Work in progress

The Islamic financial world has long lagged behind conventional markets when it comes to securitisation. However, recent developments suggest an asset-backed securities market may finally be getting off the ground. John Ferry reports

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The Islamic bond market has built its foundations on concepts and techniques pioneered in the securitisation market. But, until recently, Middle Eastern investors had yet to see a fully rated, multi-tranche securitisation of residential mortgage-backed assets. That all changed in June with the launch of a residential mortgage-backed securities (RMBS) transaction known as Tamweel. So far, its significance has been commented on very little, but it could turn out to be the deal that opened Islamic finance to the types of sophisticated securitisation techniques prevalent in more developed markets.

Tamweel is the first internationally rated, tranched Islamic structure that bears all of the hallmarks of a conventional securitisation: it has several classes of note-holders, a bankruptcy remote special-purpose vehicle (SPV), a completely secure claim on assets in the event of bankruptcy and losses that are based on the pledged assets of the structure rather than the credit risk of the borrower.

The $220 million deal was conducted on behalf of Tamweel PJSC, a provider of real estate finance in the United Arab Emirates (UAE), and was lead-managed by the Emirates National Securitization Corporation (Ensec), a Dubai-based specialist securitisation firm set up in 2004 to facilitate securitisation in the region. Morgan Stanley and Standard Chartered Bank acted as joint book-runners on the deal.

The underlying portfolio comprises around 1,000 Islamic mortgages on apartments and villas from Dubai's various free zones, the areas in which expats are allowed to buy freehold property. The transaction is rated by Fitch Ratings and Moody's Investors Service and consists of four classes of notes - under Moody's classification, Aa2, Baa1 and Ba3 tranches, plus a non-rated equity tranche (see box, page 8). It is the first global Islamic RMBS deal to be rated investment grade. Fitch gave the senior notes an AA rating.

"This is a landmark deal, in the sense that it is the first Gulf sukuk that is genuinely an internationally rated securitisation," says Khalid Howladar, vice-president for Middle Eastern and Islamic structured finance at Moody's in London. "The structure is an innovative one that shares both losses and profits (by mutual agreement) between the different investor classes in a way that is consistent with a conventional securitisation, in the sense that there are effectively senior bondholders, mezzanine bondholders and junior equity holders."

Sukuk and securitisation

Tamweel differs from traditional sukuk in some fundamental ways. The types of sukuk that regularly come out of Islamic countries are often thought of as asset-backed securities. Because sharia prohibits speculation and uncertainty, financing can generally only be raised in a form that is linked to identifiable assets, and sukuk therefore take the form of notes or certificates that represent ownership of an underlying pool of assets. This means that sukuk investors should be entitled to the ongoing cashflows and proceeds of sales from those assets. It sounds like securitisation, but the distinguishing point for investors is that, when you examine the underlying credit risks of these deals, they tend to have more in common with conventional unsecured lending than securitisation, which by definition is secured.

"Even in an asset-based transaction, which is how the majority of sukuk are currently being labelled, investors really do not have any recourse or security over the assets in the structure," says Howladar. "In the event of a corporate insolvency or bankruptcy, all those assets that were nominally pledged to investors end up getting sucked back into the insolvency estate, so the investor is just like an unsecured creditor. That's something some participants I've met in the region are actually surprised to hear."

In other words, even though terms such as 'asset-backed' and 'profit participation' may be used in the context of Islamic bonds, most sukuk have merely been a form of unsecured lending. As a result, when these issues have received a rating in the past, it has typically been the same as the corporate rating.

The portfolio of ijara contracts that make up the Tamweel securitisation comprises properties acquired by Tamweel, then rented on a long-term lease basis to the company's customers for an agreed rent and specified period. In Islamic finance, the mortgage lender owns the property and leases it out to the property purchaser, who agrees to buy the house at the end of the specified period. The purchaser pays monthly instalments to the bank, effectively comprising two parts - payment of the purchase price of the house (equal to the price paid for the house by the bank), and rent for living in the property. Once the purchaser has paid all the instalments, the bank transfers ownership of the property to the client.

The lease rentals and other payments connected with the properties, such as insurance proceeds or sales to third parties if a lessee defaults and is evicted, constitute a source of cashflows to support the payments due under the notes.

