I am retired and take educated guesses on all things financial.

October 20, 2009

October 19, 2009: Islamic Debt - The Satan Is In The Details

The Financial Times had an interesting article buried in the back pages of the second section today regarding Islamic debt defaults.

It seems as though two prominent Middle Eastern investment companies - Kuwait's Investment Dar and Saudi Arabia's Saad Group - are at the cusp of a legal battle that will largely determine the $1,000b Islamic-style bond industry. This bond industry is one of the fastest growing niches of international finance. The deal is simply this: invest in Islamic operations that can technically comply with Islamic law against interest while providing a product that creates a guaranteed or floating interest rate that is, well, not an interest rate. A product such as this is called a sukuk.

Sukuks avoid the Islamic ban on interest by allowing investors to make a steady profit from the income of an underlying asset such as rental income by placing the income in a special purpose vehicle for the duration of the "bond", rather than receive, technically again, a fixed interest rate on a specific non-maturing date.

Lawyers and bankers are now trying to determine what interest these sukuk bondholders have in a bankrupt company. In short, does a sukuk have a claim on the assets of a company which issued the "bonds".

Herein lies the problem. Experts say that the issue of claim may not be clear cut. The defaulted companies claim that "asset-based" is not the same as "asset-backed". It appears that more than a few Islamic bonds are asset-based, not asset-backed. With sukuks being structured to adhere to Islamic principles, a concern is that courts anywhere in the world may rule against the bondholders if the issue is merely asset-based.

Muslim clerics, who have to approve all Islamic products (for a fee, such as an underwriter) often disagree on how closely Islamic bonds act like other bond instruments, and what happens in case of a default.

"If someone has purchased a sukuk assuming that they automatically have recourse to the (company) assets, they might be unpleasantly surprised", stated former sharia scholar Muddassir Siddiqui, now head of Islamic finance at DentonWildeSapte."At the core of this confusion lies the subtle -some would say fictitious- distinction between 'beneficial right' and 'legal right' to the asset."

The outcome of the two legal wranglings will have a dramatic impact upon future sukuk issues. At the least, the Islamic sukuk investor will have to read fine print on so-called guaranteed Islamic bonds to see if they are as such.

Perhaps, like any investment that tries to split too many hairs to avoid offending the law or, worse yet, God, if it looks too good to be true, it is.

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