A LEGAL APPROACH - UAE Laws and Islamic Finance · PDF fileWe have been providing high quality...

ISLAMIC SECURITIZATION

A LEGAL APPROACH


A LEGAL APPROACH

by

Haluk Gurulkan, LL.M. Finance

Istanbul October 2010

This study has been prepared by the attorney of our Law Firm, Haluk Gurulkan, Esq, as an LL.M. thesis and presented to to the Institute For Law and Finance at Johann Wolfgang Goethe University, Frankfurt am Main.

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CONTENTS ABBREVATIONS INTRODUCTION

1 ISLAMIC FINANCE

1.1 What is Islamic Finance? 1

1.2 The basic principles 3

1.2.1 Ban on Interest (riba) 3

1.2.2 Ban on transactions and products with excessive uncertainty (gharar-maisir) 4

(gharar-maisir)

1.2.3 Principle of risk and profit sharing 5

1.2.4 Ethical investments that enhance society 6

1.2.5 Asset-backing 6

1.3 Main Transaction Types 7

1.3.1 Murabaha 7

1.3.2 Mudaraba 8

1.3.3 Musharaka 10

1.3.4 Diminishing Musharaka 11

1.3.5 Ijara 13

1.3.6 Salam 14

1.3.7 Istisna 16


2 SECURITIZATION

2.1 What is Securitization? 20

2.2 History of Securitization 21

2.3 Structure of Securitization 23

2.3.1 True Sale 25

2.3.2 Special Purpose Vehicle 26

2.3.3 Credit Enhancement 27

2.3.4 Credit Rating 32

2.3.5 Profit Extraction 33 ii

2.4 Motivation for Securitization 34

2.4.1 Motivation for the Originator 34

2.4.1.1 The potential for reducing costs 34

2.4.1.2 The ability to diversify funding sources 35

2.4.1.3 The ability to manage corporate risk 35

2.4.1.4 The ability to help in capital adequacy requirements 36

2.4.1.5 The opportunity to achieve off-balance financing 36

2.4.1.6 The ability to match the assets and liabilities 36

2.4.1.7 The ability to reduce credit concentration 36

2.4.1.8 The opportunity for arbitrage by repackaging 37

2.4.2 Motivation for the Investors 37


2.5 Different Classifications of Securitization 38

2.5.1 According to asset types 38

2.5.2 According to SPV types 38

2.5.3 Pass through & Pay through Securitization Structures 39

2.5.4 True sale & Synthetic Securitization Structures 40

2.5.5 Asset-backed & Future Flows Securitization Structures 41

2.6 Securitization and the recent credit crunch 42

3 ISLAMIC SECURITIZATION

3.1 What is Islamic Securitization? 46

3.2 Structure of Islamic Securitization 47

3.3 Sukuk 51

3.3.1 Types of Sukuk 54

3.3.1.1 Ijara Sukuk 54

3.3.1.2 Mudaraba (or Muqarada) Sukuk 57

3.3.1.3 Musharaka Sukuk 59

3.3.1.4 Murabaha Sukuk 61

3.3.1.5 Salam Sukuk 64

3.3.1.6 Istisna Sukuk 66

3.3.1.7 Hybrid Sukuk 68

3.3.2 AAOIFI Sharia Council’s proposals for amendments in

contemporary Sukuk issues 69 iii

3.3.3 Credit Rating Issues 71

3.3.4 Benchmarking Issues 73

3.3.5 Recent Sukuk Defaults 74


3.4 The Use of Derivatives in Islamic securitization 76

3.5 A Case study: Sorouh Securitization 80

CONCLUSION 84

BIBLIOGRAPHY 86

WEB PAGES 95


ABBREVIATIONS

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions

ABS Asset-Backed Securities

AED United Arab Emirates Dirham

AIG American International Group, Inc.

ARM Adjustable Rate Mortgages

BIB Bahrain Islamic Bank

BMA Bahrain Monetary Agency

CAGR Compound Annual Growth Rate

CDO Collateralized Debt Obligations

ECP East Cameron Partners

EIBOR Emirates Inter-bank Offered Rate

IDB Islamic Development Bank

IFSB Islamic Financial Services Board

IIRA International Islamic Rating Agency

LIBOR London Inter-bank Offered Rate

MBS Mortgage-Backed Securities

MENA Middle East & North Africa

NINA No Income No Assets

NIVA No Income Verified Assets

PLS Profit-and-loss-sharing

OC Offering Circular

OIC Organization of the Islamic Conference

ORRI Overriding Royalty Interest

OTC Over-the-counter

ROE Return on Equity

SIVA Stated Income Verified Assets


SLR Statutory Liquidity Requirement

SPC Special Purpose Company

SPE Special Purpose Entity

SPV Special Purpose Vehicle

STS Solidarity Trust Services

UAE United Arab Emirates


INTRODUCTION

1 ISLAMIC FINANCE In this part, our main aim is to give the basic principles of Islamic Finance. Obviously, one

should first understand the basics of Islamic Finance in order to have a better understanding of

Islamic Securitization as the structures of the latter have to comply with the basic rules of Islamic

Finance and are constructed on the main transaction types of Islamic Finance.

1.1 What is Islamic Finance? Islamic Finance is based on Sharia, an Arabic term that is often translated into “Islamic Law”.

However Sharia is perhaps best characterized as moral guidance or a set of principles governing all

aspects of the day-to-day activities of Muslims.1 Sharia provides guidelines for aspects of Muslim life,

including religion, politics, economics, banking, business and law.2 The concepts that underlie Islamic

finance derive from Islamic law or the Sharia, the roots of which in turn are derived from the: (1)

Qur’an, being the holy book of Islam (notably less than 3 percent of the Qur’an is legal in nature); (2)

Sunna, which are the binding authority of Prophet Muhammad’s dicta and decisions; (3) Ijma, or

“consensus” of the community of scholars; and in some parts of the Muslim world, (4) Qiyas, or

analogical deductions and reasoning.3

In the late 19th Century, the Ottomans introduced western-style banking to the Islamic world

to finance their expenditures. While some Islamic jurists approved of modern banking practices, the

majority found those practices to be violations of Islamic prohibitions against usury (Arabic term:

riba, equivalent to the Hebrew ribit, and interpreted in its classical Biblical sense of any interest

charge on loans, as opposed to the modern identification of usury with exorbitant interest). This

resentment continued through the European colonial period, which lasted into the mid-20th

Century. Islamic revival played a central role in the intellectual and social foundations of inde-

1 HM Treasury, The development of Islamic Finance in the UK: the Government’s perspective, 10 December 2008, p.7, available at http://www.hm-treasury.gov.uk/d/islamic_finance101208.pdf 2 Silva, Michael, Islamic Banking Remarks, Law and Business Review of the Americas, Vol. 12, Issue 2, Spring 2006, p. 201 3 Mayer Brown LLP, The rapidly growing market of Islamic Finance requires the knowledge of Sharia-compliant structures for finance transactions, White Paper – Islamic Finance, 15 September 2009, p. 2, available at http://www.mayerbrown.com/islamicfinance/article.asp?id=7813&nid=12368

http://www.hm-treasury.gov.uk/d/islamic_finance101208.pdf�

http://www.mayerbrown.com/islamicfinance/article.asp?id=7813&nid=12368�


pendence movements of the mid-20th Century. To many intellectual founders of the movement,

political independence was to be supplemented with economic independence, through the definition

of an Islamic economic system.4

The conceptual development of Islamic banking gained momentum after the mid-1940s.

Islamic scholars such as Qureshi (1946), Ahmad (1952), Uzair (1955), Maududi (1961), Al-Arabi

(1966), Siddiqi (1967) and Al-Sadr (1974) made significant contributions to the evolution of the

Islamic banking model.

5 The huge influx of petrodollars from the late 1970s provided a strong

impetus to the development of several Islamic banks in the Middle East. Other Muslim countries

established their own Islamic financial institutions over time. Islamic banking has made steady

progress over recent decades. In recent years it has emerged as the fastest-growing segment of

global finance due to consistently high oil prices in international markets and other favorable socio-

political factors. It is flourishing in Africa, Asia, Europe and North America. There are about 300

Islamic financial institutions across 70 countries, holding capital investments worth $500-800 billion,

with an average annual growth of 15 per cent. It has been estimated that Islamic banking will have a

market value of $4 trillion by 2010.6 It is expected to capture about 40-50 per cent of the total

savings of 1.3 billion Muslims worldwide within the next eight to ten years.7 As of 2009, it is

estimated that over $822 billion worldwide Sharia-compliant assets are managed according to the

Economist.8

Although in the past local banks in the Middle East and Malaysia held a monopoly on Islamic

finance, a number of non-Muslim institutions have begun to offer Sharia-compliant services,

particularly through the issuance of Sukuk (Islamic bonds). The major Western banks currently

engaged in this practice include HSBC, Citigroup, Barclays Capital, Deutsche Bank, BNP Paribas, and

4 El-Gamal, Mahmoud Amin, Overview of Islamic Finance, Office of International Affairs, Occasional Paper No. 4, June 2006, p. 3 5 As a result of these efforts, the first Islamic financial institution was a mutual savings bank formed in the Egyptian town of Mit Ghamar in 1963. 6 The ratings agency Standard & Poor’s has forecasted that the industry could potentially control up to $4 trillion of assets. This contrasts with $190 trillion in global assets that are currently under management. Others have suggested that the growth in the sector could be far higher, as Muslims account for 20 per cent of the global population yet currently only hold approximately 1 per cent of global financial assets. Whatever the case, it is likely that Islamic finance will become an increasingly important component of the international financial system. (The development of Islamic finance in the UK: the Government's perspective, December 2008, p. 8) 7 Khan, M. Mansour, Bhatti, M. Ishaq, Development in Islamic Banking: a financial risk-allocation approach, The Journal of Risk Finance, Vol. 9, No.1, 2008, p. 41 8 Economist article, available at http://www.economist.com/world/europe/displaystory.cfm?story_id=14859353

http://www.economist.com/world/europe/displaystory.cfm?story_id=14859353�


Standard Charter. Similarly, a number of large law firms have Islamic business departments or units.

Much of the proliferation of Islamic banking practices appears to have taken the form of non-Muslim

banks opening Sharia-compliant "windows" or branches in the Middle East. Moody's estimates that

over $200 billion individual assets lie in these Muslim "windows".9

1.2 The basic principles

Major principles of Sharia that are applicable to finance and that differ from conventional

finance are:

1.2.1 Ban on Interest (riba10

)

Any level of interest is considered to be usurious and is prohibited. The Qur’an contains

almost a dozen references to this fundamental prohibition against interest, and it is discussed often

in the Hadith11. The Qur’an proclaims: "Allah12 hath permitted trade and forbidden usury." This

fundamental prohibition is "unequivocal," and the Qu'ran and early Islamic writings clearly consider

riba a very serious offense: The Messenger of Allah cursed the one who devours riba, the one who

pays it, the one who witnesses it, and the one who documents it13 and he defined riba as “Gold for

gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like,

hand to hand, in equal amounts; and any increase is riba.”14

Sometimes it is misunderstood that only a high rate of interest is prohibited and any normal

charge on loans or debts does not come under the purview of prohibition. It is argued that a loan

9 Karasik, Theodore, Wehrey, Frederic, Strom, Steven, Islamic Finance in a Global Context: Opportunities and Challenges, Chicago Journal of International Law, Winter 2007, p. 385-386 10 Riba means and includes any increase over and above the principal amount payable in a contract obligation, not covered by a corresponding increase in labor, commodity, risk or expertise. 11 Hadith are narrations originating from the words and deeds of the prophet Mohammad. 12 Allah is the standard Arabic word for God. 13 Richardson, Christopher F., Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, Texas International Law Journal, Fall 2006, p. 125 14 El-Gamal, Mahmoud, A Basic Guide to Contemporary Islamic Banking and Finance, Rice University, June 2000, p.3


involves riba only if it carries the condition of doubling and redoubling, and the word “riba” refers

only to usurious loans on which an excessive rate of interest is charged by the creditors, which entails

exploitation. It is added that modern banking interest cannot be termed “riba” as the rate of interest

is not excessive or exploitative. However, the argument is not tenable as per the tenets of the

Qur’an. The Qur’an makes it very clear that in a loan transaction, and for that matter a trade

transaction culminating in a debt contract, any addition chargeable to the principal amount is riba.

The Qur’an says: “If you repent, then you have your principal only”. Believers have been ordered to

give up whatever amount of riba is outstanding. Further, “rate” is a relative term and any rate will,

over time, double and redouble the principal; hence, any addition over the amount of debt per se is

prohibited, irrespective of the rate.15

1.2.2 Ban on transactions and products with excessive uncertainty (gharar-maisir)

In principle, uncertainty in contractual terms and conditions is not allowed. Intrinsically, the

limitation on gharar is related to the Islamic prohibition on gambling (maisir). Unlike riba (which is an

absolute prohibition) some level of risk remains a fundamental aspect of commercial life and risk

allocation a necessary component of Islamic finance; only disproportionate risk, speculative trading

and transactions meeting exceeding limitations are considered gharar. The key element of gharar is

uncertainty.16

While riba is condemned in the Holy Qur’an, condemnation of gharar is supported by Hadith.

In business terms, gharar means to undertake a venture blindly without sufficient knowledge or to

undertake an excessively risky transaction, although minor uncertainties can be permitted when

there is some necessity. In a general context, the unanimous view of the jurists held that, in any

transaction, by failing or neglecting to define any of the essential pillars of contract relating to the

consideration or measure of the object, the parties undertake a risk which is not indispensable for

15 Ayub, Muhammad, Understanding Islamic Finance, John Wiley & Sons, Inc., 3. Edition, 2008, p. 50 16 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 127


them. This kind of risk was deemed unacceptable and tantamount to speculation because of its

inherent uncertainty. Speculative transactions with these characteristics are therefore prohibited.17

The prohibition of maisir covers gambling and other games of chance, such as lotteries and

betting on races. While general commercial risk is permissible, forms of speculation which are

regarded as akin to gambling are prohibited. Speculative trades where there is little or no certainty as

to the outcome, such as currency market speculation or investment in derivatives, would not be

permitted. Where the distinction between general commercial risk and speculation is not clear the

commercial substance of a transaction will be analyzed. Whilst distinct concepts, there is some

degree of overlap between gharar and maisir.

18

1.2.3 Principle of risk and profit sharing

In Islamic finance, those who finance investment share a good part of the risk with those who

carry out actual investment activities.19 Parties of a financial transaction must share both the

associated risks and profits. Profit-and-loss-sharing (PLS) financing is a form of partnership where

partners share profits and losses on the basis of their capital share and effort. Unlike interest-based

financing, there is no guaranteed rate of return. Islam supports the view that Muslims do not act as

nominal creditors in any investment, but are actual partners in the business. This is an equity-based

system of financing, where the justification for the PLS-financier’s share in profit rests on their effort

and the risk that they carry. In other words, they deserve to be rewarded since this profit would have

been impossible without their investment and, furthermore, if the investment were to make a loss,

then their money would also be lost.20

17 Algaoud, Latifa M., Lewis, Mervyn K., Mohammed, Islamic Critique of Conventional Financing, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p.39

18 Sandstad, Ben, Strom, Hagbarth, Islamic Finance: An Introduction, 23 June 2009, Banking and Financial Services Insight, available at http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090623/islamic_finance_an_introduction.page 19 Al-Jarhi, Mabid Ali, Islamic Banking and Finance: Philosophical Underpinnings, Ed. by Ali, Salman Syed, Ahmad, Ausaf, Islamic Banking and Finance: Fundamentals and Contemporary Issues, Selected Papers from Conference in Brunei; 5-7 January 2004, Islamic Research and Training Institute and Universiti Brunei Darussalam, p. 17 20 Venardos, Angelo M., Islamic Banking & Finance in South-East Asia, Its Development and Future, World Scientific Publishing Co. Pte. Ltd., 2005, p. 51

http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090623/islamic_finance_an_introduction.page�



Islamic scholars prefer that investors obtain some form of ownership or participating interest

in the underlying asset, although such ownership may be only indirectly beneficial in nature, and the

level of actual participation is often passive. The key, however, is that the investor's return must be

tied to the performance of the underlying asset. Because the "borrower" cannot pay interest, it

instead shares the profits from its endeavors with the investors, with each bearing some of the risk

that the underlying assets could underperform. Even though Sharia prohibits payment or receipt of

any interest on loans of money, Islamic law permits and actually encourages the allocation of risks

and rewards and sharing in the resulting profits or losses.21

1.2.4 Ethical investments that enhance society

Financing must be for a worthwhile cause. Certain industries are viewed as inappropriate

activities. Generally inappropriate business activities include gambling and casino games, alcoholic

beverages, pork consumption, pornography and prostitution, weapons/defense, and financial

services dependent on payment of interest (riba).22 In essence, Islamic investments must be socially

responsible, not encourage activities considered sinful from an Islamic point of view. For example,

the sale and trading of commodities such as wine or alcoholic products, pork and pork products is

prohibited, and contracts involving such commodities are void on the grounds of their illegality.23

The investments should also be done in a financially sound manner. Islam discourages

investment in companies with high debt levels. For equity investments in stocks, the prohibition

includes investments in companies with heavy debt (an extension of the proscription of riba and

gharar).

24

21 Berschadsky, Ariel, Innovative Financial Securities in the Middle East: Surmounting the Ban on Interest in Islamic Law, U. Miami Business Law Review 107, 2001, p. 110 22 Karasik, Wehrey, Strom, Islamic Finance in a Global Context: Opportunities and Challenges, supra, p. 382 23 Ayub, Understanding Islamic Finance, supra, p. 135 24 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, pp. 126-127


1.2.5 Asset-backing

Each financial transaction must be tied to “tangible, identifiable underlying asset”. Islam does

not recognize money as a subject-matter of trade, except in some special cases. Money has no

intrinsic utility; it is only a medium of exchange. Each unit of money is 100% equal to another unit of

the same denomination, therefore, there is no room for making profit through the exchange of these

units inter se. Profit is generated when something having intrinsic utility is sold for money or when

different currencies are exchanged, one for another. The profit earned through dealing in money (of

the same currency) or the papers representing them is interest, hence prohibited. Therefore, unlike

conventional financial institutions, financing in Islam is always based on illiquid assets which create

real assets and inventories.25

1.3 Main Transaction Types

1.3.1 Murabaha

The most popular Islamic financial instrument is murabaha, that is, a cost-plus or mark-up

contract. The word murabaha derives from the Arabic word ‘ribh’, meaning profit. A murabaha

contract is a trade contract, stipulating that one party buys a good for its own account and sells it to

the other party at the original price plus a mark-up. The mark-up can be seen as a payment for the

services provided by the intermediary, but also as a guaranteed profit margin. Payment may take

place immediately, but also at a later date or in installments.26

In financing, murabaha is used as a form of a sales contract in which the financial institution

or investors buy an asset and then later sell it to the "borrower" at a marked-up price, which includes

a profit component. Payments are made in installments, either on a deferred basis or through

25 Usmani, Mufti Muhammad Taqi, An Introduction to Islamic Finance, Kluwer Law International, 2002, pp. 14-15 26 Visser, Hans, Islamic Finance Principles and Practice, Edward Elgar Publishing Limited, 2009, p. 57


upfront payment with deferred delivery. Murabaha instruments usually supply only short-term

financing.27

Some observers see this mode of Islamic finance to be very close to a conventional interest-

based lending operation. However, a major difference between murabaha and interest-based

lending is that the mark-up in murabaha is for the services the bank provides (for example, seeking

and purchasing the required goods at the best price) and the mark-up is not stipulated in terms of a

time period. Thus, if the client fails to make a deferred payment on time, the mark-up does not

increase from the agreed price owing to delay. Also the bank owns the goods between the two sales,

which means it carries the associated risks.

