July 2012

July 29, 2012 (PDF)

The sukuk market is one of the most important areas of development in the Islamic finance industry, both for financial institutions, and pension and takaful funds because it provides a source of Shari’ah-compliant fixed income investment, which is important for portfolio diversification.

The sukuk market is growing rapidly, with 2012 seeing issuance in excess of the previous peak level in 2007.  One area has yet to develop in sukuk markets is mortgage-backed securities (MBS).  MBS can provide an important source of new issuance, but with few exceptions, there is limited issuance outside of Malaysia.  Tamweel planned a $235 million RMBS in June, but in early July pulled it when investors balked due to its complicated structure and questions about the Dubai real estate market.

The recent Saudi mortgage law is expected to be a boon for takaful operators in the Kingdom, because the properties financed will need to be insured, which should increase demand for takaful.  With this increased demand, takaful operators will need to find investments that can provide fixed income returns to balance the equity investments in the portfolio.

Since the Saudi takaful market uses, Ta’awuni model, where the takaful operator shares in the investment income in the portfolio, takaful operators will want to ensure that the portfolio generates a steady stream of income.  Even with an increasing number of sukuk issued in Saudi Arabia, the mortgage law could increase this supply if MBS are issued, backed by the increasing numbers of mortgages that could be forthcoming.

This would provide a benefit to takaful operators that rivals the benefit from the increased demand by providing a larger supply of fixed income investments for the premiums contributed by policyholders, a portion of the profits of which are paid to the takaful operator.   As the investor caution towards the Tamweel RMBS demonstrated, there is significant work that needs to be done in order to establish investor confidence in RMBS sukuk, the potential issuance is large.

In the US, the market for RMBS is huge, currently $13.7 trillion, which is roughly the size of government bonds outstanding. If successful, RMBS sukuk backed by Saudi mortgages could create a large supply of new investments for takaful firms, as well as financial institutions and pension funds.

July 22, 2012 (PDF)

In several newsletters recently, I have suggested that Islamic finance could benefit from issuing a green sukuk, and Nasser Saidi, the Chief Economist of the DIFC, adds a few additional reasons why a green sukuk makes sense.  Citing Bloomberg New Energy Finance, he notes that “global investment in clean energy reached USD 211 billion in 2012 and USD 260 billion in 2011” and most of this is done by conventional financial institutions.

Saudi Arabia, he adds, is planning $100 billion in clean energy investment in the next decade with other GCC countries, notably the UAE and Qatar, but also Oman, also working to add renewable energy resources.  So far, there has been little investment within the GCC in renewable energy, and there is no reason why a green sukuk would have to target local investors.

The Pew Charitable Trust, according to Saidi, has estimated that there will be $2.3 trillion in clean power investments during the 2010-2020 decade, and a large portion of them will be financed by institutional investors in the West.  The GCC has both solar and wind resources, and a green sukuk for renewable energy projects could offer an investment that provides these investors with geographical diversification of their renewable energy investments.

And they are interested: The working group on green sukuk uses the well established International Climate Bond Standards, which is backed by prominent institutional investors, so the primary hurdle would be to explain the sukuk structure, not show that the bonds fit with their mandate for sustainable investment.  A green sukuk targeted at both traditional Islamic investors and Western institutional investors would provide an opportunity to lower the belief that Islamic finance is just for Muslims.

It would do all this while benefiting the GCC by increasing renewable energy capacity, lowering carbon emissions and having the added benefit of freeing up oil and gas capacity for export, rather than domestic consumption, which will provide more resources for governments to finance social programs and education, to help lower poverty and the unemployment rate, particularly among young people.

July 15, 2012 (PDF)

An article in Financier Worldwide due out in August 2012 included a 10Questions piece with a restructuring expert at Deloitte, David Stark, about a draft law being developed to put in place a new restructuring and bankruptcy regime in the UAE.  The need for a new insolvency and restructuring law was on display when Dubai World was unable to pay its $3.5 billion sukuk in December 2009 and relied on an ad hoc Dubai World Tribunal to resolve the debt problems at the government-related company.

The tribunal was established in the Dubai International Financial Centre, based on UK laws, to address an urgent need.  It was conducted in English, the language spoken by most of the members of the Tribunal, and many creditors.  Clearly, a law for the UAE will be in Arabic, and Mr. Stark describes how the law will be tailored to fit local conditions (rather than cutting and pasting US, UK or some other legal system).

What becomes interesting for Islamic finance is that there will be experts involved to “ensure that any new statute meets Sharia’a requirements”.  This is an area where there has been less development and a great deal of demand.  Islamic finance bankruptcies around the world have for the most part been pushed into legal systems not concered with the transactions’ Shari’ah-compliance.

In the UK, the courts explicitly refused to consider Shari’ah-compliance in both the Beximo Pharmaceuticals and Blom Bank/TID cases.  In the US, neither the East Cameron bankruptcy nor the ongoing Arcapita bankruptcy have seen the courts get into the matter of Shari’ah-compliance, and nor are they likely to.

These jurisdictions were set up long before Islamic finance became common, and are secular legal systems. There is some flexibility in how the parties resolve a bankruptcy including involving their own Shari’ah scholars. The court will not rule on which side is right in a Shari’ah dispute and nor can they be expected to.

It will certainly take a considerable amount of time for the new insolvency law to be designed and longer still for it to develop a track record where it can be relied upon to provide certainty in an insolvency or restructuring process, but if it were able to deliver both the certainty that is needed in insolvency and restructuring and develop a good record of ensuring that the process is Shari’ah-compliance, the UAE could attract more global Islamic financial business.

July 8, 2012 (PDF)

I’m back this week after deciding to take a week off from the newsletter for the July 4th holiday.  The sukuk market has been growing rapidly for several years, after falling sharply in the financial crisis and subsequent Dubai debt crisis.

Sukuk issuance growing both as a result of refinancing activity and new issuance to replace bank debt as European banks reduce lending in the GCC and pull back to their home markets. There remain concerns about whether sukuk are in short supply, and whether there is adequate secondary market liquidity.

In the process of researching this article, I ran across a presentation from 2005 where the head of IIFM, Ijlal Alvi (PDF) lays out a broad prediction for sukuk markets (with a few recent relevant news items added):

-          Increasing demand from issuers to tap sukuk markets (South Africa is planning to issue sovereign sukuk)

-          IFIs want tradable sukuk with fixed income profile

-          Development of sukuk funds followed by growing demand for sukuk, causing issuance to “surge exponentially” (Indonesian sukuk fund managers want to expand fund size, but fear demand for sukuk will outstrip supply.  This is also true in Malaysia).

-          Sukuk will be used for liquidity management and as a money market instrument.  (IIFM held a meeting on collateralized murabaha with sukuk as collateral, which is rapidly becoming the standard alternative for unsecured commodity murabaha in inter-bank lending markets)

The items for the sukuk market to develop laid out by Mr. Alvi 7 years ago seem to be falling into line quite well, after being interrupted by the financial crisis.  There is however, a key item missing in the sukuk markets across the items above: tradability is possible, but it remains limited.

Liqudity in sukuk markets affects all the areas laid out above.  If issuers do not sell into a liquid market, they will have to pay a premium to conventional bonds.  IFIs will tend to buy-and-hold if there is not a transparent source of replacement sukuk if they do sell.  Sukuk funds will also “buy-and-hold” if they cannot get allocations in new issues.  And how narrow will the pool of acceptable collateral be if only a limited number of sukuk are both highly rated and actively traded?