Sukuk Defaults Expose Islamic Finance Soft Spot

First defaults of sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the US$1 trillion (RM3.5 trillion) Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait’s Investment Dar said in May it had defaulted on a US$100 million sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

“Secular, non-Sharia courts upholding those structures are more likely to consider sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders,” said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

A US$650 million sukuk issued by troubled Saudi group Saad, which is undergoing debt restructuring, for example is seen as an asset-based, rather than an asset-backed, sukuk. Yields of the sukuk jumped to above 70 per cent in mid-June, as investors feared a default of the issue.

Most sukuk are structured as asset-based instruments, rather than asset-backed securitisation where “you always have a claim for that particular asset that has been sold to you as the investor”, said Megat Hizaini Hassan, an Islamic banking lawyer in Kuala Lumpur.

CHASING ASSETS

“Everybody is chasing the same assets if they have not been transferred to the name of the sukuk holders,” said Samer Amro, senior associate at law firm Dewey LeBoef.

Other uncertainties are likely to arise from sukuk defaults, including a debate about how courts will interpret repurchase clauses which are structured to follow a controversial ruling by prominent jurist Sheikh Muhammad Taqi Usmani in late 2007.

Taqi had ruled that repurchase guarantees found in most sukuk contradict Islamic laws, as they violate the principle of sharing risks and returns.

“If you’re looking at the newer structures where the repurchase obligations are left to be determined at the time of repurchase, there may be some issues there,” said Megat Hizaini.

“You don’t really know how the courts will treat it in the situation,” he said.

Islamic finance is governed by scholars’ rulings, national regulators and its own standard-settings bodies such as Bahrain-based AAOIFI, the Accounting and Auditing Organisation for Islamic Financial Institutions.

“In the Middle East, it’s going to put to the test many of the legal protections that were originally built into the sukuk,” said Mohammad Faiz Azmi, global Islamic finance leader at PriceWaterhouseCoopers, adding that countries in the region typically do not have bankruptcy laws as sophisticated as in Europe.

“When these sukuk start to default, it would be very apparent which jurisdiction has a more robust system than others,” he said.


HURDLES TO TRUE SUKUK
Corporates with perceived higher risks that are facing high borrowing costs and a sluggish regional IPO market could use true sukuk sales with full ownership transfers as an avenue to the capital markets.

“It adds some credit-enhancement, it adds credit-worthiness,” said Rizwan Khan, a senior associate at law firm Norton Rose.

But the paperwork involved in registering ownership transfers in the Gulf Arab region and restrictions on foreign ownership of land make true sukuk sales difficult.

Issuers have to register the SPVs, to which asset ownership would have to be transferred, in Bahrain or the Cayman Islands, as regulatory frameworks in other Gulf countries like Saudi Arabia and Kuwait do not fully cover sukuk structures.

This turns the SPV into a foreign buyer, limiting the pool of assets.

“This is not going to change unless laws are enacted, in particular on the ownership issues,” Khan said.

From Reuters

Financial Partnerships

In theory, Islamic banking is based upon the concept of making financial profit by taking risks through financial speculation, financial partnerships and other financial transactions that are permissible under Islamic law whilst at the same time avoiding incurring debt that represents a high risk both to the individual and to the market in general.

Such debts leads to wealth being amassed by the privileged few who are capable of offering sufficient guarantees of financial solvency whereas the overwhelming majority of middle class professionals and small and medium enterprises cannot afford to incur such debts and are therefore unable to finance their own projects and achieve the desired growth and development. This type of debt would in any case suffocate the majority of small and medium businesses and ultimately lead to serious financial loss.

Small and medium businesses account for around 90 percent of companies worldwide, as well as providing between a reported 40 and 80 percent of employment. According to a study published by the Arab Orient Centre for Strategic and Civilization Studies, small and medium businesses account for around 85 percent of Britain's gross domestic product [GDP] and around 51 percent of America's GDP. In addition to this, between 1979 and 1995 around 75 percent of employment in the US was in the small and medium business sector.

Financing designs and products by continuously incurring debt will also ultimately kill off the spirit of creativity and inventions [by doing away with the concept of competition and financial solvency]. Financing is the umbilical cord that nurtures this, and since [much] financing is now obtained by taking out loans and thereby incurring debt, money inevitably end up with the privileged few when this umbilical cord is severed.

This manner of financing is warned against in the Holy Quran, "What Allah has bestowed on His Messenger (and taken away) from the people of the townships - belongs to Allah- to His Messenger and to kindred and orphans, the needy and the wayfarer; In order that it may not (merely) make a circuit between the wealthy among you. So take what the Messenger assigns to you, and deny yourselves that which he withholds from you. And fear Allah; for Allah is strict in Punishment." [Chapter Al-Hashr; Verse 7].