28

A basic structure of a murabaha transaction is as follows:

29

27 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 130 28 Mirakhor, Abbas, Zaidi, Iqbal, Profit-and-loss sharing contracts in Islamic finance, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 52 29 Mayer Brown LLP, Islamic Finance At a Glance, Banking & Finance Newsletter, March 2008, available at http://www.mayerbrown.com/islamicfinance/article.asp?id=4357&nid=12368



1.3.2 Mudaraba

Mudaraba is a special kind of partnership in which an investor or a group of investors

provides capital to an agent or manager who has to trade with it; the profit is shared according to the

pre-agreed proportion, while the loss has to be borne exclusively by the investor. The loss means a

shortfall in the capital or investment of the financier. The loss of the agent (Mudarib) is by way of

expended time and effort, for which he will not be given any remuneration. There is no restriction on

the number of persons giving funds for business or any restriction on the number of working

partners. Profit cannot be in the form of a fixed amount or any percentage of the capital employed.30

Please see below for a basic structure of Mudaraba:31

At the core of any Mudaraba contract, there are four basic conditions between the mudarib

and the rabb al-mal [capital provider(s)] as follows:

30 Ayub, Introduction to Islamic Finance, supra, pp. 320-321 31 Mayer Brown LLP, Islamic Finance At a Glance, supra


Profit, when realized, has to be shared between the two parties in accordance with a profit-

sharing ratio pre-stipulated at the time of the contract. Loss, in case it arises, would have to

be born entirely by capital providers as the mudarib only loses his/her effort.

The rabb al-mal cannot interfere in the day-to-day management of the Mudaraba, apart

from his or her right to restrict possible fields of economic activity for the Mudaraba. This

provision, however, has to be made clear within the mudarib contract.

The mudarib has a ‘hand of trust’ (yad amana) in the management of Mudaraba capital,

which means he would work to his best effort and, therefore, cannot guarantee capital or

profit to rabb al-mal.

Loss of capital can be guaranteed by the mudarib only when such loss proves to be the result

of mismanagement or delinquency of the mudarib; or where such loss results from a breach

of the contract, like violating restricted fields of economic activity.32

1.3.3 Musharaka

This is often perceived to be the preferred Islamic mode of financing, because it adheres

most closely to the principle of profit and loss sharing. Partners contribute capital to a project and

share its risks and rewards. Profits are shared between partners on a pre-agreed ratio, but losses are

shared in exact proportion to the capital invested by each party. Thus a financial institution provides

a percentage of the capital needed by its customer with the understanding that the financial

institution and customer will proportionately share in profits and losses in accordance with a formula

agreed upon before the transaction is consummated. This gives an incentive to invest wisely and take

an active interest in the investment. In Musharaka, all partners have the right but not the obligation

to participate in the management of the project, which explains why the profit-sharing ratio is

mutually agreed upon and may be different from the investment in the total capital.33

32 El-Din, Seif I. Tag, Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice, Kyoto Bulletin of Islamic Area Studies, 1-2, 2007, pp. 57-58 33 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 51


Below is a basic structure of a Musharaka transaction:34

We can sum up the special provisions in a Musharaka contract as follows:

Partners of Musharaka all have the right to engage in the day-to-day management of the

Musharaka capital, except where one party deliberately gives up (waivers) this right to other

parties. Many Islamic banks prefer to waiver their rights of Musharaka management to

clients on the grounds that clients are more qualified to run their own businesses.

Profit, when realized, has to be shared by partners in proportion to their capital

contributions (i.e. on pro-rata basis) unless otherwise agreed on reasonable ground. In the

context of Islamic banking, it is possible for the client to get a proportionately bigger share of

profit if the bank has already waivered its right in management to the client. Loss, however,

has to be strictly shared on pro-rata basis.

None of the parties can be held liable to guarantee capital or profit to other parties. Only

where mismanagement and delinquency are proved or where a breach of the Musharaka

contract is committed, the party so charged may be held liable to guarantee capital

contributions of the other parties.

Profit (or loss) cannot be prioritized within the Musharaka contract. No party (or group of

parties) can be preferred to others in terms of profit distribution or loss allocation, and no

34 Mayer Brown LLP, Islamic Finance At a Glance, supra


pre-fixed return can be promised to any. The fact that all parties have to be treated on an

equal footing (pari passu) underscores profit & loss sharing as the core concept of

Musharaka.35

1.3.4 Diminishing Musharaka

The participatory contracts that may be more suitable for financing of fixed assets and

present-day ongoing projects, particularly for financial intermediaries, can be based on the concept

of “Diminishing Musharaka”.36 It is a variant of Musharaka, and a form of co-ownership in which two

or more parties share the ownership of a tangible asset in an agreed proportion, and one of the co-

owners undertakes to buy, in periodic installments, the proportionate share of the other co-owner

until the title to such tangible asset is completely transferred to the purchasing co-owner.37

Diminishing Musharaka is applied for the purchase of tangible assets;

The key features of the diminishing Musharaka are given below:

Proportionate shares of each co-owner must be known and defined in terms of investment;

Expenses incidental to ownership may be borne jointly by the co-owners in the proportion of

their co-ownership;

Losses, if any, shall be borne by the co-owners in proportion of their respective investments;

Each periodic payment shall constitute a separate transaction of sale; and

Separate agreements/contracts shall be entered into at different times in such manner and

in such sequence so that each agreement/contract is independent from the others, in order

to ensure that each agreement is a separate transaction.38

The chart below shows the basic structure of a diminishing Musharaka transaction:39

35 El-Din, Seif I. Tag, Capital and Money Markets of Muslims: The Emerging Experience in Theory and Practice, supra, p. 58 36 Ayub, Introduction to Islamic Finance, supra, p. 337 37 Said, Pervez, Islamic Alternatives to Conventional Finance, Islamic Finance: A Guide for International Business and Investment, Ed. By Habiba Anwar, GMB Publishing, 2008, p. 18 38 Said, Islamic Alternatives to Conventional Finance, supra, p. 19


Diminishing Musharaka can be easily used for the purpose of financing fixed assets by Islamic

banks. It includes house financing, auto financing, plant and machinery financing, factory/building

financing and all other fixed asset financing.40 In the case of housing finance, for example, home

buyer and a financier jointly own a home and over time the financier’s share diminishes continuously

as the home buyer’s share increases. Usually, diminishing Musharaka is combined with ijara. In

Lariba’s home buying scheme, for instance, the client leases the financier’s share in the property and

agrees to buy that share over a period of up to 30 years. Often, the client buys the home as the

financier’s agent from the vendor and registers it directly into their own name. In the UK, however,

HSBC Amanah only transfers ownership at the end of the agreed period.41

39 Sandstad, Ben, Introduction to Islamic Finance – Part II, 24 September 2009, Banking and Financial Services Insight, available at http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090924/introduction_to_islamic_finance-part_ii.page 40 Ayub, Introduction to Islamic Finance, supra, p. 339 41 Visser, Islamic Finance Principles and Practice, supra, p. 111

http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090924/introduction_to_islamic_finance-part_ii.page�

http://www.claytonutz.com/publications/newsletters/banking_and_financial_services_insights/20090924/introduction_to_islamic_finance-part_ii.page�


1.3.5 Ijara

In Islamic law, ijara is a contract of a known and proposed usufruct of specified assets for a

specified time period against a specified and lawful return or consideration for the service or return

for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other

words, it is the transfer of usufruct for a consideration, which is rent in the case of hiring assets or

things and wages in the case of hiring people. According to the jurists, ijara is the sale of usufruct of

any commodity in exchange of ujra, wages or rent, and covers houses, shops, riding/work animals,

jewelry, clothes, etc.42

The structure below illustrates how an ijara structure works:

43

For the purpose of ijara, the subject matter giving usufruct can be divided into two types:

property or assets, like houses, vehicles, residences, etc., and labor, like the work of an engineer,

doctor, tailor, carpenter, etc. While the latter involves employing the services of a person for a wage,

the former relates to usufruct of any asset or property that is transferred to another person in

exchange for rent.44

42 Ayub, Introduction to Islamic Finance, supra, p. 279

43 Common Islamic financing structures, Minaret Capital, available at http://minaretcapital.com/structure.html 44 Ayub, Introduction to Islamic Finance, supra, p. 280

http://minaretcapital.com/structure.html�


When we look at its usage in the Islamic financing practice, ijara is a contract under which a

bank buys and leases out an asset or equipment required by its client for a rental fee. Responsibility

for maintenance/insurance rests with the lessor. During a predetermined period, the ownership of

the asset remains with the lessor (that is, the bank) who is responsible for its maintenance, which

means that it assumes the risk of ownership. Under an ijara contract, the lessor has the right to

renegotiate the terms of the lease payment at agreed intervals. This is to ensure that the rental

remains in line with market leasing rates and the residual value of the leased asset. Under this

contract, the lessee (that is, the client) does not have the option to purchase the asset during or at

the end of the lease term. However this objective may be achieved through a similar type of

contract, ijara wa iqtina (hire-purchase). It basically mimics financial leasing practices of

conventional finance. In ijara wa iqtina, the lessee commits himself to buying the asset at the end of

the rental period, at an agreed price. For example, the bank purchases a building, equipment or an

entire project and rents it to the client, but with the latter’s agreement to make payments into an

account, which will eventually result in the lessee’s purchase of the physical asset from the lessor.

Leased assets must have productive usages, like buildings, aircrafts or cars, and rent should be pre-

agreed to avoid speculation.45

1.3.6 Salam

In Islamic law, existence of some property as the object of sale is generally a condition for

contract validity. However, there are some notable exceptions that allow sales of non-existent

objects. One of the most important exceptions is an ancient contract that predates Islam, called

salam meaning “prepayment.” This contract was primarily used for financing agricultural

production.46

A salam is deferred delivery contract. It is essentially a forward agreement where delivery

occurs at a future date in exchange for spot payment of price. Unlike earlier mechanisms of

murabaha and ijara, salam was originally designed as a financing mechanism for small farmers and

traders. Under a salam agreement, a trader in need of short-term funds sells merchandize to the

45 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 52 46 El-Gamal, Mahmoud A., Islamic Finance Law, Economics and Practice, Cambridge University Press, 2006, p. 81


bank on a deferred delivery basis. It receives full price of the merchandize on the spot that serves its

financing need at present. At a pre-agreed future date, it delivers the merchandize to the bank. The

bank sells the merchandize in the market at the prevailing price. Since the spot price that the bank

pays is pegged lower than the expected future price, the transaction should result in a profit for the

bank.47

A simple salam structure is presented below:

48

Some additional considerations in salam are as follows:

The buyer should pay the price, in full, to the seller at the time of effecting the sale;

otherwise it will be tantamount to a sale of debt against debt, which is expressly prohibited

by the Sharia rulings (any unpaid price represents a debt to the buyer and a debt to the seller

for the value of such goods not paid for in advance);

47 Obaidullah Mohammed, Islamic Financial Services, Islamic Research Center, King Abdulaziz University, 2005, pp. 95-96 48 Mayer Brown LLP, Islamic Finance At a Glance, supra


The debt liability of the seller cannot be adjusted against the price for salam sale, in part or

in full.

Salam can be affected in only those goods that are normally available in the market and

whose quality and quantity can be specified exactly;

It is necessary that the quality of the goods intended to be purchased is fully specified,

leaving no ambiguity leading to dispute among the parties involved in the transaction;

The exact date and place of delivery must be specified in the salam contract. The parties may

fix any date for delivery with mutual consent; and

In order to ensure that the seller shall deliver the goods on the agreed date, the bank can

also ask the seller to furnish a security, which may be in the form of a guarantee or in the

form of a mortgage/hypothecation.49

Salam is a bit of an exception in the Islamic financial landscape, as forward contracts are not

generally acceptable. You cannot sell what you do not own and possess. Its permissibility is based on

the sunna. Salam may be a forward contract, but it differs in two important aspects from the usual

forwards and futures. First, under a salam contract, the full price of the product must be paid in

advance. Second, at maturity the buyer must take delivery of the good. Muslim scholars argue that in

this way speculative activities (maisir) are prevented, but the downside is that hedging also becomes

more difficult.50

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), has

ruled against salam contract for shares in a standard, Sharia Standard 21, that became effective in

January 2007. The reasoning appears to be that the shares cannot be described well enough for the

future, as the underlying assets may change. This means that gharar is involved. But there are

respected scholars who disagree and accept salam contract for shares, on the grounds that shares

are all identical and readily available on the market.

51

49 Said, Islamic Alternatives to Conventional Finance, supra, p. 17 50 Visser, Islamic Finance Principles and Practice, supra, p. 61 51 Visser, Islamic Finance Principles and Practice, supra, p. 62


1.3.7 Istisna

An istisna is a type of contract in which a mustasne (a client requiring the manufacturing or

construction of an asset) orders from a sane’ (manufacturer or constructor) an asset meeting certain

specifications (the masnou), with asset delivery to be within a specified period of time. The mustasne

will be required to pay the purchase price of that asset if the asset is manufactured or constructed

within the specified time period and meets the agreed-upon specifications. The sane does not need

to manufacture or construct the asset itself; it may locate the asset in the market and purchase it for

delivery to the mustasne or it may cause another party to manufacture or construct the asset. If the

original sane causes another sane to manufacture or construct, the original sane remains liable to the

original mustasne for the delivery of the masnou. In a financial transaction, the Banks or a special

purpose Funding Company would be the original sane and would contract with another sane (the

end sane) for the manufacture or construction of the asset.52

Istisna can be used for providing the facility of financing the manufacture or construction of

houses, plant, projects, bridges, roads and highways. By way of a Parallel Istisna contract with

subcontractors, Islamic banks can undertake the construction of any project/asset and its sale for a

deferred price, and subcontract the actual construction to any specialized firms.

53

The figure below illustrates the structure of an istisna transaction:

54

52 McMillen, Michael J.T., Islamic Project Finance, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 206 53 Ayub, Introduction to Islamic Finance, supra, p. 404 54 Mayer Brown LLP, Islamic Finance At a Glance, supra


The legality of istisna is accepted by the Sharia scholars because it does not contain any

prohibition, it has always been a common practice in the world and also because of ease for human

beings. Istisna is a valid contract and a normal business practice. As a financing mode it has been

legalized on the basis of the principle of Istihsan (public interest). Istisna is an agreement culminating

in a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or

construct (or cause so to do) anything to be delivered at a future date. It becomes an obligation of

the manufacturer or the builder to deliver the asset with agreed specifications at the agreed period

of time.55

financing the construction industry – apartment buildings, hospitals, schools and universities;

Potential areas that istisna structure can be used are as follows:

development of residential/commercial areas and housing finance schemes;

financing high technology industries such as the aircraft industry, locomotive and

shipbuilding industries.56

55 Ibid, p. 263 56 Ayub, Introduction to Islamic Finance, supra, p. 269


The main difference between an istisna and a salam contract is that, in istisna contracts, it

should always be something that needs manufacturing while the subject of a salam contract may be

either a natural product or a manufactured good.


Chapter 2

SECURITIZATION


2 SECURITIZATION

As we did make a beginning with the basics of Islamic Finance, we also need to grasp the idea

of conventional securitization in order to perfectly understand what Islamic Securitization is. Thus, in

this chapter, we will be trying to explain conventional securitization, its structure and main

transaction types.

2.1 What is Securitization?

As securitization is a structured finance technique,57

. . . techniques employed whenever the requirements of the originator or owner of an asset,

be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing,

off-the-shelf product or instrument. Hence, to meet this requirement, existing products and

techniques must be engineered into a tailor-made product or process. Thus, structured finance is a

flexible financial engineering tool.

one should better start with defining

what structured finance is. Even though there is no universal definition for structured finance, a good

working definition for structured finance may be the following:

58

Even though this very definition of structured finance would include not only securitization

but also structured credits, project finance, structured notes and leasing

59

57 Article “Securitization” from Wikipedia, available at

, it obviously gives a

number of clues in relation to securitization, the underlying commercial needs and its history. So

what is securitization then?

http://en.wikipedia.org/wiki/Securitization 58 Fabozzi, Frank J., Davis, Henry A., Choudhry, Moorad, Introduction to Structured Finance, John Wiley & Sons, Inc., New Jersey, 2006, p. 1 59 Ibid, p. 4

http://en.wikipedia.org/wiki/Securitization�


Securitization may be very briefly defined as the process of making a loan or mortgage into a

tradable security by issuing a bill of exchange or other negotiable paper in place of it.60

Securitization generally refers to the sale of assets, which generate cash flows, from the

institution that owns them, to another company that has been specifically set up for the purpose,

and the issuing of notes by this second company. These notes are backed by the cash flows from the

original assets.

Without any

doubt, this brief definition needs a detailed clarification in order to make the quite complicated

structure of securitization understandable for the reader.

61 The institution owning the cash flow generating assets is commonly known as the

originator. The other company mentioned in this explanation which purchases the cash flow

generating assets is known as the Special Purpose Vehicle (SPV) which is also known as Special

Purpose Company (SPC) or Special Purpose Entity (SPE).62

After a basic explanation of what securitization is

The SPV shall hold the assets purchased

from the originator as collateral for the securities issued and sold to the investors.

63

2.2 History of Securitization

, let us now move on with the history of

securitization.

Even though the modern securitization practices appeared at the beginning of 1970s in the

US, in Europe a form of mortgage funding has existed for many years that has remarkable similarities

to the present form of securitization, although the two are not the same. This instrument has existed

60 Dictionary of Banking and Finance, A & C Black Publishers Ltd, 3. Edition, London, 2005, p. 319 61 Choudry, Moorad, Corporate Bonds and Structured Financial Products, Elsevier Butterworth-Heinemann, Oxford, 2004, p. 297 62 For the purposes of this study, the concept Special Purpose Vehicle and the abbreviation SPV shall be used. 63 There are different kinds of ways to structure a securitization transaction which may vary considerably between each other. Besides, a securitization structure may be much more complex than the main concept explained in our brief definition. We will be explaining the concept in detail in the sections regarding the structure of securitization and types of securitization.


in Denmark for more than 200 years. Likewise, the German “pfandbrief”64 instrument has a long

history and is even alive today.65

The modern form of asset securitization began with the structured financing of mortgage

pools in the United States in the 1970s. In February 1970, the American department of housing and

urban development completes the first true securitization, on home loans.

66

For decades before that, banks were essentially portfolio lenders; they held loans until they

matured or were paid off. These loans were funded principally by deposits, and sometimes by debt,

which was a direct obligation of the bank (rather than a claim on specific assets).

67

But after World War II, depository institutions simply could not keep pace with the rising

demand for housing credit. Banks, as well as other financial intermediaries sensing a market

opportunity, sought ways of increasing the sources of mortgage funding. To attract investors,

investment bankers eventually developed an investment vehicle that isolated defined mortgage

pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although

it took several years to develop efficient mortgage securitization structures, loan originators quickly

realized the process was readily transferable to other types of loans as well.

