Author(s):M Kaul

The global financial market has been constantly remodeling itself, more so in the wake of the global economic meltdown which tainted asset securitization activity. One can often draw parallels between the ever-changing economy and the manner in which securitization activity is fast becoming a desired source of diversified finance enabling credit risk transfer. In the securitization, a company partly deconstructs itself by separating certain types of highly liquid assets from the risks generally associated with the company. The company can then utilize these assets to raise funds in the capital markets at a lower cost than if the company, with its associated risks, could have raised the funds directly by issuing more debt or equity. In turn, the company retains the savings generated by these lower costs, while investors in the securitized assets benefit by holding investments with lower risk. While Section one of this article deals with the captivating topic of asset securitization in the UAE as well as how companies may benefit from asset securitization, it further contemplates and examines the emergence of the asset securitization market in the GCC and more particularly the UAE financial market, where Islamic finance foothold is considered as supreme. Section two shall entail the concept of securitization within the UAE legal framework as well as the manner in which methods of security offered to the creditor through the concepts of pledge and mortgages and their enforcement thereof.

Not only is asset securitization one of the most important financing mechanisms today, but its use is rapidly expanding worldwide. Securitization can be defined as the process of transforming individual illiquid and non-tradable loans or mortgages into marketable securities. This is performed by transferring these loans to a specially created entity or trust called a special purpose vehicle (SPV). This SPV would then issue securities backed by the asset pool to the financial markets.[i]

An effective illustration is when a bank or a financial institution being an originator of mortgage-backed loans, gathers hundreds or thousands of mortgages of the borrowers and repackages them into a pool of assets and transfers it to an SPV, a company or trust formed for the specific purpose of funding the assets. The SPV shall finance the acquisition of the pooled assets by issuing interest-bearing securities to the investors. Accordingly, the investors of these securities shall be entitled to collect mortgage payments from the borrowers whose mortgages have been pooled.

Assets that may be securitized include residential mortgages, auto loans, credit card receivables, leases and utility payments and are demarcated into separate classes of assets to include and mean asset-backed securities and mortgage-backed securities. While mortgage-backed securities are securities created from the pooling of mortgages, asset-backed securities are created from the pooling of non-mortgage assets including but not limited to, credit card receivables, student loans, auto loans. However, with the change in financial markets, the types of assets that can be securitized are also expanding. That is to say, any asset with the potential of future receivables may be securitized upon adhering to the true sale and bankruptcy remote criteria.

Another important aspect to consider for the purpose of understanding the securitization structure is the concept of credit enhancement. Credit enhancement is the manner or method to improve the credit rating of a securitization transaction, as prescribed by a credit rating agency in order to attract investors into investing in such assets. To establish a method of credit enhancement, transactions are often structured to include credit enhancement by way of tranching, wherein the securities are allocated or structured in different priorities or classes of varying seniorities. The structure thus consists of several tranches, from the most senior to the most subordinated and the tranche with the highest seniority has the first right on cash flow.

The very distinction that separates securitization from collateralized or traditional asset-based lending is the fulfillment of true sale criteria, where the assets of the SPV or the issuer to whom the pool of loans are sold are legally segregated from the originator’s credit condition and marketable securities are created out of the assets’ cash flows. In asset securitization, meeting the true sale criteria is the foundation of concluding a securitization activity transaction. True sale criteria shall be considered met when there is no recourse available to the originator with respect to the pool of loans securitized. The SPV/issuer is bankruptcy remote, meaning that if the originator goes into bankruptcy, the assets of the SPV/issuer will not be distributed to the creditors of the originator and the investors shall have an unqualified right over the assets of the SPV. While several countries have stipulated conditions in its legal framework for parties entering into a securitization activity to establish a true sale, certain regulatory authorities like In India, have necessitated legal counsels facilitating securitization transaction to issue a legal opinion confirming the transaction to meet the true sale criteria and being bankruptcy remote.

Such prudent steps are necessary for wake of the global meltdown which has stigmatized the asset securitization market. Though securitization has picked up momentum since then, it has not been so without some necessary tweaking to the regulatory and legal framework by certain countries to ensure the situation does not arise again. India, for instance, ensured that the regulations applicable to the securitization and direct assignment transactions were revised to be watertight, with obligations upon the originator to service the loans for a minimum duration before passing it onto the issuer/SPV.

Islamic Securitization

The term Al-Taskik and Tawriq are terms used for securitization under Islamic law and is the process of issuing certificates that represent debts and loans (generally any type of obligations). Islamic securitization is defined as a legal structure which satisfies requirements of Islamic finance and replicates the economic purpose of a traditional asset-backed securitization structure, whereby, the right over receivables is transferred from the originator to an SPV/Issuer which in turn issues notes that are sold to investors.

