Islamic Finance: Core issues in securitisation

Last week we were in the middle of discussing the five core issues an Islamic bank should consider in an asset securitisation transaction, whether entering in it as an originator or the investor.

For the sake of completion and ease of reference, all of them are listed in this article. These are:

1) Acceptability of the type of assets
In view of securitisation having been pre-dominantly developed and existing in the non-Islamic economies, the assets typically included in securitised pools do not necessarily conform to Sharia.

Commonly, the assets in Western securitised pools are the interest-bearing debt instruments, such as credit card receivables, term loans, mortgages, etc.

Therefore, as an investor, an Islamic bank should refrain from underwriting the issues commonly available in the market. It should rather emphasise on developing structure with Islamically acceptable assets.

Such assets may include leasing, equity ownership, and murabaha contracts. For example, leasing could be applied to fund the lease of plant and equipment required by businesses, purchase of electronics, computers and cars etc by the individuals, or acquisition of homes by individuals, or replacing conventional mortgages.

2) Acceptability of the structure
There are three main structures commonly used in securitisation market. Let us examine them to know which one suits the Islamic investors or issuer the best.

These are:
1) Pass-through.
A pass-through structure represents direct ownership in a portfolio of assets that are usually similar in terms of maturity, yield, and quality.

The originator services the portfolio, including making collections and passing them on to investors, albeit at a servicing fee to them.

The investors hold the ownership of the assets in a pass-through portfolio. As such, it is not considered a debt obligation on the part of the originator and hence does not appear on his balance sheet.

In many Islamic countries, government rules restrict the foreign ownership of locally domiciled assets.

However, partial assignment or sale without recordation is allowed. In such a situation, pass-through could also be designed to represent an assignment of a part of ownership, rights and obligations, but not a conveyance of title.

2) Asset-backed bonds
Similar to the structure of pass-through, the Asset-Backed Bond ("ABB") is collateralised by a portfolio of assets, or sometimes by a portfolio of pass-throughs.

Clearly, ABBs are debt obligations on the issuers. As such, the portfolio of assets, used as collateral, remains on the issuer's book as assets, and the ABBs are reported as liability.

ABB allows the issuer to have control over the cash flow emanating from collaterals rather than dedicating it to the investors, unlike in the case of a pass-through.

However, a mitigating factor to this loosening of control is that the ABBs are generally over-collateralised in that the value of the underlying assets is significantly higher than the issuer's total obligation. This is to provide certain degree of comfort to the investors.

3) Pay-through.
It combines some of the features of a pass-through with that of the asset-backed bond. This bond is collateralised by a pool of assets and appears on the issuer's balance sheet as debt.

However, cash flow from the assets remains investor-dedicated, similar to the pass-throughs. In addition to collateralised bonds and pay-through notes, commercial paper and preferred stock were also used in the past as alternative structures for securitisation transactions.

3) Sharia Compliant Strucure.
You may have already gathered from the above that the pay-throughs, the ABBs and the commercial papers are all debt- structures, making explicit use of interest and as such are out of line as far as Sharia is concerned.

The pass-through is perhaps the structure closest to satisfying the Sharia requirements since the underlying pool of assets could be structured as murabaha, equity or ijara.

With little fine-tuning, a pass-through structure could be modified to serve the purpose of Islamic institutions to expand their activities in the securitisation business, either as an issuer or investor.

4) Ownership Conveyance
In order to comply with Sharia requirement, the pass-through structure must transfer some minimum level of ownership to the investors.

This may not necessarily be a registered title. It could rather be simple ownership attributes allowing the investor to step into the shoes of the issuer or co-owner and perform ownership-related tasks.

Likewise, these could also be the rights granting access, subject to notice. Such access might result in curing a defect caused by the operator or issuer, or even result in the taking over the operations by the investor.

Such rights and obligations might ultimately empower the investor to take control of the asset and sell it outright into the market place.

Please note that the level of conveyance varies for practical reasons and the scholars have emphasised to observe a specific level of conveyance in order to avoid the conversion of the asset-based investment into debt trading.

All three structures described above may result in the issuance of a number of documents. These may include promissory notes, mortgages or security instruments, and various documents of conveyance or assignment.

Generally, this has no bearing on the Islamic contract, so long as they do not contradict any Sharia principle.

5) Credit Enhancement
In conventional securitisation, the originators often issue two classes of securities viz. A & B. Class A holds priority over B in terms of settlement of the return and investment.

Whilst Class A securities are offered to the investors, the originators retain Class B securities, which in turn are subordinated to the investors as means of creating an 'over-collateralised environment'.

This structural split is adopted to achieve higher rating from the rating agencies for Class A securities. Higher rating based on low-risk criteria enables the originators to fetch competitive pricing from the investors on the principle of lower the risk, lower the return.

Originators of the Islamic securities should be careful in using the credit enhancement procedures commonly practiced by their conventional counterparts as some of them may include the element of misrepresentation (tadleel) or uncertainty (gharar).

Some scholars have agreed to a mechanism whereby genuine credit enhancement can be achieved by assigning the beneficial ownership of the total assets to the investors holding Class A securities.

The arrangement is supported by the originator's undertaking to lease back the assets at pre-agreed periodical rentals and an obligation to buy them back at a future date.

Another form of permissible and simple credit enhancement in Islamic securitisation is for the originator to set aside some of the asset related cash flow which is allocated to him. This could be compared to a form of takaful (self-insurance) a