68

To facilitate the securitization of non-mortgage assets, businesses substituted private credit

enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-

party and structural enhancements. In 1985, securitization techniques that had been developed in

the mortgage market were applied for the first time to a class of non-mortgage assets — automobile

loans. A pool of assets second only to mortgages in volume, auto loans were a good match for

64 The Pfandbrief (plural: Pfandbriefe) is a mostly triple-A rated German bank debenture which has become the blueprint of many covered bond models in Europe and beyond. The Pfandbrief is collateralized by long-term assets such as property mortgages or public sector loans as stipulated in the Pfandbrief Act. 65 Kothari, Vinod, Securitization The Financial Instrument of the Future, John Wiley & Sons (Asia) Pte Ltd, 2. Edition, 2006, p. 109 66 Article “Historical view of securitization”, available at http://www.banque-credit.org/EN/banks/history-securitization.html 67 Comptroller’s Handbook, Asset Securitization, Comptroller of the Currency Administrators of National Banks, 1997, p. 2 68 Ibid

http://en.wikipedia.org/wiki/Covered_bond�

http://www.banque-credit.org/EN/banks/history-securitization.html�



structured finance; their maturities, considerably shorter than those of mortgages, made the timing

of cash flows more predictable, and their long statistical histories of performance gave investors

confidence.69

Securitization only reached Europe in late 80's, when the first securitizations of mortgages

appeared in the UK. This technology only really took off in the late 90's or early 2000, thanks to the

innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts

(concept imported from the US Credit Cards), Insurance-backed transaction (such as the ones

implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset

classes (for example securitization of lottery receivables for the Greek government, executed by

Philippe Tapernoux).

70

Securitization industry became a trillion dollar industry within a few decades, approximately

75 per cent of which have originated from the US.

71

2.3 Structure of Securitization

This rapid growth experienced a very harsh decline when the housing bubble in the US burst

and the markets went into the worst financial crisis after the Great Depression of 1929. We will talk

about that later in the section 2.6 regarding securitization and the financial crisis.

In this section we will try to deeply examine how a securitization transaction is structured. In

other words, we will be going a step further than our definition section above and capture all the

important features of a transaction.

Now, before going into the elements of a securitization deal, let us try to make a summary of

a securitization transaction in order to see the phases of it or how a transaction is structured:

69 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 70 Ibid 71 Kothari, Securitization The Financial Instrument of the Future, supra, p. 112



An originator of (usually) high quality receivables, such as home mortgage loans and

consumer credit receivables, sells the receivables to a specially formed company (SPV) in

return for a purchase price payable immediately on sale.

The SPV finances the purchase price of the receivables by borrowing from banks or by a

conventional bond or note issue to sophisticated investors (“funding loan”). The SPV grants

security to investors over the receivables to secure the borrowing.

The SPV authorizes the originator as the “servicer” to collect the receivables on behalf of the

SPV which uses them to pay principal and interest on the funding loan (investing the

proceeds in the meantime). The SPV pays a servicing fee to the servicer.

The SPV is usually a thinly-capitalized single-purpose company whose shares are held by

somebody other than the originator, e.g. charitable trustees, so that the SPV is not a

subsidiary which must be consolidated on the originator’s balance sheet.

In order to ensure that the receivables are sufficient to repay the investors on time, there

may be various forms of “credit enhancement”, e.g. a third party may give a guarantee to the

SPV or the originator may agree to make a subordinated loan to the SPV.

The loan by the investors, e.g. loan notes, is often rated by a rating agency. Usually the loan

has a higher rating than would be obtainable for a direct loan to the originator.

The SPV pays surplus income from the receivables, which is not needed to repay the funding

loan, to the originator so that the originator takes the profit. The SPV may pay this profit to

the originator as servicing fees or other means.72

Below is a figure73

72 Wood, Philip R., Title Finance, Derivatives, Securitisations, Set-off and Netting, Sweet&Maxwell, 4. Edition, 2001, pp.41-42

which perfectly complements our summary:

73 Fabozzi, Frank J., Davis, Henry A., Choudhry, Moorad, Introduction to Structured Finance, supra, p. 70


The originator is the key concept in a securitization structure. The originator is the legal (or

even real) person that starts the whole process by deciding to securitize its cash flow generating

assets. Who or what can be an originator or in other terms can securitize its assets?

An originator can be any legal person as well as real persons that have cash flow generating

assets. Quite interestingly David Bowie, James Brown, the Isley Brothers, and Rod Stewart used

securitization to obtain funding from their future music royalties. The first was David Bowie who in

1997 used securitization to raise $55 million backed by the current and future revenues of his first 25

music albums (287 songs) recorded prior to 1990.74 The legal persons that use securitization may be

financial institutions, large corporates, quasi-government agencies and even local governments and

municipalities.75

As the example regarding the music royalties may give a clue, all assets can be securitized so

long as they are associated with cash flow.

76

74 Fabozzi, Frank J., Kothari, Vinod, Introduction to Securitization, John Wiley & Sons, Inc., 2008, p. 15

The securitization market in the United States and

75 Jobst, Andreas A., Asset Securitisation as a Risk Management and Funding Tool: What Does it Hold in Store for SMES? February 14, 2005, p.2, available at SSRN: http://ssrn.com/abstract=700262 76 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization

http://ssrn.com/abstract=700262�



Western Europe is dominated by a number of asset classes: residential mortgage receivables,

commercial mortgage receivables, credit card receivables, auto loans, consumer loans, trade

receivables and uncontracted future cash flows (such as toll receipts). However the type of assets

that can be securitized continues to expand (some of the key innovators in Western Europe have

been governments). In principle, any assets or entitlements representing future (predictable) cash

flows can be securitized to the extent that they can be effectively transferred to the SPV through a

true sale (or to the extent that the Originator is considered to be “bankruptcy remote”). These may,

for instance, include tax revenues or utilities payments.77

2.3.1 True Sale

It is imperative that once the sale and transfer of the assets to the SPV has been effected, it

cannot be challenged, voided or otherwise reversed in an insolvency of the Originator or otherwise.

This concept is referred to as true sale. Whether a transaction constitutes a true sale under the

applicable law (notably, whether it will be recognized as such by the competent court in the

Originator’s insolvency) must be established through a legal analysis of the transaction.78

If it is subsequently determined in a bankruptcy proceeding that the so-called sale by the

originator was merely a nomenclature or a camouflage, then a bankruptcy judge can rule that the

assets were never sold and were merely pledged as collateral for a financing. In that case, in the

event of a bankruptcy filing by the originator, the bankruptcy judge can have the assets of the SPV

treated as part of the assets of the originator. This would defeat the purpose of setting up the SPV.

Typically, a true sale opinion letter by a law firm is sought to provide additional comfort to the

parties in the transaction.

79

In order to qualify for a true sale treatment, generally, a transaction must meet the following

criteria:

77 IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, p.2, available at http://www.ifc.org/ifcext/eca.nsf/AttachmentsByTitle/Securitization1A%2B9-04/$FILE/Securitization1A%2B9-04.pdf 78 Ibid 79 Fabozzi, Kothari, Introduction to Securitization, supra, p. 9

http://www.ifc.org/ifcext/eca.nsf/AttachmentsByTitle/Securitization1A%2B9-04/$FILE/Securitization1A%2B9-04.pdf�



Legal isolation from the seller (transferred assets put “presumptively beyond the reach of the

transferor and its creditors”);

The new owner of the assets has the right to pledge or to exchange the assets (or the

beneficial interests in the assets if the new owner is a qualifying (SPV); and

The seller doesn’t have the right to buy the assets back.80

2.3.2 Special Purpose Vehicle

The originator intending to securitize its assets needs to establish a Special Purpose Vehicle

(SPV). An SPV is a company that is created solely for a particular financial transaction or series of

transactions. It may sometimes be something other than a company, such as a trust.81 So the

originator establishes an SPV in order to use it for a particular financial transaction or series of

transactions. It does so because creation of marketable securities is not possible without a conduit or

vehicle that will house the assets transferred by the originator and create securities based on such

assets. Therefore, a vehicle is required to serve as an intermediary between the originator and the

investors. A general purpose, or operating company, is not fit to hold securitized assets as such a

company might have other assets and other liabilities, each of which might interfere with the

exclusivity of rights over the assets that the transaction intends to give to the investors.82

If an operating company holds the assets, it might incur expenses, and/or incur liabilities, and

might go bankrupt, thereby destroying the transaction. By its very nature, a special purpose vehicle is

a legal shell with only the specific assets transferred by the originator, and those assets are either

beneficially held by the investors or collateralize the securities of the vehicle; there is nothing left in

the vehicle for anyone to have an interest in. A special purpose vehicle is a legal entity, but a

substantive non-entity. This is what makes a special purpose vehicle bankruptcy-remote.

83

80 Hayre, Lakhbir, Ed. by, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, John Wiley & Sons, Inc., 2001, p. 75 81 Article “SPV”, available at http://moneyterms.co.uk/spvspe/ 82 Kothari, Securitization The Financial Instrument of the Future, supra, pp. 15-16 83 Ibid, p. 16

http://moneyterms.co.uk/spvspe/�


As a result of the aforementioned, an SPV is a legal entity functioning as a conduit with no

physical presence, independent management or employees. It can take the form of limited

partnership, limited liability company, trust, corporation, collective investment fund or established

under special law but only if those laws are SPV-enabling. The SPV cannot be consolidated with the

originator for tax, accounting or legal purpose as that will effect its bankruptcy-remote position.84

Frequent issuers under US and UK law use master trust structures, which allow multiple

securitizations to be issued from the same SPV. Under such schemes, the originator transfers assets

to the master trust SPV. Notes are then issued out of the asset pool based on investor demand.

Master trusts have been used by Mortgage-Backed Securities (MBS) and credit-card Asset-Backed

Securities (ABS) originators.

For tax reasons, the SPV is mostly established in a tax-friendly jurisdiction such as

Luxembourg, Cayman Islands, Nevis, etc. in order to avoid the transfer or municipality taxes, etc.

Obviously, the originator has an expertise in the area as it is mainly dealing with that type of

business. Furthermore, the originator knows the borrowers and vice versa. So it makes perfect sense

for the originator to go on administering the portfolio of the assets.

85

2.3.3 Credit Enhancement

Unlike conventional corporate bonds which are unsecured, securities generated in a

securitization deal are "credit enhanced," meaning their credit quality is increased above that of the

originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors

84 Akamatsu, Noritaka, Role of Special Purpose Vehicles in ABS Market, August 14-18, 2006, The World Bank China, p. 3, available at http://www.slideshare.net/financedude/role-of-special-purpose-vehicles-is-abs-market 85 Choudry, Moorad, An Introduction to Bond Markets, John Wiley & Sons, 3. Edition, 2006, p. 228

http://www.slideshare.net/financedude/role-of-special-purpose-vehicles-is-abs-market�


will receive cash flows to which they are entitled, and thus causes the securities to have a higher

credit rating than the originator.86

The mechanisms for credit enhancement can be classified into three categories: (1)

originator-provided, (2) structural, and (3) third-party provided. Originator-provided credit

enhancement refers to credit support where a part of the credit risk of the asset pool is assumed by

the originator/seller. Structural credit enhancement refers to the redistribution of credit risks among

the bond classes comprising the structure, so that one bond class provides credit enhancement to

the other bond classes. Finally, third-party credit enhancement refers to the assumption of credit risk

by parties other than the originator and the other bond classes in the structure.

87

Whatever is available from the income of the transaction (after meeting senior expenses) to

meet losses on the assets is credit-enhancing excess spread.

The originator-provided credit enhancement mechanisms include excess spread, cash

collateral, over-collateralization, etc.

88 More specifically, the excess spread is

equal to the interest paid by the asset pool (which is based on the note rate of the obligors in the

asset pool) reduced by (1) the expenses of the transaction such as trustee fees; (2) senior servicing

fees; and (3) the payments made to the bond classes (which is based on the weighted average

funding cost). For example, assume a pool of loans that has a weighted average note rate of 9.5%

and the originator receives a servicing fee of 1.5%. If the weighted average funding cost is 5.0%, then

the excess spread is 3% (9.5% − 1.5% − 5%). The advantage of retaining the exc ess spread is that it

can be used to offset losses in future periods.89

86 Article “Securitization” from Wikipedia, available at

To sum up, excess spread is the funds remaining after

expenses such as principal and interest payments, as well as other fees have been paid-off are

accumulated, and can be used when SPV expenses are greater than its income.

http://en.wikipedia.org/wiki/Securitization 87 Fabozzi, Kothari, Introduction to Securitization, supra, p. 86 88 Kothari, Securitization The Financial Instrument of the Future, supra, p. 213 89 Fabozzi, Kothari, Introduction to Securitization, supra, pp. 86-87



Secondly, the originator can create a cash collateral account at the initiation of the

transaction and the cash in that account is subject to withdrawal in the event of losses that exceed

the amount provided by other forms of credit enhancement. At the termination of the transaction,

any balance in the cash collateral account is returned to the originator. The originator can also make

a subordinated loan to the SPV which has the same cash collateral effect.90

Over-collateralization is one of the most common forms of credit enhancement where the

originator transfers an asset pool that has a market value that exceeds the amount paid by the SPV.

The amount of the over-collateralization is a form of equity and is equal to the difference between

the par value of the assets transferred and the price paid.

91

Let us move on with structural credit enhancement mechanisms. The most common form of

credit enhancement for securitization transactions is the stratification of the bond classes into senior,

mezzanine, and junior (or subordinated) bond classes.

92 As this is the very principle of structured

finance –carving out securities with different risk/return attributes, structural enhancement is crucial

to a securitization transaction.93 When various classes of liabilities are issued with different

priorities—such as Class A, Class B, and Class C, the subordination of Class C provides a credit

enhancement to Class B, and both of them provide enhancement to Class A. This credit enhancement

comes from the structure of the liabilities, so it is called structured enhancement.94 This mechanism,

which is set down in the deal’s prospectus, is known as the cash flow waterfall, or simply the

waterfall.95

The figure below

That structure is also known as Tranching.

96

90 Ibid, p. 88 91 Ibid, p. 89 92 Ibid, p. 90 93 Kothari, Securitization The Financial Instrument of the Future, supra, p. 218 94 Ibid 95 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 107

is an illustration of how the waterfall structure in a securitization scenario

works. As it is noted above, in a securitization the issued notes are structured to reflect the specified

risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA.

The lower-rated notes usually have an element of over-collateralization and are thus capable of

96 Article “Tranche” from Wikipedia, available at http://en.wikipedia.org/wiki/Tranche

http://en.wikipedia.org/wiki/Tranche�


absorbing losses. The most junior note is the lowest-rated or non-rated. It is often referred to as the

first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece

is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by

the originator.97

Finally, the third-party provided credit enhancements come in the form of third-party

guarantees [such as a letter of credit (L/C) or a surety bond] that provide for first-loss protection

against losses up to a specified amount.98 In this form of credit enhancement, an insurance provider

agrees, for a fee, to guarantee the performance of a certain amount of the collateral against defaults.

If, for example, a loan in the collateral pool goes into default and the underlying collateral is

repossessed and then sold at a loss resulting in a partial payoff of the outstanding loan balance, the

bondholders would be in a position not to recover the principal outstanding for that loan. To provide

protection to the bondholders, an insurance provider will pay the difference between the loan payoff

amount and the amount due to the bondholders, thereby absorbing the loss.99

97 Choudry, An Introduction to Bond Markets, supra, p. 228 98 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 105 99 Fabozzi, Frank J., Drake, Pamela P., Finance Capital Markets, Financial Management and Investment Management, John Wiley & Sons, Inc., 2009, p. 433


It is also possible to use derivatives as third party provided credit enhancement mechanisms.

Credit derivatives were developed along the lines of other over-the-counter (OTC) derivatives but

have found an excellent companion in securitization. Credit derivatives are financial contracts

designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered

due to credit events. A payout under a credit derivative is triggered by a credit event associated with

the credit derivative's reference asset or reference entity.100 The party that provides protection

against such risk is called protection seller and the party that buys such protection, normally but not

necessarily the originator of the credit asset, is called the protection buyer.101

The most common credit derivative is the credit default swap, credit swap or default swap.

This is a bilateral contract that provides protection on the par value of a specified reference asset,

with a protection buyer that pays a periodic fixed fee or a one-off premium to a protection seller, in

return for which the seller will make a payment on the occurrence of a specified credit event.

102

At this point, while talking about credit default swaps, we should note that this instrument

was the main reason for American International Group, Inc. (AIG), one of the biggest insurance

agencies in the world, to go almost bankrupt in the recent financial crisis. It could only manage to

survive with several Federal Reserve bailouts. What AIG mainly doing was writing credit default

swaps to back Collateralized Debt Obligations (CDO) which has been a very profitable business during

the housing boom. However when the bubble burst and the AIG was downgraded to AA, it was

required to post additional collateral with its trading counter-parties, and this led AIG into a liquidity

crisis.

103

Apart from the credit risk, the parties to a securitization transaction are also under interest

rate risk. For that reason, most securitization transactions contain some form of interest rate hedging

and/or currency hedging to deal with currency risk and basis risk.

104

100 Choudry, Moorad, An Introduction to Credit Derivatives, Elsevier Butterworth-Heinemann, 2004, p.11 101 Kothari, Securitization The Financial Instrument of the Future, supra, p. 25 102 Choudry, An Introduction to Credit Derivatives, supra, p.16

An interest rate swap can be

used to alter the cash flow characteristics of the assets (liabilities) to match the characteristics of the

103 Article “American International Group” from Wikipedia, available at http://en.wikipedia.org/wiki/American_International_Group 104 Deacon, John, Global Securitization and CDOs, John Wiley & Sons Ltd, 2004, p. 31

http://en.wikipedia.org/wiki/American_International_Group�


liabilities (assets). For example, let us suppose a transaction has a pool of fixed rate, monthly

payment loans but the bond classes that are supported by the collateral have floating rate, monthly

payment characteristics. A generic or plain vanilla swap can be used to convert the monthly, fixed

rate cash flows to monthly, floating rate cash flows based on the reference rate and margin owed to

the covered classes of bonds.105

The credit enhancement is sized appropriately for the rating level to cover the expected pool

losses during the life of securitization. The amount of credit enhancement will vary according to the

expected pool losses and the historical volatility of the issuer’s losses. Therefore, prime issuers will

have the lowest credit enhancement, followed by nonprime issuers, and finally subprime issuers will

have the highest credit enhancement (and additionally, often a monoline wrap).

106

2.3.4 Credit Rating

Rating is almost indispensable in the process of securitization. All major international rating

agencies are engaged in rating securitization transactions. Every securitization transaction has a

potential to result in a given rating. For example, if a AAA rating is targeted in an auto finance pool,

originated by an A-rated issuer, it is quite possible to do so; all that is required is to work out the level

of credit enhancements or subordinated interest.107

As securitization is a structured finance device, the investors are not concerned with the

entity except for the quality of the originated portfolio. Essentially, the rating agencies are concerned

with the quality of the underlying pool.

