Friday, November 27, 2009

On the inconvenience of principal

Or principle.


When staunchly held principles come face to face with real life, ingenuity and artifice are called upon to sustain the principle against overwhelming proof of expedience. In the end there is either blind faith passing as ignorance (or vice versa), or the rise of skepticism, the death knell of most other isms.

And that is what the financial world is up against as the Financial Wizards in the Middle East and South East of Asia together with their brethren in London and other financial circles try to keep their principles from destroying their principal.

In a word, it's called sukuk.

Ali Arsalan Tariq's Masters thesis describes the context and evolution of sukuk, with these brief excerpts doing no justice to his work, which should be read in full:
Debt markets are an integral part of the financial sector and effectively supplement the funds provided by the banking sector. Islamic law (Shari’ah) prohibits the charging and paying of interest.

In addition to prohibiting interest, the Islamic law also prohibits trading under conditions that exhibit excessive uncertainty and ambiguous outcomes (Gharar).

Therefore, in countries where Muslim population constitutes an important segment of the society, traditional debt markets cannot flourish. Hence there is a high demand and need for developing alternatives to traditional debt markets that can be acceptable to the Islamic law.

In Islamic capital markets, interest rate swaps and other conventional forms of derivative instruments such as credit derivatives and detachable options are not available as Islamic law also prohibits these.

As a result, there has recently been a rapid growth of a thriving multi billion dollar market in Shari’ah compliant sovereign and corporate Islamic structured financial instruments known as Sukuk.

Due to the very novelty of Sukuks themselves there is a relative dearth of comprehensive research studies.

Mathew Goldstein outlined some of the chief characteristics of sukuk:
Islamic finance has five 'pillars':

1. The ban on interest.

2. The ban on uncertainty or speculation.

3. The ban on financing sectors deemed haram, or forbidden
-- such as weapons, pork or gambling.

4. The profit and loss sharing principle -- parties share
risks and rewards.

5. The asset-backing principle -- each transaction must
include an identifiable underlying asset.

Current risks are focused on 'pillar number five' -- asset
securitisation -- and vary according to which of two general
types an investor chooses: 'asset-based' or 'asset-backed'


The difference lies in ownership and sale of assets.

Asset-based sukuk allow the inclusion of assets that may
not be legally recognised as being owned by the investors.

The assets fulfil sharia compliance in form. But they may
not ensure that investors can recover capital, through sale of
the asset, for example, in the case of originator bankruptcy.

Asset-backed sukuk stick more closely to the ideal of
granting the investor a share of a concrete asset or business
venture, and a share of the risk commensurate with such

In this case, sukuk securitisation is structured around
investors' rights, or legal ownership, of a plot of land,
building, or other asset.


The widespread loss of liquidity and lack of investor
confidence wrought by the post-September 2008 global financial
crisis sent ripples through the world of Islamic banking, due
to originator insolvency, defaults and debt restructurings.

The website with the unfortunate name "" is a financial news site dedicated to this corner of the finance world. It offers these insights/opinions:

Basics of Islamic finance
The conceptual difference between an Islamic finance and a conventional finance transaction lies in the fact that in conventional finance, the financial institution generally lends cash for a length of time, often direct to the client or borrower, of course based on a credit rating or evaluation, on the basis that the borrower would return the borrowed amount plus an interest amount. The interest amount and the original borrowed amount is required to be repaid to the lender over the loan period or by the end of the loan period. Thus the transaction in essence is the lending of cash against the return of a higher amount of cash, and not necessarily for a specific purpose. One of the basic ideas behind the interest rate is the time value of the money lent. The excess cash returned to the lender over and above the borrowed amount is considered "riba" in Islamic finance.

In Islamic finance, there is no direct lending of cash against return of a higher amount of cash, unless the transaction is "asset backed" implying that the transaction has to involve the sale and purchase of an asset. In a typical financing transaction, the Islamic financial institution will purchase assets required to be financed by a borrower at a price and sell them to the borrower at an agreed (higher) price allowing the financial institution to make a profit. This purchase and sale of an asset basically renders the financing as "Shariah-compliant". Islamic Shariah laws allow cash to be lent, but generally only as "Qard Hassan" where only the same amount of cash is required to be returned, if returned at all.

The point to note is that in an Islamic finance transaction, the financier takes an element of risk, that of ownership of an asset and consequent non-payment by the client of the asset's sale price. Any default penalties imposed to encourage payment on time do not accrue for the benefit of the lender but get paid to charity. There are other inherent risks in the transaction but the idea is that this risk-taking is what allows the Islamic financial institution to make a profit on the financing transaction. Therefore, even though the payment terms in a conventional and Islamic financing contract may look alike, there are differences in the conceptual structure of the transaction. Usually the profit margins charged by Islamic financial institutions are about the same as interest rates of conventional financial institutions, but this is largely due to competition, the required profits of shareholders of such institutions, and also quite possibly driven by higher legal and administrative costs pertaining to the financing transactions.

