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18| pfi | Middle East Report 2009 Sukuk market GLOBAL ISLAMIC SUKUK ISSUED IN US$M US$ million

50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

2001 Source: Moody’s Investor Service

The transaction was structured on a musharaka basis, which is a form of profit-sharing involving a joint venture between partners. The SPV, Villamar Sukuk, is a Cayman Islands entity sponsored by Gulf Holding Company and provides funding for a mixed-use development in the Bahrain Financial Harbour.

Non-recourse means lenders can take the property pledged as collateral to satisfy a debt, but they have no recourse to other assets of the issuer or sponsor. Sales made with recourse allow the buyer to resell a portion of the assets back to the seller, and thus, from an account- ing perspective, are treated as financing and not a true sale.

Substance over form Yet, as upbeat as this all sounds, Moody's has made it very clear that the structuring ideal of Shariah-compliant sukuk issues still has room for improvement and it recently emphasised the need for investors and issuers to focus on substance over form.

"As sukuk issuers begin to face distress, it is important

that investors focus on the substance and not the form of their risk, which is a concern in Islamic finance," said Khalid Howladar, senior credit officer for asset-backed and sukuk finance at Moody's.

He went on to point out that sukuk issues were sup- posed to grant investors a share of an asset or business venture, along with cashflows and commensurate risk of ownership, but warned that "most current sukuk struc-

While the appetite to issue sukuk is still there spread levels remain prohibitive.

Issued Announced

Sukuk Issuances potentially reaching over US$ 45 billion based on issued and announced deals

tures are designed to replicate conventional fixed-income instruments".

2002 2003 2004 2005 2006 2007 2008

The assets in the structure are commonly there for Sharia-compliance purposes only, and ultimately have no bearing on the risk or performance of the sukuk invest- ments, particularly in a distress situation, he said. The disparity between various sukuk transactions was also highlighted by the Accounting Auditing Organisation for Islamic Financial Institutions when, in February 2008, it published six recommendations. The AAOIFI rec- ommended that issuers refrain from selling structures in which they were obliged to repurchase or guarantee the sukuk deal at a future date and at a specific price, as this would not be in accordance with the principle of Sharia, or in other words, profit and risk sharing. Moody's advice and the AAOIFI recommendations come in response to the concerns expressed by the sen- ior Islamic finance scholar over Sharia legality. The AAOIFI recommendations are aimed at bringing the product closer to the tangible and risk-sharing prin- ciples that most bankers in the region broadly agree on. That being said, their implementation can often result in complexity.

Sukuk issues can encompass many sub-sector structures – such as mudaraba, musharaka and ijara – but even within these sub-divisions the actual legal structure and risk characteristics can vary significantly from deal to deal.

"Until there is some broad standardisation, investors will need to look at each structure individually to under- stand the risk/return profile irrespective of the type of sukuk structure used," said Howladar.

As a result of the lack of standardisation, the sukuk is not a liquid instrument. That lack of liquidity has been compounded by the crisis – as Islamic banks now find it increasingly difficult to find buyers of impaired sukuk deals at what they consider satisfactory prices. The lack of liquidity has meant that the premium to other more liquid debt markets has grown, which could explain why the market has performed so poorly. The HSBC/DIFX Sukuk Index (SKBI)3 widened three-fold from August 2007 to reach 400bp prior to the collapse of Lehman Brothers, when it blew out to 900bp. While the appetite to issue sukuk is still there, given the Gulf region's long-term financing needs, spread lev- els remain prohibitive, "making banks less inclined to fund long-term projects", Moody's said. Thus, despite all the hopes for the sector, a resur- gence of the corporate and real estate market still looks set to lag issuance in the supra-sovereign and agency sec- tors – at least until spreads start to normalise. This lack of funding capacity could well prove to be a catalyst for consolidation of the fragmented Gulf region banking sector, which from a longer-term perspective is probably not a bad thing.

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