It is interesting to note that Islamic securitization fits with the notion of Islamic finance. 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[ii].

Essentially conventional securitization, which originated in non-Islamic economies, invariably involves interest-bearing debt. Investors 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. However, the issuance of interest-bearing debt securities with a secured redemption cannot be reconciled with Islamic financing principles due to the prohibition of profit from debt and speculation. 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.

Therefore, adapting the basic principles of conventional securitization for Islamic purposes requires compliance with the following conditions: (i) there should be a real purpose behind raising -funds via securitization, and the type of collateral assets realizing the securitized revenues must be clearly identified (or be capable of identification) and cannot be consumed; (ii) each transaction participant should share in both the risk and return, and investor should receive positive pay-off from profitable ventures only; (iii) collateral assets must not be debt, cash or prohibited as haram (sinful activity) and must not be associated in any way with unethical or exploitative operations or with speculation and uncertainty (gharar) from non-productive investment; (iv) the structure should provide investor compensation for business risk from direct participation in securitized assets and should not imply an exchange of debt for interest generating investment return (unless those securitized assets are interest free and sold at face value); (v) investors should hold an unconditional and unsecured payment obligation and not a guaranteed promissory note; (vi) a sufficient element of ownership must be conveyed to investors; (vii) the contribution from investors in the form of proceeds from issued notes (and any returns generated by the issuing agent from managing collateral assets) cannot be reinvested in short-term cash instruments or interest-bearing debt; (viii) the underlying assets and securitized obligations must not be employed for speculative purposes, and turnover should be kept low; (ix) because conventional insurance violates Sharia provisions, takaful (Islamic insurance, based on co-operation and mutual help) should be employed instead; and (x) any form of credit enhancement and/or liquidity support and limitations of prepayment risk must be in a permissible form.[iii]

In view of the opinion of Islamic Scholars as seen above on the nature of permissible Sharia-compliant structures and instruments, let us now draw parallels in the conventional securitization structure and the Islamic securitization structure. In order to present a securitization structure that is Sharia compliant, let us begin by examining the structure of the SPV that may need to be established. The SPV in Islamic securitization could take the form of a mudaraba comprising investors and the securitizing company as the mudarib. The mudarib may legitimately claim its share in the surplus. Alternatively, the securitizing company may act as an agent or wakil of all the investors, when organized as a musharaka[iv] company.

Now let us proceed to understand the nature of assets that may be securitized under Islamic finance. Islamic financial institutions have an asset structure that is primarily trade-based, such as Murabaha (cost-plus or markup), bai-bi-thamin ajil (Murabaha with deferred payment facility) and leasing-based financing such as ijara. Murabaha or bai-bi-thamin ajil results in a transfer of ownership of the physical commodity to the buyer and the financial institution’s assets comprise the receivables that are a form of debt. Such assets, therefore, can only be transferred to the SPV at par. Where the SPV is a musharaka company of investors, the musharaka securities would represent part ownership of the pool of assets. And since each security now represents a debt, it can only be transferred at par. Thus a secondary market in such Islamic debt securities is completely ruled out.[v]

It appears that modeling conventional securitization within the structure Islamic finance exhibits some issues. The above problem, however, has taken care of the problem by way of ijara-based securitization. Ijara or Islamic leasing, though less popular as an asset than murabaha, offers much greater flexibility. Ijara-based securitization involves securitization of physical assets and not of financial claims. It involves the transfer of ownership of physical assets and, consequently, all risks and rewards of ownership of existing assets of the company to the SPV representing investors and ownership of SPV is now made equivalent to ownership of the physical assets that are given on lease against rental income. Each investor shares in the rental income on a pro-rata basis. Each security called sukuk[vi]-al-ijara represents a pro rata ownership of physical assets as against a pro rata share in the financial claim or debt in the case of sukuk-al murabaha. While debt can only be transferred at par, ownership in physical assets can always be transferred at a mutually negotiated price. Thus sukuk-al-ijara allows for the creation of a vibrant secondary market.

The originator sells the assets to an SPV à the SPV raises finance to purchase the assets by issuing Ijara Sukuk, which represent an equity interest in SPV and thus in the assetsà SPV leases the assets back to originator à Originator makes periodic lease payments to the SPV i.e. the cash flow for SPV’s obligation to the investors à At maturity SPV sells the assets back to the originator, which shall cover all liabilities of SPV.

The view of Islamic Scholars can be summed up to mean that securitization activity can be concluded only if it adheres to the Islamic financing principles, in as much as, underlying assets which do not comply with Sharia principals, cannot be securitized. The relationship between a borrower and the originator should fall under the Sharia-compliant structures of murabaha, mudaraba, ijara etc. Also to comply with Sharia principals for sukuk issuance, it must be borne in mind that the structure must transfer a minimal level of ownership in the assets to the investors.