However the practical application of Islamic Banking has violated this, changing from a financial system founded on partnership to one based on debt. In some Islamic Banks, assets from Murabaha constitute as much as 92 percent of the overall financial portfolio. The Islamic banking system has also switched from operating via [Shariaa-compliant] rates of profit and has adopted interest rates, something that brings the Islamic Banking system closer to the conventional banking system. Islamic banking tools are also now used in risk management and credit policies; this makes the system vulnerable to the economic defects that are inherent in such practices in precisely the same manner as the conventional banking system.

Islamic banking has therefore ceased to be a safe haven for investors. It has become exposed to the risk of bad debts as the system is set up only to offer loans to a small number of individuals with substantial financial solvency as well as large corporations who are able to provide financial guarantees. These loans are provided without really examining the feasibility of the projects being funded or even knowing whether this financing is granted via Tawarruq or Murabaha. These kinds of financial practices do not occur when financing is provided via partnership or speculation.

Sukuk have also become vulnerable as a result of failures in meeting their financial obligations as a result of the legislative chaos that the Sukuk market is currently encountering and also because in many cases the assets being transferred to Sukuk-bearers are not genuine. In addition to this, Sukuk companies are now also including a contract where in the case of financial default the customer is obliged to immediately pay the value of the Sukuk in full. This only serves to increase the rate of default on Sukuk, and has therefore raised the risk that Sukuk bonds are exposed to. Islamic Banking has also become more liable to risk from individual bankruptcy as a result of the expansion seen in granting consumer credit based upon Tawarruq.

Islamic Banking has moved away from the values and principles that it was originally based on, and the Muslim community is no longer reliant upon this financial system to contribute to its progress and development. The damage caused by debt on the Islamic Banking system is therefore clear for all to see. Islamic Banking is no longer a system built upon partnership in profit and loss coming from actual financial activity that creates job opportunities and genuine products. Unfortunately, Islamic Banking is no longer a financial system that can make a difference to the world. Islamic Banking has crossed the line.

Maybank Singapore To Launch First Islamic Term Deposit For Retail Clients

Maybank Singapore will launch the first Islamic Term Deposit (Term Deposit-i) targeted at retail clients tomorrow, making it the first bank here to offer the Islamic banking product to that market segment.

As the first mover in the market, Term Deposit-i will pay profits upfront, the bank announced today, bucking the local trend of Islamic term deposits for high networth customers.

A similar product, Profit Now Account-i was launched by Maybank Islamic Bhd in Malaysia last May and it was well-received with more than RM1.3 billion total deposits to date.

In a statement here Thursday, the bank said Islamic banking products were sought after by local customers who were scouting for alternative investment avenues with the current change in investment landscape.

The bank is offering for a limited period, promotional rates of 0.6 percent, one percent and 1.4 percent for a tenure of three, six and 12 months respectively.

The minimum placement is S$10,000 (S$1=RM2.42) for a 12-month tenure or a minimum of S$25,000 for a three- and six-month tenure.

This deviates from the current available Islamic term deposit products in the market.

Some products require a minimum placement of US$500,000, catering only to the high networth segment.

The bank said Term Deposit-i was based on the commodity Murabaha principle, which was on a cost plus profit sale concept.

Under this concept, a specific syariah-compliant commodity will be identified and used as the underlying asset for the sale and purchase transaction between the customer and the bank.

Maybank Singapore currently offers other innovative Islamic banking products such as iSAVvy Savings account-i, a syariah-compliant online savings account.

The bank said since the introduction of the Islamic deposit products in 2005, it had seen an average year-on-year increase of over 40 percent in Islamic deposits.

This increase aligned with the global expected growth of over 40 percent to US$1 trillion by 2012, Maybank said.

Maybank Singapore Islamic banking head, Mohd Ismail Hussein, said the current market presented an opportune time to take on a back-to-basic approach.

"Consumers are on the lookout for an alternative to conventional products and this term deposit, being syariah-compliant may well match their needs," he said.

Mohd Ismail said Islamic banking was a fairly new concept in Singapore but was gaining momentum including from among the bank's non-Muslim Islamic banking customers.

"With Maybank being the market leader in Islamic banking in Malaysia, the operations in Singapore is in good stead to 'break the ice' between Islamic banking and the local retail market," he said.

Ambank's New Islamic Fund Aims To Perform In Bull Marts

AmIslamic Bank's second Islamic structured deposit, AmMomentum Select Islamic Negotiable Instrument of Deposit (NID-i), aims to perform in bull markets and protect investors against bear markets.

AmBank retail banking executive director, Mahdi Murad, said the NID-i was a highly innovative rule-based asset allocation strategy that used momentum to decide how to invest in a portfolio of multiple assets.