108

105 Fabozzi, Kothari, Introduction to Securitization, supra, p. 108 106 Hayre, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, supra, p. 89 107 Kothari, Securitization The Financial Instrument of the Future, supra, p. 309 108 Ibid, p. 310

Even though it is often said that the rating of the

originator is completely irrelevant for securitization transactions, it should be noted that the rating of

covered bonds depends on a composite view of the strength of the rating of the issuer and the rating

of the collateral pool; neither can be used solely – the issuer may be less relevant in jurisdictions with

stronger insolvency ring-fencing, and more relevant in other jurisdictions. The credit of the collateral


pool may change with the ability to dynamically substitute the pool.109

As rating agencies have long experience in rating securitization issues, they have developed a

benchmark for different asset classes. Mainly the most important rating agency concerns while giving

a rating are the quality of the asset portfolio, solvency of the issuer, perfection of the legal structure,

tax risks, clean and prior title to the securitized portfolio, risks of set-off and prepayment, etc.

Obviously the abilities of the

originator as the servicer will have some effect on the cash flow from the originated assets.

110

Why doesn’t a corporation always seek the highest credit rating (AAA) for the bonds backed

by the collateral in a securitization transaction? The answer is that credit enhancement does not

come without a cost. The various credit enhancement mechanisms increase the costs associated with

securitized borrowing via an asset-backed security. So, when it is seeking a higher rating, the

corporation must assess the tradeoff between the additional cost of credit enhancing the bonds

versus the reduction in funding cost by issuing a bond with a higher credit rating.

111

A change in rating for an Asset-Backed Security (ABS) or Mortgage-Backed Security (MBS)

issue may be due to deterioration in performance of the collateral, heavy utilization of credit

enhancement or downgrade of a supporting rating – for example, an insurance company that was

underwriting insurance on the pool of the assets.

112

Some recent lawsuits alone show the crucial role played by the rating agencies in

securitization transactions. Recently there have been several lawsuits attributable to the rating of

securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension

fund has filed suit in California state court in connection with $1 billion in losses that it says were

caused by “wildly inaccurate” credit ratings from the three leading ratings agencies.

113

109 Deacon, Global Securitization and CDOs, supra, p. 125 110 Kothari, Securitization The Financial Instrument of the Future, supra, pp. 310-313 111 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 72 112 Choudry, An Introduction to Bond Markets, supra, p. 232 113 Wayne, Leslie, Calpers Sues Over Ratings of Securities, NY Times, July 14, 2009, available at http://www.nytimes.com/2009/07/15/business/15calpers.html?_r=3&scp=1&sq=calpers&st=cse

http://www.nytimes.com/2009/07/15/business/15calpers.html?_r=3&scp=1&sq=calpers&st=cse�


2.3.5 Profit Extraction

In most securitizations, at least in the good old times it was the case, it is expected that the

SPV will receive more income than it needs from the securitized assets to meet its liabilities to the

investors and its own nominal profit entitlement. It is then of the essence that any such surplus

income should be returned to the originator, which is consistent with the securitization being

essentially a method of funding rather than a sale of assets, from the Originator’s perspective.114

2.4 Motivation for Securitization

Now after scrutinizing the complex structure of securitization, it is time to look at the motives

of the parties for securitization or what the reasons to undertake a securitization transaction and

invest in the securities issued are.

Even though the financial turmoil seen recently made many people think that securitization

was one of the main reasons of the credit crunch, obviously there are many reasons for the

originators to undertake securitization deals and also for the investors to invest in the securities

issued. In this part, we will try to explain these motives for the parties to a securitization transaction,

namely the originator and the investors.

2.4.1 Motivation for the Originator

The rationale for securitization varies widely from company to company.115

There is a bunch

of reasons for different kind of originators to undertake securitization transactions and here we will

try to explain the most important ones for most companies.

114 Article “Securitization: other common features” from HM Revenue & Customs, available at http://www.hmrc.gov.uk/MANUALS/cfmmanual/CFM20050.htm 115 Deacon, Global Securitization and CDOs, supra, p. 19

http://www.hmrc.gov.uk/MANUALS/cfmmanual/CFM20050.htm�


2.4.1.1 The potential for reducing costs

The segregation of receivables from the insolvency risk of the originator will enable funds to

be raised which are not linked to credit risk on the originator. For an originator that is perceived as a

bad credit risk, or has a low credit rating, this should serve to improve the all-in cost of funds to the

originator, or the amount of finance that can be raised.116 Let us give an example in order to show

how that happens. Through securitization, a company rated BB but with AAA worthy cash flow would

be able to borrow at possibly AAA rates. The difference between BB debt and AAA debt can be

multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in

January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002

and April 2002, continued to be rated AAA because of the strength of the underlying collateral and

other credit enhancements.117 By credit enhancement, it is meant that there is a source of capital

that can be used to absorb losses incurred by the asset pool.118

2.4.1.2 The ability to diversify funding sources

The ABS markets have their own investor base, some or all of which may not be current

investors in the business of the originator, whether due to unfamiliarity with the originator, or credit

concerns on the originator. Issuing in the ABS markets enables the originator to access this new base

of investors and expand their current funding sources.119 By doing so, without disturbing existing

lenders, securitization extends the pool of available funding sources to an entity by bringing in a new

class of investors. For many entities, typical securitization investors such as insurance companies,

asset managers, pension funds and the like may not be available for access, other than for

investment in a securitization program.120

116 Ibid, p. 5 117 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 118 Fabozzi, Kothari, Introduction to Securitization, supra, p. 15 119 Deacon, Global Securitization and CDOs, supra, p. 5 120 Kothari, Securitization The Financial Instrument of the Future, supra, p. 98



2.4.1.3 The ability to manage corporate risk

The credit risk and the interest rate risk of assets that have been securitized are no longer

risks faced by the originator/seller. Thus, securitization can be used as a corporate risk management

tool.121 Once assets have been securitized, the credit risk exposure on these assets for the originating

bank is reduced considerably and, if the bank does not retain a first-loss capital piece (the most

junior of the issued notes), it is removed entirely.122 Before securitizing the assets, the lenders are

also subject to the interest rate risk, as mortgages for instance carry a fixed rate of return, while the

loans taken by the lenders have a variable rate. When the mortgages are securitized, the originator

completely avoids the price risk as the entire interest rate or prepayment risk inherent in the pool is

transferred to capital markets.123

2.4.1.4 The ability to help in capital adequacy requirements

Capital adequacy requirements relate to the minimum regulatory capital for financial

intermediaries. One of the very strong motivations for securitization is that it allows the financial

entity to sell off some of its on-balance sheet assets, and thus remove them from the balance sheet

and reduce the amount of capital required for regulatory purposes124 which again can lead to cost

savings or allows the bank to allocate capital to other, perhaps more profitable, businesses.125

121 Fabozzi, Kothari, Introduction to Securitization, supra, p. 17 122 Choudry, An Introduction to Bond Markets, supra, p. 224 123 Kothari, Securitization The Financial Instrument of the Future, supra, p. 101 124 Kothari, Securitization The Financial Instrument of the Future, supra, p. 100 125 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 76


2.4.1.5 The opportunity to achieve off-balance financing

Most securitizations transfer assets and liabilities off the balance sheet, thereby reducing the

amount of the originator’s on-balance sheet leverage. The off-balance-sheet financing can help

improve the securitizer’s return on equity (ROE) and other key financial ratios.126

2.4.1.6 The ability to match the assets and liabilities

Asset liability mismatch is a serious issue for financial intermediaries such as banks and

financial companies. It refers to the maturity mismatch between assets and liabilities. Mismatch

spells either higher risk or cost, and so intermediaries try to strike a near perfect match between

maturities of assets and liabilities.127 Depending on the structure chosen, securitization can offer

perfect matched funding by eliminating funding exposure in terms of both duration and pricing

basis.128

2.4.1.7 The ability to reduce credit concentration

Securitization has also been used by many entities for reducing credit concentration.

Concentration either sectoral or geographical, implies risk. Securitization by transferring on a non-

recourse basis exposure by an entity has the effect of transferring risk to capital markets.129

2.4.1.8 The opportunity for arbitrage by repackaging

Securitization has also been used by a number of banks and financial professionals for

arbitraging purposes: Buying up assets from the market at higher spreads, accumulating them,

126 Fabozzi, Kothari, Introduction to Securitization, supra, p. 19 127 Kothari, Securitization The Financial Instrument of the Future, supra, p. 98 128 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 129 Kothari, Securitization The Financial Instrument of the Future, supra, p. 101



providing or organizing enhancements and securitizing them. These transactions are sometimes

called repackaging transactions, giving a net arbitrage profit to the repackager.130

2.4.2 Motivation for the Investors

Investor interest in the ABS market has been considerable from its inception. This is because

investors perceive asset-backed securities as possessing a number of benefits.131

First of all, securitized instruments are devices of asset-based finance. Investors have a direct

claim over a portfolio of assets, often diversified and reasonably credit-enhanced. Investors are not

affected by any of the risks that beset the originator. Thus, securitization investments are far safer

than investing directly in the debt or equity of the originator.

Now let us try to

explain what advantages securitization ensures to the investors.

132

A holding in an ABS also diversifies an investor’s risk exposure. For example, rather than

investing $100 million in an AA-rated corporate bond and be exposed to “event risk” associated with

the issuer, investors can again exposure to, for instance, 100 pooled assets. These pooled assets

clearly have lower concentration risk.

133 That is why hedge funds as well as other institutional

investors tend to like investing in bonds created through securitizations because they may be

uncorrelated to their other bonds and securities.134

Obviously securitization gives the investors the opportunity to access sectors that are

otherwise not open to them

135 and potentially earn a higher rate of return (on a risk-adjusted

basis).136

130 Ibid

131 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 79 132 Kothari, Securitization The Financial Instrument of the Future, supra, p. 102 133 Fabozzi, Davis, Choudhry, Introduction to Structured Finance, supra, p. 79 134 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization 135 Choudhry, An Introduction to Bond Markets, supra, p. 224 136 Article “Securitization” from Wikipedia, available at http://en.wikipedia.org/wiki/Securitization




2.5 Different Classifications of Securitization

2.5.1 According to asset types

One actually needs to answer the question “What can be securitized?” in order to see

different securitization structures according to asset types. We mentioned before that cash flow

generating assets can be securitized. When we look at the practice we see that the most common

assets that have traditionally been securitized are residential mortgage receivables, commercial

mortgage receivables, credit card receivables, auto loans, consumer loans, trade receivables and

uncontracted future cashflows. However the type of assets that can be securitized continues to

expand. In principle, any assets or entitlements representing future (predictable) cash flows can be

securitized to the extent that they can be effectively transferred to the SPV through a true sale (or to

the extent that the Originator is considered to be “bankruptcy remote”). These may, for instance,

include tax revenues or utilities payments.137

2.5.2 According to SPV types

In most securitization structures, the SPV is created specifically for the particular originator

and the particular transaction. The objective of this so-called one-off securitization is to provide the

originator with significant flexibility to customize the securitization in terms of its particular structure

and the types of capital market securities issued. However, because one-off structures are created

for a particular transaction, their transaction costs can be high; they can rarely achieve the

transaction cost economies of scale realized by multiseller securitization conduits.138

A multiseller securitization conduit offers originators the opportunity to minimize their

transaction costs by utilizing a common SPV. These conduits are typically administered by

commercial or investment banks and are able to achieve a transaction cost economy of scale by

137 IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p.2 138 Schwarcz, Steven L, The Alchemy of Asset Securitization, International Financial Law Review, May 1995, p. 31


allowing multiple originators to sell receivables to a single pre-existing SPV.139 Although multiseller

structure can minimize the transaction cost by achieving economy of scale, it has higher risk of

getting involved with bankruptcy claims when single originator goes bankruptcy. It can adversely

affect legal existence of the multiseller SPV. Thus, multiseller SPV is often used in transactions with

investment grades, because those originators are less likely to go bankrupt. Alternatively the

potential risk caused by originator’s bankruptcy can be mitigated by special arrangement so called

“compartment” stated in special securitization law, like the Securitization Law issued in March 2004

in Luxembourg.140

2.5.3 Pass through & Pay through Securitization Structures

A pass through securitization structure refers to the securitization structure where the SPV

makes payments, or rather, passes payments to the investors, on the same periods, and subject to

the same fluctuations, as are there in the actual receivables. That is to say, amount collected every

month is passed through to investors, after deducting fees and expenses.141 This is done by selling

direct participations in the pool of assets. In other words, a pass-through certificate represents an

ownership interest in the underlying assets and thus in the resulting cash flow. Principal and interest

collected on the assets are “passed through” to the security holders; the seller acts primarily as a

servicer.142 When substantially all the payments are collected and disbursed, the SPV is typically

dissolved.143

In a pay-through securitization structure, the issued debt instrument is a borrowing

instrument, not participation. Under the pay-through structure, the assets are typically held by a

limited purpose vehicle that issues debt collateralized by the assets. Like a pass-through, the debt

service is met by cash flow “paid through” to investors out of the pledged collateral. Investors in a

pay-through bond are not direct owners of the underlying assets; they have simply invested in a

139 Ibid, p. 32 140 Wang, Shegzhe, True Sale Securitization in Germany and China, LL.M. Finance thesis, Johann Wolfgang Goethe University, Institute for Law and Finance (ILF), 2004, pp.20-21 141 Available at http://www.vinodkothari.com/glossary/Passthro.htm 142 IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p. 7 143 Ryan, Stephen G., Financial Instruments & Institutions, Accounting and Disclosure Rules, John Wiley & Sons Inc., 2. Edition, 2007, p. 196


bond backed by some assets. Therefore, the issuing entity can manipulate the cash flows, into

separate payment streams. Thus pay-through securities may be structured so that asset cash flows

can be reconfigured to support forms of debt unlike those of the underlying assets.144

2.5.4 True sale & Synthetic Securitization Structures

One of the key aspects of ensuring the marketability of the relevant debt securities or bank

debt that will fund the securitization is to enable the relevant rating agencies to analyze the credit

risk of the relevant receivables free and clear of the credit risk of the entity that originated the

receivables in question – such that the deal is delinked from the credit of the originator. In order to

ensure that this treatment is available, a securitization transaction will usually attempt to effect a

‘‘true sale’’ under the relevant legal regime relating to the receivables – terminology used to

describe a sale of the receivables being securitized in a manner which ensures their isolation from

the bankruptcy or insolvency of the originator.145

Other objectives a true sale securitization can achieve are, inter alia, transferring of credit

risks, access to capital markets and influencing balance sheet. For accounting purpose, a true sale

securitization allows an originator to take the securitized assets off its balance sheet, thus improving

its leverage.

Obviously this will increase the rating for the

securities and consequently the financing cost will be lower than it would otherwise be.

146

As asset securitization converts assets into securities, if the assets in question are synthetic

rather than really transferred and securitized, this is a synthetic securitization. The synthetic

technology comes from the world of derivatives, where a position of risk and return emulating an

actual asset or exposure is created by a derivatives transaction. The basis of a synthetic securitization

144 IFC Technical Working Group on Securitization in Russia, Securitization Key Legal and Regulatory Issues, 2004, supra, p. 7 145 Deacon, Global Securitization and CDOs, supra, p. 37 146 Wang, True Sale Securitization in Germany and China, supra, p. 23


is a derivative or a risk transfer transaction and the purpose is to synthetically replicate actual

transfer of assets.147

A synthetic securitization securitizes a debt portfolio synthetically, not actually. In a true sale

securitization structure, the transaction includes two key features, - cash and transfer, with the

originator raising cash and making a transfer. In a synthetic transaction, both are missing; the

originator does not raise any cash, nor does he transfer any assets.

148

a true sale securitization is an off-balance sheet financing mechanism, while a synthetic

securitization is an on-balance sheet financing tool.

If we basically look at the main differences between the true sale and synthetic structures,

we will see that;

an SPV is a must in true sale securitizations but not a necessity in synthetic securitizations.

the main function of true sale securitizations is to get cheaper funding; synthetic

securitizations however mainly function as an efficient technique to hedge credit risks.149

2.5.5 Asset-backed & Future Flows Securitization Structures

While traditional asset-backed transaction relate to assets that exist, future flows

transactions relate to assets expected to exist. There is a source, a business, an infrastructure, from

which the asset will arise. The source, business or infrastructure in question will have to be worked

upon to generate the income; in other words, the income has not been originated and set apart such

that repayment of the securities is a self-liquidating exercise. On the other hand, future flows is close

to corporate funding in that there needs to be a performance on the assets or infrastructure to see

the cash flow with which the securities will be paid. As an example, an electricity company

147 Kothari, Securitization The Financial Instrument of the Future, supra, p. 524 148 Ibid, 525 149 Wang, True Sale Securitization in Germany and China, supra, p. 24-26


securitizing electricity revenues, or an airlines company securitizing air ticket sales is doing a future

flows securitization transaction.150

2.6 Securitization and the recent credit crunch

Before going into detail, let us first look at the chronological history of the financial turmoil

seen recently. The first stage of the credit crunch involved U.S. residential house prices and those

financial instruments that depended on them. This lasted from mid 2006 to mid 2007: during this

period, it was clear that trouble was ahead, but the financial system was still functioning well. The

second stage began when the institutions that had mortgage risk suffered losses. This eroded

confidence. Firms found it harder to raise money; they had less capital as it had been eroded by their

losses; and they were worried about the credit quality of many of their borrowers. Hence they made

fewer loans, and by early 2008 a general contraction of lending had begun. The Credit Crunch was

visibly underway. The third stage of the Crunch began in September 2008 with the failure of Lehman

Brothers. Confidence had been fragile before this point: but when it became clear that the U.S.

authorities would permit large institutions to fail, it was entirely lost.151

The broad industry shift from an originate-to-hold model (in which a lender initiates and then

keeps loans in its own portfolio) to an originate-to-distribute model relies on the ability to sell

mortgage-backed securities (MBS) to investors.

152 Mortgage originators passed the entire risk of

default to the ultimate purchaser of the loan security. They had, therefore, less incentive to

undertake careful underwriting. Consequently loan volume gained greater priority over loan quality

and the amount of lending to subprime borrowers153 increased.154

150 Kothari, Securitization The Financial Instrument of the Future, supra, p 475 151 Murphy, David, Unraveling the Credit Crunch, CRC Press, Taylor & Francis Group LLC, 2009, pp. 5-6 152 Barth, James R., The Rise and Fall of the U.S. Mortgage and Credit Markets, John Wiley & Sons, Inc., 2009, p. 153 153 The term subprime generally refers to borrowers who do not qualify for prime interest rates because they exhibit one or more of the following characteristics: weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, or bankruptcies; low credit scores; high debt-burden ratios; or high loan-to-value ratios. 154 Chapra, M. Umer, Innovation and Authenticity in Islamic Finance, Forum Speech delivered at Eighth Harvard University Forum on Islamic Finance, April 19-20, 2008, p. 6

Without a surprise, that caused a

housing boom.


