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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.
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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.
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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. |
What
is Securitization?
Securitization
is typically defined as the process of transforming
dormant, illiquid assets into tradeable, negotiable
and liquid assets.
It
is a process of financial intermediation which
pools assets with similar overall characteristics
and allows risks to be diversified and channeled
to a large number of investors who are able
to choose what type of risk profile matches
their investment needs.
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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.
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Figure
1 - A
Typical Securitization Structure
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Source:
Lovell's UK, Copyright 2005
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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
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