"It automatically avoids underperforming asset classes and takes advantage of bull markets," he said at the launch of the fund here Wednesday.

The NID-i is a four-year syariah-compliant principal protected structure that provides diversified exposure in 100 syariah-compliant stocks in 44 countries and in four indices namely, equity, energy, agriculture and metal.

It is essentially a deposit with a fixed tenure and returns are linked to the performance of syariah-compliant underlying assets, which may be equities, bonds, commodities, foreign exchange, indices or any combination of these assets.

Mahdi said the fund was suitable for investors who wanted to ride on the economic recovery but were uncertain about which asset classes to invest in and when was the best time to invest.

Meanwhile, the bank's structured products senior manager in treasury and markets, Hoe Cheah Kit, said investors could expect a two percent return for the first year.

"Upon completion of the four-year tenure, they can expect the principal and the two percent return if it was not drawn out before," he said.

On the expected average return for the fund, he said: "Going into the next four years, it depends on how fast the market recovers from here onwards."

Hoe said in the last seven years, where the bull run was in 2007 and early 2008, the average return was eight percent.

For the bank's first Islamic structure deposit launched last September, it gave a 1.5 percent return for the first six months, he said.

He said although the net asset value of the first fund was now lower then when it was first launched, it was now on a recovery trend.

"We went through a hard time in the second half of 2008. But even then we raised RM45 million (for the first fund) and saw momentum picked up over the last few months," he said.

The NID-i targeted a fund size of RM75 million during its 30-day offer period, he said.

Hoe said the bank aimed to launch another conventional structured product by year-end.

Economic Environment Will Improve

Malaysia believes that with further collaboration with the Gulf states it can share knowledge and expertise in Islamic finance to help improve the current economic environment.

As such, Prime Minister Datuk Seri Najib Tun Razak has called for closer cooperation between the Gulf states and Malaysia to promote the Islamic financial system for a more holistic approach to long-term economic development.

"The states, with their financial resources, and Malaysia, with the knowledge and expertise in Islamic finance, provide a natural match and synergy for closer cooperation.

"We must use the opportunities available to us, even in these difficult times, to strengthen our economies and emerge stronger when the global economic environment improves.

"I am very confident that it will surely improve, just as the sun will rise again tomorrow," he said in his article on "Playing Our Part in Building a Safer, Prosperous World" published by the Egyptian Gazette newspaper Wednesday.

The prime minister is here to attend the 15th Non-Aligned Movement (NAM) summit which was officially opened by Egyptian President Hosni Mubarak Wednesday.

Najib, who is also finance minister, said that in the wake of the current crisis and the failure of the conventional banking system, there was increased interest in Islamic finance.

He said Malaysia, a leader in this area with some 60 per cent of the world's issuance of 'sukuk' (Islamic bonds) originating from Malaysia last year, was prepared to share its expertise for the greater and common good of the Muslim world.

He said the Securities Commission (SC) and the Dubai Financial Services Authority (DFSA) had agreed to allow cross-border distribution and marketing of Islamic funds between Malaysia and the Dubai International Financial Centre (DIFC).

Najib said it could be strengthened with the establishment of an economic council between the Gulf states and Malaysia.

He said it would offer far-reaching benefits to members as well as other countries in the two regions -- Southeast Asia and the Gulf region -- and between Asean and the Gulf Cooperation Council.

"One of the most important lessons to be learned from the ongoing economic crisis is that we must never be boxed in by orthodoxy in economic matters, but focus more on what works, what is needed and what will best serve the long-term needs of our people," he said.

He said that in Malaysia, there have been criticisms from those who wanted to defend the status quo or ignore the different times we lived in.

"But without these policies, Malaysia would be left behind, ill-equipped to compete in the high-value economic sectors of the future that will propel Malaysia into the higher income group," he said.

On NAM, he said that though the organisation was set up under a very different political and economic environment, the challenges it faced today were no less important.

"The Cold War may be over but we are confronted with the most severe economic crisis in decades, new international security threats that strain relationships and questions about shifts in economic power across regions and between peoples," he said.

HSBC Shows Resilience Amid Crisis

HSBC clinched a series of major industry awards in the Asia-Pacific region in the first half of 2009, reflecting its resilience in difficult economic conditions.

The awards, organised by leading financial publications, include regional, country and territory awards as well as recognition for outstanding performance in various business areas.

Euromoney, in its 2009 Awards for Excellence programme, named HSBC Best Bank and Best Debt House in Hong Kong. In the publication's Foreign Exchange Poll 2009, HSBC was ranked number one in the "Best for Currencies - Hong Kong Dollar" category.

Earlier in the year, HSBC Amanah won Best Sukuk House, Best Fund Manager and Best Takaful House in Euromoney's Islamic Finance Awards.

