islamic securitisation

7/28/2019 Islamic Securitisation

1/18

and capital

st@ imf.org

I slam ic S ecu r i tizat ionAfter th e S u b p r im e C r is isA N D R E A S A. JOB S T

S ince last summer, securitization hascome into sharp focus on account ofits role in propagating the economicfallout honi the U.S . subprime crisis,causing a major reassessment of risk and theprice it should command across all assetclasses. In principle, securitization is a capitalmarket-based source of refinancing profitableeconomic activity in lieu of intermediateddebt finance. It provides an alternative sourceof finance that serves to mitigate disparitiesin the availability and cost of credit in pri-mary lending markets by linking singularcredit facilities to the aggregate pricing andvaluation discipline of capital markets. Thus,the emergence of securitization helps remedydeficiencies in financial markets arising fromincomplete capital allocation.The collapse ofthe securitization m arketand the ensuing market turbulence, however,have cast serious doubt on this economicproposition of unbundling, transforming, andredistributing credit risk via structured financeinstruments. In view of sweeping fiscal inter-vention in the financial sector, a widespreadretrenchment of mortgage exposures, and sub-stantial liquidity injections by central banksto support inter-bank money markets, boththe scale and persistence ofthe current creditcrisis seem to suggest that pervasive securi-tizationtogether with improvident creditorigination, inadequate valuation methods,and insufficient regulatory oversightcan

perpetuate market disruptions, with poten-tially adverse consequences for financial sta-bility and economic growth.

This charge begs the question of howsecuritization could have contributed toexcessive complacency in financial markets.In response to cost pressures and regulatoryreforms over the years, rising sophisticationin credit risk management has facilitatedcontinuous innovation in structured financeproducts and derivative instruments. Anincreasing number of financial institutionshave adopted an "originate-and-distribute"business strategy of loan origination byusingsecuritization to transfer credit risk fromtheir balance sheets to other banks, insurancecompanies, hedge funds, and other financialinstitutions.'

Issuers of securi t ized debt gener-ally benefit from more cost-efficient termsof high -cred i t -qua l i ty f inance witho utincreasing their capital base or compromisingthe profit-generating capacity of assets. Froma financial stability perspective, the transfor-mation and fragmentation of credit risk (intolong -term secured claims (see Exhibit 1)) viasecuritization was supposed to bring greaterdiversification, diffuse risk concentrations,and enhance the efficient pricing of illiquidexposures- Since credit risk is customized tothe preferences and tolerances of agents,, thetradability of securitized debt should improve

W IN TER 2009 T H E J O U K N A L OF STUUCTUREH FINANCE 41


2/18

E X H I B I T 1Modes of Secured and Unsecured Capital Market Funding

Short-term fundinginstruments Long-term fundinginstrumentsSecured funding

Unsecured funding

Repo, sale-buyback,securities lending, asset-backedcomm ercial paper (ABCP)conduits and SIVs, tenders-standing facilitiesShort-term deposits,comm ercial paper

Asset-backed securitization(ABS)^ sukuk (after Fe bruary2008)

Long-term (wholesale) deposits,asset-backed bonds (ABBs),covered bonds, sukuk (beforeFebruary 2008)the capacity ofthe financial system to bear risk andintermediate capital. Sadly, it did not. Instead, secu-ritization weakened minimum standards of prudentlending, risk management, and investment at a timewhen low returns on conventional debt products, defaultrates below the historical experience, and the availabilityof cheap hedging tools encouraged more risk-taking foryield despite early signs of heightened systemic vulner-abilities in the financial sector.

After having nearly ground to a halt last year, secu-ritization is now staging a modest comeback after therenewed turbulence in capital markets worldwide, butcurrent efforts fill short of hilly restoring investor confi-dence. An elevated premium for uiicoUateralized lending,as manifested in the rise ofthe LIBOR-Overnight IndexSwap (OIS) spread, indicates that liquidity pressures aswell as concerns about counterparty risk persist. Marketruptures caused by the headlong tlight to safety duringthe initial phase ofthe credit crisis seem not to have beencontained, and the market for securitized mortgagesremains tense and pricing depressed as banks dispose ofnon-core assets and raise capital to de-lever and bolstertheir imploding balance sheets.

That said, Islamic banking and finance remainedon the sidelines, and, so ir, have been affected by theglobal financial crisis only recently in response to infla-tionary pressures in the Gulf countries, uncertainty aboutcommodity prices, and widespread economic downturn.As policy-makers and regulators hasten to redesign thefinancial sector architecture afflicted by the demise ofstructured finance, the soul-searching in conventionalfinance has directed attention to alternative modes ofsecuritization, such as Islamic investment certificates or

i.. whose market has grown into a notable segmeof global structured finance over the last three years.This article surveys the unique structural featureofthe sukuk market (see Exhibit 1) and assesses thpotential of conflicts of interest that became apparenin the U.S. subprime mortgage crisis to contaminatthe integrity ofthe securitization process it it were conducted in compliance with shari'ah principles.INCENTIVE PROBLEMS OE CONVENTIONALSECURITIZATION

The main cause of the crisis can be traced tmarket failure stemming from conflicts of interests ithe securitization process and ill-designed mechanismto mitigate the impact of asymmetric information (seExhibits 1 and 2). In securitization, an arranger undewrites the issuance of asset-backed securities (ABSs) different maturities, notional values, and credit qualito an asset manager, who serves as an agent for capitmarket investors. These investors are repaid at a fixed ofloating rate from a trustee account funded by the casflows or premium income generated from the referencportfolio of securitized assets (or future revenues). Thoriginator services the portfolio, makes the collectionand passes them on, less servicing fee, to the SPV. Botinvestment return (principal and interest repaymenand losses are allocated among the various trancheaccording to their seniority. By substituting intermdiated lending with capital market finance, securitization, however, creates considerable agency costs (whicare ultimately borne by investors) if agents are tempte

4 2 ISLAMIC SEI.:URITIZATH.>N AFitk THL SUBI'RMF, CRISIS WINTER 20


3/18

E X H I B I T 2Basic Structure of a Conventional Securitization Transaction

Asset Originator/SponsoringEntity

Transfer of assets {truesale) or credit risk (synthetic)from the originator/sponsorto the issuer

SPV issues debt securities(asset-backed) to investors

IssuingAgent/Conduit(e.g., SpecialPurpose Vehicle (SPV))

ReferencePortfolio("collateral")

HedgeAgreementlegal fornn of transfer:legal/equitableassignment {synthetic)or contingent "perfectedsecurity interest" {true sale)assets immune frombankruptcy of originator(non-recourse financing)originator retains no legalinterest in assets, thoughsome economic benefitmay be retained

Hedge Agreementtypically structured intovariousclasses/tranches,rated by one or more ratingagencies, underwritten bythe sponsoring entity.with;- fixed/floating rate coupons- sequentiai/pro-rated payout- bullet, sinking fund orpass-through payment

CapitalMarketInvestors

IssuedAsset-backedSecurities (ABS)

SeniorTranche(s)

MezzanineTranche(s)Equity Tranche

to pursue their own economic incentives. The mostpiomiiient incentive problems involve frictions amongthe borrowers, originators, issuers, arrangers, and inves-tors as well as additional agents, such as servicers, creditrating agencies, and third-party guarantors, whose func-tions are the direct result ofthe fragmentation of riskownership in securitization (and the nicentive problemsit creates).

