© A. Jobst, 2008

Andreas A. JobstMonetary and Capital Markets Dept.International Monetary Fund (IMF)

Sukuk – Quo Vadis?Islamic Securitization After the Subprime Crisis

700 19th Street, NW, Washington, DC 20431, USA

E-mail: ajobst@imf.org

© A. Jobst, 2008

Overview

1. Macroeconomic Situation and Effect on Islamic capital market instruments

2. Developments of the Sukuk Market3. Islamic Securitization as the “Third Way”4. Challenges and Outlook

© A. Jobst, 2008

Monetary and Capital Markets Department

© A. Jobst, 2008

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Americas Europe Asia

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600

Americas Europe Asia

Financial Sector Write-downs and Capital Infusions(billions of U.S. dollars)

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100

200

300

400

500

600Write-downs by Region Infusions by RegionWrite-downs by Type

Mortgages

OtherTrading

Loans/Leveraged loans

SIVs

Monolines

Capital Shortfall new funding, dividend cutback

© A. Jobst, 2008

General Impact of the Current Market Situation

• … but there are several factors driving up spreads– series of measures announced by central banks (liquidity injections,

e.g. collateral framework, FX swaps, standing facilities) and governments (asset purchases, capital support and debt guarantees)

• only supply-side effect on secured money markets• failed to restore inter-bank lending and investment in credit-

sensitive assets• externalities of Fed/ECB/BoE actions: currency premium, trading

bias towards “guaranteed banks”– Keynesian deficit-spending: crowding out by govt debt LT govt re-

financing via debt issuance or higher taxes– financial sector de-leveraging: large ST and MT asset supply further

price depression and tight credit– higher Sharpe ratio, currency option skew, etc.

© A. Jobst, 2008

The Credit Crisis and its Effect on Islamic Finance

• Islamic finance industry in expansionary phase: average annual rates of about 15%

• >US$800 billion of deposits and investments in Islamic banks, mutual funds, insurance schemes and Islamic branches of conventional banks

• … but some factors exacerbate the impact of global credit environment:

– “imported inflation”/de-pegging in GCC, and increased local currency issuance/local investment in sukuk (Islamic “bonds”)

– asset-based concept of Islamic finance: sectoral concentration and little asset diversity slump in real estate

– “compliance risk” after recommendations by AAOIFI on sukuk structures (Feb. 2008)

© A. Jobst, 2008

Sukuk and Islamic Finance Principles

• sukuk transform bilateral risk-reward sharing between borrowers and lenders into market-based refinancing of shari’ah-compliant lending or trust-based investment in existing or future assets.

• sukuk do not pay interest, but generate returns through commoditization of capital gains from actual transactions (i.e., asset transfer), such as:– leasing (sale-leaseback): ijara (thumma al-bay)]– cost-plus sale (sale-buyback): murabahah (bay al-inah)– profit-sharing/”sweat capital”/trust: musharakah or mudarabah

shari’ah-compliant assets, usufructs or services

• investors own the underlying asset(s) via SPV that funds unsecured payments to investors from direct investment in real, religiously-sanctioned economic activity

© A. Jobst, 2008

Basic Sukuk Structure (w/ Third Party Assets)

Issuing Agent/Conduit(e.g., Special

Purpose Vehicle (SPV))

Issuing Agent/Conduit(e.g., Special

Purpose Vehicle (SPV))

Basic Sukuk Structure (murabaha and ijara)(with Third-Party Assets)

Capital Market Investors

AAA Tranche

AA Tranche

A Tranche

BBB Tranche

BB Tranche

Asset Originator/ Sponsor

Single Asset/

Commodity

OR

Reference Portfolio

(“collateral”)

ASSET

Equity (FLP)TrusteeTrustee

UnderwriterUnderwriter

distribution of sukuk certificates

Credit Enhancer(Third-Party Credit Support)

Credit Enhancer(Third-Party Credit Support)

sale ofsukuk certificates

disbursement of revenue to investors

issues debt securities

transfer of collections

offers credit and liquidity support, hedging agreement

SeniorM

ezzanineJunior

User

Single Asset/Commodity

ORReference Portfolio

(“collateral”)

