Shari’ah Frameworks of Securitization in the Capital Market

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Securitization has become a popular method of financing among corporation nowadays. Securitization is basically the process where the company pooled its illiquid assets together and issued a claim to a pool of assets. When the assets are securitised, it made the assets tradable in the financial market.

Before we go further, let us define what is securitization. Securitization has many meaning attach to it. One of the simplest meanings of securitization is that the securitization is a process where corporation converts its physical assets in to financial assets.

For the purpose of this paper, we take s ecuritization as a process of pooling of “homogeneous”, “financial”, “cash flow producing”, “illiquid” assets and issuing claims on those assets in the form of marketable securities.Homogeneous assets refer to its kind and in underwriting criteria. Assets need to be homogeneous in order to avoid any problem in valuing the securities since the value of the security depends on the value of the underlying assets.

Those assets to be securitized have to be illiquid – cannot be traded in share market or secondary market- and should also have produce cash flows over its lifetime. Besides that, the assets should have financial value so that they can be used as a claimed against the securities.

There is an increase in the number of Islamic institutions that are involved in the global securitization business over the past few years. Islamic securitization is among the recent inventions in Islamic financial practices, thus gaining knowledge in this area is important in order to avoid any misunderstandings. Consequently, this paper firstly attempts to discuss the general concepts of securitization- the basic conventional way of securitizing assets. Then, we will go to Islamic securitization and its conditions; followed by types or structures of Islamic securitization that are available in the market today. And finally, we will look at some issues pertaining Islamic securitization.

BENEFIT OF THE SECURITIZATION

Despite the fact that the securitization involves higher costs compared to traditional forms of financing, it become more popular nowadays among corporations as method of financing. The increase in popularity of securitization in current financial market is triggered by its hidden benefits. It gives benefits to both originators and investors.

From originator point of view, the main benefit that they can gain from securitization is illiquid assets are moved “off-balance sheet” and replaced by a cash equivalent. This process has improved the originator’s balance sheet.

Besides that, the originator does not have to wait until it receives payment from the assets. In most circumstances, cash flows from the assets may take a few years to be generated. Through securitization, the originator can tap resource of funding in a short period. This is because the assets are “sold” and proceed from the issuance of the bond can be used for business purposes. Besides that the company also will enjoy the income that derived from the subscription fees.

Basically, a pool of assets has better credit characteristic. It is achieve through diversification of credit risk, transaction size, and geography than an individual asset. Thus reduces the risk of holding the assets.

From the investor point of view, they could earn better yield and liquidity for their investment in securities. Besides that, they also can predict prepayment with better certainty since security paid a fixed income.

BASIC PROCESS OF SECURITIZATION

Diagram below shows the basic process of securitization:

From the diagram above, a securitization involves the sale of a large pool of assets by an entity or the originator that creates or purchases the assets in the course of its business to “bankruptcy remote”, special purpose vehicle (SPV). The SPV acts as an issuer, issue and sale the securities through either in a private placement or public offering. When securitization process is “closed” funds flow from the purchasers of the securities to the issuers and from the Issuers to the Originator. All these transaction occur virtually simultaneously.

The above description is the basic structure of securitization. The actual structures are more complex because its involve more elements and participants. We shall explain the structures of securitization under Islamic securitization later in this paper.

MAJOR PLAYERS IN SECURITIZATION PROCESS

The diagram above shows the major “players” in the securitization game. We shall briefly explain function of each player in order to have better understanding of securitization process.

The originator is the entity that either generates assets in its ordinary course of business, or purchases and assembles portfolios of assets. The originator usually works closely with the underwriter and rating agencies in structuring the securitization transaction. The Originator will sell the pool of asset to the issuer.

The issuer usually the special purpose entity that created based on agreement between the originator and the trustees. The issuer will issues the securities and avoids taxation at the entity level.

The trustee, usually a bank, is appointed by the originator. The trustee will hold the asset, receives payment on the assets and makes payments to the security holders.

The investors are the ultimate purchasers of the securities. The main investors in securitization market usually banks, insurance companies, retirement funds and other “qualified investors”.