First and foremost, valuation uncertainty aboutthe quality of securitized assets could lead to moralhazard by originators if they have limited liabilityon downside risk. Since securitization is predicatedon the transfer of credit risk from the originator to abankruptcy-remote issuing agent, such a special pur-pose vehicle (SPV) or conduit, either via a transferof title ("true sale securitization") or the purchase ofcredit protection ("synthetic securitization"), origi-nators have an incentive to limit their (unobservablebut costly) effort of screening borrowers once they areprotected from any adverse performance ofthe "refer-ence portfolio" of securitized assets. This friction isexacerbated by potential collusion between originatorsand borrowers, which may result in the misrepresenta-tion of creditor quality (see Exhibit 3).

The information advantage ofthe originator withregard to the quality of borrowers and the historical per-formance ot individual asset exposures could also giverise to adverse selection. The complex security designot securitized debt suggests superior intbrmation ofarrangers about the true valuation of securitized debt.Since arrangers underwrite the sale of asset-backed secu-rities (ABS), they might choose a particular compositionof the reference portfolio and the design of the trans-action structure to optimize their own payotTs (ratherthan the ones ot ultimate investors). Therefore, rationalissuers (and investors) would form negative beliefs aboutthe actual quality of reference assets consistent withthe lemons-market problem, la Akerlof 11970]. Onthe assumption of all (or most) assets (and transactions)to be of poor quality, they would request a reservationutility in the form of a lower selling price and/or higherreturn ("underpricing") as compensation for the antici-pated investment risk of receiving a disproportionatelylarge exposure to poorly performing assets (comparedto any residual claims retained by the originator). Anyselective bias ("cherry picking") associated with thetransfer of securitized assets also affects the relationshipot arrangers with warehouse lenders and credit rating

WINTER 2()W TH!\JOUkNAL F[NANt;E 43


4/18

E X H I B I T 3Incentive Problems of a Conventional Securitization

AssetOriginator/Sponsor

Special PurposeVehicle (SPV)fee-based credit securities

andliquidity support

retention of equity interest

agencies. Warehouse lenders provide interim ftinding forthe acquisition of assets during the "ramp-up phase" untilthe transaction can be inalized.Since required haircuts onsecuritized assets imply over-collateralization, forcing thearranger to assume a funded equity position, any changein views about credit quality increases the cost of thesecuritization transaction. Credit rating agencies face asimilar lemons problem due to limited due diligence onarrangers and originators.

In addition, the servicing of securitized assets isafflicted by possible conflicts of nterest between origina-tors (or third-party agents) on one hand, and borrowers,asset managers, and investors on the other. Unless loanservicing remains with the originator, the issuer appointsa servicer that collects payments from borrowers, makesadvances of unpaid interest, accounts for principalandinterest, holds escrow or impounds funds related to thepayment of property taxes and hazard insurance, noti-fies delinquent borrowers, and supervises foreclosures aswell as property dispositions (Ashcraft and Schuermann[2008]). Servicers commonly receive a periodic fee ascompensation for their monitoring effort, which directlyaffects the realized level of losses and the distributionof cash flows to the arranger (and ultimately to inves-tors). Almost all reimbursable expenses associated withthe administration of deteriorating asset quality, suchas the foreclosure cost of mortgages, are back-loaded,while advances of unpaid interest (and possibly principal)

occur early on. Since their fee-based income increasover time, servicers have the natural incentive to inflaexpenses to offset fixed up-front costs and keep securtized assets on their books as long as possible to assess lfees. For instance, in mortgage securitization, a servicwould prefer to modify the terms of a delinquent loand/or delay liquidation (rather than foreclose), whistands in conflict with the best interest of both assmanagers and investors to foreclose promptly once a lois deemed uncollectible so as to prevent lost interest alapses in maintenance from inflating losses.

However, the mode of payment collection ancreditor forbearance impede a coherent debt resolutiostrategy between agents. Any measure to limit debt moification (and other possible restrictions on the collectioof delinquent debt) hampers the ability of servicersresolve their own moral hazard problem with borrowerwhose willingness to pay (and preserve collateral valudeclines as their option to walk away becomes movaluable than their equity claim on the underlying colateral. This conflict of interest is compounded by tfact that mortgage loans in the United States do ninvolve asset recourse, so that borrowers do not havedeclare personal bankruptcy upon default, amplifyimoral hazard concerns surrounding the administratioof reference assets of deteriorating quality. In additiotrustees of ABS structures have the natural tendento limit any efforts aimed at reducing moral hazard

44 ISLAMIC SECUH IT IZATION AFTPH. THt SuBi'kiME Cmsis 20


5/18

the asset originator and arranger. Although they gener-ally undertake contract enforcement and hold the hen-etit of covenants and collateral for the end-user {andother creditors), the responsibilities of servicers do notinvolve monitoring activities or the obligation to actunless instructed by a majority of end-users. Thus, thepotential of "willful blindness" on part ofthe trusteeimposes a further constraint on the integrity ofthe secu-ritization process.

Finally, uncertainty about the true quality of secu-ricized assets creates a principal-agent problem betw eenasset managers and investors. Since investors cannotobserve the effort of asset man agers in screening potentia linvestments and selecting the best trades, over-relianceon credit ratings for complex transactions, such as coi-lateralizfd debt obligations (CDOs), and insufficient duediligence might encourage managers to engage in assetsubstitution. In "active" CDO structures, a manager isentrusted with the task of monitoring and, if necessary,trading credits within a dynam ic reference portfolioot one or more credit-sensitive asset classes (and pos-sibly different issuers and/or industry sectors) in orderto protect the collateral value from impairment due toa deterioration in credit qu ality. Managers wou ld adjustinvestment exposures over time to satisfy covenants onthe weighted average rating of the portfolio and posi-tion limits on low -grade securities and/o r m eet a certaindegree ot diversification in response to changes in risksensitivity, market sentiment, and /or tim ing preferences."Lightly managed" reference portfolios allow for somesubstitution in the context of a defensive managementstrategy, while "fully managed" portfolios suggesta more active role of managers, subject to limits andiivestment guideHnes that are determined by the issuers,rating agencies, and different levels of risk tolerance ofinvestors at inception. However, investors in managedCD Os do not know what specific assets the C D O m an-agers will invest in, and understand that those assets willchange over time as managers alter the composition ofthe reference portfolio. Thus, investors face both creditrisk and the risk of poor management. While creditrating agencies help resolve the apparent informationgap between investors and asset managers by enha ncingtransparency due to greater disclosure about the qualityofthe reference portfolio (and the investment mandate ofthe asset manag er), the efficacy (and objectivity) of ratingscould be hampered by the dependence of rating agencieson fees paid by the arranger ("issuer-pays model").

