safa Abdul Rahman Al-Hashem provides a criticism of products that replicate conventional financial products.

Coud the credit crisis spillover into Islamic finance? Sukuk issuance expected to exceed 2007 total

Despite delays in many planned sukuk, Kuwait Finance House expects sukuk issuance in 2008 to top the total from 2007 even though issuance through the first three quarters fell below 2006 and 2007 totals for the same period. The rationale is that since the economy is still growing rapidly in the areas in which many sukuk are originated, the GCC and Malaysia, and non-Muslims continue to invest in sukuk. This has been the case for much of the year, but there are indications that the real estate market in the GCC region is slowing from its torrid pace in 2007 and early 2008. Also, many of the non-Muslims investing in sukuk were hedge funds looking to have exposure to another asset class and many Western funds have been faced with redemption requests from their investors, damping their future demand for sukuk. KFH expects a total issuance of sukuk to be between $40 and $45 billion in 2008 compared with $32.65 billion in 2007.

An article in a newspaper in Guernsey proposes Islamic finance as an alternative to the problems created in the recent past by (conventional) financial system excesses. Overexposure to real estate investments, though, may pose a threat to the Islamic finance industry. Some Islamic finance practitioners see the Shari'ah-compliant securitization that is the heart of the sukuk market as a guard against the excesses that led to the credit crisis. I think that, not only will it not necessarily protect the Islamic finance industry, the use of some securitization products, particularly the opaque, highly structured ones could create a crisis within the Islamic finance industry, and one with a similar economic trigger: the fall in real estate values.

Also, despite growing rapidly over the past 8 years, Islamic finance has yet to make a significant impression on the global banking industry.

Without specifying who should lead, second finance minister of Malaysia Nor Mohamed Yakop wants a standardized documentation and policies for the Islamic finance industry. Currently, there are two main standards-setting bodies, AAOIFI in the GCC and the IFSB in Malaysia.

Cagamas looking to securitizing Islamic mortgages in the GCC; Details on purchasers of Indonesian sukuk

Cagamas Bhd, a Malaysian firm that issues securitized Islamic mortgages, plans expansion into the GCC region where mortgage securitization is far less common due to Shari'ah-objections about trading debt (bay al-dayn). The CEO of Cagamas, Steven Choy suggested one possible way around this problem: "If I could buy some assets from the Middle East that are globally or Gulf sharia-compliant and if I issue (bonds) out of here, there's no reason why they can't buy it back there". Whether this would be acceptable to Shari'ah boards in the GCC is unclear, but I can think of a few stipulations that would likely be put on any transaction like this (note: this my best guess because I am not a qualified Shari'ah scholar). One would be on the type of financing products which would be allowed. In general, ijara and mudaraba would be the most likely candidate. The former would include transfer of ownership in the underlying real property while the latter would be similar to trading in equities, which has been approved by Shari'ah scholars subject to some constraints.

More details about the purchasers of the Indonesian Rupiah-denominated sovereign sukuk emerged today. About 90 percent of the sukuk was purchased by domestic investors. Only 10 percent of the investors in the sukuk were Islamic banks and many of the investors were conventional banks and insurance companies in Indonesia. The amount of the issue purchased by local investors was a little surprising because Western investors like hedge funds snap up between 1/3rd and 1/2 of many sukuk. The reason may be that Western investors want to mitigate some risk by removing currency risk from an investment in an emerging market with a large budget deficit instead investing in the forthcoming dollar-denominated sukuk.

A U.K.-based Shari'ah scholar believes that the subprime crisis was the result of a lack of market discipline that would be less likely if structures used in Islamic finance were used in conventional finance.

Islamic securitizations, Islamic branding

Islamic finance is moving from asset-based sukuk where noteholders cannot claim underlying assets to asset-backed securitizations where they do. However, as Mahmoud El-Gamal notes, until there is a large sukuk default, we won't know how accurate ratings and sukuk pricing.

One lesson from the sub-prime meltdown: it is unrealistic to assume that pricing can be accurate where there is not a large secondary market actively trading asset being priced.

HSBC Amanah is waiting for a rule change allowing majority foreign ownership of Islamic banks before it enters Brunei's market.

Another article about Islamic branding

The Aga Khan is visiting Africa to check on his foundation's work, including the microbusiness program

Opinions on Islamic finance, plans & reports denied

An opinion piece about whether Islamic finance should continue creating Islamic versions of conventional products or whether it would be better served in the long run by focusing on providing products which are not currently available.

Conventional and Islamic real estate financing in the UAE should rely more on securitization, says Nasser Saidi, the cheif economist at the Dubai International Financial Centre

Gillian Tett of the Financial Times explores the new innovations in Islamic finance, as well as critics' claims that the industry should fully develop a smaller set of products before introducing new products such as Shari'ah-compliant hedge funds and derivatives. In addition to rapidly increasing the complexity of the Islamic financial industry, critics argue that despite having the contracts approved by scholars, contravene the prohibition of gharar (speculation).

Professor Bala Shanmugam of Monash University in Malaysia argues that Islamic Financial Institutions (IFIs) should offer micro loans to the poor using murabaha (cost-plus financing) or qard hassan (benevolent loan).

Another description of Gulf Finance House's (GFH) plan to issue Global Depository Receipts (GDRs) on the London Stock Exchange.

The Kuwaiti government denies reports that it is selling its stake in Kuwait Finance House.