ISLAMIC SECURITIZATION A LEGAL APPROACH

ISLAMIC SECURITIZATION A LEGAL APPROACH

by

Haluk Gurulkan, LL.M. Finance

Istanbul October 2010

This study has been prepared by the attorney of our Law Firm, Haluk Gurulkan, Esq, as an LL.M. thesis and presented to to the Institute For Law and Finance at Johann Wolfgang Goethe University, Frankfurt am Main.

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ISLAMIC SECURITIZATION

CONTENTS ABBREVATIONS INTRODUCTION 1 ISLAMIC FINANCE

1.1 What is Islamic Finance?

1

1.2 The basic principles

3

1.2.1 Ban on Interest (riba)

3

1.2.2 Ban on transactions and products with excessive uncertainty (gharar-maisir)

4

(gharar-maisir) 1.2.3 Principle of risk and profit sharing

5

1.2.4 Ethical investments that enhance society

6

1.2.5 Asset-backing

6

1.3 Main Transaction Types

7

1.3.1 Murabaha

7

1.3.2 Mudaraba

8

1.3.3 Musharaka

10

1.3.4 Diminishing Musharaka

11

1.3.5 Ijara

13

1.3.6 Salam

14

1.3.7 Istisna

16

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2 SECURITIZATION 2.1 What is Securitization?

20

2.2 History of Securitization

21

2.3 Structure of Securitization

23

2.3.1 True Sale

25

2.3.2 Special Purpose Vehicle

26

2.3.3 Credit Enhancement

27

2.3.4 Credit Rating

32

2.3.5 Profit Extraction

33 ii

2.4 Motivation for Securitization

34

2.4.1 Motivation for the Originator

34

2.4.1.1 The potential for reducing costs

34

2.4.1.2 The ability to diversify funding sources

35

2.4.1.3 The ability to manage corporate risk

35

2.4.1.4 The ability to help in capital adequacy requirements

36

2.4.1.5 The opportunity to achieve off-balance financing

36

2.4.1.6 The ability to match the assets and liabilities

36

2.4.1.7 The ability to reduce credit concentration

36

2.4.1.8 The opportunity for arbitrage by repackaging

37

2.4.2 Motivation for the Investors

37

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2.5 Different Classifications of Securitization

38

2.5.1 According to asset types

38

2.5.2 According to SPV types

38

2.5.3 Pass through & Pay through Securitization Structures

39

2.5.4 True sale & Synthetic Securitization Structures

40

2.5.5 Asset-backed & Future Flows Securitization Structures

41

2.6 Securitization and the recent credit crunch

42

3 ISLAMIC SECURITIZATION 3.1 What is Islamic Securitization?

46

3.2 Structure of Islamic Securitization

47

3.3 Sukuk

51

3.3.1 Types of Sukuk

54

3.3.1.1 Ijara Sukuk

54

3.3.1.2 Mudaraba (or Muqarada) Sukuk

57

3.3.1.3 Musharaka Sukuk

59

3.3.1.4 Murabaha Sukuk

61

3.3.1.5 Salam Sukuk

64

3.3.1.6 Istisna Sukuk

66

3.3.1.7 Hybrid Sukuk

68

3.3.2 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues

69 iii

3.3.3 Credit Rating Issues

71

3.3.4 Benchmarking Issues

73

3.3.5 Recent Sukuk Defaults

74

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3.4 The Use of Derivatives in Islamic securitization

76

3.5 A Case study: Sorouh Securitization

80

CONCLUSION

84

BIBLIOGRAPHY

86

WEB PAGES

95

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ABBREVIATIONS AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions ABS Asset-Backed Securities AED United Arab Emirates Dirham AIG American International Group, Inc. ARM Adjustable Rate Mortgages BIB Bahrain Islamic Bank BMA Bahrain Monetary Agency CAGR Compound Annual Growth Rate CDO Collateralized Debt Obligations ECP East Cameron Partners EIBOR Emirates Inter-bank Offered Rate IDB Islamic Development Bank IFSB Islamic Financial Services Board IIRA International Islamic Rating Agency LIBOR London Inter-bank Offered Rate MBS Mortgage-Backed Securities MENA Middle East & North Africa NINA No Income No Assets NIVA No Income Verified Assets PLS Profit-and-loss-sharing OC Offering Circular OIC Organization of the Islamic Conference ORRI Overriding Royalty Interest OTC Over-the-counter ROE Return on Equity SIVA Stated Income Verified Assets

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SLR Statutory Liquidity Requirement SPC Special Purpose Company SPE Special Purpose Entity SPV Special Purpose Vehicle STS Solidarity Trust Services UAE United Arab Emirates

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INTRODUCTION 1 ISLAMIC FINANCE In this part, our main aim is to give the basic principles of Islamic Finance. Obviously, one should first understand the basics of Islamic Finance in order to have a better understanding of Islamic Securitization as the structures of the latter have to comply with the basic rules of Islamic Finance and are constructed on the main transaction types of Islamic Finance.

1.1 What is Islamic Finance? Islamic Finance is based on Sharia, an Arabic term that is often translated into “Islamic Law”. However Sharia is perhaps best characterized as moral guidance or a set of principles governing all aspects of the day-to-day activities of Muslims. 1 Sharia provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business and law. 2 The concepts that underlie Islamic finance derive from Islamic law or the Sharia, the roots of which in turn are derived from the: (1) Qur’an, being the holy book of Islam (notably less than 3 percent of the Qur’an is legal in nature); (2) Sunna, which are the binding authority of Prophet Muhammad’s dicta and decisions; (3) Ijma, or “consensus” of the community of scholars; and in some parts of the Muslim world, (4) Qiyas, or analogical deductions and reasoning. 3

In the late 19th Century, the Ottomans introduced western-style banking to the Islamic world to finance their expenditures. While some Islamic jurists approved of modern banking practices, the majority found those practices to be violations of Islamic prohibitions against usury (Arabic term: riba, equivalent to the Hebrew ribit, and interpreted in its classical Biblical sense of any interest charge on loans, as opposed to the modern identification of usury with exorbitant interest). This resentment continued through the European colonial period, which lasted into the mid-20th Century. Islamic revival played a central role in the intellectual and social foundations of inde1

HM Treasury, The development of Islamic Finance in the UK: the Government’s perspective, 10 December 2008, p.7, available at http://www.hm-treasury.gov.uk/d/islamic_finance101208.pdf 2 Silva, Michael, Islamic Banking Remarks, Law and Business Review of the Americas, Vol. 12, Issue 2, Spring 2006, p. 201 3 Mayer Brown LLP, The rapidly growing market of Islamic Finance requires the knowledge of Shariacompliant structures for finance transactions, White Paper – Islamic Finance, 15 September 2009, p. 2, available at http://www.mayerbrown.com/islamicfinance/article.asp?id=7813&nid=12368

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pendence movements of the mid-20th Century. To many intellectual founders of the movement, political independence was to be supplemented with economic independence, through the definition of an Islamic economic system. 4

The conceptual development of Islamic banking gained momentum after the mid-1940s. Islamic scholars such as Qureshi (1946), Ahmad (1952), Uzair (1955), Maududi (1961), Al-Arabi (1966), Siddiqi (1967) and Al-Sadr (1974) made significant contributions to the evolution of the Islamic banking model. 5 The huge influx of petrodollars from the late 1970s provided a strong impetus to the development of several Islamic banks in the Middle East. Other Muslim countries established their own Islamic financial institutions over time. Islamic banking has made steady progress over recent decades. In recent years it has emerged as the fastest-growing segment of global finance due to consistently high oil prices in international markets and other favorable sociopolitical factors. It is flourishing in Africa, Asia, Europe and North America. There are about 300 Islamic financial institutions across 70 countries, holding capital investments worth $500-800 billion, with an average annual growth of 15 per cent. It has been estimated that Islamic banking will have a market value of $4 trillion by 2010. 6 It is expected to capture about 40-50 per cent of the total savings of 1.3 billion Muslims worldwide within the next eight to ten years. 7 As of 2009, it is estimated that over $822 billion worldwide Sharia-compliant assets are managed according to the Economist. 8

Although in the past local banks in the Middle East and Malaysia held a monopoly on Islamic finance, a number of non-Muslim institutions have begun to offer Sharia-compliant services, particularly through the issuance of Sukuk (Islamic bonds). The major Western banks currently engaged in this practice include HSBC, Citigroup, Barclays Capital, Deutsche Bank, BNP Paribas, and 4

El-Gamal, Mahmoud Amin, Overview of Islamic Finance, Office of International Affairs, Occasional Paper No. 4, June 2006, p. 3 5 As a result of these efforts, the first Islamic financial institution was a mutual savings bank formed in the Egyptian town of Mit Ghamar in 1963. 6 The ratings agency Standard & Poor’s has forecasted that the industry could potentially control up to $4 trillion of assets. This contrasts with $190 trillion in global assets that are currently under management. Others have suggested that the growth in the sector could be far higher, as Muslims account for 20 per cent of the global population yet currently only hold approximately 1 per cent of global financial assets. Whatever the case, it is likely that Islamic finance will become an increasingly important component of the international financial system. (The development of Islamic finance in the UK: the Government's perspective, December 2008, p. 8) 7 Khan, M. Mansour, Bhatti, M. Ishaq, Development in Islamic Banking: a financial risk-allocation approach, The Journal of Risk Finance, Vol. 9, No.1, 2008, p. 41 8 Economist article, available at http://www.economist.com/world/europe/displaystory.cfm?story_id=14859353

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Standard Charter. Similarly, a number of large law firms have Islamic business departments or units. Much of the proliferation of Islamic banking practices appears to have taken the form of non-Muslim banks opening Sharia-compliant "windows" or branches in the Middle East. Moody's estimates that over $200 billion individual assets lie in these Muslim "windows". 9

1.2 The basic principles

Major principles of Sharia that are applicable to finance and that differ from conventional finance are:

1.2.1 Ban on Interest (riba 10)

Any level of interest is considered to be usurious and is prohibited. The Qur’an contains almost a dozen references to this fundamental prohibition against interest, and it is discussed often in the Hadith 11. The Qur’an proclaims: "Allah 12 hath permitted trade and forbidden usury." This fundamental prohibition is "unequivocal," and the Qu'ran and early Islamic writings clearly consider riba a very serious offense: The Messenger of Allah cursed the one who devours riba, the one who pays it, the one who witnesses it, and the one who documents it 13 and he defined riba as “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is riba.” 14

Sometimes it is misunderstood that only a high rate of interest is prohibited and any normal charge on loans or debts does not come under the purview of prohibition. It is argued that a loan 9

Karasik, Theodore, Wehrey, Frederic, Strom, Steven, Islamic Finance in a Global Context: Opportunities and Challenges, Chicago Journal of International Law, Winter 2007, p. 385-386 10 Riba means and includes any increase over and above the principal amount payable in a contract obligation, not covered by a corresponding increase in labor, commodity, risk or expertise. 11 Hadith are narrations originating from the words and deeds of the prophet Mohammad. 12 Allah is the standard Arabic word for God. 13 Richardson, Christopher F., Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, Texas International Law Journal, Fall 2006, p. 125 14 El-Gamal, Mahmoud, A Basic Guide to Contemporary Islamic Banking and Finance, Rice University, June 2000, p.3

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involves riba only if it carries the condition of doubling and redoubling, and the word “riba” refers only to usurious loans on which an excessive rate of interest is charged by the creditors, which entails exploitation. It is added that modern banking interest cannot be termed “riba” as the rate of interest is not excessive or exploitative. However, the argument is not tenable as per the tenets of the Qur’an. The Qur’an makes it very clear that in a loan transaction, and for that matter a trade transaction culminating in a debt contract, any addition chargeable to the principal amount is riba. The Qur’an says: “If you repent, then you have your principal only”. Believers have been ordered to give up whatever amount of riba is outstanding. Further, “rate” is a relative term and any rate will, over time, double and redouble the principal; hence, any addition over the amount of debt per se is prohibited, irrespective of the rate. 15

1.2.2 Ban on transactions and products with excessive uncertainty (gharar-maisir)

In principle, uncertainty in contractual terms and conditions is not allowed. Intrinsically, the limitation on gharar is related to the Islamic prohibition on gambling (maisir). Unlike riba (which is an absolute prohibition) some level of risk remains a fundamental aspect of commercial life and risk allocation a necessary component of Islamic finance; only disproportionate risk, speculative trading and transactions meeting exceeding limitations are considered gharar. The key element of gharar is uncertainty. 16

While riba is condemned in the Holy Qur’an, condemnation of gharar is supported by Hadith. In business terms, gharar means to undertake a venture blindly without sufficient knowledge or to undertake an excessively risky transaction, although minor uncertainties can be permitted when there is some necessity. In a general context, the unanimous view of the jurists held that, in any transaction, by failing or neglecting to define any of the essential pillars of contract relating to the consideration or measure of the object, the parties undertake a risk which is not indispensable for

15

Ayub, Muhammad, Understanding Islamic Finance, John Wiley & Sons, Inc., 3. Edition, 2008, p. 50 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 127 16

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them. This kind of risk was deemed unacceptable and tantamount to speculation because of its inherent uncertainty. Speculative transactions with these characteristics are therefore prohibited. 17

The prohibition of maisir covers gambling and other games of chance, such as lotteries and betting on races. While general commercial risk is permissible, forms of speculation which are regarded as akin to gambling are prohibited. Speculative trades where there is little or no certainty as to the outcome, such as currency market speculation or investment in derivatives, would not be permitted. Where the distinction between general commercial risk and speculation is not clear the commercial substance of a transaction will be analyzed. Whilst distinct concepts, there is some degree of overlap between gharar and maisir. 18

1.2.3 Principle of risk and profit sharing

In Islamic finance, those who finance investment share a good part of the risk with those who carry out actual investment activities. 19 Parties of a financial transaction must share both the associated risks and profits. Profit-and-loss-sharing (PLS) financing is a form of partnership where partners share profits and losses on the basis of their capital share and effort. Unlike interest-based financing, there is no guaranteed rate of return. Islam supports the view that Muslims do not act as nominal creditors in any investment, but are actual partners in the business. This is an equity-based system of financing, where the justification for the PLS-financier’s share in profit rests on their effort and the risk that they carry. In other words, they deserve to be rewarded since this profit would have been impossible without their investment and, furthermore, if the investment were to make a loss, then their money would also be lost. 20

17

Algaoud, Latifa M., Lewis, Mervyn K., Mohammed, Islamic Critique of Conventional Financing, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p.39 18 Sandstad, Ben, Strom, Hagbarth, Islamic Finance: An Introduction, 23 June 2009, Banking and Financial Services Insight, available at http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090623/islamic _finance_an_introduction.page 19 Al-Jarhi, Mabid Ali, Islamic Banking and Finance: Philosophical Underpinnings, Ed. by Ali, Salman Syed, Ahmad, Ausaf, Islamic Banking and Finance: Fundamentals and Contemporary Issues, Selected Papers from Conference in Brunei; 5-7 January 2004, Islamic Research and Training Institute and Universiti Brunei Darussalam, p. 17 20 Venardos, Angelo M., Islamic Banking & Finance in South-East Asia, Its Development and Future, World Scientific Publishing Co. Pte. Ltd., 2005, p. 51

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Islamic scholars prefer that investors obtain some form of ownership or participating interest in the underlying asset, although such ownership may be only indirectly beneficial in nature, and the level of actual participation is often passive. The key, however, is that the investor's return must be tied to the performance of the underlying asset. Because the "borrower" cannot pay interest, it instead shares the profits from its endeavors with the investors, with each bearing some of the risk that the underlying assets could underperform. Even though Sharia prohibits payment or receipt of any interest on loans of money, Islamic law permits and actually encourages the allocation of risks and rewards and sharing in the resulting profits or losses. 21

1.2.4 Ethical investments that enhance society

Financing must be for a worthwhile cause. Certain industries are viewed as inappropriate activities. Generally inappropriate business activities include gambling and casino games, alcoholic beverages, pork consumption, pornography and prostitution, weapons/defense, and financial services dependent on payment of interest (riba). 22 In essence, Islamic investments must be socially responsible, not encourage activities considered sinful from an Islamic point of view. For example, the sale and trading of commodities such as wine or alcoholic products, pork and pork products is prohibited, and contracts involving such commodities are void on the grounds of their illegality. 23

The investments should also be done in a financially sound manner. Islam discourages investment in companies with high debt levels. For equity investments in stocks, the prohibition includes investments in companies with heavy debt (an extension of the proscription of riba and gharar). 24

21

Berschadsky, Ariel, Innovative Financial Securities in the Middle East: Surmounting the Ban on Interest in Islamic Law, U. Miami Business Law Review 107, 2001, p. 110 22 Karasik, Wehrey, Strom, Islamic Finance in a Global Context: Opportunities and Challenges, supra, p. 382 23 Ayub, Understanding Islamic Finance, supra, p. 135 24 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, pp. 126-127

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1.2.5 Asset-backing

Each financial transaction must be tied to “tangible, identifiable underlying asset”. Islam does not recognize money as a subject-matter of trade, except in some special cases. Money has no intrinsic utility; it is only a medium of exchange. Each unit of money is 100% equal to another unit of the same denomination, therefore, there is no room for making profit through the exchange of these units inter se. Profit is generated when something having intrinsic utility is sold for money or when different currencies are exchanged, one for another. The profit earned through dealing in money (of the same currency) or the papers representing them is interest, hence prohibited. Therefore, unlike conventional financial institutions, financing in Islam is always based on illiquid assets which create real assets and inventories. 25

1.3 Main Transaction Types

1.3.1 Murabaha

The most popular Islamic financial instrument is murabaha, that is, a cost-plus or mark-up contract. The word murabaha derives from the Arabic word ‘ribh’, meaning profit. A murabaha contract is a trade contract, stipulating that one party buys a good for its own account and sells it to the other party at the original price plus a mark-up. The mark-up can be seen as a payment for the services provided by the intermediary, but also as a guaranteed profit margin. Payment may take place immediately, but also at a later date or in installments. 26

In financing, murabaha is used as a form of a sales contract in which the financial institution or investors buy an asset and then later sell it to the "borrower" at a marked-up price, which includes a profit component. Payments are made in installments, either on a deferred basis or through 25