THE U.S. SURPRIME CRISIS: ASSETSUBSTITUTION AND MORAL HAZARD

The U.S. subprime mortgage crisis exposed theseverity of fundam ental incentive problem s in co n-ventional securitization and the lack of ex ante marketdiscipline. The attendant market fallout demonstratedthat remain ing conflicts of interest betwe en stake-holders entail significant agency costs, whichif leftunchecked escalate the adverse effects of deteriora tingcredit conditions, valuation difficulties, and higherleverage on financial stability. In particular, securiti-zation facilitated excessive risk-taking to a point wherethe inability of issuers to gauge actual credit risk andthe flexibility of asset managers to subvert investmentmandates intensified the potential of systemic vulner-abilities to credit shocks. Before the subprime mort-gage crisis erupte d, low interest rates fostered m ortgagelending and the expansion of housing supply in thehope of persistent real estate appreciation. Mortgagebrokers and banks addressed higher money demand byseeking funds from "conduit lenders," which woulduse securitization to refinance themselves. The avail-ability of cheap structured credit, however, resultedin a general deterioration of lending standards, as theoff-balance-sheet treatm ent of securitized debt allowedoriginators to increase money supply by acceptingmarginal borrowers, displacing concerns about risingcredit risk.At the saine time, excess market liquidity low-ered risk aversion w hile th e com plexity of securitizationstructures obscured actual loss exposures, perpetuatedbenign asset valuations, and incubated fallacious investorcomplacency. Once securitization came into its own, itaccommodated a large public stock of leveraged invest-ments, which carried the vestiges of times when highglobal cash surplus and a limited supply of financial andreal sector investments diminished asset returns and low-ered risk premia induced more risk-takingdespite first(but overlooked) signs of deteriorating underwritingstandards and rising default risk. Pervasive credit risktransfer spurred by a flurry of derivative structuresamplified risk appetite and delayed a timely rebound ofrisk premia.' As markets remained stable, greater reli-ance was placed on the resilience o fthe financial system,inducing even greater aggregate moral hazard. In addi-tion, liquidity-induced demand from managers for scarcereference assets further tightened spreads of investible

WI NTER 2i)()y THEJOURNAL OF STRUCTURED FNANCE 4 5


6/18

securities and precluded the knee-jerk adjustment ofdebt prices to reflect economic conditions adequately,In an environment ot low risk aversion, the fer-vent search for yield became the undoing of a highlyleveraged market as deteriorating credit conditionsinduced moral hazard by asset managers. When thecredit cycle eventually began to turn, doubts surfacedabout the quality, security design, and pricing of high-yield structured finance instruments. In response to ageneral repricing of securitized exposures over fears thatruptures in subprimc mortgages would prove ruinous toother credit-sensitive assets, dwindling investor demandincreased risk premia and curtailed the capacity of assetmanagers to meet liability pressures. Synthetic securiti-zation transactions structured to create partially fundedand highly leveraged investment on the performanceof a dynamic portfolio of designated credit exposures(without actually purchasing the reference assets) weremost afFected. In such arrangem ents, m anagers trade ref-erence assets to realize econom ic gains from the pricin gmismatch between investment returns from referenceassets (or credit protection premia on exposures) andlower the financing cost of generally higher-rated liabili-ties in the form of issued securities. Faced with the pros-pect of higher funding costs (and less compensation),^asset man agers, how ever, opted for riskier positions andgreater leverage.

Finally, short-term funding pressures and growinginvestor distrust conspn-ed to magnify asset price defla-tion caused by mark-to-m arket (MTM ) valuation underfair value accounting standards (FAS). Without realbuyers available, issuers also created structured invest-ment vehicles (SlVs) that borrowed short-term moneyby issuing asset-backed commercial paper (ABCP) tofund the purchase of long-da ted, credit-linked securities(at largely overstated transaction prices), thus creatingan ill-fated maturity mismatch. As the ABCP marketdried up, the fire sale of structured finance products atdistress prices forced SIVs and investors alike to m ark- to -market their positions (and holdings ot similar illiquidsecurities), causing huge valuation losses to be booked.The subsequent decrease of asset values and its etfecton market liquidity finally led to tightened lendingstandards, elevated asset price volatility, and fundingconstraints, causing profound systemic distress.Agents in the securitization process can attenuatevarious cuntlicts of interest arising from asymmetricinform ation (and limit the agency costs associated with

the lemons premium) by soliciting greater transparencabout the true value of securitized assets through signaling and screening mechanisms. Given the significant agency cost from advers

selection and moral hazard, issuers commit adtional internal and external resources to a securitization transaction, such as reserve tunds anvariable proceeds from excess spread, and retaisome securitized exposure, such as a "first loss postion" (FLP) (see Exhibit 3) which, in substanceprovides some degree of added protection to otheparties to the transaction and serves as costly signalof asset quality. In order to signal credit qualitit is still not uncommon for issuers to retain thmost junior claim in a securitization structure aslow-cost risk sharing and support mechanism. Iaddition, a subordinated security design encourageincentive-compatible behavior across investors adifferent points ofthe capital structure. Tranchinhas value if markets are incomplete or segmenteddue either to investment restrictions dictated binvestor traditions or mandates and governmenregulations that render certain assets unattainableor by the limited supply of certain categories ot debinstruments that have risk-return profiles that coulbe replicated or enhanced by securitization.

Arr ange rs, who oversee the transfer of assets tthe trust and underwrite securitization transactions (after consultation with one or more ratinagencies), conduct (continuous) due diligence oorii^inators, including the review of financial stments, underwriting guidelines, and backgrounchecks, while originators make a num ber of representations and warranties about the borrower anthe underwriting process. This requires adequatcapitalization of originators to reduce c ounterp artrisk in the event of legal recourse. Downpaymentand the modification of loan contracts, in turnlimit the originators' exposure to moral hazararising from borrower leverage." Arrangers reduce unce rtainty about the perfomance of servicers. by balancing the intensitymonitoring efforts (and costly state verificationwith the minimization of servicing expensethrough forbearance. In addition to limits on loamodifications, servicer quality ratings, and thinstallation of master servicers, which monitor th

46 S E C U R I T I / . A T O N A F T E R THE SuiiPRIME CRISIS WlNTI?.R 211


7/18

compliance with pooling and servicing agreementsand enforce remedies of servicer default, help miti-gate management risks. Arrangers themselves are subject tomarket disci-pline in the form of reputational risk, the provision

of credit support, and due diligence by the assetmanager aimed at restoring incentive compatibilitywith investors. . . | Investors overcom e the principal-ag ent problemvis--vis asset managers by imposing investnientmandates andexpost evaluation of asset per-formance relative to benchmarks, which aligninvestment strategies with their own risk-returnexpectations. Since investors do not observe themanager's effort, choice, and trading behavior,restrictions on the composition o fth e reference

portfolio are based on average rating classificationan d/o r type of eligible assets. In add ition, credit rating agencies assess the cred it riskand the suitability of a given securitization trans-action based on expectations about the short runand through-the-cycle performance ofthe refer-ence portfolio, which defines a certain risk-returnprofile. Since the business model of credit ratingagencies depends as much on structuring fees as itdoes on repu tation, any encroachment by arrangerson the objectivity ofthe rating process seems onlya remote possibility. Moreover, rating and down-grade criteria are publicly disclosed and used bysophisticated investors to re-engineer rating assess-ments, thus disciplining rating agencies.