In FinanceAsia's Country Awards for Achievement 2009, HSBC was recognised for its outstanding strength in its operations in Hong Kong and some emerging markets in Asia. HSBC in Hong Kong, in addition to winning the Best Bank title, also won Best Bond House, Best Cash Management Bank, Best Trade Finance Bank and Best Foreign Exchange Bank titles. HSBC was also named top Foreign Commercial Bank in mainland China, Malaysia and Vietnam.

HSBC in Malaysia also fared well in Islamic finance and transaction banking. In the Asset's Triple A Islamic Finance Awards 2009, the bank won Best Islamic Debt House award as well as the Best Islamic Project Finance Deal in the country and the Most Innovative Islamic Finance Deals. In the Asset's Triple A Transaction Banking Awards 2009, HSBC in Malaysia was named Best Trade Finance Bank, Best Transaction Bank, Best Sub-custodian Bank and Best Domestic Custodian. In the same awards programme, HSBC in Vietnam also won Best Trade Finance and Best Sub-custodian awards.

In The Asian Banker's Excellence in Retail Financial Services Awards 2009, HSBC won Best Regional Retail Business in Asia. In the same programme, HSBC in mainland China topped other foreign banks in retail banking while HSBC in Hong Kong won the Excellence in SME Banking award.

UAE's Islamic Financial Firms To Bring Changes In Canberra's Financial Services Sector

The first Islamic financial Services Mission of the UAE to Australia ended successfully and the Dubai Export Development Corporation is expecting new business opportunities for the Islamic Finance sector as a result of the trade mission.

UAE's Islamic financial firms, part of the delegation to Australia, have met with the Treasury officials in Canberra to discuss the current rules governing its financial services and incorporate Islamic financial products.

Jointly organised by EDC and the Australian Trade Commission (Austrade), the Trade Mission delegates are seeking to encourage changes in Australia's federal taxation which will allow Islamic financial products to be treated at par with conventional financial products. The Australian financial system, like most in other parts of the world, is based on the principle of payment and receipt of interest that disadvantages Shariah compliant financial products.

'One of the important aims of this mission is to initiate a dialogue between UAE's Islamic Financial firms and the Australian authorities so as to discuss changes that will allow Islamic Firms to be established in the country and to be treated on an equal footing with conventional financial firms,'
said Engineer Saed Al Awadi, Chief Executive Officer, EDC.

'Australia, with a Muslim population of about 400,000 people and growing at 20% per year, is an attractive market for UAE's Islamic Financial Firms. It is estimated that the annual household purchasing power of Australian Muslims is in excess of $3.3bn. Of course, Islamic Finance is not only limited to Muslims but is also popular to non-Muslims such as in the case of Dubai,' he added.

With a federation of six states and two territories, Australia levies state and federal taxes hence, Islamic financial firms have to overcome both of them. This means that for Shariah compliant products such as Murabaha mortgages tend to pay stamp duty, the most important tax at the state level, twice ie at the time of purchase and then when the loan is paid off. This adds to the borrower's burden and makes Shariah financial products uncompetitive.

However, some states in Australia such as Victoria have approved the State Taxation Act (Amendment) Act 2004, through the State Legislative Assembly and Legislative Council, which abolished double stamp duty on Islamic home finance. Other states are also considering making similar changes to their state taxation in order to accommodate Shariah compliant home finance.

Another example of double taxation is the Islamic trading of commodities requires a physical holding of the asset, which is very different from conventional commodity trading whereby the asset need not exist. Similarly, Shariah compliant deposits pay a profit rather than interest and this should not disadvantage the investor.

Al Awadi explained that, 'These challenges are being faced in most countries abroad. In 2005 and 2006, the UK government headed by the then Chancellor Gordon Brown introduced a legislation to incorporate Shariah compliant products into the UK financial services framework. Although, the UK does not mention Islamic finance it nevertheless used such contracts to base the changes in taxation. For example, the Finance Act 2005 under section 47 defines a purchase and resale contract which happens to correspond to a traditional murabaha contract. In a similar manner, a shariah compliant deposit is treated as a profit share return or in an Islamic context a Mudarabah contract.

'As a direct result of these changes, the UK now boasts two Islamic banks and a number of banks with Islamic windows. We hope to achieve similar modifications within the Australian financial system through our recent trade mission, eventually introducing Islamic financial products down under,' he concluded.

Kym Hewett, Austrade Senior Trade Commissioner in Dubai, commented, 'I am keen to see the positive experience the delegates on the initial mission translate into a great level of understanding on Islamic Financial products and deeper level of engagement between financial institutions in Australia and the UAE. Austrade's relationship with EDC continues to evolve since our Tradelink Partnership signing in 2008.'

From AME Info