ISLAMIC SECURITISATION – A PRACTICAL APPROACH
MOHAMAD EL HELW
Securitization is a process of pooling and aggregating assets of similar characteristics in a manner that motivates investors to buy interest or securities, in saleable denominations, backed by these underlying assets.
The interest of the investors could be structured as fractional or undivided interest in the pooled assets. It could also be structured in the form of a collateralised debt to the owners of the pool.
If the securitisation involves the sale of ownership rights to investors, the issuers have the right to remove the pooled assets from their balance sheet. If the issue involves the sale of collateralised debt, the assets will simply be earmarked for the investors but will remain on their balance sheet.
Securitisation is a form of structured finance that enables the issuers to repackage or rearrange the risks inherent in a class of assets. The risks may be borne entirely by, or shared among, the originator, a third-party credit enhance, and one or more classes of investors, or risks may be reduced through special accounts funded by the assets themselves.
In most of the cases of securitisation, the originating entity continues to service the pool of assets. The servicing involves the collection and remittances of periodic payments, accounting and reporting.
The pooled assets or the cash payments generated by the assets are usually deposited into a trust with a corporate trustee, which collects the revenues, invests them where appropriate and disburses them to the investors according to the instructions in the governing documents. The trustee is often remunerated by the issuer or from the pool of assets, but has a fiduciary responsibility to protect the interests of the investors.
Often some sort of credit enhancement is used in order to induce investors to buy the offered securities. In the USA, the pioneer of the securitisation process, the most common form of credit enhancing securities is the use of Ginnie Maes, Freddies Mac or Fannie Maes. These pass-through mortgage securities, have the credit support of their sponsoring agency, and normally no additional credit enhancement is needed.
But, for other securitisations, a more common form of credit enhancement is the use of over collateralisation i.e., pooling assets which exceed the total proceeds from the securities they back. Another method is the senior-subordinated structure, which in essence insures the senior, or less risky class of security with the subordinated, or the potentially riskier, class. In the absence of none of the above, third-party insurance, or cover, may be bought.
By undertaking securitisation, issuers tap a new source of funding, reduce the cost of capital, reduce risks through diversification and earn extra fee income. Securitisation also enables investors to obtain better yield and liquidity for their investment in addition to the opportunity to have direct access to the consumer credit market, and to predict prepayments with better certainty.
Islamic Considerations
Since their inception, Islamic financial institutions have been involved in the business of securitisation, albeit on a lesser scale. Back in 1981, Dar Al-Maal Al-Islami (DMI) started its operations by issuing Mudaraba certificates (Islamic securities) representing interests in a pool of assets.
Since their inception, Islamic financial institutions have been involved in the business of securitisation, albeit on a lesser scale. Back in 1981, Dar Al-Maal Al-Islami (DMI) started its operations by issuing Mudaraba certificates (Islamic securities) representing interests in a pool of assets.
The difference between an Islamic securitisation and a conventional one lies in the fact, for religious reasons, that Islamic institutions are not allowed to engage in certain types of securitisation deals. A typical list of forbidden deals includes the following:
Firstly, certain assets that generate non-Islamic services or products (alcohol, tobacco, casino machines, etc.) are not to be bought, financed, leased or securitised by an Islamic institution.
Secondly, pools of interest-bearing assets such as mortgage-backed securities are also not to be considered.
Islamic securitisation differs from a conventional securitisation also in the way investors are remunerated. Under Islamic securitisation, investors are remunerated on a profit-and-loss-sharing basis only, while a conventional securitisation allows a debt issue with fixed return with a recourse to the issuer. In practice, however, in an attempt to remove assets from their balance sheets, most of the conventional financial institutions do not offer full recourse.
A number of Islamic financial institutions in Malaysia and elsewhere have experimented with what is known as debt securitisation – issuance of securities substituted for loan (notes and bonds) – on the condition that the issuance of the debt instruments should not be preceded by the creation of the debt.
Business Considerations
In addition to the above considerations. Islamic institutions should also make certain business considerations for a successful securitisation deal:
Firstly, the assets to be securitised should have important similarities i.e., they should all be either equipment, real estate, or aeroplanes.
Secondly, the assets should have aggregate remaining economic life, which sufficiently exceeds the term of the securitisation.
Thirdly, the users of the assets (tenants or lessees) should be of investment-grade category.
Fourthly, a securitisation deal should be of a size that is big enough to absorb the cost of originating, structuring and managing the securitisation issue.
Fifthly, from a portfolio perspective, the securitisation should not suffer from undue concentration by region, etc.
Types of Securitisation Structures
Asset-backed Securitisation fall into three broad categories:
• Pass-throughs
• Pay-throughs
• Asset-backed bonds
Pass-through securities refer to type of securitisation whereby the lessor passes all cash receivable (less servicing charges and third-party expenses) direct to the investor.