The transaction uses a dual SPV structure, whereby Tamweel passes the legal title and assigns the lease rentals and all the associated rights and receivables on the properties to an SPV incorporated in the Dubai International Financial Centre. The rights and lease rental receivables are then assigned to a separate, Cayman Islands-registered, SPV. This means that the contractual terms of the structure are not affected by local laws, while overcoming any legal risk associated with the recognition of true-sale (the official term for guaranteeing that the transfer of rights and receivables is legal, valid, binding and enforceable) under Islamic law.

"Unlike most other sukuk, where if there is a default then the investors are unsecured, if Tamweel defaults or goes bankrupt then the assets do actually belong to the investors - they don't lose their investment and they still get paid. Hence they are the highest-rated (corporate) sukuk thus far and probably closer to the sharia ideal," explains Howladar. Tamweel gives investors exposure to tangible assets: the properties generate cash and that flows down the waterfall structure to pay the various levels of sukuk investors, with the equity holders taking the upside of any excess, as well as being exposed to the first losses. "From an Islamic perspective, you have genuine asset ownership. You have losses that are based on the assets and not on the initial borrower," adds Howladar.

So why has it taken until now for a tranched Islamic structure, rated by leading rating agencies, to emerge? "For a number of reasons, there was no need for securitisation in the past. For example, there were ample sources of fairly unsophisticated capital available, such as equity financing," says Sandeep Chaudhrym, Dubai-based chief executive of Ensec. "The whole economy was effectively funded by equity and bilateral funding. But, as corporations' aspirations have increased, they have started to look for differentiated and more sophisticated forms of financing."

There are also the expectations of equity investors to contend with. Chief executives and chief financial officers in the region are thought to be keen to reduce their reliance on equity financing so they can plough more profits back into their companies, rather than be forced to make big dividend payouts to hungry shareholders. By issuing highly rated notes, they can get access to relatively cheap funding while avoiding the equity market. Indeed, company chiefs now view securitisation as a competitive advantage. Tamweel's Dubai-based chief executive, Adel Alshirawi, acknowledged this in June, when he declared that his company had reduced its cost of funding by tapping international and institutional investors. "We expect that we are at least two years ahead of the competition," he added.

A look at previous transactions to come out of the Middle East shows the emergence of proper securitisation was only a matter of time. In 2005, Ensec issued what sounded like the first highly rated securitisation of mortgage assets to come out of the region, again originated by Tamweel and called Ensec Home Finance Pool 1. The $350 billion issue was rated AAA by Standard & Poor's (S&P) and Aaa by Moody's, with credit support apparently provided by mortgages and cash collateral. However, in reality, the deal was 104% cash collateralised. In other words, a little over $350 million in cash was placed offshore and put up as security on the deal, meaning it was really a securitisation of cash rather than tangible assets. "In the end, it was just a big marketing story for Dubai," says one securitisation expert.

A more credible transaction was Caravan 1, a $27 million sharia-compliant sukuk securitising a Saudi Arabian car-fleet inventory, launched in March 2004 by Beirut-based BSEC Investment Bank and Bahrain-based Shamil Bank. BSEC acted as deal arranger and structurer, while Shamil Bank underwrote the deal. The structure involved an SPV in Saudi Arabia funding the acquisition of a pool of vehicles and vehicle lease arrangements from Hanco Rent-A-Car, a large Saudi car leasing and rental company, via a separate Jersey-registered SPV. If only a local SPV had been used, it would not have been bankruptcy remote, while, under Saudi commercial law, an offshore SPV is barred from buying or leasing vehicles directly. It was structured so that, in the event of default, investors have recourse to the underlying assets and can force the sale of the cashflow-generating assets.

Caravan 1, however, failed to secure an official rating. According to a working paper from the International Monetary Fund (The Economics of Islamic Finance and Securitization, by Andreas Jobst) released in May, this was because legal risk from Islamic jurisprudence continued to impinge on the legal enforceability of investor interests. "Saudi courts and other adjudicatory authorities might apply different interpretations of sharia principles to the transaction. Since sharia remains the governing law of the transaction, legal uncertainty might compromise the ability of the Jersey-based SPV to enforce investor interests," the author wrote.

