NAZNEEN HALIM believes it is time for the Islamic finance community to come together and embrace risk. Even if it means losing some.
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 securitization. Asset-backed or asset-based, both are viewed as acceptable practice in different jurisdictions, and let’s 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.
The big ‘S’
In a nutshell, securitization 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 securitization 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 securitization 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, securitization 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 securitization is considered interesting because its characteristics differ from stocks and bonds.
Hooman Sabeti (caricature left), partner at law firm Allen & Overy, believes that asset-backed securitization 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 this year, Afaq Khan, chief executive at Standard Chartered Saadiq was quoted as saying that the current market conditions are not encouraging for full-blown securitization, 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 securitize assets due to a mismatch in 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 securitization, and how it can, and perhaps even should, be done.
Asset-backed vs asset-based
“It is not the business but the ownership that is in question when you define asset-backed and asset-based securitization,” Ahmed Muzni (caricature top), 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 return 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 don’t 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 don’t really care. Because eventually in six months, they will 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 securitization 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 (caricature), partner at Vinson & Elkins elucidated.
“There is nothing called a guarantee in Shariah. That’s 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 minimize the risk of an outright asset purchase is to do an over-collateralization 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-collateralize 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-collateralization of the asset, and even if four or five million units of the asset go bad, he has the over-collateralization 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 securitization, it is up to the investors to liquidate their assets. However, Dey (caricature) believes that many investors do not want to get their hands dirty: “Currently they don’t 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.
“The assets must show that they have been sold and are isolated from the bankruptcy of the seller. That’s how securitization 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 securitization,” he added.