Usmani, Mufti Muhammad Taqi, An Introduction to Islamic Finance, Kluwer Law International, 2002, pp. 1415 26 Visser, Hans, Islamic Finance Principles and Practice, Edward Elgar Publishing Limited, 2009, p. 57

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upfront payment with deferred delivery. Murabaha instruments usually supply only short-term financing. 27

Some observers see this mode of Islamic finance to be very close to a conventional interestbased lending operation. However, a major difference between murabaha and interest-based lending is that the mark-up in murabaha is for the services the bank provides (for example, seeking and purchasing the required goods at the best price) and the mark-up is not stipulated in terms of a time period. Thus, if the client fails to make a deferred payment on time, the mark-up does not increase from the agreed price owing to delay. Also the bank owns the goods between the two sales, which means it carries the associated risks. 28

A basic structure of a murabaha transaction is as follows: 29

27

Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 130 28 Mirakhor, Abbas, Zaidi, Iqbal, Profit-and-loss sharing contracts in Islamic finance, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 52 29 Mayer Brown LLP, Islamic Finance At a Glance, Banking & Finance Newsletter, March 2008, available at http://www.mayerbrown.com/islamicfinance/article.asp?id=4357&nid=12368

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1.3.2 Mudaraba

Mudaraba is a special kind of partnership in which an investor or a group of investors provides capital to an agent or manager who has to trade with it; the profit is shared according to the pre-agreed proportion, while the loss has to be borne exclusively by the investor. The loss means a shortfall in the capital or investment of the financier. The loss of the agent (Mudarib) is by way of expended time and effort, for which he will not be given any remuneration. There is no restriction on the number of persons giving funds for business or any restriction on the number of working partners. Profit cannot be in the form of a fixed amount or any percentage of the capital employed. 30 Please see below for a basic structure of Mudaraba: 31

At the core of any Mudaraba contract, there are four basic conditions between the mudarib and the rabb al-mal [capital provider(s)] as follows:

30 31

Ayub, Introduction to Islamic Finance, supra, pp. 320-321 Mayer Brown LLP, Islamic Finance At a Glance, supra

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 Profit, when realized, has to be shared between the two parties in accordance with a profitsharing ratio pre-stipulated at the time of the contract. Loss, in case it arises, would have to be born entirely by capital providers as the mudarib only loses his/her effort.  The rabb al-mal cannot interfere in the day-to-day management of the Mudaraba, apart from his or her right to restrict possible fields of economic activity for the Mudaraba. This provision, however, has to be made clear within the mudarib contract.  The mudarib has a ‘hand of trust’ (yad amana) in the management of Mudaraba capital, which means he would work to his best effort and, therefore, cannot guarantee capital or profit to rabb al-mal.  Loss of capital can be guaranteed by the mudarib only when such loss proves to be the result of mismanagement or delinquency of the mudarib; or where such loss results from a breach of the contract, like violating restricted fields of economic activity. 32

1.3.3 Musharaka

This is often perceived to be the preferred Islamic mode of financing, because it adheres most closely to the principle of profit and loss sharing. Partners contribute capital to a project and share its risks and rewards. Profits are shared between partners on a pre-agreed ratio, but losses are shared in exact proportion to the capital invested by each party. Thus a financial institution provides a percentage of the capital needed by its customer with the understanding that the financial institution and customer will proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is consummated. This gives an incentive to invest wisely and take an active interest in the investment. In Musharaka, all partners have the right but not the obligation to participate in the management of the project, which explains why the profit-sharing ratio is mutually agreed upon and may be different from the investment in the total capital. 33

32

El-Din, Seif I. Tag, Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice, Kyoto Bulletin of Islamic Area Studies, 1-2, 2007, pp. 57-58 33 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 51

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Below is a basic structure of a Musharaka transaction: 34

We can sum up the special provisions in a Musharaka contract as follows:

 Partners of Musharaka all have the right to engage in the day-to-day management of the Musharaka capital, except where one party deliberately gives up (waivers) this right to other parties. Many Islamic banks prefer to waiver their rights of Musharaka management to clients on the grounds that clients are more qualified to run their own businesses.  Profit, when realized, has to be shared by partners in proportion to their capital contributions (i.e. on pro-rata basis) unless otherwise agreed on reasonable ground. In the context of Islamic banking, it is possible for the client to get a proportionately bigger share of profit if the bank has already waivered its right in management to the client. Loss, however, has to be strictly shared on pro-rata basis.  None of the parties can be held liable to guarantee capital or profit to other parties. Only where mismanagement and delinquency are proved or where a breach of the Musharaka contract is committed, the party so charged may be held liable to guarantee capital contributions of the other parties.  Profit (or loss) cannot be prioritized within the Musharaka contract. No party (or group of parties) can be preferred to others in terms of profit distribution or loss allocation, and no

34

Mayer Brown LLP, Islamic Finance At a Glance, supra

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pre-fixed return can be promised to any. The fact that all parties have to be treated on an equal footing (pari passu) underscores profit & loss sharing as the core concept of Musharaka.35

1.3.4 Diminishing Musharaka

The participatory contracts that may be more suitable for financing of fixed assets and present-day ongoing projects, particularly for financial intermediaries, can be based on the concept of “Diminishing Musharaka”. 36 It is a variant of Musharaka, and a form of co-ownership in which two or more parties share the ownership of a tangible asset in an agreed proportion, and one of the coowners undertakes to buy, in periodic installments, the proportionate share of the other co-owner until the title to such tangible asset is completely transferred to the purchasing co-owner. 37

The key features of the diminishing Musharaka are given below:

 Diminishing Musharaka is applied for the purchase of tangible assets;  Proportionate shares of each co-owner must be known and defined in terms of investment;  Expenses incidental to ownership may be borne jointly by the co-owners in the proportion of their co-ownership;  Losses, if any, shall be borne by the co-owners in proportion of their respective investments;  Each periodic payment shall constitute a separate transaction of sale; and  Separate agreements/contracts shall be entered into at different times in such manner and in such sequence so that each agreement/contract is independent from the others, in order to ensure that each agreement is a separate transaction. 38

The chart below shows the basic structure of a diminishing Musharaka transaction: 39 35

El-Din, Seif I. Tag, Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice, supra, p. 58 36 Ayub, Introduction to Islamic Finance, supra, p. 337 37 Said, Pervez, Islamic Alternatives to Conventional Finance, Islamic Finance: A Guide for International Business and Investment, Ed. By Habiba Anwar, GMB Publishing, 2008, p. 18 38 Said, Islamic Alternatives to Conventional Finance, supra, p. 19

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Diminishing Musharaka can be easily used for the purpose of financing fixed assets by Islamic banks. It includes house financing, auto financing, plant and machinery financing, factory/building financing and all other fixed asset financing. 40 In the case of housing finance, for example, home buyer and a financier jointly own a home and over time the financier’s share diminishes continuously as the home buyer’s share increases. Usually, diminishing Musharaka is combined with ijara. In Lariba’s home buying scheme, for instance, the client leases the financier’s share in the property and agrees to buy that share over a period of up to 30 years. Often, the client buys the home as the financier’s agent from the vendor and registers it directly into their own name. In the UK, however, HSBC Amanah only transfers ownership at the end of the agreed period. 41

39

Sandstad, Ben, Introduction to Islamic Finance – Part II, 24 September 2009, Banking and Financial Services Insight, available at http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090924/introdu ction_to_islamic_finance-part_ii.page 40 Ayub, Introduction to Islamic Finance, supra, p. 339 41 Visser, Islamic Finance Principles and Practice, supra, p. 111

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1.3.5 Ijara

In Islamic law, ijara is a contract of a known and proposed usufruct of specified assets for a specified time period against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, it is the transfer of usufruct for a consideration, which is rent in the case of hiring assets or things and wages in the case of hiring people. According to the jurists, ijara is the sale of usufruct of any commodity in exchange of ujra, wages or rent, and covers houses, shops, riding/work animals, jewelry, clothes, etc. 42

The structure below illustrates how an ijara structure works: 43

For the purpose of ijara, the subject matter giving usufruct can be divided into two types: property or assets, like houses, vehicles, residences, etc., and labor, like the work of an engineer, doctor, tailor, carpenter, etc. While the latter involves employing the services of a person for a wage, the former relates to usufruct of any asset or property that is transferred to another person in exchange for rent. 44

42

Ayub, Introduction to Islamic Finance, supra, p. 279 Common Islamic financing structures, Minaret Capital, available at http://minaretcapital.com/structure.html 44 Ayub, Introduction to Islamic Finance, supra, p. 280 43

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When we look at its usage in the Islamic financing practice, ijara is a contract under which a bank buys and leases out an asset or equipment required by its client for a rental fee. Responsibility for maintenance/insurance rests with the lessor. During a predetermined period, the ownership of the asset remains with the lessor (that is, the bank) who is responsible for its maintenance, which means that it assumes the risk of ownership. Under an ijara contract, the lessor has the right to renegotiate the terms of the lease payment at agreed intervals. This is to ensure that the rental remains in line with market leasing rates and the residual value of the leased asset. Under this contract, the lessee (that is, the client) does not have the option to purchase the asset during or at the end of the lease term. However this objective may be achieved through a similar type of contract, ijara wa iqtina (hire-purchase). It basically mimics financial leasing practices of conventional finance. In ijara wa iqtina, the lessee commits himself to buying the asset at the end of the rental period, at an agreed price. For example, the bank purchases a building, equipment or an entire project and rents it to the client, but with the latter’s agreement to make payments into an account, which will eventually result in the lessee’s purchase of the physical asset from the lessor. Leased assets must have productive usages, like buildings, aircrafts or cars, and rent should be preagreed to avoid speculation. 45

1.3.6 Salam

In Islamic law, existence of some property as the object of sale is generally a condition for contract validity. However, there are some notable exceptions that allow sales of non-existent objects. One of the most important exceptions is an ancient contract that predates Islam, called salam meaning “prepayment.” This contract was primarily used for financing agricultural production.46

A salam is deferred delivery contract. It is essentially a forward agreement where delivery occurs at a future date in exchange for spot payment of price. Unlike earlier mechanisms of murabaha and ijara, salam was originally designed as a financing mechanism for small farmers and traders. Under a salam agreement, a trader in need of short-term funds sells merchandize to the 45

Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 52 El-Gamal, Mahmoud A., Islamic Finance Law, Economics and Practice, Cambridge University Press, 2006, p. 81

46

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bank on a deferred delivery basis. It receives full price of the merchandize on the spot that serves its financing need at present. At a pre-agreed future date, it delivers the merchandize to the bank. The bank sells the merchandize in the market at the prevailing price. Since the spot price that the bank pays is pegged lower than the expected future price, the transaction should result in a profit for the bank. 47

A simple salam structure is presented below: 48

Some additional considerations in salam are as follows:

 The buyer should pay the price, in full, to the seller at the time of effecting the sale; otherwise it will be tantamount to a sale of debt against debt, which is expressly prohibited by the Sharia rulings (any unpaid price represents a debt to the buyer and a debt to the seller for the value of such goods not paid for in advance);

47

Obaidullah Mohammed, Islamic Financial Services, Islamic Research Center, King Abdulaziz University, 2005, pp. 95-96 48 Mayer Brown LLP, Islamic Finance At a Glance, supra

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 The debt liability of the seller cannot be adjusted against the price for salam sale, in part or in full.  Salam can be affected in only those goods that are normally available in the market and whose quality and quantity can be specified exactly;  It is necessary that the quality of the goods intended to be purchased is fully specified, leaving no ambiguity leading to dispute among the parties involved in the transaction;  The exact date and place of delivery must be specified in the salam contract. The parties may fix any date for delivery with mutual consent; and  In order to ensure that the seller shall deliver the goods on the agreed date, the bank can also ask the seller to furnish a security, which may be in the form of a guarantee or in the form of a mortgage/hypothecation. 49

Salam is a bit of an exception in the Islamic financial landscape, as forward contracts are not generally acceptable. You cannot sell what you do not own and possess. Its permissibility is based on the sunna. Salam may be a forward contract, but it differs in two important aspects from the usual forwards and futures. First, under a salam contract, the full price of the product must be paid in advance. Second, at maturity the buyer must take delivery of the good. Muslim scholars argue that in this way speculative activities (maisir) are prevented, but the downside is that hedging also becomes more difficult. 50

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), has ruled against salam contract for shares in a standard, Sharia Standard 21, that became effective in January 2007. The reasoning appears to be that the shares cannot be described well enough for the future, as the underlying assets may change. This means that gharar is involved. But there are respected scholars who disagree and accept salam contract for shares, on the grounds that shares are all identical and readily available on the market. 51

49

Said, Islamic Alternatives to Conventional Finance, supra, p. 17 Visser, Islamic Finance Principles and Practice, supra, p. 61 51 Visser, Islamic Finance Principles and Practice, supra, p. 62 50

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1.3.7 Istisna

An istisna is a type of contract in which a mustasne (a client requiring the manufacturing or construction of an asset) orders from a sane’ (manufacturer or constructor) an asset meeting certain specifications (the masnou), with asset delivery to be within a specified period of time. The mustasne will be required to pay the purchase price of that asset if the asset is manufactured or constructed within the specified time period and meets the agreed-upon specifications. The sane does not need to manufacture or construct the asset itself; it may locate the asset in the market and purchase it for delivery to the mustasne or it may cause another party to manufacture or construct the asset. If the original sane causes another sane to manufacture or construct, the original sane remains liable to the original mustasne for the delivery of the masnou. In a financial transaction, the Banks or a special purpose Funding Company would be the original sane and would contract with another sane (the end sane) for the manufacture or construction of the asset. 52

Istisna can be used for providing the facility of financing the manufacture or construction of houses, plant, projects, bridges, roads and highways. By way of a Parallel Istisna contract with subcontractors, Islamic banks can undertake the construction of any project/asset and its sale for a deferred price, and subcontract the actual construction to any specialized firms. 53

The figure below illustrates the structure of an istisna transaction: 54

52

McMillen, Michael J.T., Islamic Project Finance, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 206 53 Ayub, Introduction to Islamic Finance, supra, p. 404 54 Mayer Brown LLP, Islamic Finance At a Glance, supra

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The legality of istisna is accepted by the Sharia scholars because it does not contain any prohibition, it has always been a common practice in the world and also because of ease for human beings. Istisna is a valid contract and a normal business practice. As a financing mode it has been legalized on the basis of the principle of Istihsan (public interest). Istisna is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or construct (or cause so to do) anything to be delivered at a future date. It becomes an obligation of the manufacturer or the builder to deliver the asset with agreed specifications at the agreed period of time. 55

Potential areas that istisna structure can be used are as follows:

 financing the construction industry – apartment buildings, hospitals, schools and universities;  development of residential/commercial areas and housing finance schemes; 

financing high technology industries such as the aircraft industry, locomotive and shipbuilding industries. 56

55 56

Ibid, p. 263 Ayub, Introduction to Islamic Finance, supra, p. 269

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The main difference between an istisna and a salam contract is that, in istisna contracts, it should always be something that needs manufacturing while the subject of a salam contract may be either a natural product or a manufactured good.

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Chapter 2

SECURITIZATION

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2 SECURITIZATION

As we did make a beginning with the basics of Islamic Finance, we also need to grasp the idea of conventional securitization in order to perfectly understand what Islamic Securitization is. Thus, in this chapter, we will be trying to explain conventional securitization, its structure and main transaction types.

2.1 What is Securitization?

As securitization is a structured finance technique, 57 one should better start with defining what structured finance is. Even though there is no universal definition for structured finance, a good working definition for structured finance may be the following:

. . . techniques employed whenever the requirements of the originator or owner of an asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing, off-the-shelf product or instrument. Hence, to meet this requirement, existing products and techniques must be engineered into a tailor-made product or process. Thus, structured finance is a flexible financial engineering tool. 58

Even though this very definition of structured finance would include not only securitization but also structured credits, project finance, structured notes and leasing 59, it obviously gives a number of clues in relation to securitization, the underlying commercial needs and its history. So what is securitization then?

57

Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization Fabozzi, Frank J., Davis, Henry A., Choudhry, Moorad, Introduction to Structured Finance, John Wiley & Sons, Inc., New Jersey, 2006, p. 1 59 Ibid, p. 4 58

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Securitization may be very briefly defined as the process of making a loan or mortgage into a tradable security by issuing a bill of exchange or other negotiable paper in place of it. 60 Without any doubt, this brief definition needs a detailed clarification in order to make the quite complicated structure of securitization understandable for the reader.

Securitization generally refers to the sale of assets, which generate cash flows, from the institution that owns them, to another company that has been specifically set up for the purpose, and the issuing of notes by this second company. These notes are backed by the cash flows from the original assets. 61 The institution owning the cash flow generating assets is commonly known as the originator. The other company mentioned in this explanation which purchases the cash flow generating assets is known as the Special Purpose Vehicle (SPV) which is also known as Special Purpose Company (SPC) or Special Purpose Entity (SPE). 62 The SPV shall hold the assets purchased from the originator as collateral for the securities issued and sold to the investors.

After a basic explanation of what securitization is 63, let us now move on with the history of securitization.

2.2 History of Securitization

Even though the modern securitization practices appeared at the beginning of 1970s in the US, in Europe a form of mortgage funding has existed for many years that has remarkable similarities to the present form of securitization, although the two are not the same. This instrument has existed

60

Dictionary of Banking and Finance, A & C Black Publishers Ltd, 3. Edition, London, 2005, p. 319 Choudry, Moorad, Corporate Bonds and Structured Financial Products, Elsevier Butterworth-Heinemann, Oxford, 2004, p. 297 62 For the purposes of this study, the concept Special Purpose Vehicle and the abbreviation SPV shall be used. 63 There are different kinds of ways to structure a securitization transaction which may vary considerably between each other. Besides, a securitization structure may be much more complex than the main concept explained in our brief definition. We will be explaining the concept in detail in the sections regarding the structure of securitization and types of securitization. 61

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in Denmark for more than 200 years. Likewise, the German “pfandbrief” 64 instrument has a long history and is even alive today. 65

The modern form of asset securitization began with the structured financing of mortgage pools in the United States in the 1970s. In February 1970, the American department of housing and urban development completes the first true securitization, on home loans. 66

For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). 67

But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well. 68

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved thirdparty and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for 64

The Pfandbrief (plural: Pfandbriefe) is a mostly triple-A rated German bank debenture which has become the blueprint of many covered bond models in Europe and beyond. The Pfandbrief is collateralized by long-term assets such as property mortgages or public sector loans as stipulated in the Pfandbrief Act. 65 Kothari, Vinod, Securitization The Financial Instrument of the Future, John Wiley & Sons (Asia) Pte Ltd, 2. Edition, 2006, p. 109 66 Article “Historical view of securitization”, available at http://www.banque-credit.org/EN/banks/historysecuritization.html 67 Comptroller’s Handbook, Asset Securitization, Comptroller of the Currency Administrators of National Banks, 1997, p. 2 68 Ibid

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structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.69

Securitization only reached Europe in late 80's, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90's or early 2000, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction (such as the ones implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government, executed by Philippe Tapernoux). 70 Securitization industry became a trillion dollar industry within a few decades, approximately 75 per cent of which have originated from the US. 71

This rapid growth experienced a very harsh decline when the housing bubble in the US burst and the markets went into the worst financial crisis after the Great Depression of 1929. We will talk about that later in the section 2.6 regarding securitization and the financial crisis.

