Asset-Backed Securitization (ABS), as defined in finance literature, is a creative way of raising funds through the issuance of marketable securities backed by future cash flows from revenue-producing assets. As such, securitization is the transformation of an illiquid asset into a security that is issued and more importantly it can be traded in a capital market.
The main objectives of this section are to overview on the mechanics of Sukuk Asset-Backed Securities (ABS) as a form of corporate debt financing and measure the ability of the originators to reduce their debt obligations and enhance their earning capacities in the Malaysian capital market. This section will also examine the mechanism of Sukuk ABS as opposed to conventional ABS in Malaysian capital market.
Securitization conceptually involves packaging them into securities and the process of pooling assets, and then transforming their cash flows into a form whereby they can be freely traded among investors. The market for asset backed securitization (ABS) that includes credit cards, home equity loans, equipment leases and automobile loans, has tremendously increased from $316 billion in 1996 to US$1.103 trillion in 2005 over a 10-year period. According to Giddy in 2000, even though of its complexity, the asset securitization techniques has won a secured place in corporate financing and investment portfolios because it can, paradoxically, offer originators a cheaper costs of funding and investors a superior return.
The term asset-backed security (ABS) normally is generally applied to issues backed by non-mortgage assets. These asset securitization techniques are being embraced by a number of Asian countries seeking to finance infrastructure growth, to promote home ownership, and to develop their domestic markets, including Malaysia. Asset-backed securities enable to finance companies, depository institutions, and other corporations to "liquefy" their balance sheets (i.e., raise cash by borrowing against assets) and develop new sources of capital. Assets such as automobile loans, credit cards, and home equity loans are packaged as the collateral for intermediate-term (i.e., maturity of one to five years) securities and sold into the private placements or as public markets.
Over the past few years, there is a tremendously increase in the number of Islamic institutions that are participated in the global securitization business. Islamic securitization is among the recent inventions in Islamic financial practices, thus gaining knowledge in this area is important in order to appreciate the importance of securitization to Islamic institutions. The use of securitization is importance as it will benefit the companies by bringing in the much needed liquidity to the companies. However, before the emergence of Islamic securitization, some Muslims in the past might be reluctant to take part in such dealings as they 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 that contracted to the Syariah rules. Such a situation put the Muslim companies in a lower position than others as they 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, Muslims are now able to get involve in securitization transactions, as there is now Islamic securitization.
Basic Process of Securitization
Diagram 1: The basic process of securitization:
The diagram above shows that 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 and sells it to a bankruptcy-remote Special Purpose Vehicle (SPV). The SPV then acts as an issuer to issue and sale the securities to investors through either in a private placement or public offering. When securitization process ends, the funds flow from the purchasers of the securities to the issuers (SPV) and from the Issuers to the Originator. All these transaction occur virtually simultaneously. The above description is the basic structure of securitization in conventional way. The actual structures are more complex because of the involvement of more elements and participants. Below is the diagram shows the major "players" involved the securitization.
Types of Securitization
There are basically three main structures commonly used in securitization. The originator has the option to choose between three types of structures: asset backed bond, pass-throughs, and pay-through. These structures have been developed in the secondary mortgage and non-mortgage market.
A pass-through represents direct ownership by the originator in a portfolio of assets that are usually similar in terms of maturity, quality, and yield. The originator services the portfolio, passes them, and makes collections to the investors. In pass through, ownership of the assets in the portfolio lies with the investors; thus, the securities are not debt obligations of the originator and do not appear on the originator's financial statement. Besides, pass-through may also be designed to represent an assignment of a portion of rights, ownership, and obligation, but not a conveyance of title.
The Asset-Backed Bond (ABB) is similar with the pass-through as it is collateralized by a portfolio of assets or sometimes by a portfolio of pass-troughs. The Asset-Backed Bond is a debt obligation of the issuers. Therefore, in the issuer's financial statement, the portfolio of the assets used as a collateral remains as assets and the Asset-Backed Bonds are reported as a liability. The cash flows from the collateral are not dedicated to the investors, they only receive a part of the cash flows and the residual remains with the issuers. One important aspect of ABBs is that they are over-collateralized in which the value of the underlying assets is significantly in excess of the total obligation. This is largely done for the purpose of providing some level of safety to the investors.