Apart from the above, we also have to examine the concept of credit enhancement vis-a-vis Islamic Financing. Credit enhancement is an integral part of the securitization process and when credit enhancement is for a fee that is related to the quantum of facility, it comes dangerously close to riba[vii] and is rightly frowned upon by Sharia scholars. In the alternate, it is perhaps possible to use the musharaka mechanism to introduce a credit enhancer in a profit-sharing and takaful[viii] role. The SPV would be a musharaka with a credit enhancer as one of the partners or musharik, and the partners would mutually guarantee one another.

Case Study – Sharia Compliant Securitization Executed in the UAE Financial Market

Sun Finance-Sorouh Real Estate PJSC:

Facts: The purpose of the Sun Finance Limited (incorporated in Jersey, the Channel Islands, with limited liability)(Issuer) securitization was to allow Sorouh Real Estate PJSC (Sorouh) to monetize future cash flows 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 in Abu Dhabi, UAE. In essence, there are three principle parties involved in this transaction: (a) Sorouh, the project developer who developed and sold the plots; (b) Sorouh Abu Dhabi Real Estate LLC (SPV), set up as a distinct entity from Sorouh, that purchased the plots and, in turn, sold them to individual developers; and (c) Sun Finance i.e. the Issuer, who issued sukuk-al Mudaraba certificates (Sukuk) to investors.

Working: The proceeds of the Sukuk were used to fund the mudaraba and which proceeds were used by the mudarib, the SPV, to purchase the full title to the underlying plots from Sorouh. The SPV provided the Sukuk holders with a beneficial ownership of the plots, while the SPV executed a true sale of the assets from Sorouh. A portion of the Sukuk proceeds was placed in various reserve accounts to make up any shortfall in profit payments, to fund expenses of the SPV and to finance the construction of infrastructure on the plots. The profit sharing ratio between the mudarib i.e. the SPV and rabb ul-mal i.e the Sukuk certificate holders or the investors were 1% and 99% respectively.

The receivables from the sub-developers (all 109 plots were sold by Sorouh to sub-developers before the Sukuk was issued) were to be paid to the SPV, who in turn, made periodic payments on the Sukuk to the investors. The remainder was to be paid to the mudarib (the SPV) as an incentive payment. This amount was then used to repurchase a portion of the beneficial interest held by the Sukuk holders.

The unique feature of this Sukuk was that it offered three different rated tranches, each with different priority rights and coupon amounts. The three tranches (A, B and C) had the successively higher return. The three tranches were also accorded different priority for periodic payments with the A tranche senior to the B tranche which was senior to the C tranche. The way the seniority over periodic and principal payments was structured was using a musawama structure (cost-plus sale where only the final amount is agreed between the parties). At each periodic payment date, each class was paid 2.5 percent of the rabb ul-mal's profit allocation and the remainder of both profit and amortization payments are made according to seniority with a musawama between the tranches used to create a non-pari passu payment outcome. The Sukuk had performed well with payments passed on from sub-developers to the SPV and was used to redeem the Sukuk.

When the sukuk is viewed in more detail, the structure was clearly made to mirror a multi-tranche securitization deal and the fact that it is Sharia-compliant had limited impact on its performance. The use of a non-recourse securitization removed the issuer's financial strength from the picture so long as it is able to continue servicing the receivables. The Sukuk certificates which are asset-backed by installment sales receivables from the sale by Sorouh of plots of land on the developments in Abu Dhabi have been awarded the highest credit rating to date for a non-sovereign instrument issued in the MENA (the 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 one of the world's largest Sharia-compliant securitization.

Conclusion

It can thus be justly comprehended that Islamic securitizations cannot be separated from developments in the securitization market in general terms. There is certainly a huge potential for both conventional and Sharia-compliant transactions in the region. Despite this, there have only been a small number of Sharia compliant securitizations to date. This has largely been due to the global economic slowdown which has adversely affected global Sukuk issuance and securitizations in general.

Furthermore, delay on the part of Nakheel PJSC (the development arm of Dubai World) in payment of sukuk obligations in the year 2009 also impacted investors’ confidence in the Middle Eastern debt market for a period in 2009- 2010. However, recent reports suggest that the Nakheel PJSC, which recovered strongly on the back of rising property prices in 2013 and 2014 has paid off its debts worth AED 7.9 billion and is continuing to make payments on its AED 4.4 billion sukuk, which is due to mature in August 2016.

As Herbert Spencer drew parallels between economic theories and Charles Darwin’s biological ones, it is essential for UAE to formulate a robust securitization landscape, both in conventional and Islamic structure, to survive and rise up to the challenge posed by economies having dominance in the structured finance market!

In order to paint a clearer picture for the reader, Part II of this Article shall further elaborate on the concept of securitization under the UAE legal framework.