2.3 Structure of Securitization

In this section we will try to deeply examine how a securitization transaction is structured. In other words, we will be going a step further than our definition section above and capture all the important features of a transaction.

Now, before going into the elements of a securitization deal, let us try to make a summary of a securitization transaction in order to see the phases of it or how a transaction is structured:

69

Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization Ibid 71 Kothari, Securitization The Financial Instrument of the Future, supra, p. 112 70

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 An originator of (usually) high quality receivables, such as home mortgage loans and consumer credit receivables, sells the receivables to a specially formed company (SPV) in return for a purchase price payable immediately on sale.  The SPV finances the purchase price of the receivables by borrowing from banks or by a conventional bond or note issue to sophisticated investors (“funding loan”). The SPV grants security to investors over the receivables to secure the borrowing.  The SPV authorizes the originator as the “servicer” to collect the receivables on behalf of the SPV which uses them to pay principal and interest on the funding loan (investing the proceeds in the meantime). The SPV pays a servicing fee to the servicer.  The SPV is usually a thinly-capitalized single-purpose company whose shares are held by somebody other than the originator, e.g. charitable trustees, so that the SPV is not a subsidiary which must be consolidated on the originator’s balance sheet.  In order to ensure that the receivables are sufficient to repay the investors on time, there may be various forms of “credit enhancement”, e.g. a third party may give a guarantee to the SPV or the originator may agree to make a subordinated loan to the SPV.  The loan by the investors, e.g. loan notes, is often rated by a rating agency. Usually the loan has a higher rating than would be obtainable for a direct loan to the originator.  The SPV pays surplus income from the receivables, which is not needed to repay the funding loan, to the originator so that the originator takes the profit. The SPV may pay this profit to the originator as servicing fees or other means. 72

Below is a figure 73 which perfectly complements our summary:

72

Wood, Philip R., Title Finance, Derivatives, Securitisations, Set-off and Netting, Sweet&Maxwell, 4. Edition, 2001, pp.41-42 73 Fabozzi, Frank J., Davis, Henry A., Choudhry, Moorad, Introduction to Structured Finance, supra, p. 70

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The originator is the key concept in a securitization structure. The originator is the legal (or even real) person that starts the whole process by deciding to securitize its cash flow generating assets. Who or what can be an originator or in other terms can securitize its assets?

An originator can be any legal person as well as real persons that have cash flow generating assets. Quite interestingly David Bowie, James Brown, the Isley Brothers, and Rod Stewart used securitization to obtain funding from their future music royalties. The first was David Bowie who in 1997 used securitization to raise $55 million backed by the current and future revenues of his first 25 music albums (287 songs) recorded prior to 1990. 74 The legal persons that use securitization may be financial institutions, large corporates, quasi-government agencies and even local governments and municipalities. 75

As the example regarding the music royalties may give a clue, all assets can be securitized so long as they are associated with cash flow. 76 The securitization market in the United States and

74

Fabozzi, Frank J., Kothari, Vinod, Introduction to Securitization, John Wiley & Sons, Inc., 2008, p. 15 Jobst, Andreas A., Asset Securitisation as a Risk Management and Funding Tool: What Does it Hold in Store for SMES? February 14, 2005, p.2, available at SSRN: http://ssrn.com/abstract=700262 76 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 75

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Western Europe is dominated by a number of asset classes: residential mortgage receivables, commercial mortgage receivables, credit card receivables, auto loans, consumer loans, trade receivables and uncontracted future cash flows (such as toll receipts). However the type of assets that can be securitized continues to expand (some of the key innovators in Western Europe have been governments). In principle, any assets or entitlements representing future (predictable) cash flows can be securitized to the extent that they can be effectively transferred to the SPV through a true sale (or to the extent that the Originator is considered to be “bankruptcy remote”). These may, for instance, include tax revenues or utilities payments. 77

2.3.1 True Sale

It is imperative that once the sale and transfer of the assets to the SPV has been effected, it cannot be challenged, voided or otherwise reversed in an insolvency of the Originator or otherwise. This concept is referred to as true sale. Whether a transaction constitutes a true sale under the applicable law (notably, whether it will be recognized as such by the competent court in the Originator’s insolvency) must be established through a legal analysis of the transaction. 78

If it is subsequently determined in a bankruptcy proceeding that the so-called sale by the originator was merely a nomenclature or a camouflage, then a bankruptcy judge can rule that the assets were never sold and were merely pledged as collateral for a financing. In that case, in the event of a bankruptcy filing by the originator, the bankruptcy judge can have the assets of the SPV treated as part of the assets of the originator. This would defeat the purpose of setting up the SPV. Typically, a true sale opinion letter by a law firm is sought to provide additional comfort to the parties in the transaction. 79

In order to qualify for a true sale treatment, generally, a transaction must meet the following criteria: 77

IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, p.2, available at http://www.ifc.org/ifcext/eca.nsf/AttachmentsByTitle/Securitization1A%2B904/$FILE/Securitization1A%2B9-04.pdf 78 Ibid 79 Fabozzi, Kothari, Introduction to Securitization, supra, p. 9

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 Legal isolation from the seller (transferred assets put “presumptively beyond the reach of the transferor and its creditors”);  The new owner of the assets has the right to pledge or to exchange the assets (or the beneficial interests in the assets if the new owner is a qualifying (SPV); and  The seller doesn’t have the right to buy the assets back. 80

2.3.2 Special Purpose Vehicle

The originator intending to securitize its assets needs to establish a Special Purpose Vehicle (SPV). An SPV is a company that is created solely for a particular financial transaction or series of transactions. It may sometimes be something other than a company, such as a trust. 81 So the originator establishes an SPV in order to use it for a particular financial transaction or series of transactions. It does so because creation of marketable securities is not possible without a conduit or vehicle that will house the assets transferred by the originator and create securities based on such assets. Therefore, a vehicle is required to serve as an intermediary between the originator and the investors. A general purpose, or operating company, is not fit to hold securitized assets as such a company might have other assets and other liabilities, each of which might interfere with the exclusivity of rights over the assets that the transaction intends to give to the investors. 82

If an operating company holds the assets, it might incur expenses, and/or incur liabilities, and might go bankrupt, thereby destroying the transaction. By its very nature, a special purpose vehicle is a legal shell with only the specific assets transferred by the originator, and those assets are either beneficially held by the investors or collateralize the securities of the vehicle; there is nothing left in the vehicle for anyone to have an interest in. A special purpose vehicle is a legal entity, but a substantive non-entity. This is what makes a special purpose vehicle bankruptcy-remote. 83

80

Hayre, Lakhbir, Ed. by, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, John Wiley & Sons, Inc., 2001, p. 75 81 Article “SPV”, available at http://moneyterms.co.uk/spvspe/ 82 Kothari, Securitization The Financial Instrument of the Future, supra, pp. 15-16 83 Ibid, p. 16

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As a result of the aforementioned, an SPV is a legal entity functioning as a conduit with no physical presence, independent management or employees. It can take the form of limited partnership, limited liability company, trust, corporation, collective investment fund or established under special law but only if those laws are SPV-enabling. The SPV cannot be consolidated with the originator for tax, accounting or legal purpose as that will effect its bankruptcy-remote position. 84

For tax reasons, the SPV is mostly established in a tax-friendly jurisdiction such as Luxembourg, Cayman Islands, Nevis, etc. in order to avoid the transfer or municipality taxes, etc.

Obviously, the originator has an expertise in the area as it is mainly dealing with that type of business. Furthermore, the originator knows the borrowers and vice versa. So it makes perfect sense for the originator to go on administering the portfolio of the assets.

Frequent issuers under US and UK law use master trust structures, which allow multiple securitizations to be issued from the same SPV. Under such schemes, the originator transfers assets to the master trust SPV. Notes are then issued out of the asset pool based on investor demand. Master trusts have been used by Mortgage-Backed Securities (MBS) and credit-card Asset-Backed Securities (ABS) originators. 85

2.3.3 Credit Enhancement

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhanced," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors

84

Akamatsu, Noritaka, Role of Special Purpose Vehicles in ABS Market, August 14-18, 2006, The World Bank China, p. 3, available at http://www.slideshare.net/financedude/role-of-special-purpose-vehicles-is-abs-market 85 Choudry, Moorad, An Introduction to Bond Markets, John Wiley & Sons, 3. Edition, 2006, p. 228

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will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. 86

The mechanisms for credit enhancement can be classified into three categories: (1) originator-provided, (2) structural, and (3) third-party provided. Originator-provided credit enhancement refers to credit support where a part of the credit risk of the asset pool is assumed by the originator/seller. Structural credit enhancement refers to the redistribution of credit risks among the bond classes comprising the structure, so that one bond class provides credit enhancement to the other bond classes. Finally, third-party credit enhancement refers to the assumption of credit risk by parties other than the originator and the other bond classes in the structure. 87

The originator-provided credit enhancement mechanisms include excess spread, cash collateral, over-collateralization, etc.

Whatever is available from the income of the transaction (after meeting senior expenses) to meet losses on the assets is credit-enhancing excess spread. 88 More specifically, the excess spread is equal to the interest paid by the asset pool (which is based on the note rate of the obligors in the asset pool) reduced by (1) the expenses of the transaction such as trustee fees; (2) senior servicing fees; and (3) the payments made to the bond classes (which is based on the weighted average funding cost). For example, assume a pool of loans that has a weighted average note rate of 9.5% and the originator receives a servicing fee of 1.5%. If the weighted average funding cost is 5.0%, then the excess spread is 3% (9.5%− 1.5% − 5%). The advantage of retaining the exc ess spread is that it can be used to offset losses in future periods. 89 To sum up, excess spread is the funds remaining after expenses such as principal and interest payments, as well as other fees have been paid-off are accumulated, and can be used when SPV expenses are greater than its income.

86

Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization Fabozzi, Kothari, Introduction to Securitization, supra, p. 86 88 Kothari, Securitization The Financial Instrument of the Future, supra, p. 213 89 Fabozzi, Kothari, Introduction to Securitization, supra, pp. 86-87 87

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Secondly, the originator can create a cash collateral account at the initiation of the transaction and the cash in that account is subject to withdrawal in the event of losses that exceed the amount provided by other forms of credit enhancement. At the termination of the transaction, any balance in the cash collateral account is returned to the originator. The originator can also make a subordinated loan to the SPV which has the same cash collateral effect. 90

Over-collateralization is one of the most common forms of credit enhancement where the originator transfers an asset pool that has a market value that exceeds the amount paid by the SPV. The amount of the over-collateralization is a form of equity and is equal to the difference between the par value of the assets transferred and the price paid. 91

Let us move on with structural credit enhancement mechanisms. The most common form of credit enhancement for securitization transactions is the stratification of the bond classes into senior, mezzanine, and junior (or subordinated) bond classes. 92 As this is the very principle of structured finance –carving out securities with different risk/return attributes, structural enhancement is crucial to a securitization transaction.93 When various classes of liabilities are issued with different priorities—such as Class A, Class B, and Class C, the subordination of Class C provides a credit enhancement to Class B, and both of them provide enhancement to Class A. This credit enhancement comes from the structure of the liabilities, so it is called structured enhancement. 94 This mechanism, which is set down in the deal’s prospectus, is known as the cash flow waterfall, or simply the waterfall. 95 That structure is also known as Tranching.

The figure below 96 is an illustration of how the waterfall structure in a securitization scenario works. As it is noted above, in a securitization the issued notes are structured to reflect the specified risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA. The lower-rated notes usually have an element of over-collateralization and are thus capable of

90

Ibid, p. 88 Ibid, p. 89 92 Ibid, p. 90 93 Kothari, Securitization The Financial Instrument of the Future, supra, p. 218 94 Ibid 95 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 107 96 Article “Tranche” from Wikipedia, available at http://en.wikipedia.org/wiki/Tranche 91

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absorbing losses. The most junior note is the lowest-rated or non-rated. It is often referred to as the first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator. 97

Finally, the third-party provided credit enhancements come in the form of third-party guarantees [such as a letter of credit (L/C) or a surety bond] that provide for first-loss protection against losses up to a specified amount. 98 In this form of credit enhancement, an insurance provider agrees, for a fee, to guarantee the performance of a certain amount of the collateral against defaults. If, for example, a loan in the collateral pool goes into default and the underlying collateral is repossessed and then sold at a loss resulting in a partial payoff of the outstanding loan balance, the bondholders would be in a position not to recover the principal outstanding for that loan. To provide protection to the bondholders, an insurance provider will pay the difference between the loan payoff amount and the amount due to the bondholders, thereby absorbing the loss. 99

97

Choudry, An Introduction to Bond Markets, supra, p. 228 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 105 99 Fabozzi, Frank J., Drake, Pamela P., Finance Capital Markets, Financial Management and Investment Management, John Wiley & Sons, Inc., 2009, p. 433 98

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It is also possible to use derivatives as third party provided credit enhancement mechanisms. Credit derivatives were developed along the lines of other over-the-counter (OTC) derivatives but have found an excellent companion in securitization. Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event associated with the credit derivative's reference asset or reference entity. 100 The party that provides protection against such risk is called protection seller and the party that buys such protection, normally but not necessarily the originator of the credit asset, is called the protection buyer. 101

The most common credit derivative is the credit default swap, credit swap or default swap. This is a bilateral contract that provides protection on the par value of a specified reference asset, with a protection buyer that pays a periodic fixed fee or a one-off premium to a protection seller, in return for which the seller will make a payment on the occurrence of a specified credit event. 102

At this point, while talking about credit default swaps, we should note that this instrument was the main reason for American International Group, Inc. (AIG), one of the biggest insurance agencies in the world, to go almost bankrupt in the recent financial crisis. It could only manage to survive with several Federal Reserve bailouts. What AIG mainly doing was writing credit default swaps to back Collateralized Debt Obligations (CDO) which has been a very profitable business during the housing boom. However when the bubble burst and the AIG was downgraded to AA, it was required to post additional collateral with its trading counter-parties, and this led AIG into a liquidity crisis. 103

Apart from the credit risk, the parties to a securitization transaction are also under interest rate risk. For that reason, most securitization transactions contain some form of interest rate hedging and/or currency hedging to deal with currency risk and basis risk. 104 An interest rate swap can be used to alter the cash flow characteristics of the assets (liabilities) to match the characteristics of the 100

Choudry, Moorad, An Introduction to Credit Derivatives, Elsevier Butterworth-Heinemann, 2004, p.11 Kothari, Securitization The Financial Instrument of the Future, supra, p. 25 102 Choudry, An Introduction to Credit Derivatives, supra, p.16 103 Article “American International Group” from Wikipedia, available at http://en.wikipedia.org/wiki/American_International_Group 104 Deacon, John, Global Securitization and CDOs, John Wiley & Sons Ltd, 2004, p. 31 101

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liabilities (assets). For example, let us suppose a transaction has a pool of fixed rate, monthly payment loans but the bond classes that are supported by the collateral have floating rate, monthly payment characteristics. A generic or plain vanilla swap can be used to convert the monthly, fixed rate cash flows to monthly, floating rate cash flows based on the reference rate and margin owed to the covered classes of bonds. 105 The credit enhancement is sized appropriately for the rating level to cover the expected pool losses during the life of securitization. The amount of credit enhancement will vary according to the expected pool losses and the historical volatility of the issuer’s losses. Therefore, prime issuers will have the lowest credit enhancement, followed by nonprime issuers, and finally subprime issuers will have the highest credit enhancement (and additionally, often a monoline wrap). 106

2.3.4 Credit Rating

Rating is almost indispensable in the process of securitization. All major international rating agencies are engaged in rating securitization transactions. Every securitization transaction has a potential to result in a given rating. For example, if a AAA rating is targeted in an auto finance pool, originated by an A-rated issuer, it is quite possible to do so; all that is required is to work out the level of credit enhancements or subordinated interest. 107

As securitization is a structured finance device, the investors are not concerned with the entity except for the quality of the originated portfolio. Essentially, the rating agencies are concerned with the quality of the underlying pool. 108 Even though it is often said that the rating of the originator is completely irrelevant for securitization transactions, it should be noted that the rating of covered bonds depends on a composite view of the strength of the rating of the issuer and the rating of the collateral pool; neither can be used solely – the issuer may be less relevant in jurisdictions with stronger insolvency ring-fencing, and more relevant in other jurisdictions. The credit of the collateral

105

Fabozzi, Kothari, Introduction to Securitization, supra, p. 108 Hayre, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, supra, p. 89 107 Kothari, Securitization The Financial Instrument of the Future, supra, p. 309 108 Ibid, p. 310 106

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pool may change with the ability to dynamically substitute the pool. 109 Obviously the abilities of the originator as the servicer will have some effect on the cash flow from the originated assets.