The underwriter is the party that sells or places the securities in a public offering or private placement. It plays an important role in structuring transaction. The brokers, investment banks or banks usually play roles as the underwriters.

The custodian is an entity that actually holds the assets and acts as the agent and bailee for the trustees. Commercial banks usually acts as the custodian in securitization process.

The Rating agencies are the active players in securitization game. It actively involve in structuring the transaction.

The servicer is the entity that actually deals with the assets on the day-to-day basis, collecting payment and transferring funds to the accounts controlled by the trustees. In most transaction, the originator acts as the servicer.

TYPES OF SECURITIZATION

There are three main structures commonly used in securitization. The originator chooses between three types of structures: pass-throughs, asset backed bond and pay-through.

The pass-through structures represent the direct ownership by the originator in a portfolio of assets. The originator services the portfolio, makes collections, and passes them to the investors. In pass through, the securities is not debt obligations of the originator thus, do not appear on the originator’s financial statement. Since the ownership of the assets lies with the originator, pass-through is designed to represent an assignment of a portion of ownership, rights and obligation but not a conveyance of title.

Like the pass-through, the Asset-Backed bond is collaterized by a portfolio of assets. The Asset-Backed Bond is a debt obligation of the issuers. In the issuer’s financial statement, the collateral remains as assets and the Asset-Backed Bond appears as a liability. The cash flows from the asset are not dedicated to the investors. The investors only receive a part of the cash flows and the residual remains with the issuers.

One of the important aspect of the Asset-Backed Bond is that the securities is over-collateralized i.e. the value of the underlying assets is significantly in excess of the total obligation. For example, Company A issued RM1, 000,000.00 of bond using the Asset-Backed Bond structures. The value of the underlying assets that ‘backed’ the bond is RM2, 500,000.00. The issuer chooses to over-collateralized its bond in order to provide some level of comfort to the investors.

The final structure of securitization is the pay-through structures. This structure has combination of pass-through and Asset-Backed Bond. The bond is collateralized by a pool of assets and appears on the issuer’s balance sheet as a debt. However, the cash flows arise from the assets is passed to the investors. The issuer only earns the service fees from the investors.

From the above description of the, we can see that pass-through is the structure closest to satisfy the Islamic principle. Under pass-through, the cash flows collected are dedicated to the investors and the issuer only earn the service charge. Besides that, the security does not classify as a debt by the originator.

ISLAMIC SECURITIZATION

Securitization, or asset securitization had been a useful tool in the financial market for both companies, which carried out the securitization, and also for investors (as mentioned above). But, some Muslims in the past might be reluctant to get involved in such dealings, afraid that securitization was the non-Muslim companies’ tool of obtaining capital and financial assistant from the public (investors); and hence, the dealings might involve unlawful transactions in the eyes of Islam. Such a situation is saddening because then, the Muslims were at loss- Muslim companies might not be able to thrive in businesses as they were lacking in capital, while Muslim investors might not be able to accumulate wealth by purchasing securities. Due to this, thanks to the innovative Muslim scholars, we Muslims are now able to get involve in securitization transactions, as there is now Islamic securitization.

So how does Islamic securitization differs from the conventional securitization? First and foremost, Islamic securitization, just like any other dealings including day-to-day activities, must be in line with the teachings in Quran and Sunnah; furthermore, the sayings and practices of companions (Sahabah), and sayings and practices of the great peoples in the history of Islamic teachings should also be referred to. The teaching of Islam promotes ethics in commercial dealings, and so, in Islamic securitization, ethics is an important aspect. For instance

“The Messenger of God passed by a heap of foodstuffs. He thrust his hand into it, and his fingers encountered dampness. He said, “What is this, O owner of the foodstuffs?” He said, “Rain has stricken it, O Messenger of God.” He said, ”Why do you not put it at the top of the foodstuffs, so that the people may see it? He who deceives is not of me.