ASSET

Expected Losses

cost-plus sale(murabaha)

ORlease (ijara)

deferredpurchase price

ORlease payments

separate purchase contract(ijara thumma al-bay)

purchaseprice

transferof assets

leaseback (ijara)

1

1

2

2

leasebackpayments

3

3

© A. Jobst, 2008

Past Development of Sukuk Market

• increasing appeal in non-core markets (UK, Turkey, Maghreb)

• sukuk issuance soared over the last three years in response to growing demand for alternative investments

• outstanding sukuk globally exceeded US$90 bn. at end-2007

• gross issuance of sukuk has quadrupled over the past two years, rising from US$7.2 bn. in 2004 to close to US$39 bn. by end-2007, and growth predicated at 15-25% p.a. owing in large part to large infrastructure development plans in Middle East and financial innovation

• total issuance in 2007 equivalent to roughly a quarter of conventional securitization in EM but only two percent of conventional (local and foreign) bond issuance

© A. Jobst, 2008

Current Development of Sukuk Market• moderate issuance in 2008, but

number of deals brought to market has steadily increased (139 in 2008 vs. 161 in 2007 over same time)

• sukuk volume dropped to US$15.2bn (50% from US$36.3bn.) in 2008 so far, while structured finance volume dried up with just US$387bn. issued (80%) amid stable EM issuance (US$310bn.)

• ijara structure now dominates (>50%), followed by musharaka and mudaraba sukuk

• issuance still concentrated in parts of Asia and countries of the GCC

• other currencies (but USD, SAR and MYR) hold largest share (approx. US$7 bn.)

Global Sukuk Issuance, 2005-2008(In USD billions)

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15

20

25

30

US$ b

illion

2005

2006

2007

2008YTD

Source: IFIS, Bloomberg, Dealogic, Datastream.

© A. Jobst, 2008

Prospects: Islamic Securitization as a “Third Way”?Sukuk and Covered Mortgage Bonds

• revitalize the secondary mortgage market

• covered bonds:– unsecured debt obligations, collateralized by a dedicated (“ring fenced”)

assets that are fully retained by the issuer– interest payments guaranteed and independent of cover assets– on-balance sheet treatment redress misaligned incentives that undermined ex

ante market discipline and led to demise of the structured finance

• ijara sukuk:– investors receive no institutional guarantee (and off-balance sheet)– but have direct recourse to real assets that fund secured repayment from

profitable investment

© A. Jobst, 2008

Incentive Problems in Conventional Securitization

ArrangerArrangerArrangerArranger

Issuing Agent/Conduit

(Special Purpose Vehicle (SPV))

Issuing Agent/Conduit

(Special Purpose Vehicle (SPV))

Capital Market Investors

AAA Tranche

AA Tranche

ATranche

BBB Tranche

BB Tranche

Asset Originator/ Sponsor

Reference Portfolio

Equity (FLP)

distr. of securities

issuessecurities

under-written byarranger

transfer of collections

Expected Losses

SeniorM

ezzanineJuniorServicerServicer

Cred

itors

Cred

itors

Credit Rating Agency

Credit Rating Agency

servicingfees

disburse-ment

cashcash

transfersassets

WarehouseLender

WarehouseLender

temporaryfunding

retention of equity interest

cash

servicingand

collection

1 2

4

5

7Asset

Manager/Trustee

Asset Manager/

Trustee

9

Third-party Guarantor

Third-party Guarantor

fee-based creditand

liquidity support

6

3

8

© A. Jobst, 2008

Islamic Securitization as a “Third Way”? (2)Sukuk and conventional securitization – incentive problems

• between asset manager and investor (principal-agent dilemma):– religious prohibition of gambling (maisir) and speculation (gharar) commands clear

object characteristics/delivery results and restricts trading activity to bone fide merchant transactions on real debt based on contractual certainty

– no issuer leverage on the underlying asset portfolio and excessive risk taking (asset substitution)

• between originator and issuer:– adequate disclosures underpinned by a solid foundation of religious standards

(supervised by a designated shari’ah board), which also curb and valuation problems that had infested the conventional securitization market.