As rating agencies have long experience in rating securitization issues, they have developed a benchmark for different asset classes. Mainly the most important rating agency concerns while giving a rating are the quality of the asset portfolio, solvency of the issuer, perfection of the legal structure, tax risks, clean and prior title to the securitized portfolio, risks of set-off and prepayment, etc. 110

Why doesn’t a corporation always seek the highest credit rating (AAA) for the bonds backed by the collateral in a securitization transaction? The answer is that credit enhancement does not come without a cost. The various credit enhancement mechanisms increase the costs associated with securitized borrowing via an asset-backed security. So, when it is seeking a higher rating, the corporation must assess the tradeoff between the additional cost of credit enhancing the bonds versus the reduction in funding cost by issuing a bond with a higher credit rating. 111

A change in rating for an Asset-Backed Security (ABS) or Mortgage-Backed Security (MBS) issue may be due to deterioration in performance of the collateral, heavy utilization of credit enhancement or downgrade of a supporting rating – for example, an insurance company that was underwriting insurance on the pool of the assets. 112

Some recent lawsuits alone show the crucial role played by the rating agencies in securitization transactions. Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies. 113

109

Deacon, Global Securitization and CDOs, supra, p. 125 Kothari, Securitization The Financial Instrument of the Future, supra, pp. 310-313 111 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 72 112 Choudry, An Introduction to Bond Markets, supra, p. 232 113 Wayne, Leslie, Calpers Sues Over Ratings of Securities, NY Times, July 14, 2009, available at http://www.nytimes.com/2009/07/15/business/15calpers.html?_r=3&scp=1&sq=calpers&st=cse 110

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2.3.5 Profit Extraction

In most securitizations, at least in the good old times it was the case, it is expected that the SPV will receive more income than it needs from the securitized assets to meet its liabilities to the investors and its own nominal profit entitlement. It is then of the essence that any such surplus income should be returned to the originator, which is consistent with the securitization being essentially a method of funding rather than a sale of assets, from the Originator’s perspective. 114

Now after scrutinizing the complex structure of securitization, it is time to look at the motives of the parties for securitization or what the reasons to undertake a securitization transaction and invest in the securities issued are.

2.4 Motivation for Securitization

Even though the financial turmoil seen recently made many people think that securitization was one of the main reasons of the credit crunch, obviously there are many reasons for the originators to undertake securitization deals and also for the investors to invest in the securities issued. In this part, we will try to explain these motives for the parties to a securitization transaction, namely the originator and the investors.

2.4.1 Motivation for the Originator

The rationale for securitization varies widely from company to company. 115 There is a bunch of reasons for different kind of originators to undertake securitization transactions and here we will try to explain the most important ones for most companies.

114

Article “Securitization: other common features” from HM Revenue & Customs, available at http://www.hmrc.gov.uk/MANUALS/cfmmanual/CFM20050.htm 115 Deacon, Global Securitization and CDOs, supra, p. 19

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2.4.1.1 The potential for reducing costs

The segregation of receivables from the insolvency risk of the originator will enable funds to be raised which are not linked to credit risk on the originator. For an originator that is perceived as a bad credit risk, or has a low credit rating, this should serve to improve the all-in cost of funds to the originator, or the amount of finance that can be raised. 116 Let us give an example in order to show how that happens. Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continued to be rated AAA because of the strength of the underlying collateral and other credit enhancements. 117 By credit enhancement, it is meant that there is a source of capital that can be used to absorb losses incurred by the asset pool. 118

2.4.1.2 The ability to diversify funding sources

The ABS markets have their own investor base, some or all of which may not be current investors in the business of the originator, whether due to unfamiliarity with the originator, or credit concerns on the originator. Issuing in the ABS markets enables the originator to access this new base of investors and expand their current funding sources. 119 By doing so, without disturbing existing lenders, securitization extends the pool of available funding sources to an entity by bringing in a new class of investors. For many entities, typical securitization investors such as insurance companies, asset managers, pension funds and the like may not be available for access, other than for investment in a securitization program. 120

116

Ibid, p. 5 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 118 Fabozzi, Kothari, Introduction to Securitization, supra, p. 15 119 Deacon, Global Securitization and CDOs, supra, p. 5 120 Kothari, Securitization The Financial Instrument of the Future, supra, p. 98 117

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2.4.1.3 The ability to manage corporate risk

The credit risk and the interest rate risk of assets that have been securitized are no longer risks faced by the originator/seller. Thus, securitization can be used as a corporate risk management tool. 121 Once assets have been securitized, the credit risk exposure on these assets for the originating bank is reduced considerably and, if the bank does not retain a first-loss capital piece (the most junior of the issued notes), it is removed entirely. 122 Before securitizing the assets, the lenders are also subject to the interest rate risk, as mortgages for instance carry a fixed rate of return, while the loans taken by the lenders have a variable rate. When the mortgages are securitized, the originator completely avoids the price risk as the entire interest rate or prepayment risk inherent in the pool is transferred to capital markets. 123

2.4.1.4 The ability to help in capital adequacy requirements

Capital adequacy requirements relate to the minimum regulatory capital for financial intermediaries. One of the very strong motivations for securitization is that it allows the financial entity to sell off some of its on-balance sheet assets, and thus remove them from the balance sheet and reduce the amount of capital required for regulatory purposes 124 which again can lead to cost savings or allows the bank to allocate capital to other, perhaps more profitable, businesses. 125

121

Fabozzi, Kothari, Introduction to Securitization, supra, p. 17 Choudry, An Introduction to Bond Markets, supra, p. 224 123 Kothari, Securitization The Financial Instrument of the Future, supra, p. 101 124 Kothari, Securitization The Financial Instrument of the Future, supra, p. 100 125 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 76 122

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2.4.1.5 The opportunity to achieve off-balance financing

Most securitizations transfer assets and liabilities off the balance sheet, thereby reducing the amount of the originator’s on-balance sheet leverage. The off-balance-sheet financing can help improve the securitizer’s return on equity (ROE) and other key financial ratios. 126

2.4.1.6 The ability to match the assets and liabilities

Asset liability mismatch is a serious issue for financial intermediaries such as banks and financial companies. It refers to the maturity mismatch between assets and liabilities. Mismatch spells either higher risk or cost, and so intermediaries try to strike a near perfect match between maturities of assets and liabilities. 127 Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis. 128

2.4.1.7 The ability to reduce credit concentration

Securitization has also been used by many entities for reducing credit concentration. Concentration either sectoral or geographical, implies risk. Securitization by transferring on a nonrecourse basis exposure by an entity has the effect of transferring risk to capital markets. 129

2.4.1.8 The opportunity for arbitrage by repackaging

Securitization has also been used by a number of banks and financial professionals for arbitraging purposes: Buying up assets from the market at higher spreads, accumulating them, 126 127

Fabozzi, Kothari, Introduction to Securitization, supra, p. 19

Kothari, Securitization The Financial Instrument of the Future, supra, p. 98 128 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 129 Kothari, Securitization The Financial Instrument of the Future, supra, p. 101

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providing or organizing enhancements and securitizing them. These transactions are sometimes called repackaging transactions, giving a net arbitrage profit to the repackager. 130

2.4.2 Motivation for the Investors

Investor interest in the ABS market has been considerable from its inception. This is because investors perceive asset-backed securities as possessing a number of benefits. 131 Now let us try to explain what advantages securitization ensures to the investors.

First of all, securitized instruments are devices of asset-based finance. Investors have a direct claim over a portfolio of assets, often diversified and reasonably credit-enhanced. Investors are not affected by any of the risks that beset the originator. Thus, securitization investments are far safer than investing directly in the debt or equity of the originator. 132

A holding in an ABS also diversifies an investor’s risk exposure. For example, rather than investing $100 million in an AA-rated corporate bond and be exposed to “event risk” associated with the issuer, investors can again exposure to, for instance, 100 pooled assets. These pooled assets clearly have lower concentration risk. 133 That is why hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities.134

Obviously securitization gives the investors the opportunity to access sectors that are otherwise not open to them 135 and potentially earn a higher rate of return (on a risk-adjusted basis). 136

130

Ibid Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 79 132 Kothari, Securitization The Financial Instrument of the Future, supra, p. 102 133 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 79 134 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 135 Choudhry, An Introduction to Bond Markets, supra, p. 224 136 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 131

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2.5 Different Classifications of Securitization

2.5.1 According to asset types

One actually needs to answer the question “What can be securitized?” in order to see different securitization structures according to asset types. We mentioned before that cash flow generating assets can be securitized. When we look at the practice we see that the most common assets that have traditionally been securitized are residential mortgage receivables, commercial mortgage receivables, credit card receivables, auto loans, consumer loans, trade receivables and uncontracted future cashflows. However the type of assets that can be securitized continues to expand. In principle, any assets or entitlements representing future (predictable) cash flows can be securitized to the extent that they can be effectively transferred to the SPV through a true sale (or to the extent that the Originator is considered to be “bankruptcy remote”). These may, for instance, include tax revenues or utilities payments. 137

2.5.2 According to SPV types

In most securitization structures, the SPV is created specifically for the particular originator and the particular transaction. The objective of this so-called one-off securitization is to provide the originator with significant flexibility to customize the securitization in terms of its particular structure and the types of capital market securities issued. However, because one-off structures are created for a particular transaction, their transaction costs can be high; they can rarely achieve the transaction cost economies of scale realized by multiseller securitization conduits. 138

A multiseller securitization conduit offers originators the opportunity to minimize their transaction costs by utilizing a common SPV. These conduits are typically administered by commercial or investment banks and are able to achieve a transaction cost economy of scale by 137

IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p.2 138 Schwarcz, Steven L, The Alchemy of Asset Securitization, International Financial Law Review, May 1995, p. 31

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allowing multiple originators to sell receivables to a single pre-existing SPV. 139 Although multiseller structure can minimize the transaction cost by achieving economy of scale, it has higher risk of getting involved with bankruptcy claims when single originator goes bankruptcy. It can adversely affect legal existence of the multiseller SPV. Thus, multiseller SPV is often used in transactions with investment grades, because those originators are less likely to go bankrupt. Alternatively the potential risk caused by originator’s bankruptcy can be mitigated by special arrangement so called “compartment” stated in special securitization law, like the Securitization Law issued in March 2004 in Luxembourg. 140

2.5.3 Pass through & Pay through Securitization Structures

A pass through securitization structure refers to the securitization structure where the SPV makes payments, or rather, passes payments to the investors, on the same periods, and subject to the same fluctuations, as are there in the actual receivables. That is to say, amount collected every month is passed through to investors, after deducting fees and expenses. 141 This is done by selling direct participations in the pool of assets. In other words, a pass-through certificate represents an ownership interest in the underlying assets and thus in the resulting cash flow. Principal and interest collected on the assets are “passed through” to the security holders; the seller acts primarily as a servicer. 142 When substantially all the payments are collected and disbursed, the SPV is typically dissolved. 143

In a pay-through securitization structure, the issued debt instrument is a borrowing instrument, not participation. Under the pay-through structure, the assets are typically held by a limited purpose vehicle that issues debt collateralized by the assets. Like a pass-through, the debt service is met by cash flow “paid through” to investors out of the pledged collateral. Investors in a pay-through bond are not direct owners of the underlying assets; they have simply invested in a 139

Ibid, p. 32 Wang, Shegzhe, True Sale Securitization in Germany and China, LL.M. Finance thesis, Johann Wolfgang Goethe University, Institute for Law and Finance (ILF), 2004, pp.20-21 141 Available at http://www.vinodkothari.com/glossary/Passthro.htm 142 IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p. 7 143 Ryan, Stephen G., Financial Instruments & Institutions, Accounting and Disclosure Rules, John Wiley & Sons Inc., 2. Edition, 2007, p. 196 140

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bond backed by some assets. Therefore, the issuing entity can manipulate the cash flows, into separate payment streams. Thus pay-through securities may be structured so that asset cash flows can be reconfigured to support forms of debt unlike those of the underlying assets. 144

2.5.4 True sale & Synthetic Securitization Structures

One of the key aspects of ensuring the marketability of the relevant debt securities or bank debt that will fund the securitization is to enable the relevant rating agencies to analyze the credit risk of the relevant receivables free and clear of the credit risk of the entity that originated the receivables in question – such that the deal is delinked from the credit of the originator. In order to ensure that this treatment is available, a securitization transaction will usually attempt to effect a ‘‘true sale’’ under the relevant legal regime relating to the receivables – terminology used to describe a sale of the receivables being securitized in a manner which ensures their isolation from the bankruptcy or insolvency of the originator. 145 Obviously this will increase the rating for the securities and consequently the financing cost will be lower than it would otherwise be.

Other objectives a true sale securitization can achieve are, inter alia, transferring of credit risks, access to capital markets and influencing balance sheet. For accounting purpose, a true sale securitization allows an originator to take the securitized assets off its balance sheet, thus improving its leverage. 146

As asset securitization converts assets into securities, if the assets in question are synthetic rather than really transferred and securitized, this is a synthetic securitization. The synthetic technology comes from the world of derivatives, where a position of risk and return emulating an actual asset or exposure is created by a derivatives transaction. The basis of a synthetic securitization

144

IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p. 7 145 Deacon, Global Securitization and CDOs, supra, p. 37 146 Wang, True Sale Securitization in Germany and China, supra, p. 23

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is a derivative or a risk transfer transaction and the purpose is to synthetically replicate actual transfer of assets. 147 A synthetic securitization securitizes a debt portfolio synthetically, not actually. In a true sale securitization structure, the transaction includes two key features, - cash and transfer, with the originator raising cash and making a transfer. In a synthetic transaction, both are missing; the originator does not raise any cash, nor does he transfer any assets. 148

If we basically look at the main differences between the true sale and synthetic structures, we will see that;

 a true sale securitization is an off-balance sheet financing mechanism, while a synthetic securitization is an on-balance sheet financing tool.  an SPV is a must in true sale securitizations but not a necessity in synthetic securitizations.  the main function of true sale securitizations is to get cheaper funding; synthetic securitizations however mainly function as an efficient technique to hedge credit risks. 149

2.5.5 Asset-backed & Future Flows Securitization Structures

While traditional asset-backed transaction relate to assets that exist, future flows transactions relate to assets expected to exist. There is a source, a business, an infrastructure, from which the asset will arise. The source, business or infrastructure in question will have to be worked upon to generate the income; in other words, the income has not been originated and set apart such that repayment of the securities is a self-liquidating exercise. On the other hand, future flows is close to corporate funding in that there needs to be a performance on the assets or infrastructure to see the cash flow

147

with which the securities will be paid. As an example, an electricity company

Kothari, Securitization The Financial Instrument of the Future, supra, p. 524 Ibid, 525 149 Wang, True Sale Securitization in Germany and China, supra, p. 24-26 148

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securitizing electricity revenues, or an airlines company securitizing air ticket sales is doing a future flows securitization transaction. 150

2.6 Securitization and the recent credit crunch

Before going into detail, let us first look at the chronological history of the financial turmoil seen recently. The first stage of the credit crunch involved U.S. residential house prices and those financial instruments that depended on them. This lasted from mid 2006 to mid 2007: during this period, it was clear that trouble was ahead, but the financial system was still functioning well. The second stage began when the institutions that had mortgage risk suffered losses. This eroded confidence. Firms found it harder to raise money; they had less capital as it had been eroded by their losses; and they were worried about the credit quality of many of their borrowers. Hence they made fewer loans, and by early 2008 a general contraction of lending had begun. The Credit Crunch was visibly underway. The third stage of the Crunch began in September 2008 with the failure of Lehman Brothers. Confidence had been fragile before this point: but when it became clear that the U.S. authorities would permit large institutions to fail, it was entirely lost. 151

The broad industry shift from an originate-to-hold model (in which a lender initiates and then keeps loans in its own portfolio) to an originate-to-distribute model relies on the ability to sell mortgage-backed securities (MBS) to investors. 152 Mortgage originators passed the entire risk of default to the ultimate purchaser of the loan security. They had, therefore, less incentive to undertake careful underwriting. Consequently loan volume gained greater priority over loan quality and the amount of lending to subprime borrowers 153 increased. 154 Without a surprise, that caused a housing boom.

150

Kothari, Securitization The Financial Instrument of the Future, supra, p 475 Murphy, David, Unraveling the Credit Crunch, CRC Press, Taylor & Francis Group LLC, 2009, pp. 5-6 152 Barth, James R., The Rise and Fall of the U.S. Mortgage and Credit Markets, John Wiley & Sons, Inc., 2009, p. 153 153 The term subprime generally refers to borrowers who do not qualify for prime interest rates because they exhibit one or more of the following characteristics: weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, or bankruptcies; low credit scores; high debt-burden ratios; or high loan-to-value ratios. 154 Chapra, M. Umer, Innovation and Authenticity in Islamic Finance, Forum Speech delivered at Eighth Harvard University Forum on Islamic Finance, April 19-20, 2008, p. 6 151

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Starting in mid 2007, rising delinquency and foreclosure rates in the US subprime mortgage market triggered a severe financial crisis which spread around the world. Although subprime mortgages 155, that were granted to borrowers with weak credit record and often require less documentation, only account for about 15 percent of all outstanding US mortgages, they were responsible for more than 50 percent of all mortgage loan losses in 2007. Most of the subprime losses were caused by high foreclosure rates on hybrid adjustable rate mortgages (ARM). These loans offer fixed initial interest rates at a fairly low level, which are replaced by higher rates linked to an interest rate index after two or three years. Thus, borrowers face a significant payment shock after the interest reset which increases the probability of delinquencies. In previous years, rising real estate prices and, thus, increasing home owner equity enabled mortgage associations to waive part of delinquent interest payments in exchange for an increase in nominal value of the mortgage or to renegotiate the mortgage. But during 2007 the trend in real estate prices has reversed in many regions of the United States leading to “negative equity" of many borrowers, i.e. to real estate values that are lower than their outstanding debt. Consequently, default rates increased. 156

As more borrowers stopped paying their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on housing prices, which further lowered homeowners' equity. The decline in mortgage payments also reduced the value of MBS, which eroded the net worth and financial health of banks. MBS is a financial innovation which enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally. 157

155

Throughout the time, the mortgage qualification guidelines became looser and looser. At first, the stated income, verified assets (SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to "state" it and show that they had money in the bank. Then, the no income, verified assets (NIVA) loans came out. The lender no longer required proof of employment. Borrowers just needed to show proof of money in their bank accounts. The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA. NINA is an abbreviation of No Income No Assets. Basically, NINA loans are official loan products and let you borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score. 156 Weber, Thomas, How to react to the Subprime Crisis? - The Impact of an Interest Rate Freeze on Residential Mortgage Backed Securities, Four Essays on Debt Securitization and Entrepreneurial Finance, PhD. dissertation, University of Konstanz, 2008, p.118 157 Article “Subprime Mortgage Crisis” from Wikipedia, available at http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

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Rating agencies played a crucial role in the crisis as they provide information about the quality of such securities. As of November 5, 2008, AAA-rated securities accounted for 29 to 45 percent of all rated fixed-income securities that were issued between January 1, 2000, and September 30, 2008, and are still outstanding. Investors have long assumed that a security with a AAA rating is of the highest credit quality (therefore it usually offers a relatively low yield) which obviously appeared to be a false judgment. 158

The rating process for subprime mortgage bonds was also marked by a fundamental conflict: Agencies received fees from the very issuers who requested the ratings—and almost everything wound up as AAA. Securities were “sliced and diced” precisely to obtain these high ratings, and bank regulatory authorities assign favorable capital treatment to bonds rated AAA. 159

Obviously, there should be some changes in order to ensure a healthier financial system as immune as possible from the potential problems. A more transparent system in all stages may be taken as a starting point. However, one should not blame securitization itself for all the financial turmoil seen. The advantages of slicing, dicing and repacking risks as well as all the other advantages explained above are simply too great to be sacrificed. It is very important to realize that it is only the speculative, over-leveraged excesses that have crept into securitization created recently that have contributed to the financial meltdown, not the traditional securitization process itself.

