Are Islamic bonds or sukuks now dead and buried?
Posted on 22 December 2009 with no comments from readers
The enormous bad publicity surrounding Nakheel’s $3.5 billion sukuk or Islamic bond repayment this month has exposed these debt instruments as nothing more than unsecured commercial bonds, with no recourse to underlying assets in the event of a default.
There is, of course, an irony in that Nakheel actually repaid its sukuk in full and on time thanks to the last minute intervention of the Abu Dhabi Government which dropped the Dubai Government a $10 billion lifeline.
Bond replaces sukuk
Actually it was a $10 billion conventional bond with interest of four per cent payable over five years. Abu Dhabi did not want another Islamic bond. Traditional bond finance is good enough for the richest city in the Gulf.
This does make it very easy to understand the rights and obligations of the parties. Sukuk come in a confusing number of varieties dressed up in an exotic language only understood by Islamic scholars and they seldom agreed on anything (see the ‘Diminishing musharakah’ above).
Yet in the Oil Boom of the 2000s such was the rush to invest in the Gulf States that nobody worried too much about the small print or the niceties of sukuk. Western bankers were assured that sukuk are just bonds under another name. They took the word of the sellers and ignored any protests from their lawyers.
After the Nakheel bond debacle a great many more questions will be asked about sukuks by both local and international lenders. For anybody trying to actually borrow money they will likely be more of a curse than a blessing, and a reversion back to more conventional financial instruments is clearly going to follow.
There will be exceptions to this rule. Saudi Arabia is the kingdom of the sukuk where all banks are Islamic, and not paying interest is highly profitable when your customers accept it, although the rental payments on sukuk should in theory amount to the same thing.
Financial innovation
Otherwise, it is perfectly normal after a boom period and what might be described as ‘financial innovation’ for there to be a swing back to more conservative banking practices. Lenders will be very particular in their due diligence on sukuk.
Confusingly and very significantly sukuk are asset-based but not asset-backed, so unlike a mortgage-backed security, for example, investors have no security over the asset if the issuer gets into financial difficulties and can not pay up.
No doubt sukuk will continue as a part of Islamic finance but their role in larger scale financing may now be sharply reduced.
no Comments posted by readers:
FYI – Not all Saudi banks are islamic banks and most banks charge interest. Check Arab National Bank, Saudi Holandi, SAAB…etc
I have to disagree with your assessment of sukuk. First, they are not all unsecured obligations and I among others have critiqued the over-structuring of sukuk and other Islamic financial products. Also, the use of Arabic terms like musharaka is mostly in describing the basic structures used. When it comes to actually reading the offering circulars for the sukuk, the language differs from a little from a conventional instrument. The structure is different in how a sukuk is arranged, but the language used in the offering documents is no different.
I am not a lawyer, but I was able to discern the structure used as described in the offering circular (which I did in May: http://www.zawya.com/blogs/blakegoud/090506063401/). There are clear problems with some of the structures used in sukuk and with the legal system’s ability to enforce on the land that backed the sukuk. Although it was an unsecured debt, there were fully perfected mortgages on the assets–two pieces of land in the Dubai Waterfront.
It seems like a late reaction to pile on the problems of some sukuk now after the big one drops (or is bailed out). I have been pointing out that Islamic finance is vulnerable to the economic downturn for over a year and the bursting of the Dubai real estate bubble is a direct result of this.
I think it is unhelpful to seize upon the Nakheel near-default to criticize the Islamic finance industry overall.
Ed Note: If you were raising money tomorrow would you use a sukuk now? Would it be more or less attractive than before the Dubai debacle? That is really the issue. Use a conventional bond and you avoid all the problems of understanding the sukuk risk. Abu Dhabi prefers simple debt structures and Abu Dhabi rules in the UAE.
I don’t think that the problems with Nakheel’s sukuk was a problem with the sukuk structure compared with a conventional bond. The project was a casualty of the overbuilding in Dubai and the property market bust. The fact that Nakheel issued a sukuk (guaranteed by Dubai World) rather than a conventional bond is rather immaterial. The entire project was based on the assumption of a value for the property assuming it was built within the next few years (I believe Jones Lang LaSalle used 5 or 10 years).
The Shari’ah risk was not a factor in the demise of the Nakheel sukuk to the point of requiring a bailout from Abu Dhabi. It was not a question of replacing conventional debt for Islamic debt. There are many other creditors of Dubai World’s troubled subsidiaries, both conventional and Islamic, that are calculating right now whether Abu Dhabi will be there if they push a tough line in the negotiations over a restructuring.
What do you think is the impact of the sukuk structure specifically that made this different from what would have happened if Nakheel had issued a conventional bond?
Ed Note: It would not matter but the biggest-ever sukuk issue is perceived as having gone horribly wrong. Do you think this innovative product will be bought again? Or will borrowers go back to a classic bond to restore confidence (if they can)?
I think two very relevant questions are:
a) How much of the sukuks issued between 2005 and 2007 were placed with shariah compliant institutions and how much with western investors? I believe over 80% was placed with non-shariah investors. Which brings in the question how much of that demand was really genuine from a shariah investors prespective?
b) Out of the 3 large non-sovereign sukuk issues; 1 is in default (Golden Belt), 1 is being repaid after a pretty bitter debacle (Nakheel) and 1 has to my knowledge been rescheduled (Dar). Two were real estate related issues and one was for general purposes. The question is how flexible a platform is the mechanism to accomodate non-real estate backed transactions?