THE RISE OF ISLAMIC FINANC ENow that the credit crisis has eroded market con-fidence and sapped risk appetite in conventional finance,investorsunsettled by excessive risk-taking and assetprice volatilityhave been tlocking to Islamic finance.The Islamic finance industry has grown precipitouslyin recent years. There are currently more than U.S.SHOO billion worth of deposits and investments lodgedin Islamic banks, mutual funds, insurance schemes(known as takajul), and Islamic branches of conven-tional banks. The current growtli has been fueled notonly by surging demand for shari'ah-compliant productsfrom financiers in the Middle East and other Muslimcountries, but also by investors around the world seeking

20fl9

Islamic investment as a means of diversification, thusrendering the expansion of Islamic finance a global ph e-nomenon {Hesse et al. |2008a, b, and c]).Th e cu rrent financial crisis invites a distinction ofconventional and Islamic finance principles in the con-

text of securitization and a comparison of their capacityto sustain etficient capital allocation and financial sta-bility. Islamic finance is driven by the general precept ofextending religious doctrine in the shari'ah to financialagreements and transactions. Shari'ah law bans the saleand purchase of debt contracts, profit-taking withoutreal economic purpose, and activities that are not con-sidered htihjl (i.e., shari'ah-compliant). The central tenetot this iorm ot tlnance is the prohibition of n7),i, whoseliteral mea ning, "an excess," is interpreted as any unjus-titiable increase of capital in the form of interest (i.e.,usury) whether through loans or sales.'' Islamic financeis distinct from conventional finance in so far as it sub-stitutes a temporary use of assets by the borrower tora permanent transfer of funds as asource of indebted-ness. Whereas money has become a store ofvalue inconventional finance, the a.sset-based organization ofIslamic finance implies that money is not considered acommodity but ameasure of value through which therecan be an exchange and payment of goods and services.^However, adequate compensation for the sale or tempo-rary use of an asset is encouraged.'

Besides the prohibition of interest-based tbrmsof income and unethical (or socially detrimental andsinful) activities {harani), Islamic finance is beholden bythe objective of maintaining a mutually beneficial bal-ance between borrowers and lenders with a view toserving the public interest {maslaha). Since Islamic lawdoes not recognize the concept of time value of moneyas in conventional finance, contractual relationshipsbetween financiers and borrowers are not governedby capital-based investment gains but shared businessrisk (and returns) from entrepreneurial investment inlawful activities. The financier receives returns tromthe direct participation in asset performance in the formof state-contingent payments according to an agreedschedule and amount. Since the religious overlay inIslamic finance denies creditors (debtors) the benefitof unilateral gain, shari'ah-compliant finance contractslimit asset price appreciation to the contractually agreedrepayment amount.A notable feature in modern Islamic finance isthat transactions are normally structured as composites

THF, JOURNAL OF STrtutrrunEi) FINANCE 47


8/18

of contingent claims, possibly using a set of underlyingcontract types that have a longstanding tradition undershari'ah and are commonly accepted in the legal tradi-tion (El-Gam al [2006]). The three basic forms of Islamicfinance are: 1) debt-based contracts, e.g., synthetic loans/purchase orders (murabahnh) and sale-buybacks {bay al-inah); 2) asset-based contracts, e.g., leases {[jara) andsale-leasebacks {ijara thumma al-hay); and 3) equity-basedcontracts, e.g., profit-sharing/partnership {mushamkali)and "sweat capitaF'/seed funding arrangements or trusts{mudarahah) .'^

THE CASE OF ISLAMIC SECURITIZATIONDefinition of Islamic Securitizationan d SukiikAlthough the rapid expansion of Islamic financeis taking place across the whole spectrum of financialactivities, perhaps the most striking element has beenthe fast growth ofsukuh, the most popular tbrm of secu-ritized credit finance within Islamic finance. Siikiikencompass a broad range of shari'ah-compliant financialinstruments, and can be best described as participationcertificates that grant investors return based on profit-able investment resulting from actual asset ownership.Since asset backing, entrepreneurial investment, andspecific credit participation in identified business riskare fundamental to any Islamic transaction, securitiza-tion represents a straightforward capital market-basedtbrm of Islamic finance.Suknh conimoditize the proceeds from asset trans-fers between providers and users of funds raised from dif-ferent shari'ah-compliant finance contracts (see above),such as lending transactions (installment sale) or trust-based investmeTits in existing or future assets. Whilesiikiik are structured in a similar way to conventionalasset-backed securities (ABS) or covered bonds, they canhave significantly different underlying structures and

provisions (see Exhibit 4). Most importantly, sukuklike Islamic financial instruments in general-need tocomply with shari'ah, which prohibits the receipt andpayment of interest and stipulates that income must bederived from an underlying real business risk rather thanas a guaranteed return from interest. Thus, sukuk trans-form the (intended) capital gains generated from actualtransactions, such as profit-sharin g, leasing, or cost-plus

sales, into marketable securities without explicit invement protection or principal guarantees.''In their basic concept, sukiik represent the "capimarket co rollary" to a singular lender in Islamic financOriginators sell existing or future revenues from leareceivables (asset-based), "sale-back p rofit" (debt-basedor protlt participation from private equity arrangemenby transferring legal ownership of a portfolio of Islamicaacceptable assets to a special purpose vehicle (SPV),'"refinances itself by issuing securities to market investoInvestors own the underlying asset(s) via an SPV thfunds direct investment in real, religiously sanctioneconomic activity (see Exhibit 4). As such, they assumthe role of a "collective fina ncier" whose entrepreneurinvestment does not involve guaranteed, interest-basearnings. A conventional pass-throuj^h payment struseems to be closest to the strict interpretation of Islamprinciples, which requires the transfer of a minimu m levof ownership to ensure direct investor participation the business risk associated with the performance ofdedicated collateral pool of securitized assets.Adapting Islamic securitization requires compance v^ith the following conditions (Jobst [2007]):

i. There should be a real purpose behind raisfunds via securitization (that encourages a bofide trade rather than a profitable exchange the same (or similar) items, which ensures commercial value to investor(s), wealth creatioand diversity of trade from underlying asstransfer. Any unilateral deferment of an obligtion (payment or delivery) that generates profitacceptable only if the financial contract involvdissimilar assets (as indicated by tick marks Exhibit 5). Otherwise, a transaction must occat spot without protit-taking.ii. The type of reference assets realizing the secutized revenues are clearly identified (or are capabof identification) and cannot be consumed (or perishable). Ownership and possession (qahd) rwith creditors (or their agents) throughout tlife ofthe transaction in order to ensure definperformance.iii. Each transaction participan t shares in both the riand return, and investors should receive positipay-off from profitable ventures only (and nfrom non-productive investment).

4 8 ISLAMIC SECURTIZATION AFTLR THE SUB-RIME CRISES WINTER 2(.