Securitization has become an essential component of consumer finance and of housing finance in particular. But to make securitization work, clear rules of the game are needed that help achieve transparency, assure against counterparty risk and data provision to inform trading. Markets can price and expose risk, if we give them the tools to do so. 160

158

Barth, The Rise and Fall of the U.S. Mortgage and Credit Markets, supra, p. 157 Ibid 160 Levitin, Adam J., Pavlov, Andrey D. and Wachter, Susan M., Securitization: Cause or Remedy of the Financial Crisis?, August 27, 2009, Georgetown Law and Economics Research Paper No. 1462895, p. 16 159

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Chapter 3

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3 ISLAMIC SECURITIZATION

After explaining the basics of Islamic Finance and Securitization, now it is time to scrutinize Islamic Securitization. As we did in the former two chapters, we will start with definition.

3.1 What is Islamic Securitization?

Islamic securitization can be basically defined as a legal structure which satisfies the requirements of Islamic Finance and replicates the economic purpose of a traditional asset-backed securitization structure whereby the rights over receivables are transferred from the owneroriginator to a special purpose vehicle (SPV/Issuer), which in turn issues notes that are sold to investors. 161 It involves asset transfers from an originator into a trust or similar SPV with Sukuk issuance by that SPV and payments on the Sukuk derived from the payments received in respect of those transferred assets. 162

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. 163 So basically Islamic securitization can follow the principles of conventional securitization. However, the underlying asset pool or portfolio of receivables in a securitization should, in essence, match one of the accepted Islamic financing schemes. For instance, conventional mortgages and credit cards, which are typical conventionally securitized assets, do not comply with Sharia, as they are interest-bearing loans. For a structure to comply with Sharia, some degree of ownership must be transferred to the investor. Transfer of registered title is not necessary, rather a collection of ownership rights that would allow the investors to perform duties related to ownership (if desired) or rights granting access (subject to notice) over the asset would be sufficient to satisfy Sharia. 164

161

Lahlou, Mohammad Saad and Tanega, Joseph Atangan, Islamic Securitisation: Part I - Accommodating the Disingenuous Narrative, Journal of International Banking Law and Regulation, Sweet & Maxwell, Vol. 22, Issue 6, May 2007, p. 295 162 McMillen, Michael J.T., Contractual Enforceability Issues: Sukuk and Capital Markets Development, Chicago Journal of International Law, University of Chicago, Winter 2007, p. 428 163 Jobst, Andreas A., The Economics of Islamic Finance and Securitization, Journal of Structured Finance, Vol. 13, No.1, 2007, p. 15 164 Lovells LLP, Islamic Finance: Sharia, Sukuk & Securitisation, Client Note, 2004, p.13

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Investors participate in profits and losses generated by the assets placed in the securitization pool 165 as Islamic Finance rules prohibit interest-based financing, investors are allowed to support or invest on the basis of partnership, but not on the basis of interest. 166

So Islamic Securitization is the creation of securities (or Sukuk 167) that:

 evidence ownership of a pool of tangible assets or a pool of tangible and intangible assets, either fixed or revolving, that generates cash flow plus any rights or other facilities designed to assure the servicing or timely distribution of proceeds to the security holders; and  by their terms convert into cash within a finite time period. 168

After a brief definition, we now would like to move on with the structure of Islamic Securitization. While talking about the structure, we will also try to put the differences between the conventional and Islamic securitization structures and by doing so, we will be seeking the answer of the question why there is a need for “Islamic” securitization while we already have quite improved securitization structures.

3.2 Structure of Islamic Securitization

Various parties are involved in an Islamic Securitization transaction. Key players in various issues are:

 The originator or the issuer of Sukuk, who sells its assets to the SPV and uses the realized funds. Originators are mostly governments or big corporations, but they could be banking or 165

Bi, Farmida (Norton Rose), Sharia compliant securitisations, Islamic Finance and Real Estate Forum, 4 November 2008, p.3 166 Zanev, Vassiliyan (Loyens & Loeff), Islamic Finance Securitisation in Luxembourg, Luxembourg Stock Exchange Press Release, March 13, 2008 167 We will examine Sukuk deeply in the coming sections, but for now, we may very briefly refer Sukuk as Islamic trust certificates or more generally Islamic bonds. 168 Haneef, Rafe, Asset-backed Sukuk and Asset-based Sukuk: A Primer, Fajr Capital, July 2008, p.3

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non-banking Islamic financial institutions. The issuers may delegate, for a consideration or a commission, the process of arranging the issue.  The SPV – an entity set up specifically for the securitization process and managing the issue. It purchases assets from the originator and funds the purchase price by issuing Sukuk. Sometimes, the SPV is also referred to as the issuer.  Investment banks – as issue agents for underwriting, lead managing and book-making services for Sukuk against any agreed-upon fee or commission. These services are provided by syndicates of Islamic banks and big multinational banks operating Islamic windows.  Subscribers of Sukuk – mostly central banks, Islamic banks and non-bank financial institutions and individuals who subscribe to securities issued by the SPV. 169

This list shows us the fact that an Islamic securitization structure perfectly mimics a conventional securitization in relation to the parties involved.

A widely used Islamic securitization structure, which also illustrates the exact same structure with the Sukuk issue made by the German state of Saxony-Anhalt in 2004, 170 would resemble the following scenario:

 The originator of the assets (e.g. the owner of office buildings) sells the assets to an SPV.  The SPV raises financing to purchase the assets by issuing Ijara Sukuk 171 (i.e. leasing bonds) to investors. The amount raised by issuing the Sukuk is equal to the purchase price.  The Ijara Sukuk represent equity interest in the SPV, and in turn, in the assets.  The SPV leases the assets back to the seller/originator. The seller makes periodic lease payments to the SPV, which should match the SPV’s obligations under the Ijara Sukuk.  At maturity, the SPV sells the assets back to the originator (i.e. lessee or previous seller/owner of the assets). The amount should cover any liabilities owed by the SPV under the Ijara Sukuk. 172 169

Ayub, Introduction to Islamic Finance, supra, p. 393 The Sukuk issue made by Saxony-Anhalt will be explained in detail in the sub-section 3.3.1.1 Ijara Sukuk. 171 We will explain Ijara Sukuk in sub-section 3.3.1.1 Ijara Sukuk under the section 3.3.1 Types of Sukuk. 172 Marar, Amr Daoud, The Duality of the Saudi Legal System and its Implications on Securitisations, The Company Lawyer, Volume 27, No. 11, November 2006, p. 346 170

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The figure 173 below illustrates how an Islamic securitization structure based on ijara basically works:

The cash flow produced is similar to any bond. The lease payments are similar to coupons and the repurchase proceeds paid at the end of the term constitute the principal. 174

Unlike conventional securitization, the implementation of Islamic securitization requires a two-stage “fundamental” verification process, which assesses the Sharia compliance of (i) the type of assets in the underlying reference portfolio and the generation of investment returns, and (ii) the transaction structure, which includes the configuration of credit enhancement (and other forms of credit and liquidity support) and the form of ownership conveyance. 175

173

Available at http://www.middleeastbusinessforum.com/newsletter/issue%201/Sukuk%20101.html Kamalpour, Abradat, McMillen, Michael J, Islamic Securitisation, Global Securitisation and Structured Finance 2007, Dechert LLP, 2007, p. 224 175 Jobst, The Economics of Islamic Finance and Securitization, supra, p. 16 174

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Securitization under Islamic law bars interest income and must be structured in a way that rewards investors for their direct exposure to business risk, i.e., investors receive a share of profits commensurate to the risk they take on in lieu of pre-determined interest. However conventional securitization, which originated in non-Islamic economies, invariably involves interest-bearing debt. Note holders would typically hold (secured) contingent claims on the performance of securitized assets, which entitle them to receive both pre-determined interest and the repayment of the principal amount. 176

Apart from that, one should know that while equity in contrast to interest-bearing bonds appears to be a permissible financial asset that can form part of the pool, such equity must not represent ownership of an institution dealing with interest or manufacture of haram 177 items, such as alcohol, (gambling) or pork. 178 For Islamic institutions, underlying assets that can be securitized include lease financing (e.g. of housing, aircraft, equipment, household items, cars etc.), equity ownership (in Sharia compliant assets) and, in certain cases, Murabaha receivables (provided that the Murabaha receivables comprise less than 50% of any asset pool). 179

The number of applicable structures to Islamic securitization is also limited comparing to conventional securitization. In general, the relationship between an underlying obligor and the originator should fall within one of the usual accepted Islamic financing schemes (Murabaha, Mudaraba, Ijara, Istisna, etc.). For example, when structuring a Sharia compliant mortgage securitization, the underlying assets must be Sharia compliant mortgages (usually structured around Ijara – the typical Islamic mortgage structure – or Istisna – mortgages concerning properties under construction). In the case of a Sharia auto finance securitization, the underlying finance contract must be structured in accordance with Murabaha or Ijara principles. 180

176

Ibid Non-permissible according to Islamic law, opposite of “halal”. 178 Obaidullah, Mohammed, Securitization in Islam, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p.193 179 Islamic Finance News, Legal Guide 2006, Red Money Publishing, Kuala Lumpur, 2006, p. 14 180 Ibid 177

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It should also be noted that to comply with Sharia principles for a traditional Sukuk issuance, the structure to be used must transfer a minimum level of ownership in the assets before Sharia scholars can be satisfied and approve the issuance. 181

Finally, one should be careful in relation to credit enhancement mechanisms while structuring a permissible securitization transaction according to Sharia. Credit enhancement is an integral part of conventional securitization process. When credit enhancement is for a fee that is related to the quantum of facility, this comes dangerously close to riba and is rightly frowned upon by Sharia scholars. 182 So Islamic institutions should be very selective in using credit enhancement methods; (as) using some of them may change the character of the transaction. 183 So Islamic law does not rule out the use of credit enhancement per se as long as it is optional for investors and does not change the overall character of the transaction. For instance, tranche subordination of conventional securitization can be replicated by a lease buy-back (ijara) transaction under Sharia law. 184

Like credit enhancement, liquidity enhancement too comes under a cloud in the Islamic framework. While this is easily achieved in an interest-based scenario, the Islamic framework provides for short-term (…) interest free loans. Thus, while liquidity enhancement could be provided by independent financial institutions in the conventional framework, this is possible in Islamic securitization only when there is no financial reward for the provider. 185

To sum up, securitization in Islamic Finance is better referred to as “monetization” of the underlying assets. While the sale of conventional receivables is a sale of debts, the sale of Sukuk is a sale of shares of an asset. 186 However, irrespective of religious conditions, Islamic securitization offers the same economic benefits conventional structured finance purports to generate, such as the active management of designated asset portfolio due to greater control over asset status, enhanced 181

Ibid Obaidullah, Mohammed, Securitization in Islam, supra, p. 194 183 Abdi Dualeh, Suleiman, Islamic Securitisation: Practical Aspects, Presentation for World Conference on Islamic Banking, Geneva, July 8-9 1998, p. 7 184 Jomadar, Bushan K., Islamic Finance and Securitization: Man-Made Tale or Reality, November 1, 2007, Islamic Law and Law of the Muslim World Paper No. 8-18, p. 12 185 Obaidullah, Mohammed, Securitization in Islam, supra, p. 194 186 Marar, The Duality of the Saudi Legal System and its Implications on Securitisations, supra, pp. 346-347 182

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asset-liability management and term structure transformation, as well as the isolation of certain assets in order to make them self-financing at a fair market rate. 187

At this stage, we will look at the securities created within the processes of Islamic securitization, i.e. Sukuk.

3.3 Sukuk

Sukuk is a recently-developed Islamic investment product that first appeared in 2002, when Malaysia issued a government-backed Sukuk, the first of its kind. 188 Sukuk (the plural of the word Sak, or Sanadat, meaning certificate of investment or simply certificates) 189 are certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset. 190

The Accounting and Auditing Organization for Islamic Financial Institutions ("AAOIFI") has issued the Standard for Investment Sukuk. Under the AAOIFI Sukuk Standard, Sukuk are defined as certificates of equal value put to use as common shares and rights in tangible assets, usufructs, and services or as equity in a project or investment activity. The AAOIFI Sukuk Standard carefully distinguishes Sukuk from equity, notes, and bonds. It emphasizes that Sukuk are not debts of the issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects, or investment activities. Sukuk may not be issued on a pool of receivables. Further, the underlying business or activity, and the underlying transactional structures (such as the underlying leases), must be Sharia-compliant (for example, the business or activity cannot engage in prohibited business activities). 191 To sum up, the AAOIFI standard stipulates that Sukuk must demonstrate:

187

Jobst, Andreas A., Derivatives in Islamic Finance, Islamic Economic Studies, Vol. 15, No. 1, 2007, p. 19 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 131 189 Ayub, Understanding Islamic Finance, supra, p. 392 190 Islamic Financial Services Board, Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of Islamic Money Markets, March 2008, p. 92 191 McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, pp. 428-429 188

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 that any income arising must derive from the underlying activities for which the funding has been used, and not simply comprise interest;  the Sukuk must be backed by real underlying assets and these assets must be Halal [that is, allowable under Sharia] in nature and be being utilized as part of a Halal activity; and  there must be full transparency as to rights and obligations of all parties. 192

Without a doubt, Sukuk structures became the most successful innovation of short history of Islamic finance. Globally, Sukuk issuance has increased from $7.5 billion at the end of 2000 to over $118 billion at the end of the third quarter of 2008, growing at a compound annual growth rate (CAGR) of 32% since 2000. 193 Below figure illustrates the huge success achieved within a very short period of time until the end of 2008 when the whole financial system was already in the recent turmoil:

192

Lahlou, Mohamed Saad, Tanega, Joseph, Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative, Journal of International Banking Law and Regulation, Sweet & Maxwell, Volume 22, Issue 7, June 2007, p. 367 193 Kronfol, Mohieddine, Takaful and Sukuk: A Symbiotic Relationship, Middle East Insurance Review, December 2008, p. 53

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It is important to note that – contrary to popular perception – whilst a securitization can be achieved via Sukuk, most Sukuk that have been issued to date are not securitizations. 194 The creation of Islamic financial securities can be done in two distinct ways:

 Direct structuring of securities; and  The process of asset securitization.

Direct structuring involves the initial issuance of securities, and the funds raised will be used to fund certain assets/projects with the client company. The profits generated from these assets/ projects are then distributed amongst security holders. 195

Most Sukuk offerings to date have been of the bond type (direct structuring), and the ultimate credit in most of those bond offerings has been a sovereign entity. There have been very few, if any, true asset securitizations, largely because of the inability to obtain ratings from major international rating firms (ratings have been obtained for the sovereign bond issuances based upon the rating of the sovereign credit). 196

3.3.1 Types of Sukuk

Until now there have been 14 different types of Sukuk structures most common ones of which are Sukuk al-Ijara, Sukuk al-Istisna, Sukuk al-Murabaha, Sukuk al-Musharaka and Sukuk alMudaraba. 197 The list of 14 different types of Sukuk is not an exhaustive list since other forms of Sukuk can be issued such as by copyright owners, so continuing innovation in this field is expected. 198

Here, we will try to explain the most common Sukuk structures. 194

Islamic Finance News, Legal Guide 2006, supra, p. 13 Mannan, Mansour, Islamic Capital Markets, Islamic Finance: A Guide for International Business and Investment, ed. by Habiba Anwar, GMB Publishing, 2008, p. 105 196 McMillen, Michael J.T., Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, p. 428 197 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Sharia Standards No. 17, May 2003, pp. 4-6 198 Lahlou, Tanega, Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative, supra, p. 368 195

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3.3.1.1 Ijara Sukuk

Ijara (lease) is a contract according to which a party purchases and leases out equipment required by the client for periodic rental payment. The duration of the rental and the amount payable are agreed in advance, and ownership of the asset remains with the lessor. 199

If a lessor, after executing an Ijara contract, wishes to recover his cost of purchase of the asset to get liquidity or for the purpose of profit, he can sell the leased asset wholly or partly, either to one party or to a number of individuals. The purchase of proportion of the asset can be evidenced by issuing certificates, which may be called Ijara certificates or Sukuk. The certificates must represent ownership of the pro rata undivided parts of the asset with all related rights and obligations. Hence, Ijara Sukuk are the securities representing ownership of well-defined and known assets tied up to a lease contract, rental of which is the return payable to the Sukuk holders. 200

Let us have a look how the ijara Sukuk structure works: A single or a group of assets that are admissible for ijara contract are selected. The originator creates an SPV with separate independent legal personality to whom it sells the asset(s) with the understanding that the originator will lease back the asset(s) from the SPV. Rent is negotiated and a term specific lease contract is signed. The SPV then securitizes its assets by issuing ijara Sukuk for sale to investors. These are certificates of equal value representing undivided shares in ownership of tangible assets. The Sukuk sale proceeds provide funds to SPV to pay for the asset(s) purchased from the originator. A rent-pass-through structure is adopted by the SPV to pass on the rents collected from the originator-cum-lessee to Sukuk holders. These returns along with low risk and exit possibility through secondary market (liquidity) constitute the incentives for investors to buy Sukuk. At the expiry (or termination) of the lease deed the flow of rents would stop and ownership of the asset pool would be with the Sukukholders as a group. The Sukuk contract embeds a put option to the Sukuk-holders that the originator is ready to buy the Sukuk at their face value on maturity or dissolution date. 201

