An overview of the basics of Securitization and its emergence on the Islamic Finance scene
Imagine yourself in this situation: you're the CFO (Chief Financial Officer) of a mid-sized company that operates a growing equipment leasing business. Your company's client base is growing and you're watching the assets side of your firm's balance sheet grow constantly. You're obviously happy about that. What you're not happy about is the fact that valuable financial resources are being tied up due to the time lag involved in the periodic payment structure of the leases your company has issued. How do you free up those resources you might ask.
For managers looking to access the increasing potentials of Islamic finance the answer is - you securitize your assets. But what is securitization and where do you go to do this? How can it help your company? What are the costs involved? Is it for all businesses? We'll come back to these questions and more shortly.
Islamic finance is growing - but for who?
That the growth of the Islamic finance industry is a contemporary phenomenon is no longer is dispute. In fact, it is clearly recognized and is increasingly embraced by communities around the world. A survey of US and other Western coverage of the growth of Islamic finance in the US and elsewhere is a telltale sign of this increasing recognition which is taking place on a worldwide scale. Recent articles have appeared in Forbes, BW, as well as major newspapers in cities across the US.
This recognition bodes well for the Islamic finance practitioners who are now able to capitalize and build upon the work done by the earliest scholars and finance professionals who developed the basic frameworks of Islamic finance and established the first experiments which would bring to light the possibilities inherent in this type of financing. The result has been that not only are Muslims tapping these modes of financing but non-Muslim corporates, such as Nestle, and sovereigns, like the German state of Saxony-Anholt, are tapping the global Islamic finance market. More and more, issuers see the possibilities to access a broader market as well as the ability to test new financial products.
The broad acceptance of Islamic finance is bringing to light the need for constant innovation and re-thinking if it is to be able to stand at par with its conventional counterpart. Much of the same coverage that lauds ISLAMIC Finance's rocket paced growth also establishes this need to progress and find new solutions to the financing needs of a rapidly growing customer base in line with what we at Dinar Standard reported in our last issue.
Challenges remain and a host of products need to be developed for the broader corporate markets. Large, credit worthy issuers have historically had an easier path to accessing the capital markets and the same is true for Islamic finance issuers. Smaller corporates, with assets in the $20-30 million range, who want to access the capital markets are more hard pressed due to higher fees and a lack of the critical mass needed for complex transactions such as a securitization.
In line with the focus of this piece, one of the main issues pointed out by observers is the need for Islamic finance to develop broader and more sophisticated techniques to securitize assets for the benefit of their customers and their own financial risk management. Securitization and the development of a healthy secondary market for trading the securities issued will be a major harbinger.
The IIFF (International Islamic Finance Forum), to be held from September 26-29 this year in Istanbul, Turkey, is focusing a major part of its agenda on the topic of innovation by dedicating a half day workshop to the topic of securitization in Islamic finance. The workshop will be conducted by industry experts who are themselves focused on the development of this important tool including Mohamed Asaria and Tamara Box of Lovells, UK and Tahir Naseem. Lovell's is an international firm specializing in Islamic finance.
Below, we will discuss some of the salient features of the topic of securitization and its adaptation into Islamic finance as well as the benefits it provides to the financial markets and its participants.
Securitization
According to Suleiman Abdi Dualeh, an Islamic finance professional, securitization is a distinctly American invention but no longer remains an "American curiosity". It is a field of constant innovation encompassing asset classes from commercial and residential mortgages. Securitization is often employed by companies interested in moving assets off their balance sheets, thus freeing up these financial resources for further investment/allocation.
In this process, these companies also seek to employ the low costs of funding which are usually offered by securitizing their assets as well as using the proceeds from a securitization to pay off other, more expensive, lines of credit.
Since the mid 1990s, securitization in conventional markets has expanded exponentially and come to include mortgages (both residential and commercial), car loans, leases, and receivable from inventories, credit cards, etc. In recent years, new asset classes which package already securitized assets have also come to occupy an increasing part of the financial markets.
According to the team at Lovells, UK there are two basic factors contributing to the growth of the Shari'ah compliant securitization market. First, there is a growing demand by investors for Shari'ah compliant financial instruments. Second, as mentioned above, there is a desire from corporates to be able to raise funds in a cost-effective, Shari'ah compliant manner which does not affect shareholder equity.
The basic process of a securitization involves the transfer of assets (sale) from the balance sheet of an originator to a purchaser which is usually a bankruptcy remote entity known as a special purpose vehicle (SPV) or special purpose entity (SPE) affiliated to the originator. A diagram (courtesy of Lovell's-UK) is shown below which outlines the main parties to the transaction and the flow of funds in the process of the securitization.
Following along from steps A through G, first the originator collects assets on its balance sheet through its normal business operations. As the level of assets reaches a minimum critical mass they are then sold/assigned to the SPV mentioned above, which is established for the specific purpose of funding the assets. Next, the originator is retained to service the assets by the SPV. It is the SPV then that issues tradable securities. The SPV uses the proceeds from this sale to fund the purchase of the original asset portfolio from the originator. The market and the general investing community considers the issued securities for purchase based on the characteristics of the asset pool and their confidence that the assets will suffice to repay the securities on the maturity date. The SPV has agreed to return any excess cash flow which is realized during the term of the funding back to the originator by various profit extraction methods. Lastly, any cash produced by the assets being serviced is used by the SPV to meet its payment obligations under the debt securities.
Securitizations are possible in Islamic finance for a variety of reasons. The most prominent among these is the fact that these securitizations are based upon the performance of a set of well-defined assets. For example, payments to certificate holders would be based on rents received from parcels of land or leases for the use of certain equipment, i.e. airplanes or cars. The other basic thing to keep in mind is that the contracts governing the relationships of the different parties in this process should be recognized by Islamic law. For example, the lease should be an Ijara contract. The field is constantly innovating and scholars and practitioners are debating the use of many different types of assets - real or financial - for the purposes of a securitization. We hope to write more in detail about this in following issues of Dinar Standard.
Is this really for my company?
Reading about the basic process of securitization may make it seem a little bewildering - even as it's presented in its most basic form here. The fact of the matter is that the process is not simple and may also require a considerable amount of sophistication. There are a number of technical requirements to be discussed which go beyond the scope of this article. Due to the sometimes prohibitive volume of assets required for a securitization - which may prevent a small or mid sized business from using this process - other means of accessing the capital markets are necessary for businesses who want to free up valuable assets for expansion or growth.
So for now at least, CFOs and other managers should watch the development of this key asset class. The continuing progress in Islamic corporate bonds and the need for an Islamic conduit securitization process are two such areas of focus. In the meantime we look forward to the presentations being given at the IIFF to help educate the markets and to nourish the needed exchange between bankers and businesses who will ultimately be the ones who drive innovation in the capital markets.
For more information please visit www.iiff.net or http://www.lovells.com
Sajjad Chowdhry
Dinar Standard 2006