The final structure of securitization is the pay-through structure, which combines some of the ABB and some of those of the features of the pass-through. The bond is collateralized by a pool of assets and appears on the issuer's balance sheet as a debt. Besides that, the cash flows arise from the assets, however, are passed to the investors and the issuer only earns the service fees from the investors.
Of the above widely used securitization structures, we can see that pass-through is the structure most closely to satisfy a strict interpretation of the Islamic principles. Then the pay-through and the ABB are debt- structures, which make use of interest. Under pass-through, the cash flows collected are dedicated to the investors and the issuer only earns the service charge. Besides that, the security does not classify as a debt by the originator. Hence, only a pass-through with underlying pool of assets structured as morabaha, equity statkes or ijara, could be used to facilitate Islamic institutions to expand their current activities in the securitization business.
Overview of Islamic Asset-backed Securities (ABS)
Interestingly, Malaysia was the first country in the region, probably one of the earliest among the developing countries to establish a secondary mortgage market, in which it is one of the categories in asset backed securities. The securitization process has specific benefits for Islamic institutions. Since the Islamic finance tends to relate finance to assets, hence, asset backed securitization is the right product for Islamic institutions, as long as these assets are structured in accordance with the Islamic principles. As such, we are motivated to verify that the use of Malaysian Sukuk ABS as an effective form of cheaper long-term financing for Malaysian companies. An important aspect is that the underlying asset in an Islamic asset-backed transaction cannot contain any elements that contradict Syariah. However, the mere pooling of non-interest bearing assets alone does not automatically create an Islamic securitization scheme as each facet of the Islamic securitization program requires to compliance with Syariah. The concept of asset backing is prevalent in all other Islamically- structured transactions. For instance, we use "morabaha" contract in trade finance, which allows the Islamic institutions to acquire certain goods and sell it to a client at a pre-agreed profit margin, rather than giving an interest-bearing loan to the client, which then purchases the goods. In project finance, instead of providing a project-promoter with liquid capital against payment of interest, we prefer to purchase equipment and lease it to him. Therefore, the use of securitization will bring in much needed liquidity to Islamic institutions by enabling them to free part of their capital which is tied-up with these illiquid project and trade financing activities
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'
i) Murabahah and Al-Bai-Bithaman-Ajil Asset Securitization
The processes of securitization of the assets are same for both Murabahah and Al-Bai-Bithaman-Ajil (ABBA) asset securitizations. The only difference between the two is the maturity of the securitization. Normally, Murabahah securitizations are on short-term basis, while ABBA securitizations are for long-term contracts. There are 3 steps in the securitization process. First, a company (issuer) will sell its underlying assets to financiers or investors, which will then pay cash in return. Second step is the investors will sell back the underlying assets at a price higher than when they bought the assets and the firm will then issue certificates to the financiers upon selling back of the assets to the company; and upon maturity of the certificates (bonds), the company will redeem their securities at par value.
Ijarah Asset Securitization
Sukuks
(1)
Special Purpose Vehicle (SPV)
OriginatorIjarah or leasing contract is also used in asset securitization process. Below is the diagram that illustrates the Islamic securitization on the principles of Ijarah/Leasing:
(3)
(2))
(4)
(5)
Diagram 2: Islamic Securitization on the Principles of Ijarah
1. Originator sells assets to SPV
2. SPV pays the purchase price and leases back the asset to originator on a back to back arrangement
3. SPV creates a trust in respect of the assets and issues Sukuk. Sukuk-will be listed, rated and also approved by an internationally recognized Shariah Board. The Sukuk will be traded in the Secondary Market through appointed market makers
4. Originator pays annual rentals. Lease rentals can be fixed or floating, amortising or non-amortising
5. SPV forwards the lease rentals to the Investors
6. At maturity the SPV will put the assets to the originator
Investors (Islamic/ conventional)
The lease-based securitization commences with the identification of a suitable underlying asset. To be suitable, the asset must be capable of being sold and leased. The securitization process, in terms of contractual flow, will normally starts with the originator selling the identified asset to the Special Purpose Vehicle (SPV). The SPV will then enter into a least contract with the originator that will create a stream of income in the form of rental payments in favor of the SPV. In return, the SPV will issue the sukuk that are supposed to represent an undivided proportionate ownership over the leased asset.