199

Mannan, Islamic Capital Markets, supra, p. 107 Ayub, Introduction to Islamic Finance, supra, pp. 400-401 201 Ali, Salman Syed, Islamic Capital Markets Products: Developments and Challenges, Islamic Development Bank Group Islamic Research and Training Institute, Occasional Paper No. 9, 2005, pp.30-31 200

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The figure below well explains the concept of an ijara Sukuk transaction: 202

As it was mentioned before, the Sukuk issue by German State of Saxony Anhalt in 2004 was an ijara Sukuk structure. In this issue, the underlying transactions involves a certain number specified buildings owned by the Ministry of Finance. Certificates worth €100 million were issued by an SPV incorporated in the Netherlands was to get around the municipality tax in Germany. By doing so, the Sukuk remains competitive with regards to municipality tax which would not apply to a conventional bond. Under a 100 year Head Lease Agreement, Saxoy Anhalt, acting through the Ministry of Finance, leases properties to the SPV in consideration of receiving an amount equal to the Sukuk issue as a one-time advance head-lease rental. The SPV then enters into a sub-lease agreement where it subleases the properties back to the Ministry of Finance for a period of five years. The certificates held by the investors represent a pro-rata interest in the operating rights acquired by SPV under the headlease. Under the sub-lease, the State has a direct obligation to pay lease rentals at periodic intervals which are passed on to the Sukuk holders as coupon payments. The last lease rental will include the principal amount extended under the sub-lease. This five year certificate with a coupon payment of EURIBOR (flat) was co-managed by both Citigroup and the Kuwait Finance House. The Sukuk was fully subscribed with 60 % of the issue going to investors in Bahrain and the United Arab Emirates, while the other 40 % to investors in Europe, particularly Germany and France. 203 Like other German state

202

Jobst, The Economics of Islamic Finance and Securitization, supra, p. 21 Alkhan, Rashid Khalid, Islamic Securitization A Revolution in the Banking Industry, Miracle Graphics Co., 2006, p. 66 203

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debt instruments the Sukuk was listed in Luxembourg, with an additional listing in Bahrain to attract Gulf investors. 204

The figure below shows the Saxony-Anhalt Sukuk structure: 205

Unlike some other Sukuk types, Ijara certificates can be negotiated and traded freely in the market and can serve as an instrument easily convertible into cash. 206 Sukuk representing tangible assets or usufruct of such assets can be traded in the secondary market, depending upon the quality, risk and profitability of the securitized assets. A deciding factor in this regard is whether the Sukuk create any debt obligations or they represent an ownership stake in the underlying assets or project; in the former case, the certificate will not be tradable, while in the latter case, it will be negotiable/tradable. 207

204

Wilson, Rodney, Islamic Finance in Europe, Robert Schuman Centre for Advanced Studies Policy Papers No. 2007/2, p. 5 205 Lahlou, Tanega, Islamic Securitisation: Part II - A Proposal for International Standards, Legal Guidelines and Structures, supra, p. 370 206 Ayub, Introduction to Islamic Finance, supra, p. 403 207 Ibid, p. 408

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3.3.1.2 Mudaraba (or Muqarada) Sukuk

Mudaraba means an agreement between two parties according to which one of the two parties provides the capital (capital provider) for the other (mudarib) to work with on the condition that the profit is to be shared between them according to a pre-agreed ratio. These types of Sukuk play a vital role in the process of development financing, because these are related to the profitability of the projects. 208

Mudaraba or Muqarada (Muqarada has the same meaning as that of Mudaraba) Sukuk or deeds can be instrumental in enhancing public participation in investment activities in any economy. These are certificates that represent projects or activities managed on the Mudaraba principle by appointing any of the partners or any other person as Mudarib for management of the business. As regards the relationship between the parties to the issue, the issuer of Mudaraba certificates is the Mudarib, subscribers are the owners of the capital and the realized funds are the Mudaraba capital. The certificate holders own the assets of the Mudaraba and the agreed upon share of the profits belongs to the owners of capital and they bear the loss, if any. 209

The figure below illustrates how Mudaraba Sukuk structure works: 210

This structure is of interest to originators who do not have assets that they can easily make available for an ijara Sukuk or Musharaka Sukuk, but which needs finance for additional business 208

Mannan, Islamic Capital Markets, supra, p. 108 Ayub, Introduction to Islamic Finance, supra, p. 398 210 Available at http://www.modarabas.com.pk/Sukuk.php 209

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investments or activities. It is critical for Sharia compliance that the mudarib is entitled to a share in the profits rather than a flat fee. A mudarib can also be paid an incentive fee. 211

Steps involved in the structure:

 The Sukuk issuer enters into a Mudaraba agreement with the project manager (mudarib) for construction/commissioning of a project;  The SPV issues Sukuk to raise funds, the proceeds of which are given to the mudarib;  The mudarib undertakes the project and collects regular profit payments from the activity for onward distribution to investors; and  Upon completion, the mudarib, in its capacity as obligator, purchases the assets of the project from the issuer. 212

Islamic Financial Institutions can offer Mudaraba Sukuk or certificates to the investors who would subscribe and participate in the investment transactions. The funds mobilized would be the variable capital (class B share) of any bank to be marketed regionally through the selling of the issued Mudaraba Sukuk. 213

Mudaraba Sukuk may be issued by an existing company (which acts as mudarib) to investors (who act as partners, or rab al-mal) for the purpose of financing a specific project or activity, which can be separated for accounting purposes from the company’s general activities. The profits from this separate activity are split according to an agreed percentage amongst the certificate holders. The contract may provide for future retirement of the Sukuk at the then market price, and often stipulates that a specific percentage of the mudarib’s profit share is paid periodically to the Sukuk holders to withdraw their investment in stages. 214

211

de Belder, Richard T., Invesment Banking, Islamic Finance: A Guide for International Business and Investment, ed. by Habiba Anwar, GMB Publishing, 2008, pp. 95-96 212 Mannan, Islamic Capital Markets, supra, pp. 108-109 213 Ayub, Introduction to Islamic Finance, supra, p. 399 214 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 55

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At this point, let us have a look at an example of Sukuk al-Mudaraba: Aldar Properties PJSC, an Abu Dhabi real estate development company, issued a 4.75-year Sukuk convertible into its ordinary shares. Proceeds from the transaction were used to fund Aldar’s ambitious real estate development programme with Aldar acting as the mudarib. Aldar, in its corporate capacity, also provided an undertaking to purchase the assets of the Mudaraba should the Sukuk certificate holders not convert their holdings into Aldar’s shares by the maturity date (2011). 215

3.3.1.3 Musharaka Sukuk

In a Musharaka transaction, partners contribute capital to a project and share its risks and rewards. Profits are shared between partners on a pre-agreed ratio, but losses are shared in exact proportion to the capital invested by each party. Thus a financial institution provides a percentage of the capital needed by its customer with the understanding that the financial institution and customer will proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is consummated. 216

In securitizing a Musharaka arrangement, every subscriber can be given a participation certificate, which represents his proportionate ownership in the assets of the venture or project for which financing is being raised. Subsequent to the acquisition of substantial non-liquid assets, these Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. 217

Musharaka Sukuk which are based on an underlying Musharaka contract are quite similar to mudaraba Sukuk. The only major difference is that the intermediary will be a partner of the group of subscribers or the Musharaka Sukuk holders in much the same way as the owners of a joint stock company. Almost all of the criteria applied to a Mudaraba Sukuk are also applicable to the Musharaka Sukuk, but in the Mudaraba Sukuk the capital is from just one party. The issuer of the

215

Mannan, Islamic Capital Markets, supra, p. 109 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 52 217 Akbar, Salman, Islamic Securitization from a practitioner’s Perspective, Islamic Banking Hub Bahrain Newsletter, Islamic Banking & Takaful Task Force, October 2003, p. 4 216

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certificate is the inviter to a partnership in a specific project or activity, the subscribers are the partners in the Musharaka contract, and the realized funds are the contributions of the subscribers in the Musharaka capital. The certificate holders own the assets of partnership and share the profits and losses. 218

In the structure shown below, the parties’ respective interests in the Musharaka are represented by contractual units held by each party. The issuer will make a funding contribution to the Musharaka from funds it raises from the Sukuk issue. The Musharaka party will make an in-kind contribution to the Musharaka (usually including some tangible assets). The issuer and the Musharaka party also enter into a purchase undertaking pursuant to which the issuer can require the Musharaka party to purchase a set amount of units on set dates during the term of the Sukuk. The issuer will receive profit distributions from the Musharaka and proceeds from sales of the units to the Musharaka party. The amounts received are distributed to the Sukuk holders in accordance with a set formula. This structure is viable when the Musharaka party can use its in-kind contribution for a profit-generating venture. 219

The figure below is an illustration of how Musharaka Sukuk structure works: 220

218

Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 56 Kamalpour, McMillen, Islamic Securitisation, supra, p. 225 220 Ibid 219

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After the project is started, these Musharaka certificates can be treated as negotiable instruments. Certificates based on Musharaka/Mudaraba can be bought and sold in the secondary market, subject to the condition that the portfolio of Musharaka comprises non-liquid assets valuing more than 50 %. Profit earned by the Musharaka is shared according to an agreed ratio. Loss is shared on a pro rata basis. Whenever there is a combination of liquid and non-liquid assets, it can be sold and purchased for an amount greater than the amount of liquid assets in the combination or in the pool. 221

The Musharaka structure is considered more equitable and also safer for the investors than the Mudaraba structure, as it involves both profit-and-loss-sharing between the fund manager and the Sukuk holders, not only profit-sharing. In addition, Musharaka Sukuk holders will have added comfort and security from the cushion provided by the manager’s participation in the Musharaka capital. 222

An example of Sukuk al-Musharaka is as follows: Emirates, Dubai’s national airline, issued a $550 million Sukuk transaction for seven years. The deal was a structured on a Musharaka basis. The Musharaka, or joint venture, was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport which was ultimately leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka were used to pay the periodic distribution on the trust certificates. Emirates then purchased the leased assets on maturity of the transaction. 223

3.3.1.4 Murabaha Sukuk

Murabaha Sukuk are issued on the basis of murabaha sale for short-term and medium-term financing. As mentioned earlier, the term murabaha refers to sale of goods at a price covering the

221

Ayub, Introduction to Islamic Finance, supra, p. 400 Ibid 223 Mannan, Islamic Capital Markets, supra, p. 110 222

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purchase price plus a margin of profit agreed upon by both parties concerned. The advantage of this mode of financing is that, if the required commodity in the murabaha is too expensive for an individual or a banking institution to buy from its own resources, it is possible in this mode to seek additional financiers. The financing of a project costing $50 million could be mobilized on an understanding with the would-be ultimate owner that the final price of the project would be $70 million, which would be repaid in equal installments over five years. The various financiers may share the $20 million murabaha profit in proportion to their financial contributions to the operation.224

A commonly accepted view among Sharia scholars in a number of Islamic jurisdictions is that murabaha debt cannot be securitized, thus making Sukuk backed by pools of murabaha debt impermissible. This is because the sale of a document representing money is akin to the trading of monies, which is prohibited under the rules of riba. However, the prevailing view among Malaysian scholars (in contrast to Sharia advisers in more conservative jurisdictions) is that so long as the underlying receivable is connected to a true trade transaction or to a commercial transfer of a nonmonetary interest, such a receivable can be traded freely for purposes of Sharia. 225

However, it is generally accepted that a pool of receivables consisting of only Murabaha receivables cannot be securitized for creating negotiable Sukuk to be traded in the secondary market. The purchaser on credit in a Murabaha transaction signs a note or paper to evidence his indebtedness towards the seller. That paper represents a debt receivable by the seller. Transfer of this paper to a third party must be at par value and subject to the rules of Hawala 226, meaning that its assignment also has to be at face value. A mixed portfolio consisting of a number of transactions, including Murabaha, may issue negotiable certificates subject to certain conditions. For this purpose, the pool of the assets should consist of Ijara or other fixed assets valuing more than 50% of its total worth. However, if the Hanafi 227 view is adopted, trading will be allowed even if the non-liquid assets are more than 10% of its total worth. 228

224

Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 56 Abdel-Khaleq, Ayman H., Richardson, Christopher F., New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings, Chicago Journal of International Law, Winter 2007, p. 412 226 Hawala is a system for remitting money, primarily in Islamic societies, in which a financial obligation between two parties is settled by transferring it to a third party, as when money owed by a debtor to a creditor is paid by a person who owes the debtor money. Hawala transactions are usually based on trust and leave no written record. 227 The Hanafi School is one of the four Madhhab (schools of law) in jurisprudence (Fiqh) within Sunni Islam. 228 Ayub, Introduction to Islamic Finance, supra, p. 405 225

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Now, let us see how a direct murabaha Sukuk structure works:

1. Company seeks advice from Investment Bank regarding issue of securities; an SPV is created for the purpose; 2. SPV issues securities to investors; 3. SPV collects funds from investors; 4. SPV pays to Vendor for purchase of Assets; 5. Company as agent of SPV takes delivery of Assets; 6. Company purchases Assets from SPV on deferred payment basis and makes payment of installments to SPV;

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7. SPV passes them on to investors after deducting mudarib share/wakala 229 fee for itself. 230

The following constitutes a practical example how a negotiable murabaha Sukuk can be created: Arcapita Bank B.S.C (Bahrain) issued five-year multicurrency Murabaha-backed Sukuk in 2005 with a five-year bullet maturity. The proceeds of the Sukuk are used for sale and purchase of assets via a series of commodity Murabaha transactions. As Murabaha may yield a fixed return, the Sukuk holders have been offered a return equivalent to three-month LIBOR + 175 bps. The SPV will have full recourse to Arcapita and, therefore, the Sukuk are a freely transferable instrument on the basis of a mechanism approved by Arcapita’s Sharia supervisory board. It is presumed that the SPV will be maintaining a sufficient amount of inventory or fixed assets, making its Sukuk negotiable. 231

3.3.1.5 Salam Sukuk

As we noted earlier, a salam is deferred delivery contract. It is essentially a forward agreement where delivery occurs at a future date in exchange for spot payment of price.

Salam Sukuk are certificates of equal value issued for the sake of mobilizing capital that is paid in advance in the shape of the price of the commodity to be delivered later. The seller of the Salam commodity issues the certificates, while the subscribers are the buyers of that commodity, i.e. they are the owners of the commodity when delivered. Salam sale is attractive to the seller, whose cash flow is enhanced in advance, and to the buyer, as the Salam price is normally lower than the prevailing spot price. 232

Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in lieu of a promise to deliver a commodity at a future date. All standard Sharia requirements that apply to salam contract also apply 229

Wakala is a trust contract whereby money can be placed with an Islamic institution which then pays a return based on the assets on its balance sheet. 230 Obaidullah, Islamic Financial Services, supra, p. 161 231 Ayub, Introduction to Islamic Finance, supra, p. 406 232 Ibid, p. 403

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to salam Sukuk, such as, full payment by the buyer at the time of effecting the sale, fungibility or standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like. At the same time the SPV can appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The difference between the purchase price and the sale price is the profit to the SPV and hence, to the holders of Sukuk. Such Sukuk obviously involve market risk as the price of the underlying asset may go down instead of moving up in future. 233

The steps involved in Salam Sukuk transaction may be summarized as follows:

 SPV signs an undertaking with an obligator to source both commodities and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.  Salam certificates are issued to investors and SPV receives Sukuk proceeds.  The Salam proceeds are passed onto the obligator who sells commodity on forward basis  SPV receives the commodities from the obligator  Obligator, on behalf of Sukuk holders, sells the commodities for a profit.  Sukuk holders receive the commodity sale proceeds. 234

The market risk or price risk for the investors can be mitigated if a third party makes a unilateral promise to buy the commodity at a predetermined price at a future time period. Since the SPV representing investors need not participate in the market, it would be insulated from price risk. This third party may be one of the prospective customers of the company. The unilateral promise is binding on this customer. Once the rights resulting from the promise are transferred to the SPV, it assumes the role of seller to the third party customer at the specified future date. The SPV is able to realize a higher predetermined price without participating in the market. The risk mitigation can some times come through sovereign guarantees, as is the case with recent issue of Sukuk-al-salam by the Bahrain Monetary Agency (BMA). 235

233

Obaidullah, Islamic Financial Services, supra, p. 164 Nisar, Shariq, Islamic Bonds (Sukuk): Its Introduction and Application, available at http://www.financeinislam.com/article/8/1/546 235 Obaidullah, Islamic Financial Services, supra, p. 164 234

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A number of bond structures could be synthesized from the salam contract. The most prolific issuer of salam bonds to date has been the Bahrain Monetary Agency, aiming to provide Islamic banks liquidity management tools. 236 The BMA, in June 2001, developed Salam-based securities with LIBOR-related three-month tenures used by Islamic banks for maintaining statutory liquidity requirement (SLR). The Bahrain government sells aluminum to Bahrain Islamic Bank (BIB), which has been nominated to represent the other banks wishing to participate in the Salam contract. The government undertakes to supply a specified amount of aluminum on the basis of Salam at a future date. At the same time, BIB appoints the government its agent to market the aluminum at the time of delivery through its channels of distribution. 237 The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to Al Salam security holders equivalent returns to those available through other conventional short-term money market instruments. 238 This means that the securities have the characteristics of short-term government treasury bills. 239

So far, secondary market trading of Salam Sukuk is considered impermissible on the grounds that the certificates represent a share in the Salam debt, in which case they are subject to the rules of debt trading. 240

3.3.1.6 Istisna Sukuk

We already mentioned that istisna is a contractual agreement for manufacturing goods, allowing cash payment in advance and future delivery or a future payment and future delivery of the goods manufactured, as per the contract. 236

El-Gamal, Islamic Finance Law, Economics and Practice, supra, p. 114 Ayub, Introduction to Islamic Finance, supra, pp. 403-404 238 In our email correspondence with Prof. Dr. Mahmoud El-Gamal, a highly respected Islamic Finance expert and chairman of Department of Economics in Rice University, Houston; he referred to this Sukuk structure as “It is one of many forms of what I call "Sharia Arbitrage," which is the mode of operation in today's so-called Islamic finance.” He defines Sharia Arbitrage as “using legal devices, often employing special-purpose vehicles, restructuring interest-bearing debt and collecting interest in the form of rent or price mark-up” in his article “Incoherent pietism and Sharia arbitrage” published in Islamic Finance 2007 Report of Financial Times. Available at http://www.ft.com/reports/islamicfinance2007 239 Obaidullah, Islamic Financial Services, supra, p. 165 240 Ayub, Introduction to Islamic Finance, supra, p. 404 237