Starting in mid 2007, rising delinquency and foreclosure rates in the US subprime mortgage

market triggered a severe financial crisis which spread around the world. Although subprime

mortgages155, that were granted to borrowers with weak credit record and often require less

documentation, only account for about 15 percent of all outstanding US mortgages, they were

responsible for more than 50 percent of all mortgage loan losses in 2007. Most of the subprime

losses were caused by high foreclosure rates on hybrid adjustable rate mortgages (ARM). These loans

offer fixed initial interest rates at a fairly low level, which are replaced by higher rates linked to an

interest rate index after two or three years. Thus, borrowers face a significant payment shock after

the interest reset which increases the probability of delinquencies. In previous years, rising real

estate prices and, thus, increasing home owner equity enabled mortgage associations to waive part

of delinquent interest payments in exchange for an increase in nominal value of the mortgage or to

renegotiate the mortgage. But during 2007 the trend in real estate prices has reversed in many

regions of the United States leading to “negative equity" of many borrowers, i.e. to real estate values

that are lower than their outstanding debt. Consequently, default rates increased.156

As more borrowers stopped paying their mortgage payments, foreclosures and the supply of

homes for sale increased. This placed downward pressure on housing prices, which further lowered

homeowners' equity. The decline in mortgage payments also reduced the value of MBS, which

eroded the net worth and financial health of banks. MBS is a financial innovation which enabled

institutions and investors around the world to invest in the U.S. housing market. As housing prices

declined, major global financial institutions that had borrowed and invested heavily in subprime MBS

reported significant losses. Defaults and losses on other loan types also increased significantly as the

crisis expanded from the housing market to other parts of the economy. Total losses are estimated in

the trillions of U.S. dollars globally.

157

155 Throughout the time, the mortgage qualification guidelines became looser and looser. At first, the stated income, verified assets (SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to "state" it and show that they had money in the bank. Then, the no income, verified assets (NIVA) loans came out. The lender no longer required proof of employment. Borrowers just needed to show proof of money in their bank accounts. The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA. NINA is an abbreviation of No Income No Assets. Basically, NINA loans are official loan products and let you borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score. 156 Weber, Thomas, How to react to the Subprime Crisis? - The Impact of an Interest Rate Freeze on Residential Mortgage Backed Securities, Four Essays on Debt Securitization and Entrepreneurial Finance, PhD. dissertation, University of Konstanz, 2008, p.118 157 Article “Subprime Mortgage Crisis” from Wikipedia, available at http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

http://en.wikipedia.org/wiki/Subprime_mortgage_crisis�


Rating agencies played a crucial role in the crisis as they provide information about the

quality of such securities. As of November 5, 2008, AAA-rated securities accounted for 29 to 45

percent of all rated fixed-income securities that were issued between January 1, 2000, and

September 30, 2008, and are still outstanding. Investors have long assumed that a security with a

AAA rating is of the highest credit quality (therefore it usually offers a relatively low yield) which

obviously appeared to be a false judgment.158

The rating process for subprime mortgage bonds was also marked by a fundamental conflict:

Agencies received fees from the very issuers who requested the ratings—and almost everything

wound up as AAA. Securities were “sliced and diced” precisely to obtain these high ratings, and bank

regulatory authorities assign favorable capital treatment to bonds rated AAA.

159

Securitization has become an essential component of consumer finance and of housing

finance in particular. But to make securitization work, clear rules of the game are needed that help

achieve transparency, assure against counterparty risk and data provision to inform trading. Markets

can price and expose risk, if we give them the tools to do so.

Obviously, there should be some changes in order to ensure a healthier financial system as

immune as possible from the potential problems. A more transparent system in all stages may be

taken as a starting point. However, one should not blame securitization itself for all the financial

turmoil seen. The advantages of slicing, dicing and repacking risks as well as all the other advantages

explained above are simply too great to be sacrificed. It is very important to realize that it is only the

speculative, over-leveraged excesses that have crept into securitization created recently that have

contributed to the financial meltdown, not the traditional securitization process itself.

160

158 Barth, The Rise and Fall of the U.S. Mortgage and Credit Markets, supra, p. 157 159 Ibid 160 Levitin, Adam J., Pavlov, Andrey D. and Wachter, Susan M., Securitization: Cause or Remedy of the Financial Crisis?, August 27, 2009, Georgetown Law and Economics Research Paper No. 1462895, p. 16


Chapter 3



3 ISLAMIC SECURITIZATION

After explaining the basics of Islamic Finance and Securitization, now it is time to scrutinize

Islamic Securitization. As we did in the former two chapters, we will start with definition.

3.1 What is Islamic Securitization?

Islamic securitization can be basically defined as a legal structure which satisfies the

requirements of Islamic Finance and replicates the economic purpose of a traditional asset-backed

securitization structure whereby the rights over receivables are transferred from the owner-

originator to a special purpose vehicle (SPV/Issuer), which in turn issues notes that are sold to

investors.161 It involves asset transfers from an originator into a trust or similar SPV with Sukuk

issuance by that SPV and payments on the Sukuk derived from the payments received in respect of

those transferred assets.162

Since most Islamic financial products are based on the concept of asset backing, the

economic concept of asset securitization is particularly amenable to the basic tenets of Islamic

finance.

163 So basically Islamic securitization can follow the principles of conventional securitization.

However, the underlying asset pool or portfolio of receivables in a securitization should, in essence,

match one of the accepted Islamic financing schemes. For instance, conventional mortgages and

credit cards, which are typical conventionally securitized assets, do not comply with Sharia, as they

are interest-bearing loans. For a structure to comply with Sharia, some degree of ownership must be

transferred to the investor. Transfer of registered title is not necessary, rather a collection of

ownership rights that would allow the investors to perform duties related to ownership (if desired) or

rights granting access (subject to notice) over the asset would be sufficient to satisfy Sharia.164

161 Lahlou, Mohammad Saad and Tanega, Joseph Atangan, Islamic Securitisation: Part I - Accommodating the Disingenuous Narrative, Journal of International Banking Law and Regulation, Sweet & Maxwell, Vol. 22, Issue 6, May 2007, p. 295 162 McMillen, Michael J.T., Contractual Enforceability Issues: Sukuk and Capital Markets Development, Chicago Journal of International Law, University of Chicago, Winter 2007, p. 428 163 Jobst, Andreas A., The Economics of Islamic Finance and Securitization, Journal of Structured Finance, Vol. 13, No.1, 2007, p. 15 164 Lovells LLP, Islamic Finance: Sharia, Sukuk & Securitisation, Client Note, 2004, p.13


Investors participate in profits and losses generated by the assets placed in the securitization pool165

as Islamic Finance rules prohibit interest-based financing, investors are allowed to support or invest

on the basis of partnership, but not on the basis of interest.166

So Islamic Securitization is the creation of securities (or Sukuk

167

evidence ownership of a pool of tangible assets or a pool of tangible and intangible assets,

either fixed or revolving, that generates cash flow plus any rights or other facilities designed

to assure the servicing or timely distribution of proceeds to the security holders; and

) that:

by their terms convert into cash within a finite time period.168

After a brief definition, we now would like to move on with the structure of Islamic

Securitization. While talking about the structure, we will also try to put the differences between the

conventional and Islamic securitization structures and by doing so, we will be seeking the answer of

the question why there is a need for “Islamic” securitization while we already have quite improved

securitization structures.

3.2 Structure of Islamic Securitization

Various parties are involved in an Islamic Securitization transaction. Key players in various

issues are:

The originator or the issuer of Sukuk, who sells its assets to the SPV and uses the realized

funds. Originators are mostly governments or big corporations, but they could be banking or

165 Bi, Farmida (Norton Rose), Sharia compliant securitisations, Islamic Finance and Real Estate Forum, 4 November 2008, p.3 166 Zanev, Vassiliyan (Loyens & Loeff), Islamic Finance Securitisation in Luxembourg, Luxembourg Stock Exchange Press Release, March 13, 2008 167 We will examine Sukuk deeply in the coming sections, but for now, we may very briefly refer Sukuk as Islamic trust certificates or more generally Islamic bonds. 168 Haneef, Rafe, Asset-backed Sukuk and Asset-based Sukuk: A Primer, Fajr Capital, July 2008, p.3


non-banking Islamic financial institutions. The issuers may delegate, for a consideration or a

commission, the process of arranging the issue.

The SPV – an entity set up specifically for the securitization process and managing the issue.

It purchases assets from the originator and funds the purchase price by issuing Sukuk.

Sometimes, the SPV is also referred to as the issuer.

Investment banks – as issue agents for underwriting, lead managing and book-making

services for Sukuk against any agreed-upon fee or commission. These services are provided

by syndicates of Islamic banks and big multinational banks operating Islamic windows.

Subscribers of Sukuk – mostly central banks, Islamic banks and non-bank financial institutions

and individuals who subscribe to securities issued by the SPV.169

This list shows us the fact that an Islamic securitization structure perfectly mimics a

conventional securitization in relation to the parties involved.

A widely used Islamic securitization structure, which also illustrates the exact same structure

with the Sukuk issue made by the German state of Saxony-Anhalt in 2004,170

The originator of the assets (e.g. the owner of office buildings) sells the assets to an SPV.

would resemble the

following scenario:

The SPV raises financing to purchase the assets by issuing Ijara Sukuk171

The Ijara Sukuk represent equity interest in the SPV, and in turn, in the assets.

(i.e. leasing

bonds) to investors. The amount raised by issuing the Sukuk is equal to the purchase

price.

The SPV leases the assets back to the seller/originator. The seller makes periodic lease

payments to the SPV, which should match the SPV’s obligations under the Ijara Sukuk.

At maturity, the SPV sells the assets back to the originator (i.e. lessee or previous

seller/owner of the assets). The amount should cover any liabilities owed by the SPV

under the Ijara Sukuk.172

169 Ayub, Introduction to Islamic Finance, supra, p. 393 170 The Sukuk issue made by Saxony-Anhalt will be explained in detail in the sub-section 3.3.1.1 Ijara Sukuk. 171 We will explain Ijara Sukuk in sub-section 3.3.1.1 Ijara Sukuk under the section 3.3.1 Types of Sukuk. 172 Marar, Amr Daoud, The Duality of the Saudi Legal System and its Implications on Securitisations, The Company Lawyer, Volume 27, No. 11, November 2006, p. 346


The figure173

below illustrates how an Islamic securitization structure based on ijara basically

works:

The cash flow produced is similar to any bond. The lease payments are similar to coupons

and the repurchase proceeds paid at the end of the term constitute the principal.174

Unlike conventional securitization, the implementation of Islamic securitization requires a

two-stage “fundamental” verification process, which assesses the Sharia compliance of (i) the type of

assets in the underlying reference portfolio and the generation of investment returns, and (ii) the

transaction structure, which includes the configuration of credit enhancement (and other forms of

credit and liquidity support) and the form of ownership conveyance.

175

173 Available at

http://www.middleeastbusinessforum.com/newsletter/issue%201/Sukuk%20101.html 174 Kamalpour, Abradat, McMillen, Michael J, Islamic Securitisation, Global Securitisation and Structured Finance 2007, Dechert LLP, 2007, p. 224 175 Jobst, The Economics of Islamic Finance and Securitization, supra, p. 16

http://www.middleeastbusinessforum.com/newsletter/issue%201/sukuk%20101.html�


Securitization under Islamic law bars interest income and must be structured in a way that

rewards investors for their direct exposure to business risk, i.e., investors receive a share of profits

commensurate to the risk they take on in lieu of pre-determined interest. However conventional

securitization, which originated in non-Islamic economies, invariably involves interest-bearing debt.

Note holders would typically hold (secured) contingent claims on the performance of securitized

assets, which entitle them to receive both pre-determined interest and the repayment of the

principal amount.176

Apart from that, one should know that while equity in contrast to interest-bearing bonds

appears to be a permissible financial asset that can form part of the pool, such equity must not

represent ownership of an institution dealing with interest or manufacture of haram

177 items, such

as alcohol, (gambling) or pork.178 For Islamic institutions, underlying assets that can be securitized

include lease financing (e.g. of housing, aircraft, equipment, household items, cars etc.), equity

ownership (in Sharia compliant assets) and, in certain cases, Murabaha receivables (provided that

the Murabaha receivables comprise less than 50% of any asset pool).179

The number of applicable structures to Islamic securitization is also limited comparing to

conventional securitization. In general, the relationship between an underlying obligor and the

originator should fall within one of the usual accepted Islamic financing schemes (Murabaha,

Mudaraba, Ijara, Istisna, etc.). For example, when structuring a Sharia compliant mortgage

securitization, the underlying assets must be Sharia compliant mortgages (usually structured around

Ijara – the typical Islamic mortgage structure – or Istisna – mortgages concerning properties under

construction). In the case of a Sharia auto finance securitization, the underlying finance contract

must be structured in accordance with Murabaha or Ijara principles.

180

176 Ibid 177 Non-permissible according to Islamic law, opposite of “halal”. 178 Obaidullah, Mohammed, Securitization in Islam, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p.193 179 Islamic Finance News, Legal Guide 2006, Red Money Publishing, Kuala Lumpur, 2006, p. 14 180 Ibid


It should also be noted that to comply with Sharia principles for a traditional Sukuk issuance,

the structure to be used must transfer a minimum level of ownership in the assets before Sharia

scholars can be satisfied and approve the issuance.181

Finally, one should be careful in relation to credit enhancement mechanisms while

structuring a permissible securitization transaction according to Sharia. Credit enhancement is an

integral part of conventional securitization process. When credit enhancement is for a fee that is

related to the quantum of facility, this comes dangerously close to riba and is rightly frowned upon

by Sharia scholars.

182 So Islamic institutions should be very selective in using credit enhancement

methods; (as) using some of them may change the character of the transaction.183 So Islamic law

does not rule out the use of credit enhancement per se as long as it is optional for investors and does

not change the overall character of the transaction. For instance, tranche subordination of

conventional securitization can be replicated by a lease buy-back (ijara) transaction under Sharia

law.184

Like credit enhancement, liquidity enhancement too comes under a cloud in the Islamic

framework. While this is easily achieved in an interest-based scenario, the Islamic framework

provides for short-term (…) interest free loans. Thus, while liquidity enhancement could be provided

by independent financial institutions in the conventional framework, this is possible in Islamic

securitization only when there is no financial reward for the provider.

185

To sum up, securitization in Islamic Finance is better referred to as “monetization” of the

underlying assets. While the sale of conventional receivables is a sale of debts, the sale of Sukuk is a

sale of shares of an asset.

186

181 Ibid 182 Obaidullah, Mohammed, Securitization in Islam, supra, p. 194 183 Abdi Dualeh, Suleiman, Islamic Securitisation: Practical Aspects, Presentation for World Conference on Islamic Banking, Geneva, July 8-9 1998, p. 7 184 Jomadar, Bushan K., Islamic Finance and Securitization: Man-Made Tale or Reality, November 1, 2007, Islamic Law and Law of the Muslim World Paper No. 8-18, p. 12 185 Obaidullah, Mohammed, Securitization in Islam, supra, p. 194 186 Marar, The Duality of the Saudi Legal System and its Implications on Securitisations, supra, pp. 346-347

However, irrespective of religious conditions, Islamic securitization

offers the same economic benefits conventional structured finance purports to generate, such as the

active management of designated asset portfolio due to greater control over asset status, enhanced


asset-liability management and term structure transformation, as well as the isolation of certain

assets in order to make them self-financing at a fair market rate.187

3.3 Sukuk

At this stage, we will look at the securities created within the processes of Islamic

securitization, i.e. Sukuk.

Sukuk is a recently-developed Islamic investment product that first appeared in 2002, when

Malaysia issued a government-backed Sukuk, the first of its kind.188 Sukuk (the plural of the word Sak,

or Sanadat, meaning certificate of investment or simply certificates)189 are certificates that represent

the holder’s proportionate ownership in an undivided part of an underlying asset where the holder

assumes all rights and obligations to such asset.190

The Accounting and Auditing Organization for Islamic Financial Institutions ("AAOIFI") has

issued the Standard for Investment Sukuk. Under the AAOIFI Sukuk Standard, Sukuk are defined as

certificates of equal value put to use as common shares and rights in tangible assets, usufructs, and

services or as equity in a project or investment activity. The AAOIFI Sukuk Standard carefully

distinguishes Sukuk from equity, notes, and bonds. It emphasizes that Sukuk are not debts of the

issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects,

or investment activities. Sukuk may not be issued on a pool of receivables. Further, the underlying

business or activity, and the underlying transactional structures (such as the underlying leases), must

be Sharia-compliant (for example, the business or activity cannot engage in prohibited business

activities).

191

To sum up, the AAOIFI standard stipulates that Sukuk must demonstrate:

187 Jobst, Andreas A., Derivatives in Islamic Finance, Islamic Economic Studies, Vol. 15, No. 1, 2007, p. 19 188 Richardson, Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field, supra, p. 131 189 Ayub, Understanding Islamic Finance, supra, p. 392 190 Islamic Financial Services Board, Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of Islamic Money Markets, March 2008, p. 92 191 McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, pp. 428-429


that any income arising must derive from the underlying activities for which the funding has

been used, and not simply comprise interest;

the Sukuk must be backed by real underlying assets and these assets must be Halal [that is,

allowable under Sharia] in nature and be being utilized as part of a Halal activity; and

there must be full transparency as to rights and obligations of all parties.192

Without a doubt, Sukuk structures became the most successful innovation of short history of

Islamic finance. Globally, Sukuk issuance has increased from $7.5 billion at the end of 2000 to over

$118 billion at the end of the third quarter of 2008, growing at a compound annual growth rate

(CAGR) of 32% since 2000.193

Below figure illustrates the huge success achieved within a very short

period of time until the end of 2008 when the whole financial system was already in the recent

turmoil:

192 Lahlou, Mohamed Saad, Tanega, Joseph, Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative, Journal of International Banking Law and Regulation, Sweet & Maxwell, Volume 22, Issue 7, June 2007, p. 367 193 Kronfol, Mohieddine, Takaful and Sukuk: A Symbiotic Relationship, Middle East Insurance Review, December 2008, p. 53


It is important to note that – contrary to popular perception – whilst a securitization can be

achieved via Sukuk, most Sukuk that have been issued to date are not securitizations.194

Direct structuring of securities; and

The creation

of Islamic financial securities can be done in two distinct ways:

The process of asset securitization.

Direct structuring involves the initial issuance of securities, and the funds raised will be used

to fund certain assets/projects with the client company. The profits generated from these assets/

projects are then distributed amongst security holders.195

Most Sukuk offerings to date have been of the bond type (direct structuring), and the

ultimate credit in most of those bond offerings has been a sovereign entity. There have been very

few, if any, true asset securitizations, largely because of the inability to obtain ratings from major

international rating firms (ratings have been obtained for the sovereign bond issuances based upon

the rating of the sovereign credit).

196

3.3.1 Types of Sukuk

Until now there have been 14 different types of Sukuk structures most common ones of

which are Sukuk al-Ijara, Sukuk al-Istisna, Sukuk al-Murabaha, Sukuk al-Musharaka and Sukuk al-

Mudaraba.197 The list of 14 different types of Sukuk is not an exhaustive list since other forms of

Sukuk can be issued such as by copyright owners, so continuing innovation in this field is expected.198

Here, we will try to explain the most common Sukuk structures.

194 Islamic Finance News, Legal Guide 2006, supra, p. 13 195 Mannan, Mansour, Islamic Capital Markets, Islamic Finance: A Guide for International Business and Investment, ed. by Habiba Anwar, GMB Publishing, 2008, p. 105 196 McMillen, Michael J.T., Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, p. 428 197 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Sharia Standards No. 17, May 2003, pp. 4-6 198 Lahlou, Tanega, Islamic Securitisation: Part II – Accommodating the Disingenuous Narrative, supra, p. 368


3.3.1.1 Ijara Sukuk

Ijara (lease) is a contract according to which a party purchases and leases out equipment

required by the client for periodic rental payment. The duration of the rental and the amount

payable are agreed in advance, and ownership of the asset remains with the lessor.199

If a lessor, after executing an Ijara contract, wishes to recover his cost of purchase of the

asset to get liquidity or for the purpose of profit, he can sell the leased asset wholly or partly, either

to one party or to a number of individuals. The purchase of proportion of the asset can be evidenced

by issuing certificates, which may be called Ijara certificates or Sukuk. The certificates must represent

ownership of the pro rata undivided parts of the asset with all related rights and obligations. Hence,

Ijara Sukuk are the securities representing ownership of well-defined and known assets tied up to a

lease contract, rental of which is the return payable to the Sukuk holders.