Based on this saying, an important ethical consideration in commercial activity is the need to be honest and the importance of disclosure. Thus, in Islamic securitization, companies, which plan to securitize their assets, must make sure that proper valuations of the assets are carried out, and if there are any defects in the assets, they must be revealed to the investors. Furthermore, to express the importance of ethical conduct, Prophet Muhammad said:

“A trustworthy, an honest and a truthful businessman will rise up with martyrs on the Day of Resurrection.”(Ibn Majah)

The above Hadith thus ascertains the importance of being ethical in the business world. To actually put ethical businessmen in the same category as martyrs indeed shows the importance of being ethical. Unlike the Islamic system, conventional dealings are lacking in stressing the importance of being ethical; instead, the conventional dealings rely only on legal enactments for enforcement.

Aside from being ethical, the difference between Islamic and conventional asset securitization is in the assets themselves. The conventional securitization allows any assets to be securitized, including haram assets. However, in Islamic securitization, assets relating to riba’, gambling and usury, and assets which are used to manufacture and/or selling of haram goods (like pork and liquor) are not allowed to be securitized, and if these haram assets are securitized, Muslim investors must refrain from investing in the related securities. The sources of prohibitions are as follows:

i) In relation to assets based on riba’:

“…God hath permitted trade and forbidden usury…”

Some assets like credit card receivables, for instance which are in the balance sheets of banks, are sometimes used as an asset to be securitized. For conventional credit cards, the receivables are interest bearing. Thus, under Islamic principles, such asset cannot be securitized.

ii) In relation to gambling:

“O you who believe! Intoxicants and gambling, (dedication of) stones and (divination by) arrows are and abomination- of Satan’s handiwork. Eschew such (abomination) that you may prosper. Satan’s plan is (but) to excite enmity and hatred between you with intoxicants and gambling and hinder you from the remembrance of Allah (swt) and from prayer. Will you not then abstain?”

For instance, some companies own assets like slot machines, and when they are in need of capital, they might securitize these assets in order to issue bonds. Thus, Muslims are prohibited from buying these bonds.

iii) In relation to manufacturing and/or selling of haram goods:

“…surely Allah and His Messenger have prohibited the sale of wine, the flesh of dead animals, swine and idols.

Then again, just like the above example, Muslims are prohibited from investing in companies by buying bonds of companies, which securitize haram goods like statues that are used for worshipping, for example.

iv) In relation to gharar (uncertainty):

“The Messenger of Allah (swt) forbade the sale through fraudulent means or sale by uncertainty.”

Assets, which are uncertain like receivables from debtors, are not allowed to be securitized. The reason is because there are part of the receivables that might turn into bad debt, thus, the value of the securitized assets will be lesser. Hence, when a person buys the bonds of companies, which securitize assets that are uncertain, they are unsure whether or not their investment will be worthwhile.

In relation to Islamic asset securitization, there are a few considerations, which must be fulfilled:

i) When a group of assets are to be securitized, the assets must have important similarities.

ii) Assets must have aggregate remaining economic life, exceeding the term of securitization.

iii) Securitization deal must be big enough to absorb the cost of originating, structuring and managing the securitization issue.

iv) From a portfolio perspective, securitization should not suffer from undue concentration by region.

The considerations outlined above are important, especially in protecting investors, reducing risks and for risk diversification of companies. For instance, in relation to the second point, if assets’ economic life is shorter than the term of securitization, before the bonds matures, the assets will be worthless, and thus, so does the bonds. Hence, the claims from investors are on things, which are of no use and cannot generate income. Thus, in this case, investors are at risk. Furthermore, when we refer to the fourth point, which says that securitization should not suffer from undue concentration by region, this indicates the in Islamic securitization, diversification is also of importance. By securitizing assets, which are not pooled together in the same place, in case if anything happens to assets in one place, the other assets will not be affected. For instance, if a company securitizes its assets in different regions, and suddenly the assets in one region are being stolen, thus, the other assets in other regions are not affected; thus, although the claims from investors on the assets have reduced in value, the claims are not totally worthless.