9/18

E X H I B I T 4Basic Siikuk Structure (with the Purchase of Debtor or Third-Party Assets)

^ ^ ^ ^ ^Single Asset/CommodityORReferencePortfolio("collateral")ASSETExpectedLosses

"V*

A5set Originator/SponsorSingle Asset/Commodity

ORReferencePortfolio("collateral")

ASSET

cost-p lus sale {murabaha) ORlease (ijara) [+ purchase{ihumma al-bay)]

defer red purchase pr ice ORlease payments [+purchase price(thiimma al-bay)]

Underwr i ter

issues debt securities

Issuing Agent /Conduit(e.g., SpecialPurpose Vehicle (SPV))

c sale-repurchase (bay al-inah) 0R > , , ,,r transfer of collectionst}J lease-back (ijara) .c defer red purchase pr ice ORi> lease payments Trustee

\

disbursement ofrevenue to investors

asset transferXasset purchase price

offers credit and iiquidity support.hedging agreementas voluntary guaranteeOR commercial value to investor

>

Credi t Enhancer(Third-Party CreditSupport)

distribution ofsukuk certificates

sale ofsukuk cedificates

Possible risk-retum shanngamong investors in keepingwith subordination structure of conventionalI securitization

E X H I B I T 5Permissible Trading Assets Under Islamic Law"

GoldSilverWheatBarleyDatesSalt

Gold =00IZI0

Silver

=0ElIZI0

Wheat[710

0 =0

Barley

ZI

=

Dates0El0

=

Salt000

=

WiNTEH. 2009 T H E JOURNAL OFSTRUI^TURED FINANCE 49


10/18

iv. Reference assets must not be debt, cash, or pro-hibited as haram (sinful activity), be employed forspeculative purposes, or associated in any waywith unethical or exploitative operations or withspeculation and avoidable uncertainty {gliarar) inthe form of zero-sum payoffs at inception.V. The structure should provide investor (uncondi-tional) compensation for business risk from directparticipation in the performance of securitized assets(based on actual ownership) and should not implyan exchange of debt for (guaranteed) interest-gen-erating investment return (unless those securitizedassets are interest-free and sold at net or fair marketvalue unless repurchase price is pre-ag reed).vi. The contribution from investors in the form of pro-ceeds from issued notes (and any returns generated

by the issuing agent from managing collateral assets)cannot be reinvested in short-ter m cash instrumentsor interest-bearing debt'- (and turnover in managedportfolios should be kept low).vii. Since convenrional insurance violates shari'ah provi-sions, takafui (Islamic insurance, based on coopera-tion and mutual help) should be employed instead.viii. Any form of credit enhancement and/or liquiditysupport (and limitations of prepayment risk) mustbe in a permissible form, and guarantees can beemployed only to cover cases of negligence, mis-

conduct, or breach of contract (representations andwarranties).

Current Market SituationSukuk issuance has soared over the last three yearsin response to growing demand for alternative invest-ments (Jobst et al. [2008]). At the end of 2007, the out-standing volume o sukuk globally exceeded U.S. $9itbillion (Moody's [2007 and 2()08|). Gross issuance has

quadrupled over the past tw o years, rising from U.S . $7.2billion in 2004 to close to U.S. $39 billion by the endof 2007, owing in large part to enabling capital marketregulations, a favorable macroeconomic environment,large infrastructure development plans in some MiddleEastern economies, and financial innovation aimed atestablishing shari'ah compliance (IOSCO [2008]).The sukuk market has not escaped unscathed fromthe credit crisis that erupted last year, with investmentbanks and finance houses worldwide still reeling from

the collapse of the U.S. subp rime mortgag e markand the breakdown ofthe wholesale money markeAlthough the issuance o sukuk in the first half of 20has diminished and still remains somewhat below t2007 record, volumes have held up, while the numbof deals brought to market has steadily increased, chping away at a significant backlog of shelved sukuk issin 2007.The sukuk volume dropped to U .S. $15.2 blion (down by about 35% on an annualized basis) 2008 so far, while the issuance of conventional strutured finance instruments collapsed to just under U$387 billion (down by about 80%) over the same tim(see Exhibit 6). On the assumption of a stable rategrowth, the volume o sukuk issued by governments acorporations will surpass the U.S. $150 billion mark 2010, spurred by demand especially from banks, insance com panies, and pension funds in both Islamic anon-Islamic countries.

Sukuk: The Good Side of Securitization?Recent excesses in conventional financial mkets have shed light on Islamic finance as an alternatframework for securitization. Preda tory lending, deteorating u nde rwritin g standards, and a series of incentiproblems between originators, arrangers, and sponsoall of which have infested the conventional securitizati

process, belie fundamental Islamic principle s.Any financial transaction unde r shari'ah law impldirect participation in underlying asset performance aassigns to financiers clearly identifiable rights and obgations for which they are entitled to receive commesurate return in the form of state-contingent paymesubject to contractual certainty and the supremacypublic interest in social justice. Profits are earned in lwith shari'ah prescriptions and cannot be guaranteex ante but accrue only if the investment itself yieincom e. Thu s, investment is not guaranteed b ut secuon the basis of profitable ventures based on real assewhich mitigates adverse selection and moral hazardboth lenders and borrowers.

Sukuk might be a viable source of funds that cohelp stabilize the securitization market, as they alreacontain many contractual features that are now beconsidered instrumental to a resolution of inherconflicts of interest betwee n agents in the conventiosecuritization model. Wh ile sukuk are structured simto ABS, risk-sharing and the full participation of bo

50 ; SECUaiTIZATION AFTF.H TH E SUlll'KiMh CRISIS WlNTKR 2


11/18

E X H I B I T 6Global Sukuk Issuance (2005-08, in USD billion)

30

2006 2007 2008 YTD

Source: IF!S, Btooiitberg, Dc.i/iijjic, Dtiiastrcdni.

issuers and investors in the underlying asset performance(and how it affects the capital structure ofthe transaction)offer an alternative mechanism to conventional securiti-zation in establishing incentive compatible behavior.

There are several Islamic principles ot'sukuk, whichcould potentially redress many conflicts of interest andvaluation problems that infested the conventional secu-ritization process (see Exhibit 2):

Between asset m atiaj^er and investor ("principal-agentdilemma"):- The religious prohibition of both gambling

(maisir) and speculation (j^harar) prevents exces-sive risk-taking (in the form of asset substitu-tion) and commands clear object characteristicsand/or delivery results as part of contractualcertainty.- The trading activity of asset managers isrestricted to hiniafide merchant transactions onmi/ debt while investor return must be derivedfrom defined asset value associated with effec-tive (or intended) ownership interest.- Since there is definite performance underpinnedby actual and direct transfer of an asset as an object

of unconditional sale in Islamic contracts, i.e., nomutual deferment of contractual obligations, anycontingency risk from unfunded claims is limitedto pre-defined timing mismatch of delivery orpayment in accepted contracts {saiam/istima vs.hay ai'ajal/bay bithaman ajil) (see Appendix) .Asset managers cannot create leverage on theunderlying asset portfolio, as unilateral gains(i.e., benefit from moral hazard in response toredistribution of risk/no consequence of badoutcomes) are limited to the nominal value ofthe reference portfolio in asset-based contractsor the scope of profit-sharing in equity-basedcontracts respectively.Trust-based contracts in Islamic law, such asmudaraba, limit the liability ofthe asset manager{mudarib) to cases of negligence, misconduct,or breach of contract (representations and war-ranties). That being said, partnership structureswith fixed contribution ratios {musharaka)andthe possibility of additional participation ofprofits depending on verified effort choiceorprincipal-agent contracts (icntii/.i)'^ with tlxedmanagement tees (including performance

WINT I R 2 (H ) 9 THE J OURNAL UF STRUCT URED FINANCE 5 1


12/18

remuneration), keep incentive problems tromcompromising pre-agreed investment strategieswhile maintaining positive-sum payoffs of bothagents and investors.