The paper goes on to state that the integrity of the funding agreement in the dual-SPV structure hinges on the capacity of the offshore SPV to oblige the Saudi SPV to make pre-specified and contingent payments from lease revenues to repay sukuk investors, and that the enforcement of this guarantee "runs against the condition of investment under the basic tenets of sharia law". With Tamweel, the transfer of title of the properties to the Dubai-registered SPV is governed by Dubai law, with the remaining transaction documents governed by English law.

"Caravan was the first auto-lease Islamic securitisation, but issued one class of note and was not rated by S&P, Moody's or Fitch," says Gohar Bilal, part of the asset securitisation group at BNP Paribas in London. "While there have been rating agencies established in the Middle East, such as the Islamic International Rating Agency and Capital Intelligence, which provide credit analysis for financial institutions and corporates in the Middle East, it is important for Islamic transactions to be rated by the international rating agencies such as S&P, Moody's and Fitch, as this will widen the investor base for these transactions."

The Tamweel deal proved this, and more Middle Eastern countries are now waking up to the benefits of securitisation, Bilal adds. "Middle Eastern banks and Islamic banks are realising the benefits of accessing capital markets, so we see countries such as Qatar, Bahrain and the UAE trying to come up with more flexible, securitisation-friendly environments," she says. "In Qatar, they have the Qatar Financial Centre (QFC). While the Qatar legal environment is based on civil law, the QFC is based on common law, which is an offshore jurisdiction within Qatar. In the future, we are likely to see the platforms such as the QFC and, in Dubai, the Dubai International Financial Centre becoming hubs for securitisation. These centres have been established not only to promote securitisation for conventional transactions but also for Islamic transactions."

More on the horizon

With Tamweel breaking new ground, new sharia-compliant, multi-tranche RMBS deals are likely to emerge. Islamic commercial mortgage-backed securities (CMBSs) should also make an appearance. In June, HSBC issued a $67 million tranched CMBS deal - UAE CMBS Vehicle No.1 - which was secured on the back of new property in Dubai's Technology and Media Free Zone. The securitisation comprises four classes of nine-year notes, rated Aa3 through to Baa3 by Moody's, and is the first CMBS deal involving property in Dubai. However, it has not been constructed to be sharia-compliant.

Chaudhrym says recent activity is just a hint of what is to come, noting that Ensec, whose stated aim is to become a conduit for securitisation in the region in a manner similar to Fannie Mae and Freddie Mac in the US, is working on a large CMBS transaction and an equally large future flow receivables deal. "We are currently working on wrapping up several transactions across RMBS, CMBS and future flow asset classes, and once this technology is in the market we will see deal flow increasing over time and across the economy," says Chaudhrym.

Meanwhile, thanks to the continuing oil boom, Islamic financial institutions are flush with cash like never before, and are increasingly looking at sharia-compliant investments to accommodate their excess liquidity. The General Council for Islamic Banking and Finance Institutions, an Islamic central bank group, reports that roughly 200 Islamic financial institutions operating in 48 countries hold more than $300 billion in assets under management.

As with banks globally, many financial institutions in the Middle East are aware of, and are preparing for, the new Basel II capital Accord, which, under the standardised approach to measuring credit risk, has an emphasis on ratings. Basel II will create a further incentive to structure securitisations that come with the highest credit ratings - banks around the world will be even more eager to fill their vaults with highly rated notes in order to gain as much capital relief as possible to allow them to conduct more business.

Another signal of a future increase in Middle Eastern securitisation is the number of companies in the region seeking ratings from the leading rating agencies. Howladar says Moody's did not rate any companies in 2005 and rated just two firms in 2006. However, by the end of the first half of this year, it had provided ratings on 14 companies across the Middle East. "I think debt-like capital markets will grow at a breakneck pace as the region moves towards a balance in the forms of financing that are available. Sukuk and securitisation are a part of that phenomenon," adds Howladar.

The move away from equity financing towards fixed-income-type funding is just getting under way in the Middle East. As corporate treasurers in the region's companies and financial institutions get more comfortable with securitisation structures, and as opportunities to invest in sharia-compliant securitisations increase, the only way for the market to go seems to be up.

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