STRUCTURES OF ISLAMIC ASSET SECURITIZATION

There are basically four types of Islamic financial contracts, which are being used as the basis for Islamic asset securitization, and which are in existence in Malaysia:

i) Murabahah

ii) Al-Bai-Bithaman-Ajil (ABBA)

iii) Ijarah

i) Istisna’

MURABAHAH AND AL-BAI-BITHAMAN-AJIL ASSET SECURITIZATION

For both Murabahah and Al-Bai-Bithaman-Ajil (ABBA) asset securitization, the processes of securitizing the assets are the same. The difference between the two is in the maturity of the securitization. Normally, Murabahah securitizations are on short-term basis, while ABBA securitizations are for long-term contracts. Below is the diagram of the process of securitizing assets through Murabahah and ABBA conracts, which then lead to the issuance of Murabahah Notes Issuance Facility (MuNif) and ABBA Islamic Debt Securities (BAIDS):

The securitization process is from step one to step three, whereby a company (issuer) will first sell its underlying assets to financiers or investors. For this, the investors will pay cash. Then, the investors will sell back the underlying assets at a price higher than when they bought the assets. Upon selling back of the assets to the company, the firm will then issue certificates to the financiers; and upon maturity of the certificates (bonds), the company will redeem their securities at par value.

IJARAH ASSET SECURITIZATION

Ijarah or leasing contract is also used in asset securitization process. Below is the diagram of the processes involved in ijarah asset securitization:

Ijarah, according to the above diagram is used in project financing, which involves Project Company or Special Purpose Vehicle (SPV). The SPV is created by a parent company to undertake a specific project, and when the project ends, the SPV will cease to exist. The SPV obtains its assets from the parent company. In step one, the SPV sells its assets to financiers (investors) for cash considerations. The money (proceed) will then go to the Project Company; at this point, the asset will belong to the investors. Since the Project Company will want to use the asset for its operations, the investors will lease out the asset to the Project Company; upon maturity, the ownership of the asset may revert back to the Project Company, depending on the agreement between investors and Project Company. When the investors agree to lease the asset to the SPV, the SPV will issue Ijarah IDS (Islamic Debt Security) to the investors (financiers), as a proof of claim against the SPV. The total amount of leasing will be higher than the amount investors paid the SPV when they purchase the asset from them. The Ijarah IDS will be presented to the Project Company every month or quarterly, depending on the agreement, to claim rent payments; this is akin claiming for coupon payments for bonds issued by companies. Additionally, upon maturity of the Ijarah IDS, which normally occur when the project has finished, the Project Company will redeem the certificates at par value.

ISTISNA’ ASSET SECURITIZATION

Just like ijarah asset securitization, istisna’ asset securitization also involves Project Company, which is created to undertake a specific project, which will then cease to exist upon termination of the project. The difference between ijarah and istisna’ securitization is that under istisna’ the asset in which the SPV wishes to securitize is not in existence yet. Under istisna’ securitization, the asset to be securitized is the project work itself (that is, the project infrastructure that will be built using capital obtained through issuance of Istisna’ IPDS (Islamic Private Debt Securities)), as depicted in the diagram below:

The process of securitization from the above diagram is from step one to step three. In relation to istisna’ securitization, as mentioned above, the Project Company (SPV) will sell the proposed project work, which involves the contract of istisna’ to the financiers (investors). The sale proceeds will the go to the account of the SPV, and immediately, the investors will resell the project work back to the SPV. Upon reselling of the project work, the Project Company will then issue Istisna’ IPDS to the investors, as an evidence of indebtedness. Upon maturity, just like other Islamic securities, the Project Company will redeem the certificates from the investors, for monetary considerations, at par value.

Below are examples of Islamic Debt Securities (IDS) in Malaysia, and their underlying assets (assets, which are securitized and investors have claim on):

Source: Rating Agency Malaysia 1998

Referring to the above examples, in Malaysia, it seems that securitizing assets through Murabahah and Al-Bai’-Bithaman-Ajil contracts are common in the Malaysian financial market.

ISSUES IN RELATION TO ISLAMIC ASSET SECURITIZATION

As mentioned, assets are securitized to enable companies to obtain financing through the issuance of debt certificates. Thus, when we talk about Islamic asset securitization, two issues arise: one relates to asset securitization process (issue of bay’ al-‘inah), and the other relates to the debt securities (bay’ al-dayn).