200

Let us have a look how the ijara Sukuk structure works: A single or a group of assets that are

admissible for ijara contract are selected. The originator creates an SPV with separate independent

legal personality to whom it sells the asset(s) with the understanding that the originator will lease

back the asset(s) from the SPV. Rent is negotiated and a term specific lease contract is signed. The

SPV then securitizes its assets by issuing ijara Sukuk for sale to investors. These are certificates of

equal value representing undivided shares in ownership of tangible assets. The Sukuk sale proceeds

provide funds to SPV to pay for the asset(s) purchased from the originator. A rent-pass-through

structure is adopted by the SPV to pass on the rents collected from the originator-cum-lessee to

Sukuk holders. These returns along with low risk and exit possibility through secondary market

(liquidity) constitute the incentives for investors to buy Sukuk. At the expiry (or termination) of the

lease deed the flow of rents would stop and ownership of the asset pool would be with the Sukuk-

holders as a group. The Sukuk contract embeds a put option to the Sukuk-holders that the originator

is ready to buy the Sukuk at their face value on maturity or dissolution date.

201

199 Mannan, Islamic Capital Markets, supra, p. 107 200 Ayub, Introduction to Islamic Finance, supra, pp. 400-401 201 Ali, Salman Syed, Islamic Capital Markets Products: Developments and Challenges, Islamic Development Bank Group Islamic Research and Training Institute, Occasional Paper No. 9, 2005, pp.30-31


The figure below well explains the concept of an ijara Sukuk transaction:202

As it was mentioned before, the Sukuk issue by German State of Saxony Anhalt in 2004 was

an ijara Sukuk structure. In this issue, the underlying transactions involves a certain number specified

buildings owned by the Ministry of Finance. Certificates worth €100 million were issued by an SPV

incorporated in the Netherlands was to get around the municipality tax in Germany. By doing so, the

Sukuk remains competitive with regards to municipality tax which would not apply to a conventional

bond. Under a 100 year Head Lease Agreement, Saxoy Anhalt, acting through the Ministry of Finance,

leases properties to the SPV in consideration of receiving an amount equal to the Sukuk issue as a

one-time advance head-lease rental. The SPV then enters into a sub-lease agreement where it sub-

leases the properties back to the Ministry of Finance for a period of five years. The certificates held

by the investors represent a pro-rata interest in the operating rights acquired by SPV under the head-

lease. Under the sub-lease, the State has a direct obligation to pay lease rentals at periodic intervals

which are passed on to the Sukuk holders as coupon payments. The last lease rental will include the

principal amount extended under the sub-lease. This five year certificate with a coupon payment of

EURIBOR (flat) was co-managed by both Citigroup and the Kuwait Finance House. The Sukuk was fully

subscribed with 60 % of the issue going to investors in Bahrain and the United Arab Emirates, while

the other 40 % to investors in Europe, particularly Germany and France.203

202 Jobst, The Economics of Islamic Finance and Securitization, supra, p. 21 203 Alkhan, Rashid Khalid, Islamic Securitization A Revolution in the Banking Industry, Miracle Graphics Co., 2006, p. 66

Like other German state


debt instruments the Sukuk was listed in Luxembourg, with an additional listing in Bahrain to attract

Gulf investors.204

The figure below shows the Saxony-Anhalt Sukuk structure:

205

Unlike some other Sukuk types, Ijara certificates can be negotiated and traded freely in the

market and can serve as an instrument easily convertible into cash.206 Sukuk representing tangible

assets or usufruct of such assets can be traded in the secondary market, depending upon the quality,

risk and profitability of the securitized assets. A deciding factor in this regard is whether the Sukuk

create any debt obligations or they represent an ownership stake in the underlying assets or project;

in the former case, the certificate will not be tradable, while in the latter case, it will be

negotiable/tradable.207

204 Wilson, Rodney, Islamic Finance in Europe, Robert Schuman Centre for Advanced Studies Policy Papers No. 2007/2, p. 5 205 Lahlou, Tanega, Islamic Securitisation: Part II - A Proposal for International Standards, Legal Guidelines and Structures, supra, p. 370 206 Ayub, Introduction to Islamic Finance, supra, p. 403 207 Ibid, p. 408


3.3.1.2 Mudaraba (or Muqarada) Sukuk

Mudaraba means an agreement between two parties according to which one of the two

parties provides the capital (capital provider) for the other (mudarib) to work with on the condition

that the profit is to be shared between them according to a pre-agreed ratio. These types of Sukuk

play a vital role in the process of development financing, because these are related to the

profitability of the projects.208

Mudaraba or Muqarada (Muqarada has the same meaning as that of Mudaraba) Sukuk or

deeds can be instrumental in enhancing public participation in investment activities in any economy.

These are certificates that represent projects or activities managed on the Mudaraba principle by

appointing any of the partners or any other person as Mudarib for management of the business. As

regards the relationship between the parties to the issue, the issuer of Mudaraba certificates is the

Mudarib, subscribers are the owners of the capital and the realized funds are the Mudaraba capital.

The certificate holders own the assets of the Mudaraba and the agreed upon share of the profits

belongs to the owners of capital and they bear the loss, if any.

209

The figure below illustrates how Mudaraba Sukuk structure works:

210

This structure is of interest to originators who do not have assets that they can easily make

available for an ijara Sukuk or Musharaka Sukuk, but which needs finance for additional business

208 Mannan, Islamic Capital Markets, supra, p. 108 209 Ayub, Introduction to Islamic Finance, supra, p. 398 210 Available at http://www.modarabas.com.pk/Sukuk.php

http://www.modarabas.com.pk/sukuk.php�


investments or activities. It is critical for Sharia compliance that the mudarib is entitled to a share in

the profits rather than a flat fee. A mudarib can also be paid an incentive fee.211

The Sukuk issuer enters into a Mudaraba agreement with the project manager (mudarib) for

construction/commissioning of a project;

Steps involved in the structure:

The SPV issues Sukuk to raise funds, the proceeds of which are given to the mudarib;

The mudarib undertakes the project and collects regular profit payments from the activity for

onward distribution to investors; and

Upon completion, the mudarib, in its capacity as obligator, purchases the assets of the

project from the issuer.212

Islamic Financial Institutions can offer Mudaraba Sukuk or certificates to the investors who

would subscribe and participate in the investment transactions. The funds mobilized would be the

variable capital (class B share) of any bank to be marketed regionally through the selling of the issued

Mudaraba Sukuk.213

Mudaraba Sukuk may be issued by an existing company (which acts as mudarib) to investors

(who act as partners, or rab al-mal) for the purpose of financing a specific project or activity, which

can be separated for accounting purposes from the company’s general activities. The profits from

this separate activity are split according to an agreed percentage amongst the certificate holders. The

contract may provide for future retirement of the Sukuk at the then market price, and often

stipulates that a specific percentage of the mudarib’s profit share is paid periodically to the Sukuk

holders to withdraw their investment in stages.

214

211 de Belder, Richard T., Invesment Banking, Islamic Finance: A Guide for International Business and Investment, ed. by Habiba Anwar, GMB Publishing, 2008, pp. 95-96 212 Mannan, Islamic Capital Markets, supra, pp. 108-109 213 Ayub, Introduction to Islamic Finance, supra, p. 399 214 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 55


At this point, let us have a look at an example of Sukuk al-Mudaraba: Aldar Properties PJSC,

an Abu Dhabi real estate development company, issued a 4.75-year Sukuk convertible into its

ordinary shares. Proceeds from the transaction were used to fund Aldar’s ambitious real estate

development programme with Aldar acting as the mudarib. Aldar, in its corporate capacity, also

provided an undertaking to purchase the assets of the Mudaraba should the Sukuk certificate holders

not convert their holdings into Aldar’s shares by the maturity date (2011).215

3.3.1.3 Musharaka Sukuk

In a Musharaka transaction, partners contribute capital to a project and share its risks and

rewards. Profits are shared between partners on a pre-agreed ratio, but losses are shared in exact

proportion to the capital invested by each party. Thus a financial institution provides a percentage of

the capital needed by its customer with the understanding that the financial institution and customer

will proportionately share in profits and losses in accordance with a formula agreed upon before the

transaction is consummated.216

In securitizing a Musharaka arrangement, every subscriber can be given a participation

certificate, which represents his proportionate ownership in the assets of the venture or project for

which financing is being raised. Subsequent to the acquisition of substantial non-liquid assets, these

Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the

secondary market.

217

Musharaka Sukuk which are based on an underlying Musharaka contract are quite similar to

mudaraba Sukuk. The only major difference is that the intermediary will be a partner of the group of

subscribers or the Musharaka Sukuk holders in much the same way as the owners of a joint stock

company. Almost all of the criteria applied to a Mudaraba Sukuk are also applicable to the

Musharaka Sukuk, but in the Mudaraba Sukuk the capital is from just one party. The issuer of the

215 Mannan, Islamic Capital Markets, supra, p. 109 216 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 52 217 Akbar, Salman, Islamic Securitization from a practitioner’s Perspective, Islamic Banking Hub Bahrain Newsletter, Islamic Banking & Takaful Task Force, October 2003, p. 4


certificate is the inviter to a partnership in a specific project or activity, the subscribers are the

partners in the Musharaka contract, and the realized funds are the contributions of the subscribers

in the Musharaka capital. The certificate holders own the assets of partnership and share the profits

and losses.218

In the structure shown below, the parties’ respective interests in the Musharaka are

represented by contractual units held by each party. The issuer will make a funding contribution to

the Musharaka from funds it raises from the Sukuk issue. The Musharaka party will make an in-kind

contribution to the Musharaka (usually including some tangible assets). The issuer and the

Musharaka party also enter into a purchase undertaking pursuant to which the issuer can require the

Musharaka party to purchase a set amount of units on set dates during the term of the Sukuk. The

issuer will receive profit distributions from the Musharaka and proceeds from sales of the units to

the Musharaka party. The amounts received are distributed to the Sukuk holders in accordance with

a set formula. This structure is viable when the Musharaka party can use its in-kind contribution for a

profit-generating venture.

219

The figure below is an illustration of how Musharaka Sukuk structure works:

220

218 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 56 219 Kamalpour, McMillen, Islamic Securitisation, supra, p. 225 220 Ibid


After the project is started, these Musharaka certificates can be treated as negotiable

instruments. Certificates based on Musharaka/Mudaraba can be bought and sold in the secondary

market, subject to the condition that the portfolio of Musharaka comprises non-liquid assets valuing

more than 50 %. Profit earned by the Musharaka is shared according to an agreed ratio. Loss is

shared on a pro rata basis. Whenever there is a combination of liquid and non-liquid assets, it can be

sold and purchased for an amount greater than the amount of liquid assets in the combination or in

the pool.221

The Musharaka structure is considered more equitable and also safer for the investors than

the Mudaraba structure, as it involves both profit-and-loss-sharing between the fund manager and

the Sukuk holders, not only profit-sharing. In addition, Musharaka Sukuk holders will have added

comfort and security from the cushion provided by the manager’s participation in the Musharaka

capital.

222

An example of Sukuk al-Musharaka is as follows: Emirates, Dubai’s national airline, issued a

$550 million Sukuk transaction for seven years. The deal was a structured on a Musharaka basis. The

Musharaka, or joint venture, was set up to develop a new engineering centre and a new

headquarters building on land situated near Dubai’s airport which was ultimately leased to Emirates.

Profit, in the form of lease returns, generated from the Musharaka were used to pay the periodic

distribution on the trust certificates. Emirates then purchased the leased assets on maturity of the

transaction.

223

3.3.1.4 Murabaha Sukuk

Murabaha Sukuk are issued on the basis of murabaha sale for short-term and medium-term

financing. As mentioned earlier, the term murabaha refers to sale of goods at a price covering the

221 Ayub, Introduction to Islamic Finance, supra, p. 400 222 Ibid 223 Mannan, Islamic Capital Markets, supra, p. 110


purchase price plus a margin of profit agreed upon by both parties concerned. The advantage of this

mode of financing is that, if the required commodity in the murabaha is too expensive for an

individual or a banking institution to buy from its own resources, it is possible in this mode to seek

additional financiers. The financing of a project costing $50 million could be mobilized on an

understanding with the would-be ultimate owner that the final price of the project would be $70

million, which would be repaid in equal installments over five years. The various financiers may share

the $20 million murabaha profit in proportion to their financial contributions to the operation.224

A commonly accepted view among Sharia scholars in a number of Islamic jurisdictions is that

murabaha debt cannot be securitized, thus making Sukuk backed by pools of murabaha debt

impermissible. This is because the sale of a document representing money is akin to the trading of

monies, which is prohibited under the rules of riba. However, the prevailing view among Malaysian

scholars (in contrast to Sharia advisers in more conservative jurisdictions) is that so long as the

underlying receivable is connected to a true trade transaction or to a commercial transfer of a non-

monetary interest, such a receivable can be traded freely for purposes of Sharia.

225

However, it is generally accepted that a pool of receivables consisting of only Murabaha

receivables cannot be securitized for creating negotiable Sukuk to be traded in the secondary market.

The purchaser on credit in a Murabaha transaction signs a note or paper to evidence his

indebtedness towards the seller. That paper represents a debt receivable by the seller. Transfer of

this paper to a third party must be at par value and subject to the rules of Hawala

226, meaning that

its assignment also has to be at face value. A mixed portfolio consisting of a number of transactions,

including Murabaha, may issue negotiable certificates subject to certain conditions. For this purpose,

the pool of the assets should consist of Ijara or other fixed assets valuing more than 50% of its total

worth. However, if the Hanafi227 view is adopted, trading will be allowed even if the non-liquid assets

are more than 10% of its total worth.228

224 Mirakhor, Zaidi, Profit-and-loss sharing contracts in Islamic finance, supra, p. 56

225 Abdel-Khaleq, Ayman H., Richardson, Christopher F., New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings, Chicago Journal of International Law, Winter 2007, p. 412 226 Hawala is a system for remitting money, primarily in Islamic societies, in which a financial obligation between two parties is settled by transferring it to a third party, as when money owed by a debtor to a creditor is paid by a person who owes the debtor money. Hawala transactions are usually based on trust and leave no written record. 227 The Hanafi School is one of the four Madhhab (schools of law) in jurisprudence (Fiqh) within Sunni Islam. 228 Ayub, Introduction to Islamic Finance, supra, p. 405


Now, let us see how a direct murabaha Sukuk structure works:

1. Company seeks advice from Investment Bank regarding issue of securities; an SPV is created for

the purpose;

2. SPV issues securities to investors;

3. SPV collects funds from investors;

4. SPV pays to Vendor for purchase of Assets;

5. Company as agent of SPV takes delivery of Assets;

6. Company purchases Assets from SPV on deferred payment basis and makes payment of

installments to SPV;


7. SPV passes them on to investors after deducting mudarib share/wakala229 fee for itself.230

The following constitutes a practical example how a negotiable murabaha Sukuk can be

created: Arcapita Bank B.S.C (Bahrain) issued five-year multicurrency Murabaha-backed Sukuk in

2005 with a five-year bullet maturity. The proceeds of the Sukuk are used for sale and purchase of

assets via a series of commodity Murabaha transactions. As Murabaha may yield a fixed return, the

Sukuk holders have been offered a return equivalent to three-month LIBOR + 175 bps. The SPV will

have full recourse to Arcapita and, therefore, the Sukuk are a freely transferable instrument on the

basis of a mechanism approved by Arcapita’s Sharia supervisory board. It is presumed that the SPV

will be maintaining a sufficient amount of inventory or fixed assets, making its Sukuk negotiable.

231

3.3.1.5 Salam Sukuk

As we noted earlier, a salam is deferred delivery contract. It is essentially a forward

agreement where delivery occurs at a future date in exchange for spot payment of price.

Salam Sukuk are certificates of equal value issued for the sake of mobilizing capital that is

paid in advance in the shape of the price of the commodity to be delivered later. The seller of the

Salam commodity issues the certificates, while the subscribers are the buyers of that commodity, i.e.

they are the owners of the commodity when delivered. Salam sale is attractive to the seller, whose

cash flow is enhanced in advance, and to the buyer, as the Salam price is normally lower than the

prevailing spot price.232

Salam-based securities may be created and sold by an SPV under which the funds mobilized

from investors are paid as an advance to the company SPV in lieu of a promise to deliver a

commodity at a future date. All standard Sharia requirements that apply to salam contract also apply

229 Wakala is a trust contract whereby money can be placed with an Islamic institution which then pays a return based on the assets on its balance sheet. 230 Obaidullah, Islamic Financial Services, supra, p. 161 231 Ayub, Introduction to Islamic Finance, supra, p. 406 232 Ibid, p. 403


to salam Sukuk, such as, full payment by the buyer at the time of effecting the sale, fungibility or

standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of

delivery of the asset and the like. At the same time the SPV can appoint an agent to market the

promised quantity at the time of delivery perhaps at a higher price. The difference between the

purchase price and the sale price is the profit to the SPV and hence, to the holders of Sukuk. Such

Sukuk obviously involve market risk as the price of the underlying asset may go down instead of

moving up in future.233

SPV signs an undertaking with an obligator to source both commodities and buyers. The

obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to

sell it for the profit of the Sukuk holders.

The steps involved in Salam Sukuk transaction may be summarized as follows:

Salam certificates are issued to investors and SPV receives Sukuk proceeds.

The Salam proceeds are passed onto the obligator who sells commodity on forward basis

SPV receives the commodities from the obligator

Obligator, on behalf of Sukuk holders, sells the commodities for a profit.

Sukuk holders receive the commodity sale proceeds.234

The market risk or price risk for the investors can be mitigated if a third party makes a

unilateral promise to buy the commodity at a predetermined price at a future time period. Since the

SPV representing investors need not participate in the market, it would be insulated from price risk.

This third party may be one of the prospective customers of the company. The unilateral promise is

binding on this customer. Once the rights resulting from the promise are transferred to the SPV, it

assumes the role of seller to the third party customer at the specified future date. The SPV is able to

realize a higher predetermined price without participating in the market. The risk mitigation can

some times come through sovereign guarantees, as is the case with recent issue of Sukuk-al-salam by

the Bahrain Monetary Agency (BMA).235

233 Obaidullah, Islamic Financial Services, supra, p. 164

234 Nisar, Shariq, Islamic Bonds (Sukuk): Its Introduction and Application, available at http://www.financeinislam.com/article/8/1/546 235 Obaidullah, Islamic Financial Services, supra, p. 164

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A number of bond structures could be synthesized from the salam contract. The most prolific

issuer of salam bonds to date has been the Bahrain Monetary Agency, aiming to provide Islamic

banks liquidity management tools.236 The BMA, in June 2001, developed Salam-based securities with

LIBOR-related three-month tenures used by Islamic banks for maintaining statutory liquidity

requirement (SLR). The Bahrain government sells aluminum to Bahrain Islamic Bank (BIB), which has

been nominated to represent the other banks wishing to participate in the Salam contract. The

government undertakes to supply a specified amount of aluminum on the basis of Salam at a future

date. At the same time, BIB appoints the government its agent to market the aluminum at the time

of delivery through its channels of distribution.237 The Government of Bahrain provides an additional

undertaking to the representative (BIB) to market the aluminum at a price, which will provide a

return to Al Salam security holders equivalent returns to those available through other conventional

short-term money market instruments.238 This means that the securities have the characteristics of

short-term government treasury bills.239

So far, secondary market trading of Salam Sukuk is considered impermissible on the grounds

that the certificates represent a share in the Salam debt, in which case they are subject to the rules

of debt trading.

