The Trade-Off

Islamic finance is undergoing some sort of schizophrenia. Perhaps this is characteristic of every nascent market, but the underlying issue is not the structures and big numbers in all its technical glory but rather, a simple question of whether or not market players are ready to bear the risk that comes with the rewards.

For a while now, there has been internal debate brewing on the issue of asset securitisation. Asset-backed or asset-based, both are viewed as acceptable practice in different jurisdictions and let us not kid ourselves – Islamic banking now is perhaps as abstract as Pablo Picasso and Georges Braque’s concept of cubism in 1910. But of course, being such a young industry, we have actually had much to juggle on our shoulders. For one, there is the conventional banking system to compete against, then there are the conventional investors to attract and of course, who can forget the basis on which this system is derived – Islam.

Having to amalgamate and consider so many facets while not losing the essence of the religion is perhaps the industry’s greatest challenge, which is why it is perhaps easier to agree to disagree at this point.

The Big ‘S’

In a nutshell, securitisation allows companies to package assets such as loans, rental properties or infrastructure projects and sell them to investors to transfer risk from their balance sheets and free up funds for expansion.

According to Debashish Dey, Islamic finance partner at Clifford Chance, a true securitisation does not show the balance sheet of the credit institution; rather, it only includes statistical data on the assets. “In the Western market, if you look at a securities document, there is no data on the balance sheet of the company which created the assets because in essence, it is irrelevant. What is important is the credit strength of the assets.

“Therefore, a classic Western securitisation document contains lots of data on the pool of the assets, who the underlying customers are in the asset pool, the terms of the assets and even the last three years’ financial data on the assets. However, from a sukuk perspective, there are pages and pages on the balance sheet of the corporate but no data on the asset whatsoever,” Dey divulged.

From the point of view of a borrower and investor, securitisation makes sense because it allows them to borrow money using any financial assets they might have and gain a decent financing cost for it. For the investor, asset-backed securitisation is considered interesting because its characteristics differ from stocks and bonds.

Hooman Sabeti, partner at law firm Allen & Overy, believes that asset-backed securitisation allows for the diversification of the investors’ portfolio: “They (asset-backed securities) behave differently under different economic circumstances. It helps them diversify their portfolio and the securities created are tradable and interchangeable. If you buy 1% of securities, you basically own 1% of the pool, therefore, your share is the same as anybody else’s.”

Earlier last year, Afaq Khan, chief executive at Standard Chartered Saadiq, was quoted as saying that the current market conditions are not encouraging for a full-blown securitisation despite a thirst for it. “It is the next stage of evolution for Islamic financial institutions,” Khan said. However, the slump in real estate and housing has somewhat dampened such plans.

“Once credit markets recover and Islamic banks resume lending, banks will need to securitise assets due to a mismatch in the growth of their capital bases and asset books because the capital of Islamic banks are not growing by 15% to 20% but their assets are, so you have to find new instruments to move off the assets from your balance sheet,” he added.

Which brings one to the question of why such movement is not evident in the current process of Islamic securitisation and how it can and perhaps even should be done.

Asset-backed versus Asset-based

“It is not the business but the ownership that is in question when you define asset-backed and asset-based securitisation,” Ahmed Muzni, co-chief operating officer at Saudi-based Siraj Capital, explained.

The fundamentals of Islamic trade connote that one cannot sell what is not his or hers; therefore, in an asset-backed transaction, there is a true sale of the asset and focus lies on what is being sold rather than who is selling it. However, industry players have conceded that the current pool of investors are not entirely interested in the performance of the assets but rather, the performance of the company selling the assets.

Sabeti explains that asset-backed and asset-based transactions have a different analysis of risk and finance all together. “When people talk about asset-based, what they usually mean is a sukuk where there is a physical asset in the structure somewhere but put only to create a compliant structure, not to enhance the credit quality of the deal or giving investors recourse to that physical asset.”

Investors are said to still be fixated on a bond-type returns from the balance sheet of the corporate. And some industry players have been bold enough to say that most corporates disguise the transactions to look Islamic when in fact, they are not. “The attitude now is such that investors do not care what happens to the asset – they can burn in hell for all they care,” an industry player said.

There are some cases, according to a source, where not even the lenders are aware of the asset’s performance. “Nobody knows other than real estate in some cases – because you can track it – what happened to the asset. In cases where you say, for instance, this security is backed by 1,000 cars, they do not really care because in six months, they will eventually look to the borrower or obligor to make the payment,” he added.

It is important, Muzni says, to begin educating investors about the fundamental structures of what they are buying into. “Whatever papers we have today are quasi-equity. They have never been debt. We have to start educating investors about that and if they do not want to accept it, I believe we are targeting the wrong investors.