BAY’ AL-‘INAH

Under bay’ al-‘inah asset securitization, investors purchase assets from a company and then sell the asset back to the same company at a mark-up price; the payment to the investors will be made at a future date. For instance, a company has assets worth RM 2 million, which are then securitized in order to obtain financing. The assets will be sold to investors at the price of RM 2 million. Then, the investors will resell the assets back to the company at RM 2.5 million (price higher than RM 2 million). The bay’ al-‘inah concept is used when assets are securitized using murabahah and Al-Bai-Bithaman-Ajil contracts.

There are scholars who claim that bay’ al-‘inah contract is impermissible under Islamic principles because the difference between the original price that a company sells to the investors, and the price that investors resell to the company conveys the existence of riba’ (usury), and the motive behind the contract is to legalize something which is illegal. However, according to Shafi’i School, such a transaction is valid by the external evidence that they were properly concluded; the unlawful intention is immaterial, unless it is explicitly mentioned in the contract.

Contradictory to the Maliki and Hanbali jurists, the contract of bay’ al-‘inah is not valid because it constitutes a legal device to get a loan with interest (motive of bay’ al-‘inah); these jurists also highlights the importance of motives in determining the legality or illegality of contracts. The prohibition of such a contract is also based on the consensus of Islamic jurists (Ijma’ Ulama’) and the Hadith narrated by Ibn Qayyim:

“A time is certainty coming to mankind when they legalize (Yastahillun) the Riba under the name of Bay.’”

BAY’ AL-DAYN

When companies issue securities or certificates to investor, as an evidence of indebtedness, sometimes these securities are traded in the secondary market, that is, the investors sell the certificates to a third party. Since the certificates represent debt of the companies to investors, trading of these certificates is called bay’ al-dayn.

In Malaysia, Shariah scholars said that trading of debt at market prices is allowed because debt, which are created according to Islamic principles are considered as assets. This is so because debt (bonds) represents financial rights to the holder and financial obligation to the borrower (company issuing the certificates).

However, most Hanafis, Hanbalis and Shafi’is jurists agreed that debts are not allowed to be sold to non-debtor or a third party at all because the selling of debt involves the element of gharar and selling of something, which the seller does not possess. Nevertheless, there are Malikis and some Hanbalis and Shafi’is jurists who allow selling of al-dayn to a third party; their argument was that since the creditors (investors) has the right to sell the debt to the debtor or companies (when bonds are redeemed), thus the creditor has the right to sell it to a third party provided that the following rules are adhered to:

i) The dayn must be a conformed debt and the contract must be performed on the spot, not deferred in order to avoid selling of debt for debt, which is prohibited in Islam.

ii) The debtor or company issuing the debt certificates must be financially capable of fulfilling the debt, and must accept and recognize the sale made by investors to third parties so that the debtor will not deny the sale. The purpose of this condition is to avoid any dispute between the parties.

iii) If debt is money, its price in another debt must be equal in terms of amount or quantity; thus, if the value of the debt certificate is RM1000, then its selling price (to third party) must equal to RM1000 too.

CONCLUSION

 Islamic securitization is a helpful and important tool, which must be carried out prior to the issuance of Islamic bonds or Islamic Debt Securities. By securitizing assets, the Islamic way, Muslim investors can now participate in the bond market without worrying that the process of securitizing the assets and issuing of the bonds are contradictory to the Islamic teachings.

Despite the fact that bay’ al-‘inah concept (which is used when assets are securitized using Murabahah or Al-Bai-Bithaman-Ajil contract) is still in question regarding its permissibility under Shariah perspective, the concept is widely used, not only for the purpose of securitizing assets. For instance, banks in offering products like Islamic credit cards, and in helping their clients to purchase cars and houses use the concept of bay‘ al-’ inah. Thus, bay’ al-‘inah is an important tool in the Islamic financial market. The riba’ element associated with bay’ al-‘inah arises when reselling of the underlying assets is at a mark-up price; the mark-up portion is claimed to be usurious. Therefore, it is important to state why the mark-up portion is in existence.

And finally, when we talk about bay’ al-dayn, it is unfair to immediately rule out that the transaction is prohibited under Islamic principles. This is because there are considerations or conditions, which were being specified by Muslim scholars in allowing for debts to be traded. Hence, if these conditions are fulfilled, then there is no reason to forbid this transaction from taking place.