According to Christine Paval of Citibank, an authority on the subject: “A pass-through represents direct ownership in a portfolio of assets that are usually similar in terms of maturity, interest rate and quality.”
Because of the similarity with a typical sale transaction, pass-throughs are generally associated with sale structure for tax purposes, which enable the issuer to remove the pooled assets from his balance sheet.
The asset-backed bond is the oldest form of securitisation. It is a debt obligation of the issuer collateralised by a portfolio of loans or sometimes by a portfolio of pass-through securities such as Ginnie Maes. The assets of this type of securitisation will remain in the books of the issuer. This kind of issue is often characterised by over-collateralisation, as the cash flow is not totally dedicated to the investors; the amount of principal and interest obligations (plus charges) may probably be lower than the cash generated by the underlying assets.
Pay-through securities refer to another type of securitisation whereby the lessor reconfigures the cash flow to suit its payment obligations. This type combines some of the features of the pass-through with some of those of the asset-backed bond; while the assets of the issue will appear in the balance sheets of the issuer, the cash flow from the underlying assets (less expenses) is often totally dedicated to the investors. Because of its similarities with a loan, pay-throughs are mostly considered as loan transactions for tax purposes.
Another common form of classifying securitisations is to classify them into assetbacked and debt-based; pass-throughs are categorised as asset-backed issues, the other two (debt-backed bonds and pay-throughs) as debt-based. One of the tests in determining whether a transaction is asset-backed or debt-based is the recourse to the issuer.
However, such distinction is not financially relevant in the case where the issuer is a special-purpose company; in that case, a recourse given by such issuer is of no value, as the only assets to support the recourse are the same as those backing the securitisation in the first place. Most of the upside potential is also passed on to the investors in the form of charges payable to them through the holding of a special class of securers by the investors themselves.
The choice between one type of securitisation and another is largely related to accounting and tax preferences. In most countries, authorities require issuers of paythroughs and asset-backed bonds to book the issue as a liability in their balance sheets. These regulations often limit the business scope of the issuing entity, by imposing a capital adequacy criterion for taking additional loans.
The Islamic financial system adds one degree of flexibility to the categorisation. While fiscal authorities may categorise a securitisation as, for example, a debt-based time-type on the basis of its cash flow configuration. Islamic principles and the substance of the transaction may not necessarily support that categorisation. Therefore, it is quite permissible to have one transaction categorised by the tax authority as debt-based, while, for Islamic reasons, it could still be called asset-backed.
While Islamic financial institutions should sparingly use debt securitasation, they should do so only in “form” with the intent of gaining tax benefits (if any) and/or giving their client the comfort of having a certain predictable cash flow. A typical example is a securitisation of a portfolio of finance leases in the USA owned by a foreign entity located in a low-tax jurisdiction.
The income generated by the underlying assets would be classified as portfolio-interest income for tax reasons. Such income is tax exempt and there is nothing wrong, legally and religiously, in this kind of structure. In the West, it is perfectly legal to act in the most tax efficient manner as long as you do not resort to acts of tax evasion.
Case Studies
In the five years of its existence, Faisal Finance (Switzerland), the Geneva-based operating entity of DMI, has successfully closed a number of securitisation deals. I shall focus on two major deals, involving different classes of assets and different legal structures:
1. Faisal Finance Leasing Fund (FFLF)
2. Faisal Finance Real Estate Income Fund II (FFRFIF – II)
FFLF was set up in 1993 as an offshore entity in Curacao, Netherlands Antilles in the form of a Mudaraba offering. These units represented a fractional interest in underlying equipment leases owned by three offshore leasing companies of the USA.
FFS raised a total of $30 million from the market on the basis of 1 year renewable, until the maturity of all leases. Each year, a number of Mudaraba units are redeemed, to match with the overall redemption in the underlying leases.
FFREIF-II was recently set up as a partnership in Jersey. Its operation is similar to that of the typical equity Real Estate Investment Trust (REIT). The partnership is set up to own 40 per cent equity interests in a portfolio of $100 million-worth of real estate, being acquired in the USA, through a pass-through entity also located in Jersey.
The structure involves another entity in Jersey that also provides tax-free debt funding for the acquisition of the properties in the USA. Th e remaining 60 per cent of the funding is to be provided by a third party in the form of Islamically accepted lease finance. This will be the subject of a forthcoming securitisation of finance leases written for real estate acquisition – an Islamic to mortgage.
Conclusion
Securitisation offers both opportunity and challenge to Islamic financial institutions. On the one hand, it enables Islamic institutions to enter new markets, appeal to new classes of investors, clean their balance sheets and earn fee income. On the other hand, Islamic financial concepts demand extra caution in respecting the basic tenets of Islamic financial principles.
The goal of FFS is to take a pioneering role in applying Islamic principles, as they should be, in the field of securitization.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.