Between originator and issuer.- The shari'ah approval and certification process,as well as ongoing monitoring, promote ade-

quate disclosures underpinned by a solid foun-dation of religious standards.

Between issuer and investor:- Investor return derived from effective (or

intended) ownership of real asset(s) underlyingthe securitization structure (after actual anddirect transfer as object of an unconditional sale)generates indebtedness and amounts subject todirect recourse.

Between seruicer and investor/asset manager:- Contract certainty rules out potential of infiated,

back-loaded (and variable) servicer expenses(and cannot be prioritized due to prohibitionof provisions aimed at creating unilateral gainsfrom interim changes in asset characteristics andvaluation). Servicer fees are fixed and definedex ante.

Between borrower and originator:- The Islamic principle of social benefit as public

interest {maslaha) and the precept of supporting asystem of distributive justice would preclude anymoral hazard of originators {"predatory lending"or borrowers ("walking a\vay")). Moreover, theshari'ah prohibits debt modification and unilat-eral gains (which are considered exploitation).

Between arranger and guarantor:- Guarantees must not establish the possibility

of mutual deferment of contractual obligationswithout actual transfer of asset. Thus, only fundedagency contracts with pre-specified terms wouldbe deemed sufficient to rule out contingencyrisk of payment and actual delivery.

As one measure to revitalize the secondary mort-gage market, policy-makers in the United States (andother countries) have drawn up plans to encouragethe issuance of covered mortgage bonds, popular insome other countries, such as Germany, to redress themisaligned incentives of asset managers that under-mined ex ante market discipline and led to the even-

tual demise of the structured finance market. Coverebonds are unsecured (on-balance-sheet) debt obligtions collateralized by a dedicated reference portfolio assets that are fully retained by the issuer. The interepayments are guaranteed and do not depend on thperformance ofthe underlying cover assets. Similarlmost sukukare still unsecured, based on a pool of undelying assets (like covered bonds) with principal guaantee provided by the issuer via a repurchase agreeme(see Exhibit 5) while coupons ("periodic distributioamounts") are protected by a liquidity provision. Pathrough bonds collateralized by on-balance-sheet assetwhose asset proceeds are dedicated but conveyed througinterest-bearing debt, would not qualify as suitable secrities under Islamic law.

After recommendations by the Accounting anAuditing Organization of Islamic Finance Institution(AAIFI) in February 2008, however, sukuk havbecome more akin to pass-through, off-balance-shestructures without institutional guarantee on asset peformance. But unlike ABS, snknk imply direct recourto a defined portfolio of underlying real assets, whfund secured repayment from profitable investment religiously sanctioned, real economic activity. If secritized assets are removed from the originator's balansheet, ownership conveyance through true sale ensur1) the exclusive dedication of cash flows from the undelying asset to establish the linkage of ownership intereto identifiable economic activity, and 2) secured bunconditional repayment from underlying assets. Townership of sukuk investors in real assets generatincommoditized indebtedness is tantamount to the instutional guarantee afforded to covered bonds.

Nonetheless, many pitfalls of financial innovatiothat contributed to the U.S. subprime crisis also appto Islamic finance by an even larger measure, such sound risk assessment, adequate rating processes, and tuse of integrated risk mitigants. For instance, inflateasset prices of difficult-to-value collateral could obfucate lower-than-expected asset performance, increaresidual equity, and help maintain artificial arbitraggains of asset managers. Also, high execution costheightened administration, and collection risks caamplify the potential for principal-agent problems the absence of long default histories, robust recoverate estimates due to untested collateral enforcemeprocedures, and sufficient asset diversity.

52 ISL.\.M1C SEtURlTlZATlON APTER THE SUBPRIME CRISIS W INT E R 20


13/18

Economic Challenges o IslamicSecuritizationDespite considerable, and growing, demand forshari'ah-compliant assets, the further development of

sukuk depends on essential economic, regulatory, andinfrastructural conditions.Amid weak reliance on capital market financingm many Islamic countries, issuers of sukuk are first andforemost faced with several criticai economic impedi-ments that pertain to their ability to 1) identify refer-ence assets that meet shari'ah requirements and offerattractive returns, and 2) substitute standard structuralfeatures in conventional securitization structures, suchas credit enhancement and liquidity support, which arenot permissible in an Islamic context. Given the lim-

ited sourcing and structuring of eligible asset portfo-lios, Islamic issuers have begun to originate their ownIslamically acceptable assets rather than buy asset poolsin the market.However, the sukuk market is still plagued by illi-quidity in the secondary market, with the combinationof high originator concentration and regional fragmenta-tion clouding the overall positive outlook. Although theconcept of asset backing is inherent to Islamic finance,structured credit transactions are few and far betweenwhere financial transactions have to follow the preceptsofthe shari'ah. The current level ot"sukuk issuance bycorporations and public-sector entities still remains afraction ofthe global fixed income markets. Since onlya handtul of large banks and managers are behind thebulk of transactions completed by a small number ofrepeat issuers, origination and servicer risk from narrowasset supply poses challenges to investor diversification.In addition, the lack of information from private sourcesabout se curitized assets in many sukuk and the prevalenceof "buy-and-hold" investments inhibit efficient pricediscovery and information dissemination.An even bigger diversification issue arises frompoor asset diversity, given the narrow range of deal typesand maturity tenors in the existing market. Sukuk areavailable at maturities of 3, 5, and 10 years, but not forshort-term maturities, which significantly limits theirapplication for money markets. Although Islamic banksare currently among the largest buyers of shari'ah-com-pliant products (at long maturities), they would benefitmost from issues at shorter tenors. There is some hopethat th e launch of different sukuk funds in the near future

W I N T E R 2009

might potentially unlock liquidity constraints, but thismight on ly create new dem and w ithout sufficiently alle-viating supply constraints. It is currently also difficult toset up iukuk funds with sufficient diversification.Legal Challenges of IslamicSecuritizationRegulatory Consolidationand Supervisory HarmonizationDespite the phenomenal growth of sukuk overthe last three years, future development of sukukcould be arrested by insufficient superviso ry and legalharmonization across national boundaries and theongoing controversy about the innovation in Islamicfinance.Gov ernance issues, especially the shari'ah com pli-

ance of products and activities, constitute a major chal-lenge for the Islamic tlnance industry. Although shari'ahrulings {fatwas) by legal scholars are disclosed, there arecurrently no unified principles (and no precedent) onwhich shari'ah scholars decide on the shari'ah com-pliance of new products. Fatwas are not consolidated,which inhibits the dissemination, adoption, and cross-fertilization of jurisp rude nce across different countriesand schools of thought. Moreover, there is still consider-able heterogeneity of scholastic opinion about shari'ahcompliance, which undermines the creation of a con-sistent regulatory framework and governance principles.Therefore, the fragmented opinions of shari'ah boards,which act as quasi-regulatory bodies, remain a sourceof continued divergence of legal opinion.

