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Asset-Backed Sukuks: Some Drama, but No Action
Asset Securitization Report--SourceMedia (October 2, 2009)

By felipe Ossa

A sense of relief is percolating through the market of Shariah-compliant bonds, known as sukuks.

Standard & Poor's records show that issuance in the first seven months of the year came in at slightly more than $9.3 billion, compared with $11.1 billion during the same timeframe last year, a drop of 16%. But the market was far grimmer about the sector's prospects only earlier this summer. And it seems that something akin to optimism is seeping through.

In a recent podcast from talk radio station Dubai Eye, Mahommed Dawood, director of debt capital markets at HSBC Amanah, referred to a "very, very buoyant" pipeline and pointed to indications that government-owned developer Nakheel would likely make the December coupon on a troubled $3.5 billion sukuk.

S&P also mentioned a $50 billion sukuk pipeline, based on formal announcement and talked-about deals.

While a good sign for Islamic bonds overall, the turnaround does not necessarily indicate that the prospects for true sukuk securitizations have improved. The asset-backed sukuk market is drawing attention with East Cameron Partners' challenge of the true-sale opinion in its landmark U.S.-based sukuk, but this niche of Islamic finance is still overshadowed by its asset-based peers.

With no single set of rules, sukuks in many ways defy easy classification. Indeed, Islamic scholars have disagreed on what can and cannot qualify as a sukuk. This lack of codification has often frustrated Western participants, and some see it as an impediment to more robust growth. In general, however, all sukuks share some features. Chief among them is the prohibition against paying interest or riba. Sukuk returns and cash flows are required to be generated from designated tangible assets, or flows that come from assets once constructed. This has led structures to incorporate an effective transfer of assets.

But that transfer does not mean that investors have claims on the assets. And, in fact, in the vast majority of sukuks out there, they do not.

"In form, asset-based sukuks look a lot like an ABS, but in any kind of bankruptcy situation this perception would fall apart - there's no security here," said Khalid Howladar, senior credit officer at Moody's Investors Service. In the agency's view, the assets in asset-based deals are frequently there merely for Shariah compliance and have no bearing on the risk or performance of the transaction. As such, Moody's gives little or no benefit to the collateral in an asset-based sukuk.

The risk, therefore, is essentially corporate in nature. "To maintain Shariah compliance there has to be a transfer of assets- but because investors have no recourse to the assets, the transactions do not focus on asset risk but on the sponsors of the sukuk," said Salim Nathoo, a partner at Allen & Overy.

S&P sees the sukuk market as divided into three potential parts, with a likewise clear distinction between asset-backed and asset-based.

S&P Associate Mohamed Damak said the first type of sukuk carries a full credit enhancement mechanism, where a third party (usually the originator) provides the enhancement. This entity takes the commitment to provide for any shortfall in the return on the pool of assets and the return [promised] to the investors.

"All the sukuks issued by financial institutions that we have rated fall under this category," he added. "The enhancement provider provides a commitment to buy back assets at maturity at a price to pay back investors."

The second type is a sukuk with no credit enhancement. "[Here] the cash flows of the underlying asset serve as the payment," Damak said. "We look at the performance of the assets in the different stress scenarios. It's like rating a normal securitization."

The third type of sukuk combines the two features. "[The enhancement] can be provided on the coupon payment or on the principal, but not on both. The rating approach is a combination [of the first two]," Damak said. S&P has not yet rated a sukuk in this category.

In the sukuk universe, which has seen more than $80 billion in issuance since 2001, only a tiny share is asset-backed.

And within that share, there has been a great deal of attention focused on a single, small deal, a $165.6 million, 13-year sukuk issued in 2006 called East Cameron Gas Co.

Many observers believe the definitive outcome of a court case will prove a strong test case of an asset-backed Shariah in a Western jurisdiction.

The deal was backed by overriding royalty interests (ORRI) linked to gas and oil compounds extracted from deposits in the Gulf of Mexico. S&P downgraded the transaction to 'CC' from 'CCC+' - its original rating - last January when the structure hit a trigger, breaching a 90% minimum stressed reserve level of the hydrocarbon mix threshold.

In March, the agency cut the deal to 'D' on skipped payments and withdrew the rating, the latter event in response to a failure to receive servicer reports. Now $146 million, the transaction stopped amortizing in September 2008.

The deal initially stood at 'CCC+' largely because significant amounts of the energy deposits that collateralize the deal were proven undeveloped at that time. Merrill Lynch was the sole bookrunner and co-arranger with Beirut-based BSEC.

Neither bank returned requests for comment.

The breach occurred after the originator, East Cameron Partners, filed for Chapter 11 in Louisiana. The company also sought to basically re-characterize the true sale of the ORRI to the East Cameron Gas as a secured loan. When the deal closed, the structure's legal opinion characterized the transfer as a true sale, which thereby gave investors claim to the underlying assets. A judge in the case ruled that the true sale was valid but has left room open for the originator to make further arguments.

In an online interview published by Banker Middle East in 2006, Ibrahim Mardam-Bey, a director of BSEC, said that the majority of buyers in the deal were "non-Shariah conventional brand-name hedge fund investors."