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Istisna contracts can be securitized to raise funds on the basis of the rental income that the asset (for example, a building or bridge) will generate. In that case it will generate fixed return securities, or it can be securitized on the basis of variable income (such as a toll tax on the bridge), generating variable-return securities. 241

Under such a scheme the SPV representing investors becomes seller-contractormanufacturer of an asset to a buyer (say, the government) and uses back-to-back istisna for creation of the facility. In other words, the SPV takes upon itself the legal responsibility of getting the facilities constructed, and sub-contracts the work to manufacturers/contractors. The deferred price that the buyer will pay may be in the form of Sukuk that are an evidence of indebtedness whose total facevalue exactly equals the total deferred price. These Sukuk may have different maturities to match the installment plan that has been agreed upon by the two parties. They represent buyer’s debt and hence, Sharia precludes sale of these debt certificates to a third party at any price other than the face value of such certificates. 242

Steps involved in the structure:

 The SPV issues Sukuk certificates to raise funds for the project;  Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future project;  Title to assets is transferred to the SPV;  Property/project is leased or sold to the end buyer. The end buyer pays monthly installments to the SPV; and  The returns are distributed among the Sukuk holders. 243

241

Khan, M. Fahim, Islamic methods for government borrowing and monetary management, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 294 242 Obaidullah, Islamic Financial Services, supra, p. 165 243 Mannan, Islamic Capital Markets, supra, p. 111

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The prohibition of riba precludes the sale of these debt certificates to a third party at any price other than their face value. Therefore, such certificates, which may be cashed only on maturity, cannot have a secondary market. As noted above, they can be transferred at face value to a third party. 244

An example of Sukuk al-istisna is as follows: The Durrat Al Bahrain, a $1 billion world-class residential and leisure destination situated in the Kingdom of Bahrain, issued the Durrat Sukuk to finance the reclamation and infrastructure for the initial stage of the project. The Sukuk was structured to provide quarterly returns with an overall tenure of five years and an option for early redemption. The proceeds of the issue (cash) were used by the issuer to finance the reclamation of the land and the development of base infrastructure through multiple project finance (istisna) agreements. As the works carried out under each istisna were completed by the contractor and delivered to the issuer, the issuer gives notice to the project company under a Master Ijara Agreement to lease such infrastructure on the basis of a lease to own transaction. During the istisna period, the istisna receivable (amounts held as cash) was only subject to trading at par value. Later, upon completion of the istisna period and when lease agreements were put in place, the Sukuk became tradable. 245

3.3.1.7 Hybrid Sukuk

Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk - hybrid or mixed asset Sukuk - emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. 246

244

Ayub, Introduction to Islamic Finance, supra, p. 405 Mannan, Islamic Capital Markets, supra, p. 111 246 Ibid, pp. 111-112 245

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Steps involved in a hybrid Sukuk structure are as follows:

 Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.  SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are used by the Islamic finance originator.  Islamic finance originator purchases these assets from the SPV over an agreed period of time.  Investors receive fixed payment of return on the assets. 247

A prominent example of such mixed portfolio Sukuk are Islamic Development Bank’s (IDB) Solidarity Trust Sukuk for $ 400 million issued in 2003. Solidarity Trust Services (STS) served as trustee to issue the fixed-rate trust certificates that were issued to purchase a portfolio of Sukuk assets comprising Ijara, Murabaha and Istisna contracts originated by the IDB. Each certificate represented an undivided beneficial ownership in trust assets and ranked pari passu with other trust certificates. Most of the assets (over 50 %) would, at all times during the period, comprise Ijara assets. If, at any time, the proportion of assets evidenced by Ijara contracts fell below 25 %, a dissolution event would occur, and IDB, by virtue of its separate undertaking, would be obliged to purchase all of the assets owned by the trustee pursuant to the terms of the “purchase undertaking deed”. Profit on Sukuk assets, net of expenses of the trust, would be used to give a periodic return to the certificate holders. Certificates would be redeemed at 100% of their principal value. In the case of any early dissolution event, the redemption would be according to adjustment, keeping in mind the return accumulation period. Principal amounts of Sukuk would be reinvested in Ijara and Musharaka contracts to form a part of Sukuk assets. 248

The modus operandi of issuing mixed portfolio Sukuk is an effective tool for converting nonmarketable and illiquid assets to negotiable instruments having a secondary market, particularly suitable for investment banks and development finance institutes. 249

247

Ibid, p. 112 Ayub, Introduction to Islamic Finance, supra, p. 406 249 Ibid, p. 407 248

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This list of Sukuk forms is not exhaustive; financiers are free to devise other varieties. One development is the convertible Sukuk, which can be exchanged for equity. Dubai Ports, for example, issued a $3.5 billion pre-IPO convertible Sukuk in January 2006. 250

So, we have reviewed various methods of creating fixed income debt securities based on the classical Islamic contracts of murabaha, mudaraba, musharaka, ijara, salam and istisna that are free from riba. Of all these, salam-based instruments seem to be too restrictive in scope. Istisna-based instruments are quite useful for financing large infrastructure projects, while murabaha is useful for financing trade. Murabaha however, involves sale of debt or receivables and hence suffer from the restrictions on their negotiability. A secondary market in this instrument is almost ruled out. Compared to these, ijara-based instruments are free from all these constraints. Ijara seems to offer maximum flexibility in terms of negotiability, management of price risk etc. And hence Sukuk-al-ijara are expected to play a significant role in development of an Islamic debt market. 251

3.3.2 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues

A Sukuk flotation can be seen as a securitization of assets. Not all forms meet with universal approval of Islamic jurists. If, for instance, lease claims are securitized and sold to the public in the form of Sukuk, the buyer receives a financial instrument that pays a fixed income and carries a low risk. Does this involve riba or is it a claim on a fraction of a very stable stream of profits? Opinions differ. In the same way, Musharaka participations can be securitized by issuing negotiable certificates, or Sukuk. This may make sense in the case of large investments, such as infrastructure projects or large industrial complexes. Such securitization took off on a large scale in Malaysia after the Shafi School ruled it halal. Hanafis and most Hanbalis, by contrast, consider it haram, and Malikis 252 deem it admissible only under very strict conditions. 253 The division goes so deep that Bahraini Islamic banks refuse to trade with Malaysian Islamic banks. 254

250

Visser, Islamic Finance Principles and Practice, supra, p. 65 Obaidullah, Islamic Financial Services, supra, pp. 165-166 252 Hanafi, Shafi, Maliki and Hanbali are the four “Madhhab”s (schools of law) in jurisprudence within Sunni Islam. 253 El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance, supra, p.6 254 Dudley, Nigel, Islamic Banks tap a Rich New Business, Euromoney, Issue No.392, December 2001, p. 95 251

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However in relation to Sukuk, the real earthquake was created by the fatwa (religious opinion concerning Islamic law issued by an Islamic scholar) issued by the AAOIFI in February 2008. The fatwa basically claimed that 80-85 % of the Sukuk issued until then is not Sharia-compliant and recommended six principles in order to reach permissible structures.

The recommendations of AAOIFI’s Sharia Committee are:

 Tradable Sukuk must represent ownership for Sukuk holders, with all of the rights and obligations that accompany ownership, in real assets, whether tangible or usufructs or services, that may be possessed and disposed of legally and in accordance with the Sharia. The manager of a Sukuk issuance must establish the transfer of ownership of such assets in its books, and must not retain them as its own assets.  It is not permissible for tradable Sukuk to represent either revenue streams or debt except in the case of a trading or financial entity that is selling all of its assets, or a portfolio which includes a standing financial obligation such that debt was incurred indirectly, incidental to a physical asset or a usufruct.  It is not permissible for the manager of Sukuk, regardless of whether the manager acts as an investment manager, or a partner, or an investment agent, to undertake to offer loans to Sukuk holders when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve for the purpose of covering such shortfalls to the extent possible, on condition that the same be mentioned in the prospectus.  It is not permissible for the investment manager, partner, or investment agent to agree to purchase assets from Sukuk holders or from whoever represents them for a nominal value of those assets at the time the Sukuk are extinguished at the end of their tenors. It is permissible, however, to agree to purchase the assets for their net value, or market value, or fair market value, or for a price agreed to at the time of their purchase, in accordance with Sharia rules of Partnership and modern partnerships, and on the subject of Guarantees.  It is permissible for the lessee in a Sukuk Al-Ijara to agree to purchase the leased assets when the Sukuk are extinguished for their nominal value, as long as the lessee is not also an investment partner, investment manager, or agent.  Sharia supervisory boards must not consider their responsibility to be over when they issue a fatwa on the structure of Sukuk. Rather, they must review all contracts and documentation

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related to the actual transaction, and then oversee the ways that these are implemented in order to be certain that the operation complies at every stage with Sharia guidelines. 255

However, AAOIFI recommendations do not have the force of law and it remains to be seen how the industry will react to it. 256 The immediate reaction of some bankers has been that the recommendations may put a dampener on the issuance of future Sukuk because of these extra ‘constraints’ and thus affect their future tradability. 257

3.3.3 Credit Rating Issues

If Sukuk are to achieve their macroeconomic and microeconomic benefits, it is essential that asset securitization Sukuk be issued and traded on a large scale. To achieve widespread issuance and trading, such Sukuk will have to be rated by international rating agencies. At present, however, it is difficult to obtain ratings from major international rating agencies on transactions that are dependent, at any level, upon laws in most jurisdictions within the Islamic economic sphere. The main legal impediments relate to the inability to obtain satisfactory legal opinions with respect to a range of enforceability issues, including true sales of assets and various bankruptcy law matters. There are general issues as to whether and to what extent the Sharia or Sharia-compliant transactions can be enforced in jurisdictions in which the Sharia is not incorporated to any extent in the secular law of the land ("purely secular jurisdictions"), as well as in jurisdictions in which the Sharia is incorporated to some extent in the secular law of the land ("Sharia-incorporated jurisdictions"). 258

255

The original declaration of AAOIFI in relation to amendments in contemporary Sukuk issues is available at http://www.aaoifi.com/aaoifi_sb_Sukuk_Feb2008_Eng.pdf 256 AAOIFI is not a statutory industry-wide body, but is an organization based in Bahrain in which leading Sharia scholars participate in order to resolve issues and try and reach agreed settled positions. 257 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues, May 2008, Available at http://islamicfinancenews.wordpress.com/2008/05/21/aaoifi-Sharia-councils-proposals-for-amendments-incontemporary-Sukuk-issues/ 258 McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, pp. 431-432

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When we look at the ratings given to Sukuk structures, we see that generally the credit rating is directly linked to the credit rating of the originator. Let us read from the Standard & Poor’s’ Islamic Finance Outlook 2009 Edition:

“To date, Standard & Poor’s has assigned ratings to 23 Sukuk issued by sovereigns, supranationals, regional governments, corporations, and financial institutions. Most Sukuk we rate benefit from full external guarantees, falling in the first category (where there is an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral and the guarantor provides Sharia-compliant shortfall amounts in case the issuing vehicle (usually a special-purpose entity or SPE) cannot make payment.) We therefore have assigned them ratings equivalent to those on their guarantors and view them as ranking pari passu with the senior unsecured obligations of guarantors.” 259

The Offering Circular (OC) of Qatar Global Sukuk issuance is a fine example showing the said rating agency’s approach: On page 9 of the OC, the Sukuk rating is linked directly to that of its sovereign issuer: “The ratings of the Certificates will be based primarily on the credit rating of Qatar.” 260

Obviously this means that, for now, a very important benefit of securitization does not really work for Islamic structures. Without any doubt, there are many reasons for that: On the one hand, the shortfalls of judicial systems in the countries of Sukuk issuances, on the other, rating agencies’ interpretations on the transaction structures.

The International Islamic Rating Agency (IIRA), which has been established in Bahrain, is a step in the right direction to overcome the latter of the aforementioned issues. It will perform a number of functions including the rating of all public and private issuers of credit instruments with respect to their financial strength, fiduciary risk and creditworthiness. It will also assess the compliance with the Sharia of financial instruments as well as their issuers. It will have a Sharia board

259 260

Standard & Poor’s, Islamic Finance Outlook 2009, 20 February 2009, p. 30 El-Gamal, Islamic Finance Law, Economics and Practice, supra, p. 108

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of its own to advise it on Sharia issues. It will, thus, complement the work of the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in setting standards for adequate disclosure. 261

3.3.4 Benchmarking Issues

In most Sukuk structures, the variable rent is calculated by reference to a conventional interest rate such as LIBOR (London Inter-bank Offer rate) as the table below proves: 262

An argument often heard from investment bankers is that Sharia requirements achieve the same end result that conventional investment or finance products would achieve in a number of situations. The difference is the utilization of different mechanisms and finance techniques. While this is true in a number of ways, it is important to note that an Islamic investment product is a factor of both utilizing specific mechanisms and respecting the fact that the form by which investments are made is as important under Sharia as the substance. 263

261

Chapra, M. Umer, Challenges facing the Islamic financial industry, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 331 262 Cakir, Selim and Raei, Faezeh, Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?, IMF Working Paper 07/237, October 2007, p.3 263 Abdel-Khaleq, Ayman H., Richardson, Christopher F., New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings, Chicago Journal of International Law, Winter 2007, pp. 412-413

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Mohammad Ayub makes the following interpretation on the issue:

“The question arises whether any interest rate benchmark like LIBOR can be agreed as the benchmark for rental. According to a minority of the scholars, with such benchmarks the transaction becomes similar to an interest-based transaction and, therefore, is not permissible. This is not the correct viewpoint, because as long as the basic requirements of Sharia are being complied with, any benchmark can be used to price sale or lease transactions. Benchmarking the transaction’s pricing to an interest-based rate does not render it Haram.” 264

The use of interest rates as benchmarks for determining mark-ups, and more generally for pricing Islamic financial instruments, is widely accepted by Sharia scholars, be it with some lack of enthusiasm. 265 Saying that, we may conclude with the fact that the better position is that the reference to an interest rate is acceptable based on the Sharia grounds of necessity or public need because, at present, there is no viable Sharia compliant alternative. 266

3.3.5 Recent Sukuk Defaults

As Islamic banks operate within the global financial system, they have not been completely insulated from the recent economic and financial shocks. For instance, on the one hand, the Islamic financial industry is considered by many to be less risky because financial transactions are backed by physical assets. On the other hand, Islamic banks may be more vulnerable to fluctuations in the mortgage market, given their high activity in the real estate sector compared to conventional banks.

264

Ayub, Introduction to Islamic Finance, supra, p. 284 Visser, Islamic Finance Principles and Practice, supra, p. 57 266 de Belder, Richard T., Investment Banking, supra, p. 95 265

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The recent slowdown in real estate activity in the Gulf economies raises concerns about some Islamic banks’ financial positions. 267

The Islamic finance industry is undergoing a big test as defaults and restructurings appear in the Sukuk market for the first time. Investment Dar, a Kuwaiti investment company that owns a 50% stake in luxury-car maker Aston Martin Lagonda Ltd, said in May 2009 it had defaulted on a $100 million Sukuk issued in 2005 and registered in Bahrain and became the first Middle Eastern company to default on Islamic bonds. 268 In June 2009, there was a default on a $650 million Islamic bond launched in 2007 by an offshore vehicle linked to Maan Al Sanea’s troubled Saudi group, Saad. 269

These defaults follow last autumn’s (2008) bankruptcy of Texas-based East Cameron Gas Company, which issued a $167 million Islamic securitization in 2006. A court in Louisiana is deciding what rights, if any, the noteholders have. There is uncertainty as to whether the issuer of the notes is bankruptcy remote and whether a true sale of the assets took place. 270

Dubai managed to avoid defaulting on a $4bn Sukuk held by developer Nakheel in December – thanks to a loan from Abu Dhabi – but Saad Group in Saudi Arabia, Kuwait’s The Investment Dar, and East Cameron Partners in the US have all defaulted on Islamic bonds since the financial crisis erupted. 271

Despite the black clouds on the Islamic securitization, future prospects still seem bright. These defaults are taken by the market as a natural result of the hardest crash since the Great Depression of 1929. Even though Islamic Finance has been shown as a potential cure for the crisis by

267

Ilias, Shayerah, Islamic Finance: Overview and Policy Concerns, Congressional Research Service, February 2009, p. 3 268 Fidler, Stephen, Defaults Pose Latest Snag In Islamic-Bond Market, Wall Street Journal, June 16, 2009, available at http://online.wsj.com/article/SB124510859262816907.html 269 O’Neill, Dominic, Islamic Finance: Sukuk market on trial as Islamic bonds default, Euromoney Magazine, July 2009, available at http://www.euromoney.com/Article/2245562/ChannelPage/0/AssetCategory/14/Islamicfinance-Sukuk-market-on-trial-as-Islamic-bonds-default.html 270 Ibid 271 Wigglesworth, Robin, Sukuk forecast to ride rough patch, Financial Times, 14 April 2010, available at http://www.ft.com/cms/s/0/ed243650-47da-11df-b998-00144feab49a.html

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Vatican, 272 the whole financial system in the world is so much linked as of the first decade of the 21. Century. Thus, Islamic finance can not be crisis-proof alone while the whole financial system in the world is suffering more than ever, investment banking is becoming a subject in history books, thousands of highly educated finance (and financial law) experts are losing their jobs, etc. There’s a degree of nervousness about defaults in the Sukuk market but that is outweighed by the bullishness demonstrated by the new Sukuk deals currently being done and those likely to come to the market in the course of this year (2009)," says Qudeer Latif, partner at law firm Clifford Chance in Dubai. He points out that the $750 million Bahrain sovereign Sukuk last month (June 2009) had an order book of $2 billion; while in February (2009) Indonesia’s $650 million sovereign Sukuk had an order book of $3 billion. Even so, one of the bookrunners tells Euromoney that the Middle East, North Africa and Asia accounted for 70% of the buyers of the Bahrain Sukuk. In 2007, however, western buyers sometimes accounted for more than 80% of Sukuk investors. 273 Again, David Oakley of Financial Times says “It is also hoped that non-Muslim European investors, who were increasingly buying Sukuk as a way to diversify, before the credit crisis, will return to the market.” 274