• between originator/servicer and issuer/asset manager:– contract certainty rules out potential of inflated, back-loaded (and variable) servicer

expenses (and cannot be prioritized)– fixed, ex ante premium for transfer of “asset obligations” to servicer

• between borrower and originator:– no predatory lending due to sanctioned exploitation (and unilateral gains); no moral

hazard of “walking away” or debt modification (prohibited under shari’ah); social benefit as public interest and system of distributive justice (maslaha)

7

2

4-6

1

© A. Jobst, 2008

Incentive Problems in Conventional Securitization

ArrangerArrangerArrangerArranger

Issuing Agent/Conduit

(Special Purpose Vehicle (SPV))

Issuing Agent/Conduit

(Special Purpose Vehicle (SPV))

Capital Market Investors

AAA Tranche

AA Tranche

ATranche

BBB Tranche

BB Tranche

Asset Originator/ Sponsor

Reference Portfolio

Equity (FLP)

distr. of securities

issuessecurities

under-written byarranger

transfer of collections

Expected Losses

SeniorM

ezzanineJuniorServicerServicer

Cred

itors

Cred

itors

Credit Rating Agency

Credit Rating Agency

servicingfees

disburse-ment

cashcash

transfersassets

WarehouseLender

WarehouseLender

temporaryfunding

retention of equity interest

cash

servicingand

collection

1 2

4

5

7Asset

Manager/Trustee

Asset Manager/

Trustee

9

Third-party Guarantor

Third-party Guarantor

fee-based creditand

liquidity support

6

3

8

© A. Jobst, 2008

AAOIFI Recommendations (Feb. ’08) (1)

Key recommendations relate to the role of asset ownership, investment guarantees, and the shari’ah advisory and approval process in sukuk origination and trading maintain tenet of risk-reward sharing (otherwise interest-bearing loan)

Entrepreneurial investment: investors become legal owners (with all of the rights and obligations) rather than nominal holders of the securities transforms pari passu asset-based sukuk into tranched asset-backed securities (ABS).

Credit support: must not offer loans to investors in case of profit shortfall Compliance of collateral: no revenue streams or debt Shari’ah certification: review of all contracts/documentation

© A. Jobst, 2008

AAOIFI Recommendations (Feb. ’08) (2)

Purchase price guarantee: issuer/agent (wakil), partner (musharik) or manager (mudarib) cannot guarantee principal through re-purchase of underlying assets or guarantee except:

– repurchase at net value or fair market value, or a price agreed at the time of purchase

– ijara sukuk (remaining lease payments or nominal value)– trust guarantees to cover cases of negligence, misconduct or breach

of contract (representations and warranties)– alternatives:

• amortizing clause for underlying assets (cf. Villamar sukuk) or• (separate) voluntary guarantee agreement by agent in

mudarabah/musharaka sukuk

© A. Jobst, 2008

Current Economic and Regulatory Challenges

• origination and servicer risk from narrow asset supply poses challenges to investor diversification

• poor asset diversity given narrow range of deal types and maturities

• future development could be arrested by insufficient supervisory harmonization and the ongoing controversy about financial innovation

• Islamic jurisprudence neither definite nor bound by precedent and no universal recognition and enforceability of rulings

– cross-referencing of fatwas– regional diversity of secondary sources: ijtihad (independent analytical

reasoning), ijma (consensus) and qiyas (deduction by analogy)

© A. Jobst, 2008

Čihák, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund).

Hesse, Heiko, Andreas A. Jobst and Juan Solé, 2008, “Trends and Challenges in Islamic Finance,” World Economics (April-June).

Jobst, Andreas A., Peter Kunzel, Paul Mills and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management, Vol. 1, No. 4.

Jobst, Andreas A., 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22.

Solé, Juan, 2007, “Introducing Islamic Banks into Conventional Banking Systems”, IMF Working Paper 07/175 (Washington: International Monetary Fund).

References