240

3.3.1.6 Istisna Sukuk

We already mentioned that istisna is a contractual agreement for manufacturing goods,

allowing cash payment in advance and future delivery or a future payment and future delivery of the

goods manufactured, as per the contract.

236 El-Gamal, Islamic Finance Law, Economics and Practice, supra, p. 114 237 Ayub, Introduction to Islamic Finance, supra, pp. 403-404 238 In our email correspondence with Prof. Dr. Mahmoud El-Gamal, a highly respected Islamic Finance expert and chairman of Department of Economics in Rice University, Houston; he referred to this Sukuk structure as “It is one of many forms of what I call "Sharia Arbitrage," which is the mode of operation in today's so-called Islamic finance.” He defines Sharia Arbitrage as “using legal devices, often employing special-purpose vehicles, restructuring interest-bearing debt and collecting interest in the form of rent or price mark-up” in his article “Incoherent pietism and Sharia arbitrage” published in Islamic Finance 2007 Report of Financial Times. Available at http://www.ft.com/reports/islamicfinance2007 239 Obaidullah, Islamic Financial Services, supra, p. 165 240 Ayub, Introduction to Islamic Finance, supra, p. 404

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Istisna contracts can be securitized to raise funds on the basis of the rental income that the

asset (for example, a building or bridge) will generate. In that case it will generate fixed return

securities, or it can be securitized on the basis of variable income (such as a toll tax on the bridge),

generating variable-return securities.241

Under such a scheme the SPV representing investors becomes seller-contractor-

manufacturer of an asset to a buyer (say, the government) and uses back-to-back istisna for creation

of the facility. In other words, the SPV takes upon itself the legal responsibility of getting the facilities

constructed, and sub-contracts the work to manufacturers/contractors. The deferred price that the

buyer will pay may be in the form of Sukuk that are an evidence of indebtedness whose total face-

value exactly equals the total deferred price. These Sukuk may have different maturities to match the

installment plan that has been agreed upon by the two parties. They represent buyer’s debt and

hence, Sharia precludes sale of these debt certificates to a third party at any price other than the

face value of such certificates.

242

The SPV issues Sukuk certificates to raise funds for the project;

Steps involved in the structure:

Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future

project;

Title to assets is transferred to the SPV;

Property/project is leased or sold to the end buyer. The end buyer pays monthly installments

to the SPV; and

The returns are distributed among the Sukuk holders.243

241 Khan, M. Fahim, Islamic methods for government borrowing and monetary management, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 294 242 Obaidullah, Islamic Financial Services, supra, p. 165 243 Mannan, Islamic Capital Markets, supra, p. 111


The prohibition of riba precludes the sale of these debt certificates to a third party at any

price other than their face value. Therefore, such certificates, which may be cashed only on maturity,

cannot have a secondary market. As noted above, they can be transferred at face value to a third

party.244

An example of Sukuk al-istisna is as follows: The Durrat Al Bahrain, a $1 billion world-class

residential and leisure destination situated in the Kingdom of Bahrain, issued the Durrat Sukuk to

finance the reclamation and infrastructure for the initial stage of the project. The Sukuk was

structured to provide quarterly returns with an overall tenure of five years and an option for early

redemption. The proceeds of the issue (cash) were used by the issuer to finance the reclamation of

the land and the development of base infrastructure through multiple project finance (istisna)

agreements. As the works carried out under each istisna were completed by the contractor and

delivered to the issuer, the issuer gives notice to the project company under a Master Ijara

Agreement to lease such infrastructure on the basis of a lease to own transaction. During the istisna

period, the istisna receivable (amounts held as cash) was only subject to trading at par value. Later,

upon completion of the istisna period and when lease agreements were put in place, the Sukuk

became tradable.

245

3.3.1.7 Hybrid Sukuk

Considering the fact that Sukuk issuance and trading are important means of investment and

taking into account the various demands of investors, a more diversified Sukuk - hybrid or mixed

asset Sukuk - emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of

Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different

classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts

cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a

hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk.246

244 Ayub, Introduction to Islamic Finance, supra, p. 405 245 Mannan, Islamic Capital Markets, supra, p. 111 246 Ibid, pp. 111-112


Steps involved in a hybrid Sukuk structure are as follows:

Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.

SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are

used by the Islamic finance originator.

Islamic finance originator purchases these assets from the SPV over an agreed period of time.

Investors receive fixed payment of return on the assets.247

A prominent example of such mixed portfolio Sukuk are Islamic Development Bank’s (IDB)

Solidarity Trust Sukuk for $ 400 million issued in 2003. Solidarity Trust Services (STS) served as trustee

to issue the fixed-rate trust certificates that were issued to purchase a portfolio of Sukuk assets

comprising Ijara, Murabaha and Istisna contracts originated by the IDB. Each certificate represented

an undivided beneficial ownership in trust assets and ranked pari passu with other trust certificates.

Most of the assets (over 50 %) would, at all times during the period, comprise Ijara assets. If, at any

time, the proportion of assets evidenced by Ijara contracts fell below 25 %, a dissolution event would

occur, and IDB, by virtue of its separate undertaking, would be obliged to purchase all of the assets

owned by the trustee pursuant to the terms of the “purchase undertaking deed”. Profit on Sukuk

assets, net of expenses of the trust, would be used to give a periodic return to the certificate holders.

Certificates would be redeemed at 100% of their principal value. In the case of any early dissolution

event, the redemption would be according to adjustment, keeping in mind the return accumulation

period. Principal amounts of Sukuk would be reinvested in Ijara and Musharaka contracts to form a

part of Sukuk assets.248

The modus operandi of issuing mixed portfolio Sukuk is an effective tool for converting non-

marketable and illiquid assets to negotiable instruments having a secondary market, particularly

suitable for investment banks and development finance institutes.

249

247 Ibid, p. 112 248 Ayub, Introduction to Islamic Finance, supra, p. 406 249 Ibid, p. 407


This list of Sukuk forms is not exhaustive; financiers are free to devise other varieties. One

development is the convertible Sukuk, which can be exchanged for equity. Dubai Ports, for example,

issued a $3.5 billion pre-IPO convertible Sukuk in January 2006.250

So, we have reviewed various methods of creating fixed income debt securities based on the

classical Islamic contracts of murabaha, mudaraba, musharaka, ijara, salam and istisna that are free

from riba. Of all these, salam-based instruments seem to be too restrictive in scope. Istisna-based

instruments are quite useful for financing large infrastructure projects, while murabaha is useful for

financing trade. Murabaha however, involves sale of debt or receivables and hence suffer from the

restrictions on their negotiability. A secondary market in this instrument is almost ruled out.

Compared to these, ijara-based instruments are free from all these constraints. Ijara seems to offer

maximum flexibility in terms of negotiability, management of price risk etc. And hence Sukuk-al-ijara

are expected to play a significant role in development of an Islamic debt market.

251

3.3.2 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues

A Sukuk flotation can be seen as a securitization of assets. Not all forms meet with universal

approval of Islamic jurists. If, for instance, lease claims are securitized and sold to the public in the

form of Sukuk, the buyer receives a financial instrument that pays a fixed income and carries a low

risk. Does this involve riba or is it a claim on a fraction of a very stable stream of profits? Opinions

differ. In the same way, Musharaka participations can be securitized by issuing negotiable

certificates, or Sukuk. This may make sense in the case of large investments, such as infrastructure

projects or large industrial complexes. Such securitization took off on a large scale in Malaysia after

the Shafi School ruled it halal. Hanafis and most Hanbalis, by contrast, consider it haram, and

Malikis252 deem it admissible only under very strict conditions.253 The division goes so deep that

Bahraini Islamic banks refuse to trade with Malaysian Islamic banks.254

250 Visser, Islamic Finance Principles and Practice, supra, p. 65 251 Obaidullah, Islamic Financial Services, supra, pp. 165-166 252 Hanafi, Shafi, Maliki and Hanbali are the four “Madhhab”s (schools of law) in jurisprudence within Sunni Islam. 253 El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance, supra, p.6 254 Dudley, Nigel, Islamic Banks tap a Rich New Business, Euromoney, Issue No.392, December 2001, p. 95


However in relation to Sukuk, the real earthquake was created by the fatwa (religious

opinion concerning Islamic law issued by an Islamic scholar) issued by the AAOIFI in February 2008.

The fatwa basically claimed that 80-85 % of the Sukuk issued until then is not Sharia-compliant and

recommended six principles in order to reach permissible structures.

The recommendations of AAOIFI’s Sharia Committee are:

Tradable Sukuk must represent ownership for Sukuk holders, with all of the rights and

obligations that accompany ownership, in real assets, whether tangible or usufructs or

services, that may be possessed and disposed of legally and in accordance with the Sharia.

The manager of a Sukuk issuance must establish the transfer of ownership of such assets in

its books, and must not retain them as its own assets.

It is not permissible for tradable Sukuk to represent either revenue streams or debt except in

the case of a trading or financial entity that is selling all of its assets, or a portfolio which

includes a standing financial obligation such that debt was incurred indirectly, incidental to a

physical asset or a usufruct.

It is not permissible for the manager of Sukuk, regardless of whether the manager acts as an

investment manager, or a partner, or an investment agent, to undertake to offer loans to

Sukuk holders when actual earnings fall short of expected earnings. It is permissible,

however, to establish a reserve for the purpose of covering such shortfalls to the extent

possible, on condition that the same be mentioned in the prospectus.

It is not permissible for the investment manager, partner, or investment agent to agree to

purchase assets from Sukuk holders or from whoever represents them for a nominal value of

those assets at the time the Sukuk are extinguished at the end of their tenors. It is

permissible, however, to agree to purchase the assets for their net value, or market value, or

fair market value, or for a price agreed to at the time of their purchase, in accordance with

Sharia rules of Partnership and modern partnerships, and on the subject of Guarantees.

It is permissible for the lessee in a Sukuk Al-Ijara to agree to purchase the leased assets when

the Sukuk are extinguished for their nominal value, as long as the lessee is not also an

investment partner, investment manager, or agent.

Sharia supervisory boards must not consider their responsibility to be over when they issue a

fatwa on the structure of Sukuk. Rather, they must review all contracts and documentation


related to the actual transaction, and then oversee the ways that these are implemented in

order to be certain that the operation complies at every stage with Sharia guidelines.255

However, AAOIFI recommendations do not have the force of law and it remains to be seen

how the industry will react to it.256 The immediate reaction of some bankers has been that the

recommendations may put a dampener on the issuance of future Sukuk because of these extra

‘constraints’ and thus affect their future tradability.257

3.3.3 Credit Rating Issues

If Sukuk are to achieve their macroeconomic and microeconomic benefits, it is essential that

asset securitization Sukuk be issued and traded on a large scale. To achieve widespread issuance and

trading, such Sukuk will have to be rated by international rating agencies. At present, however, it is

difficult to obtain ratings from major international rating agencies on transactions that are

dependent, at any level, upon laws in most jurisdictions within the Islamic economic sphere. The

main legal impediments relate to the inability to obtain satisfactory legal opinions with respect to a

range of enforceability issues, including true sales of assets and various bankruptcy law matters.

There are general issues as to whether and to what extent the Sharia or Sharia-compliant

transactions can be enforced in jurisdictions in which the Sharia is not incorporated to any extent in

the secular law of the land ("purely secular jurisdictions"), as well as in jurisdictions in which the

Sharia is incorporated to some extent in the secular law of the land ("Sharia-incorporated

jurisdictions").258

255 The original declaration of AAOIFI in relation to amendments in contemporary Sukuk issues is available at

http://www.aaoifi.com/aaoifi_sb_Sukuk_Feb2008_Eng.pdf 256 AAOIFI is not a statutory industry-wide body, but is an organization based in Bahrain in which leading Sharia scholars participate in order to resolve issues and try and reach agreed settled positions. 257 AAOIFI Sharia Council’s proposals for amendments in contemporary Sukuk issues, May 2008, Available at http://islamicfinancenews.wordpress.com/2008/05/21/aaoifi-Sharia-councils-proposals-for-amendments-in-contemporary-Sukuk-issues/ 258 McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, supra, pp. 431-432

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When we look at the ratings given to Sukuk structures, we see that generally the credit rating

is directly linked to the credit rating of the originator. Let us read from the Standard & Poor’s’ Islamic

Finance Outlook 2009 Edition:

“To date, Standard & Poor’s has assigned ratings to 23 Sukuk issued by sovereigns,

supranationals, regional governments, corporations, and financial institutions. Most Sukuk

we rate benefit from full external guarantees, falling in the first category (where there is an

irrevocable third-party guarantee, usually by a parent or original owner of the underlying

collateral and the guarantor provides Sharia-compliant shortfall amounts in case the issuing

vehicle (usually a special-purpose entity or SPE) cannot make payment.) We therefore have

assigned them ratings equivalent to those on their guarantors and view them as ranking pari

passu with the senior unsecured obligations of guarantors.”259

The Offering Circular (OC) of Qatar Global Sukuk issuance is a fine example showing the said

rating agency’s approach: On page 9 of the OC, the Sukuk rating is linked directly to that of its

sovereign issuer: “The ratings of the Certificates will be based primarily on the credit rating of

Qatar.”

260

The International Islamic Rating Agency (IIRA), which has been established in Bahrain, is a

step in the right direction to overcome the latter of the aforementioned issues. It will perform a

number of functions including the rating of all public and private issuers of credit instruments with

respect to their financial strength, fiduciary risk and creditworthiness. It will also assess the

compliance with the Sharia of financial instruments as well as their issuers. It will have a Sharia board

Obviously this means that, for now, a very important benefit of securitization does not really

work for Islamic structures. Without any doubt, there are many reasons for that: On the one hand,

the shortfalls of judicial systems in the countries of Sukuk issuances, on the other, rating agencies’

interpretations on the transaction structures.

259 Standard & Poor’s, Islamic Finance Outlook 2009, 20 February 2009, p. 30 260 El-Gamal, Islamic Finance Law, Economics and Practice, supra, p. 108


of its own to advise it on Sharia issues. It will, thus, complement the work of the Islamic Financial

Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions

(AAOIFI) in setting standards for adequate disclosure.261

3.3.4 Benchmarking Issues

In most Sukuk structures, the variable rent is calculated by reference to a conventional

interest rate such as LIBOR (London Inter-bank Offer rate) as the table below proves:262

An argument often heard from investment bankers is that Sharia requirements achieve the

same end result that conventional investment or finance products would achieve in a number of

situations. The difference is the utilization of different mechanisms and finance techniques. While

this is true in a number of ways, it is important to note that an Islamic investment product is a factor

of both utilizing specific mechanisms and respecting the fact that the form by which investments are

made is as important under Sharia as the substance.263

261 Chapra, M. Umer, Challenges facing the Islamic financial industry, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn K., Edward Elgar Publishing, Inc., 2007, p. 331 262 Cakir, Selim and Raei, Faezeh, Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?, IMF Working Paper 07/237, October 2007, p.3 263 Abdel-Khaleq, Ayman H., Richardson, Christopher F., New Horizons For Islamic Securities: Emerging Trends in Sukuk Offerings, Chicago Journal of International Law, Winter 2007, pp. 412-413


Mohammad Ayub makes the following interpretation on the issue:

“The question arises whether any interest rate benchmark like LIBOR can be agreed as the

benchmark for rental. According to a minority of the scholars, with such benchmarks the

transaction becomes similar to an interest-based transaction and, therefore, is not

permissible. This is not the correct viewpoint, because as long as the basic requirements of

Sharia are being complied with, any benchmark can be used to price sale or lease

transactions. Benchmarking the transaction’s pricing to an interest-based rate does not

render it Haram.”264

The use of interest rates as benchmarks for determining mark-ups, and more generally for

pricing Islamic financial instruments, is widely accepted by Sharia scholars, be it with some lack of

enthusiasm.

265 Saying that, we may conclude with the fact that the better position is that the

reference to an interest rate is acceptable based on the Sharia grounds of necessity or public need

because, at present, there is no viable Sharia compliant alternative.266

3.3.5 Recent Sukuk Defaults

As Islamic banks operate within the global financial system, they have not been completely

insulated from the recent economic and financial shocks. For instance, on the one hand, the Islamic

financial industry is considered by many to be less risky because financial transactions are backed by

physical assets. On the other hand, Islamic banks may be more vulnerable to fluctuations in the

mortgage market, given their high activity in the real estate sector compared to conventional banks.

264 Ayub, Introduction to Islamic Finance, supra, p. 284 265 Visser, Islamic Finance Principles and Practice, supra, p. 57 266 de Belder, Richard T., Investment Banking, supra, p. 95


The recent slowdown in real estate activity in the Gulf economies raises concerns about some Islamic

banks’ financial positions.267

The Islamic finance industry is undergoing a big test as defaults and restructurings appear in

the Sukuk market for the first time. Investment Dar, a Kuwaiti investment company that owns a 50%

stake in luxury-car maker Aston Martin Lagonda Ltd, said in May 2009 it had defaulted on a $100

million Sukuk issued in 2005 and registered in Bahrain and became the first Middle Eastern company

to default on Islamic bonds.

268 In June 2009, there was a default on a $650 million Islamic bond

launched in 2007 by an offshore vehicle linked to Maan Al Sanea’s troubled Saudi group, Saad.269

These defaults follow last autumn’s (2008) bankruptcy of Texas-based East Cameron Gas

Company, which issued a $167 million Islamic securitization in 2006. A court in Louisiana is deciding

what rights, if any, the noteholders have. There is uncertainty as to whether the issuer of the notes is

bankruptcy remote and whether a true sale of the assets took place.

270

Dubai managed to avoid defaulting on a $4bn Sukuk held by developer Nakheel in December

– thanks to a loan from Abu Dhabi – but Saad Group in Saudi Arabia, Kuwait’s The Investment Dar,

and East Cameron Partners in the US have all defaulted on Islamic bonds since the financial crisis

erupted.

271

Despite the black clouds on the Islamic securitization, future prospects still seem bright.

