Securitising the Sharia way
With Dubai’s announcement that it would open up the real estate market to non-citizens in 2002, Shaikh Mohammed Bin Rashid al Maktoum made history. By Sandeep Chaudhry, CEO, Syed Kashif Hussain and Ramin Takin, ENSEC.
Properties announced by government owned developers such as Emaar and Nakheel were sold in a matter of hours. Fully fledged banking institutions initially stayed away from the nascent mortgage market that followed, presenting an opportunity for non-banking finance companies to build the market.
Non-banking financial institutions such as Tamweel PJSC and Amlak Finance PJSC were set up to fill the void. Backed by strong institutional shareholders and the government, they built large portfolios over a very short span of time.
Amlak was created in 2002 to cater to the need for mortgages. In January 2005, it decided to convert to an Islamic finance company in view of the significant demand for Islamic finance in the region.
Tamweel PJSC was formed as an Islamic finance company in Dubai and opened its doors to business in March 2004. It has a reputation for providing innovative Islamic finance products catering only to the real estate market.
Being unable to take deposits and having the lion's share of the market, these two leading Islamic finance institutions were funding operations through equity and short-term borrowings. As the market grew, such financing methods were not able to keep pace with the growth and strategic plans of the institutions as they continued to develop with the markets at home and expand into other countries.
With a booming economy, prepayment rates grew as investors booked profits and home buyers upgraded to bigger properties. It became a challenge for Islamic organisations to match maturity profiles and terms of funding due to Sharia constraints.
The RMBS helps to address these points and has the natural benefits of lowering cost of funds, reducing capital requirement, diversifying the financiers available to the enterprise and creating matched (pass-through) funding. Emirates National Securitization Corporation was formed with a view to facilitating the real estate market in Dubai. The structure developed by ENSEC represents a step forward from its first securitisation transaction launched in 2004.
Islamic home finance products
As with conventional versions, Islamic home finance products reflect the varying needs of different customers. Istisna and forward Ijara products are commonly used for under-construction properties. For completed properties ijaras and murabahas are used. An ijara resembles a finance lease, whereas the murabaha is a deferred payment product. A key difference between the two products is title to the property, which resides with the customer in case of a murabaha but is passed on to the Islamic finance company in the case of an ijara. Also, the murabaha is a fixed-rate product whereas ijaras are often tailored to suit a fixed or floating-rate product.
Money in Islamic finance is only a measure of value. Renting or trading money is strictly prohibited by Sharia principles, as is the case for charging interest. Transactions that comply with Sharia principles have to be structured around income-generating assets or businesses that are not ‘haram’, ie, prohibited in Islam.
Tamweel securitised its book of UAE dirham-denominated ijara contracts amounting to US$210m comprising 763 contracts. The contracts generate variable rentals at rates linked to the Emirates interbank offered rate.
Key highlights of the asset pool for the transaction:
* Low weighted average current lease to values;
* Seasoned assets with a weighted average seasoning of more than 19 months;
* Most of the pool is comprised of villas, which during an economic cycle are expected to show a lower price volatility;
* Good credit characteristics of the lessees, in particular most of the pool is represented by employees;
* All leases are current.
The issuance of US$210m was divided into notes of four classes with a legal maturity in 2037. Classes A, B and C were rated by Moody’s and Fitch and the unrated Class D was retained by the originator. The issuance was made under Reg S and the IFC invested US$20m in Class B and Class C Notes in a bilateral transaction with the originator. Class A notes were distributed by Morgan Stanley and Standard Chartered Bank.
Under the ijara framework of the lessor-lessee relationship, Tamweel owned legal title to the properties before the securitisation. ENSEC has designed a two-tier structure whereby the issuer SPV located in the Cayman Islands issued the notes amounting to US$210m. The sale proceeds were used to acquire from another SPV, registered in the Dubai International Financial Center (purchasing SPV) within Dubai, the properties and all related rights to receive lease rentals as well as any sale, insurance and expropriation proceeds. The purchasing SPV acquired the legal title to all the properties from Tamweel and continues to hold the legal title in trust for the issuer SPV.
All cash generated from the properties flows directly in the accounts of the issuer SPV. Since all the ijaras are denominated in UAE dirham, all collections resulting from the leases are collected in that currency. The cash collected is converted to US dollars in a spot transaction after retaining sufficient dirham to meet dirham-denominated expenses. The funds are then applied in accordance with the payment priorities (1) to pay expenses, (2) repayment of the liquidity facilities, (3) profit on the notes, (4) principal on the notes and (5) excess spread to Tamweel.
The transaction benefits from an exchange rate undertaking that protects the transaction against the UAE dirham depreciating below past levels as well as from an interest-free liquidity facility for any liquidity shortfalls.
Since the assets are floating in dirham based on the originator's base rate, the servicer covenanted that the weighted-average yield on the pool of securitised assets will not fall below one-month Libor plus 200bp in year one, Libor plus 175bp in year two, Libor plus 150bp in year three and then Libor plus 125bp.
As with any innovative financial product, a considerable effort was spent in adapting the principles of conventional securitisations into the Sharia framework and making it work in the new and untested legal jurisdiction of Dubai and the United Arab Emirates.
The transaction involves the first ever issuance of various classes of notes in an Islamic transaction. Subordination of rights among various noteholders is something that had remained untested in all sukuk transactions. Developing a structure with subordination of rights among the various classes of noteholders meant developing a hybrid Islamic structure.
A liquidity facility commitment in a conventional securitisation is interest-based. A specialised non-interest based liquidity facility was structured that met conventional RMBS requirements and adhered to Sharia principles. Cross-currency swaps are not Sharia-compliant and thus a unique option structure was created to meet Sharia principles and to provide exchange rate protection to the transaction.
The Dubai Land Department had only recently begun its process of registering properties in the Emirate, records of which had previously been maintained by master developers of the various projects in Dubai. As a result, details of only about half the properties underlying the pool were registered at closing. In order to allow time to register all remaining properties, that portion of the issuance was placed in escrow to be released gradually. The escrow account yields a profit on a monthly basis and is available for six months, which is the deadline assigned to complete the registration process.
The infancy of the property law and registration processes posed issues in terms of application of the laws and administrative processes and procedures. This is one of the first perfected sale structures used in a securitisation transaction from the UAE.