From the Islamic legal perspective, the purchasers of the sukuk become co-owners of the asset through effectively bought a portion of the leased asset. As owners, the sukuk-holders are also the lessors to the originator, thus entitled to the stream of rental payments. At the end of the lease period, which reflecting the maturity of the sukuk, the originator will redeem the sukuk from the holders by effectively buying back the underlying asset from them. Therefore, a number of Islamic legal observations can be made based on above explanations on the sukuk al-ijarah structure. First, the sukuk does not represent debt instead it represents undivided proportionate ownership of the leased asset. In this sense, the sukuk are not debt instruments, but more of participatory certificates which is similar to equities. Second, the Islamic legal difficulties in the sale of monetary-debts with a discount do not arise because the sukuk are not debts nor monetary. Third, sukuk represent the leased property (normally real assets), and thus, can be bought and sold at whatever prices as long as the parties agreed to it. All these factors explain the worldwide endorsement of sukuk al-ijarah as syariah compliant securities.
Istisna' Asset Securitization
Similar to ijarah asset securitization, istisna' asset securitization also involves Project Company. The purpose it created is to undertake a specific project, and it will cease to exist upon termination of the project. The difference between ijarah and istisna' securitization is that under istisna' asset securitization, the asset in which the SPV wishes to securitize is not in existence yet, this is because 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' Islamic Private Debt Securities (IPDS).
The process of Istisna' securitization begins when the Project Company (SPV) sells the proposed project work that involves the contract of Istisna' to the financiers or investors. The sale proceeds will the go to the account of the SPV, and the investors will resell the project work back to the SPV immediately. Upon reselling of the project work, the Istisna' IPDS will then be issued by Project Company to the investors as an evidence of indebtedness. Just like other Islamic securities, upon maturity of the bonds, the Project Company will redeem the certificates from the investors for monetary considerations at par value.
Differences between Islamic Securitization and Conventional Securitization
How does Islamic securitization differs from the conventional securitization?
First and foremost, just like any other dealings including day-to-day activities, Islamic securitization 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. Ethics is known as an important aspect in Islamic securitization as the teaching of Islam promotes ethics in commercial dealings. The need to be honest and the importance of disclosure constitute the important ethical consideration in commercial activity. Thus, in Islamic securitization, companies, which plan to securitize their assets, must ensure that valuations of the assets are carried out in a proper manner, and if there are any defects in the assets, a sufficient reveal must be made to the investors.
On the other hand, unlike the Islamic system, conventional dealings are seriously lacking in stressing the importance of being ethical; and 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, such as pork and liquor. However, in Islamic securitization, assets relating to riba', gambling and usury, and assets which are used to manufacture and/or selling of haram goods are prohibited from being securitized. If these assets mentioned above are securitized, Muslim investors must refrain themselves from investing in the related securities.
The sources of prohibitions are as follows:
In relation to assets based on riba'; some assets like credit card receivables. For conventional credit cards, these type of receivables are interest bearing. Thus, such asset cannot be securitized under the Islamic principles.
In relation to gambling; an example is that some companies own assets like slot machines, and when they have immediate need of capital, they might securitize these assets in order to issue bonds. Therefore, Muslims are prohibited from acquiring such bonds.
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." As cited above shows that Muslims are prohibited from investing in companies by buying bonds of companies, which securitize haram goods such as statues that are used for worshipping and etc.
In relation to gharar (uncertainty); Assets, which contained the element of uncertainty like receivables from debtors, are prohibited to be securitized. This is because they are part of the receivables that might turn into bad debt in the event of default, 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 not sure whether or not their investment will be worthwhile.
In addition, there are a few considerations in relation to Islamic asset securitization which must be fulfilled:
The assets in a group must have important similarities when they are pooled together to be securitized.
Assets must have aggregate remaining economic life that exceeds the term of securitization.
Securitization deal must be large enough in order to absorb the cost of originating, structuring and managing the securitization issue.
From a portfolio perspective, securitization should not suffer from undue concentration by region.
The considerations above are important especially in protecting the investors, reducing risks and for risk diversification of companies. For example, regarding 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. In this case, the claims from investors are of no use and cannot generate income; thus, this put the investors at risk. Furthermore, referring 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 in a manner not pooling together all in the same place, this will 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, if suddenly the assets in one region are being stolen, the other assets in other regions will not be affected; hence, although the claims from investors on the assets have diminished in value, the claims are not totally worthless.
Ownership of Assets
In practicing the ABS securitization, the Islamic securitization is also different from conventional securitization in terms of ownership of asset. As mentioned in above, in conventional securitization, loans or receivables are pooled and sold to a special purpose vehicle (SPV). The SPV in turn issues one or more debt instruments or securities backed by the loan receivables and other enhancements like guarantees, and these will be sold to interested investors. This is illustrated in the Diagram 1: The basic process of securitization.