Moody’s, the credit rating agency, in a report recently predicted that Islamic bond sales in 2010 could exceed last year’s $24bn as global regulatory and legislative initiatives, and a possible Dubai World restructuring settlement, boost issuance. Most sales will come in the second half of this year (2010) as the global economic recovery gathers pace and boosts investor risk appetite and corporate profits, Moody’s argued. “I think we will have a good Sukuk year in 2010, probably equal to or better than last year,” says Razi Fakih, deputy chief executive of HSBC Amanah. “The underlying reasons being that there are still a lot of infrastructure investments to come for which some of the financing will probably be raised through Sukuk, and there remains underlying demand from local investors.” 275

272

Totaro, Lorenzo, Vatican Says Islamic Finance May Help Western Banks in Crisis, March 4, 2009, available at http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy 273 O’Neill, Dominic, Islamic Finance: Sukuk market on trial as Islamic bonds default, supra 274 Oakley, David, Credit Freeze victim shows signs of a thaw, Islamic Finance Financial Times Special Report, May 6, 2009, p. 3 275 Wigglesworth, Sukuk forecast to ride rough patch, supra

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3.4 The Use of Derivatives in Islamic securitization

Islamic finance is still struggling to determine whether or not it has a parallel approach to western risk management. Structured systemic Islamic financial products require structured innovation within Sharia confines. 276

The non-existence of interest rates in Islamic finance apparently makes the need for derivative instruments redundant in Islamic markets. However, we need to note some important qualifiers. First, it shall be noted that the prohibition of interest and gharar does not close the room for financial engineering in compliance with the Sharia. Second, Sukuk cannot avoid being competitive if they are to operate in traditional financial markets. Third, the positive aspects of derivative markets can be beneficial for developing capital markets if replicated in the emerging markets. 277

When structuring derivatives products, four main difficulties arise with respect to compatibility with Sharia law, namely the Sharia prohibitions on riba, gharar, maisir and debt exchange. 278 Specialist derivatives practitioners are now facing both an exciting opportunity and an interesting challenge, namely to produce products which provide parties with the unquestioned benefits of conventional derivatives (particularly with respect to effective hedging and general risk management) whilst also adhering to and respecting the core tenets of Sharia. 279

276

Thomas, Abdelkader, Risk Management and Derivatives, ed. by Thomas, Abdelkader, Cox, Stella, Kraty, Bryan, Structuring Islamic Finance Transactions, Euromoney Books, 2005, p. 184 277 Tariq, Ali Arsalan, Managing Financial Risks of Sukuk Structures, M.Sc. in International Banking thesis, Loughborough University, 2004, p. 63 278 Tredgett, Richard, Islamic Derivatives Case study: A cross currency swap, Allen & Overy LLP Article, 18 June 2008, Available at http://www.allenovery.com/AOWeb/binaries/45568.pdf 279 Uberoi, Priya, Evans, Nick, Profit Rate Swap, Allen & Overy Article, 7 October 2008, Available at http://www.allenovery.com/AOWeb/binaries/47753.PDF

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Aside from a narrow focus on the contractual framework, Islamic scholars must take into consideration the potential “welfare loss” when deciding on the permissibility of derivative instruments. 280

Perhaps the most important derivatives question made after an examination of the substance of the contract is whether it serves a public benefit or maslahah 281 to such an overriding degree that it may be transacted. In the case of salam and istisna, Islamic scholars from the time of the Prophet Muhammad have agreed that the public good outweighs the break from generally accepted contractual forms. 282

It is now agreed that there is nothing inherently objectionable in granting an option, exercising it over a period of time or charging a fee for it, and that options trading like other varieties of trade is permissible, and as such, it is simply an extension of the basic liberty that the Qur’an has granted. With that in mind, strong opposition to derivatives seems to be inherited from a pathology of religious interpretation that turns a blind eye to the fact that derivatives are a new phenomenon in an Islamic context. 283

Notwithstanding the religious constraints and legal uncertainty surrounding the enforceability of investor interest under Islamic jurisprudence, Islamic finance can synthesize close equivalents to equity, mortgages, and derivatives known in conventional finance. To this end, it relies on structural arrangements of asset transfer between borrowers and lenders to emulate traditional interest-bearing financial contracts. 284

Anouar Hassoune, vice president of Moody’s recently authored a report in relation to derivatives in Islamic Finance and in his report, he noted that, “If employed with care, derivatives can

280

Bacha, Obiyathulla Ismath, Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration, International Journal of Islamic Financial Services, Vol. 1, No.1, April-June 1999, p. 28 281 Maslahah means that an underlying process may have some problematic issues or prospectively harmful elements from a Sharia perspective, but the good achieved by its application outweighs harm. 282 Thomas, Risk Management and Derivatives, supra, p. 185 283 Jobst, Derivatives in Islamic Finance, supra, p. 26 284 Ibid, p. 2

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enhance efficiency in Islamic Financial Institutions through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty, two practices forbidden under Sharia.” 285

In principle, futures and options may be compatible with Islamic law if they (i) are employed to address genuine hedging demand on asset performance associated with direct ownership interest, (ii) disavow mutual deferment without actual asset transfer, and (iii) eschew avertable uncertainty (gharar) as prohibited sinful activity (haram) in a bid to create an equitable system of distributive justice in consideration of public interest. Sharia-compliant derivatives would also maintain risk sharing between contract parties by forgoing the zero-sum proposition of many conventional derivative transactions in favor of win-win situations from changes in the value of the underlying asset. However, the de facto application of many derivative contracts is still objectionable, mainly because of the possibility of speculation (or deficient hedging need) and the absence of entrepreneurial investment violate of the tenets of distributive justice and equal risk sharing subject to religious restrictions on the sale and purchase of debt contracts as well as profit taking without real economic activity and asset transfer. 286

The closest approximation to a conventional option contract within Islamic finance is the arboun contract. The contract affords the buyer of a good to make a deposit whereby if he decides to buy the specified product in the future he will pay the difference between the full price and the deposit. If circumstances dictate that he will not buy the commodity then the seller keeps the deposit. In a sense, the arboun contract ostensibly replicates the functions of a conventional call option. The permissibility of the contract within Islamic doctrines is debated and much of debate is with regards to historical records of the use of the contract during the time of the Prophet Muhammad. Several schools of thought are in the impression that the uncertainty arising from the use of the contract amounts to gharar and is thus unfair on the seller. On the other hand, other schools of thought uphold the contract citing inaccuracies in the historical records of its alleged reproach. The applicability of the contract is particular to the condition that commodity in question is 285

Moody’s sees huge global potential for Islamic banking industry, Pakistan Chronicle, April 7, 2010, available at http://www.pakistanchronicle.com/content/moody%E2%80%99s-sees-huge-global-potential-islamic-bankingindustry 286 Jobst, Derivatives in Islamic Finance, supra, p. 28

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specified and unique to the contract. According to Sharia, the arboun cannot be used for generic commodities which hinder its possibility to fully replicate the functions of conventional option contracts that are on unspecified underlying assets. According to the Organization of the Islamic Conference (OIC) Academy, an option contract is not tradable. Firstly, the option contract amounts to investing in something intangible. Secondly, the uncertainty involved in the contract is tantamount to gharar making it invalid within the sphere of Sharia. 287

The first Islamic securitization transaction in the U.S. demonstrates the Sharia-compliant use of derivatives in structured finance. In July 2006, East Cameron Partners (ECP), an independent oil and gas exploration and production company based in Houston, Texas, raised $165.67 million from the issuance of a Sukuk al-Musharaka backed by natural oil and gas royalties. Its two-tier securitization structure consists of a “purchaser SPV” (incorporated in Delaware), which acquires the underlying assets, and an “issuer SPV”, registered in the Cayman Islands, which funds the asset purchase by issuing investment trust certificates (Sukuk notes). The relationship between both SPVs is governed by a “funding agreement”, which includes periodic funding repayments and the transfer of net profits. The funding agreement aims at materializing the contribution of the “issuer SPV” (as a musharek) and (ii) conveying to the “issuer SPV” a certain risk and reward profile, which is passed on to the Sukuk note holders, pursuant to the following provisions: (i) the purchase of overriding royalty interest (ORRI) from the originator for $113.84 million, (ii) the payment of the development plan for $38.28 million, (iii) the funding of the reserve account with an initial balance of $9.5 million, and (iv) the acquisition of natural gas put options for $4.05 million in a specific hedge agreement with an outside party. The commodity price hedge as part of the funding agreement to protect investor interest is remarkable in the context of Islamic finance. The hedge constitutes a Sharia-compliant obligation, since it confers true commercial value (rather than speculative interest). 288 Overall, Sharia compliance of the transaction is established by the uncertainty of cash flows from the asset performance of permissible real economic activity with identified and direct investor participation, which does not imply the payment or receipt of any interest guarantee. While deferrals are possible, in the default event, investors have recourse to the underlying assets and can force the sale of the cash flow generating assets. 289

287

Tariq, Managing Financial Risks of Sukuk Structures, supra, pp. 64-65 Jobst, Derivatives in Islamic Finance, supra, p. 22 289 Ibid 288

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However, one should note that the legal risk from Islamic jurisprudence could affect the legal enforceability of the funding arrangement and the asset control of investors. 290

3.5 A Case study: Sorouh Securitization 291 The purpose of the Sun Finance Limited (incorporated in Jersey, the Channel Islands, with limited liability) securitization is to allow Sorouh Real Estate PJSC (hereinafter referred to as Sorouh) to monetize future cash flows for from the sale of real estate plots to property developers. Sorouh applied the proceeds of the monetization toward funding the utility infrastructure for two of its flagship real estate developments: a) Shams Abu Dhabi, a 170-hectare development and $3.1 billion 292 residential project on Al Reem Island, and b) Saraya ($290 million, mixed-use) development in Abu Dhabi's central business district.

The transaction was closed in August 2008, thereby affected by the credit crunch, and the total issue was AED4 Billion ($1.1 billion). Citigroup, Abu Dhabi Commercial Bank, First Gulf Bank, National Bank of Abu Dhabi, Noor Islamic Bank took part in the transaction as joint bookrunners while Clifford Chance LLP, Afridi & Angell, Freshfields Bruckhaus Deringer LLP and Bedell Cristin Jersey Partnership acted as legal counsels for different parties in the transaction.

In essence, there are three principle parties involved in this transaction: Sorouh, a project developer that sells the plots; Sorouh Abu Dhabi Real Estate LLC (Propco), that purchases the plots and, in turn, sells them to individual developers; and Sun Finance (Issuer) that issues the AlMudaraba Al-Muqayyada certificates to investors.

290

One should remember that East Cameron Partners Sukuk defaulted during the harshest days of the recent financial crisis and the conflict is before an American court at the moment. The decision of the court in relation to enforceability may potentially affect the future Sukuk structures. 291 While preparing the case study, our main tool was the Offering Circular of the deal. Apart from that, we used the related reports and media releases of Clifford Chance LLP, Freshfields Bruckhaus Deringer LLP, Moody’s, Standard & Poor’s and the Economist as well as Sorouh Real Estate PJSC’s ADX Financial Report dated June 30, 2009. 292 Despite the conservative assessment of the Economist, some, mostly Middle Eastern sources claim that the project is worth actually AED25 billion ($6.9 billion).

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Sorouh securitization comprises three classes of notes rated by Moody’s and Standard & Poor’s. The below table 293 shows the relevant profit rates 294 and ratings from the said agencies as well as some other details accordingly:

The transaction is capitalized by Sun Finance applying the certificate proceeds toward a mudareb (investor of capital). The certificate proceeds amount to the Issuer’s beneficial interest in the mudareb. Propco, effectively a partner in the mudareb, buys the plots from Sorouh, sells them to the developers, and puts the purchase price toward the investors’ (that is, trust certificate holders’) returns and funding for the infrastructure works. As payments from the developers come in through plot sales, ownership of the land incrementally shifts to the developers. In turn, Propco incrementally purchases the Issuer’s beneficial interest in the Mudaraba (trust) as it receives funds from plot sales, thereby amortizing the certificates. When a plot sale payment is received, Propco releases the relevant plot to the developer.

Propco purchase undertaking is backed solely by the sale proceeds from the real estate plots. If plots are not sold or purchase prices not achieved, Propco will likely not be in a position to meet is obligations under the purchase undertaking. The Issuer’s ability to service the certificates lies ultimately in the ability of Propco to sell and be paid for the plots. The significance of this feature is that the credit quality of Sorouh is effectively not an issue once the sale of the plots to Propco is completed, effectively making the Sun Finance transaction a non-recourse Sukuk.

293 294

The table is taken from the Offering Circular (OC) of Sorouh securitization, p. 2 EIBOR is the abbreviation for Emirates Interbank Offered Rate.

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Propco is 99%-owned by the chairman and managing director of Sorouh, the remaining 1% being held by an independent director. In the event of a payment default by Sorouh, transaction documentation indicates that the 99% share would be transferred to the independent director, who would then own 100% of Propco.

The structure features both senior and subordinated certificates. It benefits from a fatwa to the effect that it's Sharia-compliant.

Investors do not have security as much as they hold a beneficial ownership interest in the mudareb. Such interest is not the same as outright legal ownership though. While the Issuer has a fixed and floating charge under U.K. law over the assets of Propco, there is some question as to whether such charge would be enforceable in the UAE where the assets are located.

As noted above, in the event of the insolvency of Sorouh, the issuer is entitled to instruct the independent director to force a sale of the assets held by Propco. In summary, there is a degree of legal and country risk in each transaction.

Below is a structure diagram of the Sorouh securitization transaction: 295

295

The diagram is taken from the Offering Circular (OC) of Sorouh securitization, p. 9

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It is the first ever securitization of installment sales receivables which was Sharia compliant. The Sukuk certificates which are asset backed by installment sales receivables from the sale by Sorouh of plots of land on the iconic Shams and Saraya Master Developments in Abu Dhabi have been awarded the highest credit rating to date for a non-sovereign instrument issued in the MENA (Middle East & North Africa) region. The transaction is also unique in many other ways, but notably, apart from being the first ever securitization of this asset class, marks the first asset-backed securitization out of Abu Dhabi. It is also Abu Dhabi’s first ever local currency securitization deal. The transaction is also the world's largest Sharia compliant securitization 296 to date, including Sharia compliant tranches and representing one of the few fully distributed asset backed transactions since the advent of the "credit crunch".

“Objectively speaking, it was an incredible deal for many reasons,” says Khalid Howladar, a senior analyst in the Middle East and Islamic structure finance group at Moody’s Investors Service. “I’ve never seen anything like it.” 297

296

Robin Ward, a director at Citi says “In contrast to past full-recourse deals, this transaction features partial recourse to the originator. Sharia scholars have recently expressed concern over pure-recourse deals and as a consequence previously Sharia-compliant deals would no longer be compliant if proposed today.” Available at http://www.isr-e.com/story.asp?storycode=284065 297 Deal of the Year 2008 – Emerging Markets, Winner: Sun Finance, 1 December 2008, Available at http://www.isr-e.com/story.asp?storycode=284065

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CONCLUSION

We tried to explain the quite complex and hence, interesting world of Islamic Securitization. We hope we at least managed to give a broad picture which may give the reader a basic understanding of this quite young branch of financing universe.

Securitization which is in its essence a Sharia compliant structure perfectly fits with the needs of Islamic financial institutions that have traditionally accepted the model of originate-to-hold. That is why Islamic financial institutions may benefit a lot from the liquidity and risk management features of securitization. This mere reality is making Islamic Finance and Securitization great partners. We do believe that securitization in Islamic Finance will be the impulsive power of Islamic Finance in its challenge to become a player in the mainstream financing.

Obviously the aforementioned success will not come with ease. As one may well argue, the “different interpretations of Islamic law” is a serious issue concerning the sound growth of Islamic Securitization as well as other structures of Islamic Finance. The lack of standardization may have an adverse effect on the spectacular up-going trend in the long run. The efforts of institutions like AAOIFI are very important regarding standardization as we mentioned their suggestions in relation to Sukuk issues echoed all around the world.

We believe that the importance of these efforts is beyond having standardized structures. This is almost a matter of life and death to Islamic Securitization and Islamic Finance in general. Our point to this argument is that without universally accepted structures, there is a huge risk of witnessing individual issuers simply mimicking conventional structures and calling the structures they created “Islamic”. This may cause Islamic Finance lose its nature and identity in the long run. That is why we believe that this problem is a matter of life and death.

Lack of expertise has always been an issue regarding the success of Islamic finance. As the number of Islamic finance experts all around the world, both Muslim and non-Muslim, is increasing in

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multiples, this issue is becoming less important gradually. Obviously, it is not possible to deny the contribution of the international law firms most of which have a quite deep and wide Islamic Finance expertise and practice. Most of the innovative structures were created with the effort of the partners and associates of these firms working in the offices in the Middle East or other locations particularly London.

We gave some numbers in our thesis regarding the potential of Islamic finance which shows there is still a lot of way to go. Provided that the aforementioned efforts continue to exist (or even increase as one may suggest) and the recession fears ease, it is not impossible to beat these “potential” forecasts. There are many parameters which make us believe that the potential numbers seem to be quite modest. Apart from the others, even the increases in these forecasts, coming one after another, prove that there is, in fact, much more potential than it is claimed at the moment. Only time will tell…

----- O -----

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Çektir&Başarı Law Firm Çektir&Başarı is a premium full service Turkish law firm with a culture of international performance. We provide bilingual, cross-cultural specialist services to domestic and international clients and have a very well established reputation in corporate governance matters as well in other fields of Turkish Law. We have a solid background in litigation matters, employment law and public international law. In this regard, we are providing our legal services to numerous distinguished corporations from Turkey as well as foreign companies from all around the world. We have been providing high quality legal service to government authorities, distinguished multinational companies and market leaders. Our key strength is our expertise and strong ability in obtaining positive results on behalf of our clients while providing comprehensive legal services at international standards. As a promising emerging market with immense opportunities, Iraq is of our main focus and expertise. We advice major business actors including banking and finance institutions, construction companies, and retail chains with regards to their investment plans in Iraq. Our office located in Erbil together with multilingual lawyers equips us to provide innovative and creative solutions regarding legal issues in local law.

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