Banking on sukuk in a crisis
Abu Dhabi, Dubai and Qatar all have issued billions of dollars worth of conventional bonds in recent months.

Bahrain went a step further and issued a $750 million sovereign sukuk that attracted an order book of about $4 billion with strong demand from the Middle East. (Islamic bonds, or sukuk, are underpinned by physical assets whose returns are used to pay bond-holders, to account for Islam's prohibition of interest.)

Are these isolated instances of Gulf governments trying to increase their liquidity?

They are not. Regional governments are co-coordinating efforts to develop secondary bond trading. In the past creditors tended to hold the few bonds that were issued to maturity. The new government issuance will help develop a yield curve, which will make for more efficient pricing and give corporate issuers a benchmark to price against.

Also, it is a push by the region to further develop their debt markets and shift the pressure of bank lending to fund the mega-projects that have come to characterise the region.

The high-cost and long-term nature of these ventures, which include new economic cities, refineries and airport expansions, requires longer-term financing that has been increasingly difficult to secure as the global recession has tightened credit markets and sapped liquidity.

Kuwait and Saudi Arabia would be next in line to issue sukuks. Saudi Electricity plans to issue sukuk that could be worth about 5 billion riyals ($1.33 billion). Saudi Arabia also launched its new market for both conventional bonds and sukuk to offer firms new sources of funding amid tight credit conditions.

But, despite all the euphoria the fact remains that sukuks are more often illiquid.

Which brings us to the dubious world of the ego investing of Dubai. You see, if one of these sukuks were to blow up, how is the fall out handled? In bankruptcy court?

Not if it's a western court because the very first order of business in bankruptcy courts is to separate the debt from the equity, and shift the balance of powers to the debt holders. But a strict application of shariah would, at first blush, mean there is no debt: all is equity. What then? Who has priorities, and over what?

That is likely one main reason the world's markets are in a bit of uncertainty and dither over the latest from Dubai World and its tentacles, particularly since this is not the first shoe to fall on the matter.

Fears rise over Islamic bonds
Dubai’s request for a debt standstill for one of its largest state-owned conglomerates has raised the possibility of the largest Islamic bond default on record and rattled the global Islamic debt markets.

Nakheel, the Dubai developer behind many of the emirate’s gaudiest projects, has to find $4bn to repay an Islamic bond, known as sukuk, by December 14.

The Nakheel sukuk has been seen as an important indicator of how Dubai will manage the liabilities of its multifarious government-related entities, but a failure to repay the bond fully and on time could impact the global sukuk market, estimated at over $100bn.

“There is a lot of shock and a little bit of anger,” said Nish Popat at ING Investment Management in Dubai. “This is a major blow to the sukuk market. If it defaults, it would be the third one in the Gulf, and the largest Islamic bond default ever, and we’re still waiting to see how sukuk-holders are treated in situations like this. There aren’t any precedents.”

Western investors watch nervously as worth of Islamic bond is tested
According to Neale Downes, a Bahrein-resident partner at Trowers & Hamlins, the law firm, it is not clear how creditors will rank in an insolvency.

Islamic bond problems herald due-diligence era
"If there are lessons to be learned here, it is that due diligence is all important. Compliance to sharia in its structuring does not ensure the success of a sukuk or of any product or business," said Yusuf Talal DeLorenzo, chief sharia officer at fund management company Shariah Capital
Dubai Government Shock May Not Be Last
With sovereign finances stretched, investors need to remember that governments can and will change the rules when necessary. Asset prices buoyed by a faith in policy support may need to adjust to that.

Dubai's decision may mark a watershed. Throughout the crisis, governments have so far looked to prop up key assets: after the global banking bailout, support was extended to key automakers in the U.S. and Europe. At a sovereign level, countries have banded together to provide support to peers in trouble, such as Latvia. Dubai itself set up a Financial Support Fund for its government-related companies.

But all of this support carries a cost. Governments are under increasing pressure to rein in their borrowing, particularly as central banks start to withdraw their extraordinary policy measures, thereby removing some of the support for government bond markets. As a result, they may no longer be able to provide such wide-ranging support. The result could be more nasty surprises as government cast other unviable investments adrift.


Dubai Debt Woes Raise Fear of Wider Problem
“Dubai shows us that what we are now facing is a solvency issue, not a liquidity issue,” said Jonathan Tepper, a partner at Variant Perception, a research house in London that has been outspoken on the debt problems facing European economies.

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Blogger Jack said...

God is good.

29 November 2009 at 3:40:00 am GMT+10  
Blogger Guambat Stew said...

Good as gold.

29 November 2009 at 4:13:00 am GMT+10  

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