However, in an Islamic securitization, the originator, which is the Islamic bank, must sell the assets that are associated with the receivables to the SPV. This means that the originator must have the ownership title over the assets to be securitized. The SPV must be provided the title of the assets to be securitized by the originator in order for them to securitizing the asset. The SPV will then issue notes to investors entitling them to the shares in the SPV.
In practice, the ownerships of the SPV over the assets to be securitized are stripped into pieces and distributed to investors. Otherwise, the transaction is considered as contradict to the Shariah requirements. This leads to the problem of securitization of cost plus assets. Cost plus financing is a buy and sale transaction in which the cash flows that generated from the cost plus financing are considered as debt obligation. The bank only entitles the right to the debts but the debts cannot be traded, unless at face value because some jurists see any profit created from the sale and purchase of a debt is riba, which is prohibited from the Islam principle.
On the other hand, the Shariah permits the selling of debt by its equivalent in quantity and time of maturity given that it is paid in full. However, this does not benefits the purchaser at all since there are no titles of ownership that can be transferred to the SPV that can be stripped into pieces and sold to investors. The ownership of the title is transferred with the sale of the asset and the asset belongs to the borrower (buyer) and not the bank. Therefore Islamic banks are not allowed sell assets that are not rightfully theirs.
The securitization of assets based on the contract of leasing, as mentioned in above, complies with the Islamic Shariah requirements because the bank possesses the ownership title of the assets. In this case, the originator or Islamic bank will sell the assets that provide the streams of cash flow to the SPV. The SPV will then purchase the assets; lease it under a back-to-back arrangement to the originator. After that, the SPV will issue Sukuks, which are Islamic bonds or notes, that entitling the owners of the Sukuks to a prorate ownership of the SPV and also the right to receive a proportion of the rental payments. These Sukuks can be traded in the secondary market. At the time of maturity, the SPV will sell the assets to the originator for a nominal amount. An example of the structure of Islamic securitization is illustrated in Diagram 2 above. From the diagram, the assets that generating the income stream of rentals are actually sold to the SPV and the originator no longer has ownership rights to the assets as well as the income stream generated from the assets.
Furthermore, investors posses a prorate ownership of the SPV by actually having a share in the SPV. The ownership element is an important aspect for a securitization to comply with Shariah requirements. Firstly, a legal transfer of ownership of the assets from originator to the SPV must exist. Secondly, the investors shared ownership of the SPV; this enables investors to participate in the investments therefore allowing them to share any risk and reward from the investments.
Credit Enhancement
In addition, the credit enhancement for both the securitization is also differs in a variety way. The rating given to the issuer of an ABS deal will depend on the credit enhancement. In conventional ABS, there are two types of credit enhancement- internal and external credit enhancement, in which a variety of them are used to increase the likelihood that investors will receive the cash flow that they are entitled to. Examples of internal credit enhancements are over collateralization yield spread, senior/subordinated tranches and reserve fund, while external credit enhancements includes cash-collateral-account method, surety bonds, and third party guarantee or standby letter of credit.
For instance, conventional commercial banks are entitled to provide two types of credit enhancements. One is a cash collateral account where a bank will make a loan to the SPV to absorb losses. A letter of credit is another form of bank's credit enhancement. It is a promise by a financial institution to provide loans to the SPV in the event of income shortfalls. An issuer may add credit enhancements to improve the rating of the securities issued.
On the other hand, the type of credit enhancement for Islamic ABS must adhere to the Shariah requirement. Some of the credit enhancements available in conventional ABS, however, may not be suitable in an Islamic ABS. For example, according to Archer, credit enhancement in the form of guarantee is not permissible in the Shariah requirement if guarantee is provided in return for a fee. Therefore, credit enhancement in the form of guarantee is out of question because this type of credit enhancement should have a form of risk sharing element in it. This is in adherence to the Islamic Shariah requirements that investors are participating in the sharing of profit and loss of the activity.
Last but not least, we have identified four main issues of concern to Islamic institutions, which are that the type of asset must be acceptable to Islamic investors; the structures to be used in securitization must be acceptable; a sufficient element of ownership must be conveyed to comply with the Islamic principles governing asset sales and assignments; and any form of credit enhancement must be in permissible form.
