July 2010

JULY 25, 2010

This weekend, I started reading an interesting book on the financial crisis, Balancing the Banks: Global Lessons from the Financial Crisis by Mathias Dewatripont, Jean-Charles Rochet and Jean Tirole.  While reading about the impact of capital requirements on banks and between regulated and unregulated firms, I began thinking about the frequent call for Islamic banks to move away from products that resemble conventional loans and towards profit-and-loss sharing contracts.  The idea that I am working on (which I expect to include in a future newsletter) is that contrary to the conventional wisdom and rhetoric, profit-and-loss sharing banks would be incentivized to become either more risky or have difficulty attracting customers because they are less profitable than either conventional (commercial) banks or Islamic banks as they operate today.

The crux of my argument is that the profit-and-loss sharing bank would be forced to hold more capital because their assets are more risky and would carry a higher risk-weighting under the current rules.  They would also have lower leverage because their capital would consist primarily of equity and retained earnings with no debt-equivalent financing and even if their profitability were the same as a conventional or Islamic bank today, it would be divided amongst more equity investors than a bank that can use long-term subordinated debt as Tier 2 capital alongside its Tier 1 equity capital.

A profit-and-loss sharing (PLS) bank operating in a mixed market of conventional, non-PLS Islamic banks and PLS banks would have a hard time attracting depositors unless the expected payout to depositors were comparable to competitors.  With that constraint in mind, the remaining profit per unit of equity would likely be lower than its competitors, making it difficult to attract investors with the choice between either non-PLS banks and PLS banks.

In order to overcome this disadvantage, the PLS bank would have to raise the profit sharing rate with its ‘borrowers’ to increase the expected return.  In doing so, it would likely attract more risky clients that would raise the expected default rate in normal periods but leave the PLS bank more exposed to serious losses in adverse economic situations.  It is likely that the risk from very adverse, but relatively rare events (‘black swan’ events) would make a PLS bank significantly more vulnerable than either a conventional bank or non-PLS Islamic bank.  (Note: I am assuming the comparable conventional banks would be those with most of their activity in lending, not in derivatives or structured products).

I am still working through this idea into something a little more structured and formal, so I would appreciate any feedback from readers of this newsletter.

JULY 18, 2010

An article during the past week from Bloomberg discussed the asset-based versus asset-backed debate in sukuk structuring.  Sheikh Yusuf DeLorenzo said that investors are demanding more asset-backed sukuk in the wake of several asset-backed sukuk defaults.  He was quoted as saying that “Clearly, Islamic investors have felt that the present generation of sukuk has not met expectations for ownership, so changes are being demanded [and they] will require greater due diligence with regard to transfer of ownership”.  James Atkinson, a senior associate at Norton Rose (Asia), countered that “being a secured creditor doesn’t automatically place you in a better position than you would be where you only have a direct contractual claim against an issuer or guarantor.  If it’s a low-quality credit, it will provide little in the way of credit support”.

I think that each point has merits; there have been some asset-based sukuk that have performed very poorly and their asset-based structure may be a part of the problem.  However, the claims by some investors that it was not clear at the outset that although an asset is involved, investors do not have recourse to that asset in a default is disingenuous. The investors in the sukuk are institutional investors with enough sophistication to understand from the prospectuses that the asset-based sukuk provide no additional protections than unsecured debt.  Mr. Atkinson also makes a good point because much of the distressed sukuk would not have performed much better and could have performed worse if they were asset-backed because of the decline in the value of the assets underlying them.  Many sukuk were based on assets related to real estate and generally those assets’ values fell as the property bubble turned to bust.

There are examples where an asset-backed structure has performed well: the Sun Finance (Sorouh) securitization sukuk, which securitized plots of land being sold to developers which was issued in August 2008 and will be redeemed soon.  However, even successful sukuk like this have risks to investors that may not be fully realized.  In the Sun Finance sukuk, for example, although the assets were sold in a true sale to the SPV, the issuer (Sorouh) was able to redeem them before all the payments were made by developers (with funds raised in conventional and Islamic debt sales).  This represents a loss to investors of the periodic payments if the sukuk matured on the original schedule.  However, because the sukuk was asset-backed, if the asset value fell significantly. the investors would have no recourse against the issuer and the issuer would be unlikely to redeem the sukuk.  If the asset value had fallen significantly, the investors (particularly in the lower tranches) would have probably fared better if they had recourse against the issuer and not just the assets.

There are positives and negatives associated with any structure: secured or unsecured.  It is up to the issuer and the investors to determine which risks they want to assume and recognize that there is a tradeoff between secured and unsecured debt; one is not necessarily superior to another.  However, the larger lesson from the asset-based versus asset-backed issue is that if the projects being financed may be exposed to a bubble that is becoming unsustainable, if that bubble pops, the structure will not matter.  That being said, I think that asset-backed sukuk probably represent more closely the image of how Islamic finance is commonly understood, even though asset-based sukuk are perfectly legitimate, Shari’ah-compliant structures.

JULY 12, 2010

Indonesia has finally tackled its failed sukuk auctions.  However, it has not tackled the problem head on.  The auction method is expected to be abandoned in favor of the book-building sale.  While this will attract more non-domestic investors, it will avoid the issue of why the auctions failed in the first place:.  Auctions failed because the demand for the sukuk was conditioned on a yield to compensate for both Indonesia’s country-specific risk but also an liquidity premium for the sukuk because secondary markets are so thin.

Instead of dealing with the primary issue, Indonesia took the easy answer of finding new investors who are comfortable with illiquid investments instead of tackling the primary issue.  While this provides the funding Indonesia needs to finance its budget deficit, it does nothing to develop a liquid secondary market in sukuk, which is what is needed.  It will take more than one country issuing sovereign sukuk to create sufficient supply to use for a benchmark in pricing corporate sukuk (and new sovereign sukuk).

JULY 5, 2010

This week’s email is a day late due to the July 4th holiday in the US.  One of the news items I covered briefly in the blog this week was the raise by Sorouh of $640 million in conventional and Islamic debt that was, in part used to repay the remaining balance on the Sun Finance securitization.  I reviewed the basics of that sukuk in early June (linked in today’s post below).  First, the repayment of the sukuk completes its life successfully, which is notable given the default of other real estate-based sukuk and also the Sorouh sukuk’s issuance shortly before the financial crisis intensified.

In addition to the positive outcome of the sukuk, it does raise a question of whether the sukuk holders would prefer not to have the sukuk redeemed until the source of funds (it was an asset-backed sukuk), the developer payments, are paid in full.  The early redemption (prepayment) risk is common among most securitizations (particularly residential and commercial mortgage-backed securities) and in general is compensated for with higher periodic (interest) payments.  However, should Islamic finance structures (particularly an asset-backed, true sale-based one) have a similar risk of early repayment by the issuer?

It would be one thing to leave the prepayment risk from developer payments (which are then used to “constructively dissolve” the sukuk) as a risk.  It is a result of changes in the underlying assets.  However, the prepayment risk from the issuer repurchasing the assets adds another level of risk because the issuer can call in the debt regardless of the underlying assets performance.  This is likely to happen when it is beneficial for the issuer, although if the sukuk did run into trouble, the investors have recourse only against the underlying assets.

In some ways, it is a “heads I win, tails you lose” proposition for the issuer.  If the developers make payments and the issuer is able to find replacement financing, it can redeem the sukuk (and keep the future profits from the sukuk assets) while if the developers default the investors bear the losses.  For a mudaraba sukuk, the investors bearing losses fits in with the basic concept.  However, the early redemption appears to place the issuer (mudarib) in a more advantageous position than the investors (rabb ul-maal).