Three years down the road and it appears some more traditional investors are holders as well. In a court filing as part of the ongoing court case, the certificate holders were listed as Camulos Master Fund; Cheyne Capital Management; The DuPont Pension Trust; Merrill Lynch, Pierce, Fenner & Smith; and Plainfield Direct. In short, they are not your typical Shariah investors.

This group of bondholders either declined to comment or did not reply to a request for comment.

When it was issued, the Cameron deal was treated as more than just another sukuk. Euromoney named it the "Most Innovative Islamic Finance Deal of the Year" in 2006 and Islamic Finance News awarded it "Best Structured Finance Deal of the Year" and "Best USA Deal of the Year."

East Cameron's sukuk investors may be grappling with the originator in the courts, but in the few other outstanding asset-backed sukuks, bondholders have nothing to complain about. For instance, Sun Finance Limited, a hybrid of ABS and project finance, has been performing in line with expectations, despite the crash in real estate prices in the United Arab Emirates.

Issued just before the Lehman Brothers collapse in September 2008, the deal has amortized down to AED3.8 billion ($1.0 billion) from AED5.0 billion at closing.

The idea behind Sun Finance securitization was for originator Sorouh Real Estate to monetize future cash flows from the sale, to property developers, of real estate plots in Abu Dhabi's Reem Island development. The way the deal is structured, bondholders are assuming the risk of the project's success, which is largely delinked from Sorouh's financial health, Moody's said in a report.

The lead managers on Sun Finance were Abu Dhabi Commercial Bank, Citigroup Global Markets, First Gulf Bank, National Bank of Abu Dhabi and Noor Islamic Bank.

Given the calamitous fall in property prices, the performance of the deal is surprising. Delinquencies have peaked at 2.81% so far, according to Moody's most recent report dating from September. Out of a current pool of 52 obligors, the pool had seen nine pool substitutions - a sign, if anything, that liquidity has not entirely evaporated.

Another asset-backed sukuk, Tamweel, has similarly performed well. Tamweel was the first globally placed RMBS in the region.

Other sukuk deals in the Middle East have flailed in the bursting of the asset bubble. In May, Kuwait powerhouse Investment Dar (TID), which owns half of Aston Martin, missed a payment on its $100 million sukuk, according to several news reports. The company reached a standstill agreement with creditors last month.

Earlier this year, government-owned real estate developer Nakheel was expected to default on its $3.5 billion sukuk due in December, but confidence has risen that it will meet its payments even if it needs to lean on the Dubai government for help.

For asset-backed players, the conclusions from the crisis are not straightforward - it is true that East Cameron has, so far at least, shown that true sale can hold against a legal challenge in a U.S. court. But the asset-backed deals in the Middle East have yet to be genuinely tested.

What is more, a series of recommendations by a major Islamic body that could have hailed a new age of asset-backed deals appears to have had a negligible impact so far, at least as far as strict securitization is concerned.

In February 2008, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) released six principles that basically invalidated 85% of outstanding deals as Shariah-compliant. One of the organization's major points was that investors must effectively have claims on the assets - the transfer had to be true sale, sources said.

Some blamed AAOFI principles for the decline in issuance in 2008, but others say the announcement simply coincided with the onset of the global crisis. But even the issuance that has taken place since then hasn't seen a notable shift toward asset-backed deals, sources said.

The recent revival of sukuk issuance has been primarily sovereign-centered.

"Right from the first principle it would seem ideal for asset-backed," said Moody's Howladar. "But corporate credits don't want to give up assets - they want unsecured."

And as the AAOFI cannot single-handedly determine what a sukuk is for everyone else, the market has continued to develop without a central set of rules.

S&P's Damak sees a move toward the AAOFI providing a more formal rubber stamp on deals. "The AAOFI will start labeling products," he said. "In Malaysia, we've seen a move like that. The Parliament has passed a law that gives the national Shariah advisory council of the Central Bank of Malaysia the legal status of final arbiter."

Damak added: "We view these steps positively because they could make investors more confident in Shariah-compliant products."

But ultimately, the problem may be the same one that faces all emerging markets: a dearth of securitizable assets, particularly in a world that is more leery of those linked to real estate.

"There aren't the financialassets available to do that yet," said Allen & Overy's Nathoo. "If you look at the originators that have done deals in the Middle East, they'veusedreal estateassets."

History is important as well.

"[In other asset classes] there's not enough of a track record,so not enoughexperience that agencies can bite on," Nathoo added. "The fact that the scholars said you have to do it more of an asset-backed waytherefore hasn't encouraged [issuers]."

The buyside is also a hurdle. Demand has to come first, and if Shariah investors are happy to take asset-based product then it will continue to have overwhelming primacy.

One market source pointed out that global ABS investors, even if they don't particularly care about the Shariah compliance of an asset-backed sukuk, might be reticent to invest for fear that a shift in Shariah rules would lead the bulk of buyers to dump the paper. Here is where the lack of codification might make a sizable portion of potential Western investors skittish. "It's a liquidity issue, and as we found out [in the crisis], liquidity is king," the source said.

But ultimately the sukuk market is no longer an isolated part of the world, and its rise - including the nascence of the asset-backeds among them - was in tandem with increased financial globalization.

"In my opinion, the whole Islamic finance sector is part of the global financial system. It reflects the trends of the global financial system." Howladar said. "If you don't have global ABS, you won't [yet] have a sizable asset-backed sukuk market."

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.
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