“We are targeting fixed income investors when we should be targeting equity investors who understand equity risk. Investors’ misconception really comes down to what we have been saying. For the past 20 years, we have drummed it into their heads that this is a bond-like quasi-debt instrument when we should be emphasising on the fact that we are selling equity instruments,” Muzni added.

Asset-backed Default

Perhaps the most famous case of an asset-backed security is the US$165.7 million East Cameron Sukuk – the first sukuk to originate out of the US in 2006. Although the company is currently beleaguered in debt and filing for bankruptcy, industry analysts, surprisingly, are in praise of the C-rated paper. It is touted to be the first ever Shariah-compliant gas-backed securitisation and was structured under musharakah in terms of the management of assets.

“In the case of East Cameron, the investors went in ready for the risk. It was described in the paper and when they bought it, they knew it was a C-rated paper,” Ayman Khaleq, partner at Vinson & Elkins, elucidated.

“There was nothing wrong with the structure. Companies file for bankruptcy; it happens. The conventional investors who bought the paper are going about it the right way, trying to get a court settlement, but 20% of the Islamic investors are panicking,” he added.

The papers, which promised an 11.5% yield, was predominantly subscribed by hedge fund investors – a shift from the typical bankers and fixed income investors. “If the coupon is attractive enough, there will be enough investors who will go in and buy the sukuk. Equity investors will buy sukuk if the returns are high and if you are going on that premise, then I dare say there should be lots more sukuk coming out in musharakah and mudarabah structures than Ijarah,” Muzni said.

“There is nothing called a guarantee in Shariah. That is the difference between Bay-al-Arboon and the call option and between a guaranteed fund and a protected fund. It is not just form over substance; there is a reason for it,” Ayman stressed.

Khalid Rashid, head of international banking at Standard Chartered Pakistan, concedes that an asset-backed transaction is indeed more complex compared to an asset-based structure. However, he was candid in saying that the Pakistani market is not as mature as that in Malaysia and Indonesia, therefore, allowing for only asset-based lending at the moment.

“What investors could do to minimise the risk of an outright asset purchase is to do an over-collateralisation of the risk – instead of taking 100 dollars in assets, for 100 dollars worth of bonds, they can take 110 dollars worth of assets and over-collateralise that,” Khalid suggested.

He goes on to explain how profit sharing comes into play, by the investor becoming the co-owner in the pool and having the right over the first 100 dollars of profit. “Any remaining profit goes to other co-owners, who are the borrowers. That way, the investor is satisfied by the fact that he has over-collateralisation of the asset and even if four or five million units of the asset go bad, he has the over-collateralisation from the extra 10 dollars to cover his risk.

“At the time of maturity, the borrower pays back 100 dollars to the investor and the investor sells back part of the asset to the borrower. That would be a much stronger case for Islamic asset-backed than asset-based,” he added.

Power to the People

The general consensus across the board is that what the market wants, the market gets. Industry players are ready to cater to investor appetite at whatever cost. However, many still believe that investors are not willing to take the risk that comes with the true purchase of assets.

Although investors understand and want Shariah-compliant products, many say that they would prefer to have credit reliance on corporate balance sheets rather than asset risk and consider it to be a safer investment bet.

In the case of a default of a full securitisation, it is up to the investors to liquidate their assets. However, Dey believes that many investors do not want to get their hands dirty: “Currently, they do not want to manage or run the assets – treat me like a creditor and give my money back.”

Khalid Rashid of Standard Chartered concurs, stating that for as long as Shariah boards deliver the fatwa on certain transactions, Islamic investors will be happy to buy into them.

“Obviously, from the Shariah point of view, an asset-backed transaction would be more potent because it is an outright sale. But to be honest, it does not make that much of a difference to the investor at this point.”

“Islamic principles do fit very well with securitisation. If we want to do securitisation, three things need to change: investor desire, company desire to sell their assets – and that would have many implications, such as accounting and equity-shareholder implications – as well as legal framework,” Dey offered.

“The assets must show that they have been sold and are isolated from the bankruptcy of the seller. That is how securitisation works. Bankruptcy laws and asset-selling laws have to be clean and in many jurisdictions right now, bankruptcy and true sale laws are quite opaque and often are not sophisticated enough to easily do securitisation,” he added.

Perhaps it is unfair to will such drastic change right now, seeing the youth of the Islamic markets. The political will to pass laws to create a more user-friendly environment to transfer assets over to special purpose vehicles also has to be strong for the industry to evolve and move towards more true and tangible sales. However, the lingering question remains: How do you change the investors’ minds if they are already happy?

This article first appeared in Islamic Finance Asia (Pg 14, December 2009/January 2010 issue). For more information, please visit