When Dubai's biggest investment conglomerate, Dubai World, stunned markets last November with a request to freeze repayments on $26 billion in debt, the upstart Gulf emirate was met with harsh criticism about its financial transparency. Yet investor ire didn't halt there. The announcement led to fears that Dubai World's real estate subsidiary Nakheel would default on repayment of $4.1 billion in Islamic bonds, known as sukuk. As the news came after a series of high-profile sukuk defaults in the region, some bankers and analysts questioned the sustainability of the trillion-dollar Islamic finance market as well.
Kuwait University finance professor Amani Bouresli has been following these events. One of the problems with the criticism, she says, was the lack of comprehension of Islamic finance among international investors. They did not understand the structure of sukuk, or the Islamic principle of shared financial risk. "The sukuk market for international investors is a grey area," Bouresli says. "It is hard for them to understand it. It is not like the conventional bond sector."
In the wake of Dubai's woes and similar problems affecting other sukuk issuances in the Gulf region, those involved in Islamic finance readily agree the 40-year-old market has reached a juncture where it must develop further transparency to address concerns about the security of its products. Some, like Bouresli, suggest implementing uniform credit ratings of sukuk as a step towards that goal.
Bouresli recently launched Capital Standards, which she claims is the only independent credit ratings agency in the Gulf. The effort is part of her vision, she says, to help build a more integrated financial market in the region. Her past efforts include helping draft Kuwait's financial market law, consulting for the country's Ministry of Commerce and Industry, and heading the Capital Market Authority Government Project. "We are located in Kuwait, we understand the region," she says.
In addition to targeting local businesses not rated by international firms, Bouresli says Capital Standards will focus on analyzing the credit worthiness of Islamic financial products. "We place a special emphasis on sukuk and Islamic financial instruments," she says. "There is a big shortage of information in the region. When we begin issuing ratings for sukuk, it will increase transparency and add to efficiency in the market."
Exuberance before Diligence
While Western markets were reeling from toxic U.S. housing debt, the Islamic financial market seemed like a secure alternative. Investors were encouraged by robust figures – a February report from Standard & Poor's noted assets of the top 500 Islamic banks reached $822 billion in 2009, compared with $639 billion in 2008. There was the inherent security of a market abiding by the conservative morality of Shariah (Islamic law). There were also assurances that Islamic financial investments avoided high-risk products, and that governments would guarantee their sukuk issues.
Just like their Western counterparts, though, Islamic financial institutions and state-issued sukuk were overexposed to speculative real estate, and suffered capital shortages in the global downturn. "The exuberance in Dubai at the time was that the sky was the limit, and no one listened to the fact that it could be a bubble," says Wharton finance professor N. Bulent Gultekin, formerly the head of Turkey's Privatization and Housing department and later a governor of its central bank. "There was an asset bubble around the world. And with the expansion of the bubble, people vastly misunderstood the risks."
That exuberance blinded many investors and institutions to the fundamentals of sukuk structure, Gultekin says. Whether they were not told about the risks, or didn't do the due diligence, some were surprised to learn that under Shariah they were exposed to losses, and subtle variations in sukuk would prevent them from recouping some of their investments.
Bolstering that attitude was the fact that many of the first Islamic-branded financial products in the market were no different than conventional ones, says Jarmo T. Kotilaine, chief economist for Saudi Arabia's NCB Capital. "Everyone assumed that a Shariah-compliant product behaved like a conventional product, and only the structure was different."
"Sukuk are not supposed to be bonds, but like equity or profit-sharing instruments," Gultekin explains. "In a profit-sharing structure you take an equity risk. If things go well, that's great. But if not, that's it. This is supposed to be the idea of Islamic finance."
Tradition and Practice
In a conventional bond, the issuer raises capital with a promise to pay back the principal and interest. Interest, though, is forbidden in Islam, so traditionally, a sukuk raises capital by leasing a tangible asset, such as real estate. The sukuk investor purchases a proportional ownership of that asset, and earns profit off the leasing arrangement.
In practice, though, many sukuk in the modern Islamic financial market are indistinguishable from conventional debt financing, Gultekin says. At least 14 kinds of sukuk exist. Many are structured not only on tangible assets, but also on debts, businesses, and investments, according to the market's leading Shariah compliance body, the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
While the development of sukuk removed from traditional definitions brings criticism from Islamic scholars, many accept the need for rating a sukuk similarly as a conventional bond. "People are asking, 'Is there a way to classify the risk in advance?' and there is," Gultekin says. "Depending on who is issuing the sukuk, and the type of asset it is based on, helps determine its riskiness."
