The difficulties in the subprime mortgage were the result of lax lending to borrowers who had little prospect of meeting their debt obligations when interest rates rose. It would be easy for those involved in Islamic finance to be complacent, and suggest because Shariah compliance means interest avoidance, similar problems are unlikely to arise. In practice where variable charges are made for Islamic finance, interest rate exposure is an issue even though the payments themselves are rents, not interest. Hence Islamic financial institutions need to screen clients carefully, and ensure asset quality is maintained. There are also lessons from the wider implications of the difficulties with subprime mortgages that were securitized. These mortgages were used as asset backing in a similar way to Sukuk being asset backed. For Islamic financial institutions, the requirement for asset backing should not be a mere legal formality to ensure Shariah compliance. Rather, the value of the underlying asset really matters in the event of default, and the contractual documentation should ensure that the investors have a clear right to the underlining asset which will usually be held by a special purpose vehicle. Ratings agencies usually evaluate the issuer, not the underlying asset, which may be a shortcoming in their methodology which needs re-examination.
PROFESSOR RODNEY WILSON:
Indeed many lessons to be learnt, but critical is the need for more investor education. Much of the recent global volatility has been caused by a lack of market understanding and product confusion. When times are good, investors are not worried about the risks. At the first “problem”, they overreact creating excess market volatility. The pace of innovation and development of local (Islamic) markets must go hand in hand with good financial and regulatory institutions as well as investor education. KHALID HOWLADAR: Vice-President and Senior Analyst, Middle East and Islamic Structured FinanceMoody’s Investors Service
Yes, very much so.Not all Islamic structures are real asset-based, and not all investors fully appreciate the basis of ratings and underlying assumptions. We must ensure that the market is fully aware of the true transactions. KHALID MAHMOOD BHAIMIA: Managing Director, Hong Leong Islamic Bank
Of course! Before moving to BMB Islamic, I had nearly signed a contract with a major investment bank to structure an Islamic collateralized debt obligation, with a reference portfolio comprising residential mortgages from the US and Europe. I feel so relieved now for not working on that transaction, as that would have exposed (directly and indirectly) Islamic investors to the recent subprime problem in the financial markets. I think that while Sukuk and other Islamic securitization programs are essential for the further development of Islamic financial markets, care must be taken in selecting the underlying assets. If the wrong type and mix of assets are used to structure and issue tradable Islamic securities (Sukuk and other asset backed securities), it may cause a contagion effect, similar to what is observed in conventional financial markets. This may prove to be much more damaging for Islamic financial markets than conventional markets, as the latter has more depth and resilience than the former, which is at best just out of its infancy. This observation is even more important in the wake of an increasingly lenient Middle Eastern stance on debt trading. Dr HUMAYON DAR:span> CEO, BMB Islamic
I CHRIS COOK: Principal, Partnerships Consulting
I CHRIS COOK: Principal, Partnerships Consulting
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