These defaults are taken by the market as a natural result of the hardest crash since the Great

Depression of 1929. Even though Islamic Finance has been shown as a potential cure for the crisis by

267 Ilias, Shayerah, Islamic Finance: Overview and Policy Concerns, Congressional Research Service, February 2009, p. 3 268 Fidler, Stephen, Defaults Pose Latest Snag In Islamic-Bond Market, Wall Street Journal, June 16, 2009, available at http://online.wsj.com/article/SB124510859262816907.html 269 O’Neill, Dominic, Islamic Finance: Sukuk market on trial as Islamic bonds default, Euromoney Magazine, July 2009, available at http://www.euromoney.com/Article/2245562/ChannelPage/0/AssetCategory/14/Islamic-finance-Sukuk-market-on-trial-as-Islamic-bonds-default.html 270 Ibid 271 Wigglesworth, Robin, Sukuk forecast to ride rough patch, Financial Times, 14 April 2010, available at http://www.ft.com/cms/s/0/ed243650-47da-11df-b998-00144feab49a.html

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Vatican,272

There’s a degree of nervousness about defaults in the Sukuk market but that is outweighed

by the bullishness demonstrated by the new Sukuk deals currently being done and those likely to

come to the market in the course of this year (2009)," says Qudeer Latif, partner at law firm Clifford

Chance in Dubai. He points out that the $750 million Bahrain sovereign Sukuk last month (June 2009)

had an order book of $2 billion; while in February (2009) Indonesia’s $650 million sovereign Sukuk

had an order book of $3 billion. Even so, one of the bookrunners tells Euromoney that the Middle

East, North Africa and Asia accounted for 70% of the buyers of the Bahrain Sukuk. In 2007, however,

western buyers sometimes accounted for more than 80% of Sukuk investors.

the whole financial system in the world is so much linked as of the first decade of the 21.

Century. Thus, Islamic finance can not be crisis-proof alone while the whole financial system in the

world is suffering more than ever, investment banking is becoming a subject in history books,

thousands of highly educated finance (and financial law) experts are losing their jobs, etc.

273 Again, David Oakley

of Financial Times says “It is also hoped that non-Muslim European investors, who were increasingly

buying Sukuk as a way to diversify, before the credit crisis, will return to the market.”274

Moody’s, the credit rating agency, in a report recently predicted that Islamic bond sales in

2010 could exceed last year’s $24bn as global regulatory and legislative initiatives, and a possible

Dubai World restructuring settlement, boost issuance. Most sales will come in the second half of this

year (2010) as the global economic recovery gathers pace and boosts investor risk appetite and

corporate profits, Moody’s argued. “I think we will have a good Sukuk year in 2010, probably equal to

or better than last year,” says Razi Fakih, deputy chief executive of HSBC Amanah. “The underlying

reasons being that there are still a lot of infrastructure investments to come for which some of the

financing will probably be raised through Sukuk, and there remains underlying demand from local

investors.”

275

272 Totaro, Lorenzo, Vatican Says Islamic Finance May Help Western Banks in Crisis, March 4, 2009, available at

http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy 273 O’Neill, Dominic, Islamic Finance: Sukuk market on trial as Islamic bonds default, supra 274 Oakley, David, Credit Freeze victim shows signs of a thaw, Islamic Finance Financial Times Special Report, May 6, 2009, p. 3 275 Wigglesworth, Sukuk forecast to ride rough patch, supra

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3.4 The Use of Derivatives in Islamic securitization

Islamic finance is still struggling to determine whether or not it has a parallel approach to

western risk management. Structured systemic Islamic financial products require structured

innovation within Sharia confines.276

The non-existence of interest rates in Islamic finance apparently makes the need for

derivative instruments redundant in Islamic markets. However, we need to note some important

qualifiers. First, it shall be noted that the prohibition of interest and gharar does not close the room

for financial engineering in compliance with the Sharia. Second, Sukuk cannot avoid being

competitive if they are to operate in traditional financial markets. Third, the positive aspects of

derivative markets can be beneficial for developing capital markets if replicated in the emerging

markets.

277

When structuring derivatives products, four main difficulties arise with respect to

compatibility with Sharia law, namely the Sharia prohibitions on riba, gharar, maisir and debt

exchange.

278 Specialist derivatives practitioners are now facing both an exciting opportunity and an

interesting challenge, namely to produce products which provide parties with the unquestioned

benefits of conventional derivatives (particularly with respect to effective hedging and general risk

management) whilst also adhering to and respecting the core tenets of Sharia.279

276 Thomas, Abdelkader, Risk Management and Derivatives, ed. by Thomas, Abdelkader, Cox, Stella, Kraty, Bryan, Structuring Islamic Finance Transactions, Euromoney Books, 2005, p. 184 277 Tariq, Ali Arsalan, Managing Financial Risks of Sukuk Structures, M.Sc. in International Banking thesis, Loughborough University, 2004, p. 63

278 Tredgett, Richard, Islamic Derivatives Case study: A cross currency swap, Allen & Overy LLP Article, 18 June 2008, Available at http://www.allenovery.com/AOWeb/binaries/45568.pdf 279 Uberoi, Priya, Evans, Nick, Profit Rate Swap, Allen & Overy Article, 7 October 2008, Available at http://www.allenovery.com/AOWeb/binaries/47753.PDF

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Aside from a narrow focus on the contractual framework, Islamic scholars must take into

consideration the potential “welfare loss” when deciding on the permissibility of derivative

instruments.280

Perhaps the most important derivatives question made after an examination of the

substance of the contract is whether it serves a public benefit or maslahah

281 to such an overriding

degree that it may be transacted. In the case of salam and istisna, Islamic scholars from the time of

the Prophet Muhammad have agreed that the public good outweighs the break from generally

accepted contractual forms.282

It is now agreed that there is nothing inherently objectionable in granting an option,

exercising it over a period of time or charging a fee for it, and that options trading like other varieties

of trade is permissible, and as such, it is simply an extension of the basic liberty that the Qur’an has

granted. With that in mind, strong opposition to derivatives seems to be inherited from a pathology

of religious interpretation that turns a blind eye to the fact that derivatives are a new phenomenon

in an Islamic context.

283

Notwithstanding the religious constraints and legal uncertainty surrounding the

enforceability of investor interest under Islamic jurisprudence, Islamic finance can synthesize close

equivalents to equity, mortgages, and derivatives known in conventional finance. To this end, it relies

on structural arrangements of asset transfer between borrowers and lenders to emulate traditional

interest-bearing financial contracts.

284

Anouar Hassoune, vice president of Moody’s recently authored a report in relation to

derivatives in Islamic Finance and in his report, he noted that, “If employed with care, derivatives can

280 Bacha, Obiyathulla Ismath, Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration, International Journal of Islamic Financial Services, Vol. 1, No.1, April-June 1999, p. 28 281 Maslahah means that an underlying process may have some problematic issues or prospectively harmful elements from a Sharia perspective, but the good achieved by its application outweighs harm. 282 Thomas, Risk Management and Derivatives, supra, p. 185 283 Jobst, Derivatives in Islamic Finance, supra, p. 26 284 Ibid, p. 2


enhance efficiency in Islamic Financial Institutions through risk mitigation, thereby making them

more competitive as well as appealing to customers. However, their application in Islamic finance is

highly controversial for reasons of speculation and uncertainty, two practices forbidden under

Sharia.”285

In principle, futures and options may be compatible with Islamic law if they (i) are employed

to address genuine hedging demand on asset performance associated with direct ownership interest,

(ii) disavow mutual deferment without actual asset transfer, and (iii) eschew avertable uncertainty

(gharar) as prohibited sinful activity (haram) in a bid to create an equitable system of distributive

justice in consideration of public interest. Sharia-compliant derivatives would also maintain risk

sharing between contract parties by forgoing the zero-sum proposition of many conventional

derivative transactions in favor of win-win situations from changes in the value of the underlying

asset. However, the de facto application of many derivative contracts is still objectionable, mainly

because of the possibility of speculation (or deficient hedging need) and the absence of

entrepreneurial investment violate of the tenets of distributive justice and equal risk sharing subject

to religious restrictions on the sale and purchase of debt contracts as well as profit taking without

real economic activity and asset transfer.

286

The closest approximation to a conventional option contract within Islamic finance is the

arboun contract. The contract affords the buyer of a good to make a deposit whereby if he decides to

buy the specified product in the future he will pay the difference between the full price and the

deposit. If circumstances dictate that he will not buy the commodity then the seller keeps the

deposit. In a sense, the arboun contract ostensibly replicates the functions of a conventional call

option. The permissibility of the contract within Islamic doctrines is debated and much of debate is

with regards to historical records of the use of the contract during the time of the Prophet

Muhammad. Several schools of thought are in the impression that the uncertainty arising from the

use of the contract amounts to gharar and is thus unfair on the seller. On the other hand, other

schools of thought uphold the contract citing inaccuracies in the historical records of its alleged

reproach. The applicability of the contract is particular to the condition that commodity in question is

285 Moody’s sees huge global potential for Islamic banking industry, Pakistan Chronicle, April 7, 2010, available at http://www.pakistanchronicle.com/content/moody%E2%80%99s-sees-huge-global-potential-islamic-banking-industry 286 Jobst, Derivatives in Islamic Finance, supra, p. 28

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specified and unique to the contract. According to Sharia, the arboun cannot be used for generic

commodities which hinder its possibility to fully replicate the functions of conventional option

contracts that are on unspecified underlying assets. According to the Organization of the Islamic

Conference (OIC) Academy, an option contract is not tradable. Firstly, the option contract amounts to

investing in something intangible. Secondly, the uncertainty involved in the contract is tantamount to

gharar making it invalid within the sphere of Sharia.287

The first Islamic securitization transaction in the U.S. demonstrates the Sharia-compliant use

of derivatives in structured finance. In July 2006, East Cameron Partners (ECP), an independent oil

and gas exploration and production company based in Houston, Texas, raised $165.67 million from

the issuance of a Sukuk al-Musharaka backed by natural oil and gas royalties. Its two-tier

securitization structure consists of a “purchaser SPV” (incorporated in Delaware), which acquires the

underlying assets, and an “issuer SPV”, registered in the Cayman Islands, which funds the asset

purchase by issuing investment trust certificates (Sukuk notes). The relationship between both SPVs

is governed by a “funding agreement”, which includes periodic funding repayments and the transfer

of net profits. The funding agreement aims at materializing the contribution of the “issuer SPV” (as a

musharek) and (ii) conveying to the “issuer SPV” a certain risk and reward profile, which is passed on

to the Sukuk note holders, pursuant to the following provisions: (i) the purchase of overriding royalty

interest (ORRI) from the originator for $113.84 million, (ii) the payment of the development plan for

$38.28 million, (iii) the funding of the reserve account with an initial balance of $9.5 million, and (iv)

the acquisition of natural gas put options for $4.05 million in a specific hedge agreement with an

outside party. The commodity price hedge as part of the funding agreement to protect investor

interest is remarkable in the context of Islamic finance. The hedge constitutes a Sharia-compliant

obligation, since it confers true commercial value (rather than speculative interest).

288 Overall, Sharia

compliance of the transaction is established by the uncertainty of cash flows from the asset

performance of permissible real economic activity with identified and direct investor participation,

which does not imply the payment or receipt of any interest guarantee. While deferrals are possible,

in the default event, investors have recourse to the underlying assets and can force the sale of the

cash flow generating assets.289

287 Tariq, Managing Financial Risks of Sukuk Structures, supra, pp. 64-65 288 Jobst, Derivatives in Islamic Finance, supra, p. 22 289 Ibid


However, one should note that the legal risk from Islamic jurisprudence could affect the legal

enforceability of the funding arrangement and the asset control of investors.290

3.5 A Case study: Sorouh Securitization

291

The purpose of the Sun Finance Limited (incorporated in Jersey, the Channel Islands, with

limited liability) securitization is to allow Sorouh Real Estate PJSC (hereinafter referred to as Sorouh)

to monetize future cash flows for from the sale of real estate plots to property developers. Sorouh

applied the proceeds of the monetization toward funding the utility infrastructure for two of its

flagship real estate developments: a) Shams Abu Dhabi, a 170-hectare development and $3.1

billion292

290 One should remember that East Cameron Partners Sukuk defaulted during the harshest days of the recent financial crisis and the conflict is before an American court at the moment. The decision of the court in relation to enforceability may potentially affect the future Sukuk structures. 291 While preparing the case study, our main tool was the Offering Circular of the deal. Apart from that, we used the related reports and media releases of Clifford Chance LLP, Freshfields Bruckhaus Deringer LLP, Moody’s, Standard & Poor’s and the Economist as well as Sorouh Real Estate PJSC’s ADX Financial Report dated June 30, 2009. 292 Despite the conservative assessment of the Economist, some, mostly Middle Eastern sources claim that the project is worth actually AED25 billion ($6.9 billion).

residential project on Al Reem Island, and b) Saraya ($290 million, mixed-use) development

in Abu Dhabi's central business district.

The transaction was closed in August 2008, thereby affected by the credit crunch, and the

total issue was AED4 Billion ($1.1 billion). Citigroup, Abu Dhabi Commercial Bank, First Gulf Bank,

National Bank of Abu Dhabi, Noor Islamic Bank took part in the transaction as joint bookrunners

while Clifford Chance LLP, Afridi & Angell, Freshfields Bruckhaus Deringer LLP and Bedell Cristin

Jersey Partnership acted as legal counsels for different parties in the transaction.

In essence, there are three principle parties involved in this transaction: Sorouh, a project

developer that sells the plots; Sorouh Abu Dhabi Real Estate LLC (Propco), that purchases the plots

and, in turn, sells them to individual developers; and Sun Finance (Issuer) that issues the Al-

Mudaraba Al-Muqayyada certificates to investors.


Sorouh securitization comprises three classes of notes rated by Moody’s and Standard &

Poor’s. The below table293 shows the relevant profit rates294

The transaction is capitalized by Sun Finance applying the certificate proceeds toward a

mudareb (investor of capital). The certificate proceeds amount to the Issuer’s beneficial interest in

the mudareb. Propco, effectively a partner in the mudareb, buys the plots from Sorouh, sells them to

the developers, and puts the purchase price toward the investors’ (that is, trust certificate holders’)

returns and funding for the infrastructure works.

As payments from the developers come in through plot sales, ownership of the land

incrementally shifts to the developers. In turn, Propco incrementally purchases the Issuer’s beneficial

interest in the Mudaraba (trust) as it receives funds from plot sales, thereby amortizing the

certificates. When a plot sale payment is received, Propco releases the relevant plot to the

developer.

Propco purchase undertaking is backed solely by the sale proceeds from the real estate plots.

If plots are not sold or purchase prices not achieved, Propco will likely not be in a position to meet is

obligations under the purchase undertaking. The Issuer’s ability to service the certificates lies

ultimately in the ability of Propco to sell and be paid for the plots. The significance of this feature is

that the credit quality of Sorouh is effectively not an issue once the sale of the plots to Propco is

completed, effectively making the Sun Finance transaction a non-recourse Sukuk.

and ratings from the said agencies as

well as some other details accordingly:

293 The table is taken from the Offering Circular (OC) of Sorouh securitization, p. 2 294 EIBOR is the abbreviation for Emirates Interbank Offered Rate.


Propco is 99%-owned by the chairman and managing director of Sorouh, the remaining 1%

being held by an independent director. In the event of a payment default by Sorouh, transaction

documentation indicates that the 99% share would be transferred to the independent director, who

would then own 100% of Propco.

The structure features both senior and subordinated certificates. It benefits from a fatwa to

the effect that it's Sharia-compliant.

Investors do not have security as much as they hold a beneficial ownership interest in the

mudareb. Such interest is not the same as outright legal ownership though. While the Issuer has a

fixed and floating charge under U.K. law over the assets of Propco, there is some question as to

whether such charge would be enforceable in the UAE where the assets are located.

As noted above, in the event of the insolvency of Sorouh, the issuer is entitled to instruct the

independent director to force a sale of the assets held by Propco. In summary, there is a degree of

legal and country risk in each transaction.

Below is a structure diagram of the Sorouh securitization transaction:295

295 The diagram is taken from the Offering Circular (OC) of Sorouh securitization, p. 9


It is the first ever securitization of installment sales receivables which was Sharia compliant.

The Sukuk certificates which are asset backed by installment sales receivables from the sale by

Sorouh of plots of land on the iconic Shams and Saraya Master Developments in Abu Dhabi have

been awarded the highest credit rating to date for a non-sovereign instrument issued in the MENA

(Middle East & North Africa) region. The transaction is also unique in many other ways, but notably,

apart from being the first ever securitization of this asset class, marks the first asset-backed

securitization out of Abu Dhabi. It is also Abu Dhabi’s first ever local currency securitization deal. The

transaction is also the world's largest Sharia compliant securitization296

“Objectively speaking, it was an incredible deal for many reasons,” says Khalid Howladar, a

senior analyst in the Middle East and Islamic structure finance group at Moody’s Investors Service.

“I’ve never seen anything like it.”

to date, including Sharia

compliant tranches and representing one of the few fully distributed asset backed transactions since

the advent of the "credit crunch".

297

296 Robin Ward, a director at Citi says “In contrast to past full-recourse deals, this transaction features partial recourse to the originator. Sharia scholars have recently expressed concern over pure-recourse deals and as a consequence previously Sharia-compliant deals would no longer be compliant if proposed today.” Available at http://www.isr-e.com/story.asp?storycode=284065 297 Deal of the Year 2008 – Emerging Markets, Winner: Sun Finance, 1 December 2008, Available at http://www.isr-e.com/story.asp?storycode=284065

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CONCLUSION

We tried to explain the quite complex and hence, interesting world of Islamic Securitization.

We hope we at least managed to give a broad picture which may give the reader a basic

understanding of this quite young branch of financing universe.

Securitization which is in its essence a Sharia compliant structure perfectly fits with the needs

of Islamic financial institutions that have traditionally accepted the model of originate-to-hold. That is

why Islamic financial institutions may benefit a lot from the liquidity and risk management features

of securitization. This mere reality is making Islamic Finance and Securitization great partners. We do

believe that securitization in Islamic Finance will be the impulsive power of Islamic Finance in its

challenge to become a player in the mainstream financing.

Obviously the aforementioned success will not come with ease. As one may well argue, the

“different interpretations of Islamic law” is a serious issue concerning the sound growth of Islamic

Securitization as well as other structures of Islamic Finance. The lack of standardization may have an

adverse effect on the spectacular up-going trend in the long run. The efforts of institutions like

AAOIFI are very important regarding standardization as we mentioned their suggestions in relation to

Sukuk issues echoed all around the world.

We believe that the importance of these efforts is beyond having standardized structures.

This is almost a matter of life and death to Islamic Securitization and Islamic Finance in general. Our

point to this argument is that without universally accepted structures, there is a huge risk of

witnessing individual issuers simply mimicking conventional structures and calling the structures they

created “Islamic”. This may cause Islamic Finance lose its nature and identity in the long run. That is

why we believe that this problem is a matter of life and death.

Lack of expertise has always been an issue regarding the success of Islamic finance. As the

number of Islamic finance experts all around the world, both Muslim and non-Muslim, is increasing in


multiples, this issue is becoming less important gradually. Obviously, it is not possible to deny the

contribution of the international law firms most of which have a quite deep and wide Islamic Finance

expertise and practice. Most of the innovative structures were created with the effort of the partners

and associates of these firms working in the offices in the Middle East or other locations particularly

London.

We gave some numbers in our thesis regarding the potential of Islamic finance which shows

there is still a lot of way to go. Provided that the aforementioned efforts continue to exist (or even

increase as one may suggest) and the recession fears ease, it is not impossible to beat these

“potential” forecasts. There are many parameters which make us believe that the potential numbers

seem to be quite modest. Apart from the others, even the increases in these forecasts, coming one

after another, prove that there is, in fact, much more potential than it is claimed at the moment.

Only time will tell…

----- O -----


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http://www.vinodkothari.com/glossary/Passthro.htm�

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