The absence of uniform and definitive guid-ance on shari'ah compliance atlects the legal integrityofthe restitution interest of investors in sukuk. Islamicinvestors are concerned not only with the complianceof both cover assets and the transaction structure withthe shari'ah, but also with legal entbrceability of assetclaims under contract law. In this context, the questionarises whether Islamic law governs sukuk by substanceor form. W hile th e conclusion of financial tra nsac-tions und er different legal regimes can lead to the sameoutcome (i.e., substance), the legal process (i.e., form),and possibly the associated rights and obligations oft hecontractual parties, might vary considerably. If shari'ahcompliance is treated (only) as a matter of substanceand upholds in spirit what was created in form, suchas perfected security interest defined by com merciallaw, the violation ofthe shari'ah would temper investor

THEJOURNAL OF STRUCTURED FINANCE 5 3


14/18

intt'ifst but not preclude legal enforceability of investorclaims. However, if the transaction were governedsolely by shari'ah law as a matter of form, the opiniotiof shari'ah courts could override commercial legal con-cepts and re-qualify the legal nature of a securitizationtransaction. For instance, insolvency officials inIslamic jurisdictions could invalidate the substantivenon-consolidation and "re-character ize" a true salesecuritization as an unsecured loan.

Recent efforts to achieve regulatory consolidationand standard setting have addressed legal contingenciesimposed by Islamic jurispruden ce and poorly developeduniformity of market practices. Leading regulatory orga-nizations in Islamic fniance, such as AAO IFI, the GeneralCouncil for Islamic Banking and Finance Institutions(GCIBFI) , the Islamic International Rating Agency(IIRA), the Islamic Financial Services Board (IFSB),and the Fiqh Acadciny in Jeddah, have been working onaligning shari'ah principles on a consistent basis.

However, current regulatory changes concerningthe structure osiihiih warrant careful consideration andmight mute some ofthe recent enthusiasm for Islamiccapital market products. These proposed rules attractedsignificant attention prior to their release, following astatement by the chairman ofthe shari'ah committeein November 2(107 indicating that 85% of sukuk issuesin the GCC do not concur with shari'ah principles.Shari'ah scholars raised objections to principal guar-antees via repurchase agreements, asset retentions byoriginators adept at minimizing withholding tax obliga-tions of issuing conduits, and the concurrent transfer ofcertain proportiotis of debt associated with underlyingassets, such as interest-bearing liens. Most sukuk havebeen sold with a borrower/creditor guarantee to repaythe full notional amount at maturity, or, in the eventof default or early redemption, mirror the structure andpayout of a conventional bond. Such a promise (andno t the option) to repay capital violates the principle ofrisk-and-profit-sharing under Islamic law. The debateabout the general applicability of these recommenda-tions with regard to the approval process of sukuk (andthe screening of both their structure and characteristics

of underlying assets) has raised concerns about the ecoomies of Islamic securitization and the shari'ah govenance of Islamic capital markets at large.Ou t lo o kAs Islamic finance comes into its own., and companies turn to capital market-based sources of fmancsukuk will become essential to the competitivenesscorporations and banks alike. Since conventiotial secritization is virtually absent in Islamic countries, cosiderable demand for shari'ah-compliant investmeassets, such as sukuk, provides an untapped market fstructured fmance as a means to advance capital markdevelopment. Islamic securitization also complementhe battered ABS market as an alternative and mo

diversified funding option that broadens the pricispectrum and asset supply.With more than U.S. $2 trillion of credit demaprojected to be unme t in the next three years as the coventional securitization market remains dysfunctionthe current market situation provides a windowopportunity for sukuk. Seemingly, the religious overof sukuk has helped temper unfettered financial innovtion and structural complexity, which have become tundoing of conventional securitization in the currefinancial crisis. Iti spite of having been hemmed in

the credit crisis, the widespread economic downturand the slump in the real estate sector ofthe CJCthe sukuk market is expected to soon gain momentuagain, largely due to past windfall from high commodiprices, especially oil revenues in the GCC.Nonetheless, for sukuk to fill some ofthe void lbehind by conventional structured finance, much wdepend on the resurgence of financial innovation geartowards exploring options for (and greater flexibilin) the interpretation of different modes of secondasources of Islamic faith supporting religious doctri

(analogous deduction (qiyas), independent analyticreasoning (ijiiliad), and scholarly consensus {ijuia) bon first principles).

5 4 ISLAMIC SECURITIZATION AFTER THE SuHPRiMb CRISIS WiNTLR 20


15/18

A P P E N D I XIslamic Finance ContractsBasic Terminology

TermAmana(Demand deposits)Bay mu'ajal or bay bithaman ajl l(BBA)(Pre-delivery, deferred payment)

Salam(Pre-payment, de ferred delivery)jara(Lease, lease purchase)

Istisna(Deferred payment an d delivery)

Ju'aia(Service charge)

Kifata

Mudaraba(Trust-based contract)

Murabaha(Mark-up financing)Musharaka(Equity participation or"sweat capital finance")Qard Hassana

ExplanationDeposits held at the bank for safekeeping purpose. They areguaranteed in capital value, and earn no return.The seller can sell a product on the basis of a deferredpayment, in installments or in a lump sum . The price of theproduct is agreed upon between the buyer and the seller at thetime of the sale, and cannot include any charges for deferringpayment. In a BBA contract, the lender is not compelled todisclose the profit margin.The buyer pays the seller the full negotiated price of a productthat the seller promises to deliver at a future date.A party leases a particular product for a specific sum and aspecific time period. In the case of a lease purchase, eachpayment includes a portion that goes toward the final purchaseand transfer of ownership of the product.A manufacturer (contractor) agrees to produce (build) anddeliver a certain good (or premise) at a given price on a givendate in the future. The price does not have to be paid inadvance (in contrast to bay salam). It may be paid ininstallments or part may be paid in advance with the balance tobe paid later on, based on the preferences of the parties.A party pays another a specified am ount of money as a fee forrendering a specific service in accordance with the terms of thecontract stipulated be tween the two parties. This mode usuallyapplies to transactions such as consultations and professionalservices, fund placemen ts, and trust services.It is a pledge given to a creditor that the debtor will pay the debt,fine, or liability. A third party becomes surety for the payment ofthe debt if unpaid by the person originally liable.Rabb -ul- mai (capital's owner) provides the entire capitalneeded to finance a project while the entrepreneur offers hislabor and expertise. Profits are shared between them at acertain fixed ratio, whereas financial losses are exclusivelyborne by rabb -ul- mal. The liability of the entrepreneur is limitedonly to his time and effort.The seller informs the buyer of his cost of acquiring or producinga specified product. The profit margin is then negotiatedbetween them. The total cost is usually paid in installments.The bank enters into an equity partnership agreement with oneor more partners to jointly finance an investment project. Profits(and losses) are shared strictly in relation to the respectivecapital contributions.These are zero-return loans that the Qur'an encouragesMuslims to make to the needy. Banks are allowed to chargeborrowers a service fee to cover the administrative expenses ofhandling the loan. The fee should not be related to the loanamoun t or maturity.

