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Asset Backed v Asset Based Sukuk

Date post: 29-Jul-2015
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Asset Backed v Asset Based Sukuk BY: CAMILLE PALDI CEO OF FAAIF
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Page 1: Asset Backed v Asset Based Sukuk

Asset Backed v Asset Based Sukuk BY: CAMILLE PALDI

CEO OF FAAIF

Page 2: Asset Backed v Asset Based Sukuk

There are some contentious issues related to the contemporary sukuk from Shari’ah perspective.

One issue relates to the sale of assets and its implications to risks and returns for investors and issuers of sukuk.

Page 3: Asset Backed v Asset Based Sukuk

An asset-backed sukuk will involve a true sale and transfer the assets from the originator to the sukuk-holders.

The transfer of ownership in the legal sense will involve effective registration of the property in the name of new owners and will be binding in any court process.

Page 4: Asset Backed v Asset Based Sukuk

As a result of the sale, the asset would move from the balance-sheet of the obligor to the investors (through the SPV).

In the case of bankruptcy of the obligor, the investors would have recourse to the asset and will have priority claims over unsecured creditors.

Page 5: Asset Backed v Asset Based Sukuk

Asset-based sukuk replicates a conventional unsecured bond, but uses an asset in the contract to fulfill the formal Shari’ah requirements.

The requirement of transfer of ownership in the sale of the asset is allegedly fulfilled in its beneficial or constructive ownership by the investors.

In reality, the sale of the underlying asset is not true either from accounting or legal perspectives.

Page 6: Asset Backed v Asset Based Sukuk

A key element in these types of sukuk is the use of a purchase undertaking whereby the originator promises to purchase the asset back at par value either at maturity or in the case of early termination (such as bankruptcy of the originator).

Through the sale brought about by the undertaking, the credit exposure of the investors is transferred to the obligor and the investors will rank paripassu with other unsecured debtors in terms of their claims.

As ratings are based on the substance, Moody’s considers the asset-based sukuk as a conventional unsecured bond with no recourse to the asset and rates the instruments according to the obligor’s credit worthiness.

Page 7: Asset Backed v Asset Based Sukuk

The sukuk market is dominated overwhelmingly by the asset-based sukuk.

Only 11 out of 560 sukuk issues or around 2% qualify to be asset-backed as these fulfill the Shari’ah requirements on an actual sale of the underlying asset to the investors.

Concerned about the incoherent practice in the market, the Shari’ah Board of AAOIFI issued a statement in February 2008 to stress that sale of the assets to the sukuk holders must be true with all associated rights and obligations of ownership and must be reflected in the accounting books.

Page 8: Asset Backed v Asset Based Sukuk

The dominance of asset-based sukuk is sometimes blamed on the inconsistency of Islamic contracts with the prevailing non-Islamic legal framework and economic incentives of suppliers and demanders of sukuk.

The fact that some asset-backed sukuk have been issued in Malaysia and the Gulf Cooperation Council region and that these resemble the widely prevalent asset-based securities in conventional markets indicate that the legal obstacles are not constraining factors.

Page 9: Asset Backed v Asset Based Sukuk

Yet, the economic arguments of not using asset-backed sukuk are also weak.

On the supply side, the originators can get relatively higher ratings compared to their asset-based counterparts, which can substantially reduce the cost of funds.

For instance, Moody’s rated the Tamweel’s asset-backed sukuk the maximum possible in the UAE of Aa2.

Page 10: Asset Backed v Asset Based Sukuk

An asset-based sukuk by the same company was four notches below A3 during 2009.

On the demand side, the asset-backed sukuk provides a safer bankruptcy remote investment option to the investors.

Page 11: Asset Backed v Asset Based Sukuk

Simply put, asset-backed sukuk are similar to asset-backed securities with the necessary securitization element present.

The originator who wants to raise funds sells the income of the generating asset to a special purpose vehicle (SPV) under a legal true sale.

As a result of the legal true sale, the investors (i.e. sukuk holders) enjoy bankruptcy remoteness where the creditors of the originator cannot claw back the asset from the sukuk holders if the originator is facing bankruptcy.

Page 12: Asset Backed v Asset Based Sukuk

Therefore, the underlying assets are the sole recourse to the sukuk holders and the actual performance of the underlying asset will determine the return to the sukuk holders.

If the underlying asset is performing while the originator is facing bankruptcy, the sukuk holders’ payment will be uninterrupted.

Page 13: Asset Backed v Asset Based Sukuk

If the underlying asset is not performing, the sukuk holders are affected because they have no recourse to the originator.

In asset-backed sukuk, investors have recourse to the asset and not the originator.

Page 14: Asset Backed v Asset Based Sukuk

In asset-backed sukuk, investors enjoy asset-backing, they benefit over some form of security or lien over the assets, and are therefore in a preferential position over other, unsecured creditors.

In other words, in the event the issuer were to default or become insolvent, the note holders would be able to recover their exposure by taking control of and ultimately realizing the value from the asset(s).

It also requires the element of securitization to be present – true sale, bankruptcy remoteness, and enforceability of security.

Page 15: Asset Backed v Asset Based Sukuk

In asset-based sukuk, the originator undertakes to repurchase assets from the issuer at maturity of the sukuk, or upon a pre-defined early termination event, for an amount equal to the principal repayment.

In such a repurchase undertaking, the true market value of the underlying asset (or asset portfolio) is irrelevant to the sukuk note holders, as the amount is defined to be equivalent to the notes.

In this case, note holders have no special rights over the assets and rely wholly on the originator’s creditworthiness for repayment, either from internal sources or from its ability to refinance.

Page 16: Asset Backed v Asset Based Sukuk

Thus, if the originator is unable to honor its obligation to repurchase the assets, the note holders are in no preferential position to any other creditors, or indeed in no weaker position to any other unsecured creditor stressing the importance that the purchase undertaking ranks pari passu with any other of the originator’s senior unsecured obligations.

Page 17: Asset Backed v Asset Based Sukuk

In an asset-based sukuk, although an asset may be used in the structure, it does not necessarily drive the return to the sukuk holders.

Through a number of credit enhancement features (purchase undertaking, liquidity facility, etc.) the recourse of the sukuk holders is not to the asset but to the issuer.

If the asset is not performing, the issuer may still have to pay the expected return by exercising the credit enhancements

Page 18: Asset Backed v Asset Based Sukuk

If the issuer defaults, the sukuk holders will only have limited right of disposal because they will be required to sell the asset (if any) to the issuer.

Asset-based sukuk attempts to emulate the behavior of bond issuance in conventional space.

Page 19: Asset Backed v Asset Based Sukuk

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