Bouresli's firm and the international credit ratings agencies have taken that approach to analyzing sukuk, generally dividing the market into two types of structures. The first is popularly known as an 'asset-backed' sukuk, which follows the traditional ideal of providing an asset as the basis of the issue. The other is known as an 'asset-based' sukuk, which is structured on the expected profit of an asset, or the worth of the issuer, rather than a tangible asset itself.
The majority of sukuk on the market are asset-based, according to a recent Moody's report. In the rating firm's opinion, these are unsecure investments. Investors quickly learned in the downturn such sukuk do not provide the opportunity to recoup lost investment, since they are not associated with assets that can be valued. "'Asset-backed' and 'asset-based' are semantically similar descriptions," the Moody's report notes, "but mask significant differences in credit risk."
Cause for Concern
Among investors, a product deemed to be an asset-based sukuk is now a cause for concern, says Nabil Issa, a partner in Dubai-based law firm King & Spalding. He explains clients have become more skeptical, asking questions about the assets a sukuk is structured on, and about how easy it would be for them to recoup their investments in the case of a default. "Future sukuk will have to provide investors with more robust security," Issa says.
It is a lesson learned from watching Nakheel nearly default on its $4.1 billion in financing from an asset-based sukuk (a loan from neighboring Abu Dhabi helped avoid that outcome). Nakheel's sukuk issue was the largest in the Islamic financial market, and investors were jolted when Dubai announced it would not guarantee its repayment.
Similar troubles befell the Kuwaiti shareholding company Investment Dar, which defaulted on a $100 million sukuk last May, and later in November, Saudi Arabian conglomerate Saad Group missed payments on its $650 million sukuk. These high-profile cases have contributed to a slowdown in the regional sukuk market. In the Gulf, only one sukuk issue has occurred so far this year.
"We need to do more work on how distressed situations are handled," says NCB Capital's Kotilaine, adding that when many state and sovereign sukuk were issued, the Gulf economy was booming. Today, as these instruments mature, nobody expected the region to be in the economic situation it finds itself in. "Clearly it's a question for the higher ups. What do we do if a sovereign corporation goes under?"
Kotilaine adds a good sukuk rating should now focus on the basis of the financing structure. "Any credit rating should not start out with the single credit worthiness of the issuer, but the quality of the underlying assets on which the sukuk is structured," he says. "You need absolutely to assess the total variation in value. In distressed situations, you need to know what can be disposed of."
Interestingly, despite the religious dictates that define it, rating a sukuk on its compliance with Shariah is not a major consideration, as that doesn't bear any effect on the issue's finances. Only once, when the AAOIFI in 2008 ruled that sukuk structured with no transfer of collateral were not following Islamic law, did religious rulings add monetary risk to a sukuk.
Issa is unenthusiastic about measuring sukuk in religious terms. "It's a dangerous game," he says, noting there are four schools of thought just within Sunni Islamic tradition. "One scholar in Jeddah may have one interpretation, and another in Karachi may come down with a different interpretation." Still, one organization in Bahrain, the Islamic International Rating Agency, provides an assessment of the 'Shariah quality' of an Islamic financial instrument based on its own methodology. "People prefer them over conventional products in order to avoid what is forbidden by the Shariah," the firm states on its website. "There has to be an evaluation of institutions or products according to the extent that they adhere and respect this element of legitimacy."
Despite the setbacks it has witnessed, the Islamic financial market is expanding. The first European sukuk was issued out of Germany, and the United Kingdom is now host to several Islamic financial institutions. Last November, General Electric Capital became the first U.S. corporate issuer of a sukuk. Dubai too is staging a modest recovery, earning back support with a $23.5 billion restructuring deal for Dubai World's obligations, including paying off all of Nakheel's debt.
The Islamic finance industry must improve, says Kotilaine, by promoting familiar market standards, such as ratings, that increase transparency. "The crisis has highlighted the youth and fragility of the industry," he says. "Comparing bonds and sukuk, bonds are long established financial products. There are decades of market leadership, standards, know-how, and tradition … Sukuk issues have been structured for small, captive audiences. If we want the sukuk market to evolve, it needs to become more like the conventional bond market."
Bouresli says her firm has benefited from efforts to open markets, having signed an agreement to set up in Oman, and expected agreements with Bahrain. She hopes Dubai will follow, as they build up clientele in the Gulf. They are too small and new to compete with Moody's or Standard and Poor's, she says, but the goal is to get there. "We have international banks and local banks in the region, why not have a local ratings agency?" she asks. "Competition is good."
Considering the wider interest in sukuk, Gultekin says common securities ratings would make them more marketable. But the sukuk defaults and restructuring raise questions that need to be answered, he adds. "Problems do happen and will again in the future … People will have to recognize and clarify what the structure of these securities are, and what they are not. There has to be a better understanding of the legal structure, and what to do in the event of a failure to fulfill a promise."