W I N T E R 2009 T H E J O U R N A L O F S T R U C T U R E D F I N A N C E 5 5


16/18

ENDNOTESThe views expressed in this article are those oftheauthor and should not be attributed to the IM F, its ExecutiveBoard, or its manageriient. Any errors and omissions are thesole responsibility of the author.'Asset securitization involves con verting a pool of des-ignated fmancial assets into tradable Hability and equity obli-gations as contingent claims backed by identifiable cash flowsfrom the credit and payment performance of these asset expo -sures. From an issuer perspective, securitization registers asan alternative, market-based source of refinancing protltableeconomic activity in lieu of intermediated debt finance.~In February 2008, the shar i'ah com mit tee o f th eAcco unting and Au diting Organ ization of Islamic FinancialInst i tut ions (AAOIFI) issued recommendations regardingthe role of asset ow nership, investment guaran tees, and the

shari 'ah advisory and approval process in sukuk originat ionand trading. These recommendations led to a critical re-assessment of outstanding sitkuk issues and lengthened theapproval process of new issues in 2008 .^More than two years before the mortgage crisis,market practitioners voiced considerable skepticism aboutthe plethora of new issues and deal structures, as well as theentry ofnew managers in the market for collateralized debtobligations (CDOs), which compounded concerns that creditquality had been ona mon otonously low trajectory w ith littlepromise of imminent recovery.^Iii efTicient: ma rkets, risk -neu tral m anagers d o n ot b en -

efit from dynamic asset .illocation (ignoring transaction costs)by substituting badly performing assets, because the ability toweed o ut certain reference assets comes at a prem ium . U nde rwo rsening cred it conditions, better asset performance is gen -erally harder to com e by, ma king managers no b etter off thanbefore once they d ivert funds to safer but highly coveted andmore costly territory (or accept higher hedging costs).^This definition refers to any positive and predeter-min ed re turn that is tied to the maturity and amount of prin-cipal, resulting in wealth creation regardless ofthe outcomeof asset performance (or the success ofthe business operationsofthe borrower).''Stripped of its religious elements, this concept par-allels the free-money theory of interest ("Freiwirtschaft"),which postulates an econom ic system where the m ost talentedpeople would have the highest income, without forgery byinterest and rent charge (Gesell [1958]).^Besides interest earnings, Islamic lawalso prohibits1) the direct or indirect association of contracts with (andinvestment in) lines of business involving alcohol, porkproducts, firearms, tobacco, and adult entertainment, 2) bet-ting and gambling (maisir), including the speculative trade,rescheduling, interest discounting, or exchange of money

for debt wilhotil an underlying asset transfer, 3) the tradiofthe same object between huyer and seller (hay' al-itialiit creates indebtedness, and 4) preventable uncertainty anrisk with delusion (gharar). See also Errico and Farrahbaksh [1998] and El-Haw a

et al. [2004] as well as the Appendix to this article. Nothat in many cases, returns from investment in unaccepable sources if they occur together with shari 'ah-compliainvestment may be regarded acceptable if these proceeds andonated to charity.'According to the latest recommendations by t

Acanmdn^ andAuditing Orj^anizatioit of Islamic Finance Instittions (AAIOFI), sukuk are equivalent in form to asset-backsecurities (ABS), which would also hold out the possibiliof investor subordination through co-participation schem(see Exh ibit 4).

'"In conventional securitization, a SPV is set up solefor the purpose ofthe securitization and might be a truslimited-liability company, partnership, or corporat ion. IIslamic securitization, the objectives set out in the constittional documents ofthe SPValso must not infringe on thprohibition of n7>fl and liaram under Islamic law.

"Ex hibit 5 illustrates the possible pairing of traditioncommodities (money: gold and silver; staple foods: wheabarley, dates, salt) for shari'ah-compliant trade according tth e qu'raii. These categories are to be viewed as "proxifor similar commodities that arc more prevalent today. Thsymbols signify that trade is either unre stricted (as indicateby the checked box) or legitimate only if it occurs 1)spot (indicated by the clock symhol) without profit, and/or 2) fthe consideration ofthe same quality and quantity (as indcated by the equality sign).

'-Instead, commodities could serve as religiously accepable, short-term investments.^^Wakala defines a principal-agent relationship in wha fund manager acts as the agent of investors in accordanwith pre-agreed investment parameters. The primary feefixed, for instance, as a percentage of assets under managment. There may also be a performance-based fee but notsimple sharing of profits.

REFERENCESAkerlof, G.A. "The M arket for Lemons: Quality Uncertainan d the Market Mechanism.'" Quarterly Joumal of Econom84 (1970), pp. 488-500.Ashcraft, Adam B., and Till Schuermann. "Understandinthe Securitization of Subprime Mortgage Credit." MimeFederal Reserve Bank of New York, 2008.

56 ISLAMIC SECUR[TrzATtON AFTEII THE SUBPRIME CRISIS W IN TER 2(tL


17/18

E l - G a m a l , M a h m o u d A . Islamic Finance: Law, Economies andPractice. New York; Cam bridge University Press, 2006.Ei-Ha\vary, Dahlia, Wafik Grais, and Zamir Iqbal. "Regu-lating Ishimic Financial Institutions: The N ature of the Re gu -lated." World Bank Working Paper 3227, 20(14.Errico, Luca, and Mitra Farrahbaksh. "Islamic Banking: issuesni Prudential Regulation and Supervision." IMF WorkingPaper 98 /30, 1998. |Gesell, Silvio. The Naiiiral Economie Order, revised edition.London: Peter Ow en, 1958. IHesse, H eiko, A ndreas A. jobsc, and Juan Sol. "Trend s andChallenges in Islamic Finance." World Economics, Vol. 9, No . 2(2008a), pp. 175-193.

. "Trends and Challenges in Islamic Finance." Islmica,September 2008b. pp. 28-33. 1

. "Q uo Vadis Islamic Finance?" RGEMonitor, November27, 2008c, pp. 2 8-3 3 (available at: http://vvww .rgemonitor.coni/us-monitor/254573/quo_vadis_islaniic_finance).IO SC O. "Annlysis of the Appliciition of lOS CO 's Objectivesand Principles of Securities Regulacin for Islamic SecuritiesProducts." Internationa] Organization of Securities Commis-sions (lOSC O), September 200 8, Paris.

Jobst, Andreas A. "The Economics of Islamic Finance andSec uritiz ation ." Joiirfii)/ of Structurea Fiiuwcc. Vol. 13, No. (Spring 2007), pp. 1-22. Also published as IMF WorkingPaper 07/117.

Jobst, Andreas A., Peter Kunzel, Paul Mills, and Sy Amadou."Islamic Bond Issuance^What Sovereign Debt ManagersNeed to Know." Iniernalional Journal of Islamic & MiddleEasi Finance an d Management, Vol., No. 4 (2008). Publishedalso in IM F Survey Magazine, Internat ional Monetary Eund,Septemb er 19. 2007 .Mood y's Investors Service. "Focus on the M iddle East." insideMoody's, Spring 2008 .

-. "Focus on the Middle East." Inside Moody's, Spring2007.

To order reprints of this article, please contact Dewey Palmieriat [email protected] or 212-224-3675.

WINTER 2009 T H E J O U R N A L O F S T R U C T U R E D F I N A N CE 5 7


18/18

islamic securitisation

Documents