Sukuk-based Securitization for
Development of a Stable and Thriving
Housing Market
By Farhan Malik
ABSTRACT
This paper describes the framework for developing a Sukuk-based Securitization structure for
the Housing Market. The relationship between the home-owner and the investor is redefined
to conform to Islamic principles; a combination of Musharakah and Ijarah (“Contract”) is
used. This framework can be broken down into three basic segments, purchase of the
property by the investor and home-owner as a Musharakah contract, leasing of the property to
the home-owner in shape of an Ijarah and lastly placing the Contract into a Securitization
vehicle.
The issuer that originates the Contract takes advantage of a securitization structure to move it
off the balance sheet. Securitization is used to bundle together a number of individual
Contracts to create a Sukuk which in turn can be sold to investors. The Sukuk structure
defined in this paper is very unique in nature, it behaves like a Non-Agency RMBS
(Residential Mortgage-Backed Security) in sense that there is credit risk involved and at the
same time works like an Agency RMBS structure given that there is no credit tranching
involved. The end-investor is essentially buying a vertical slice of an unlevered RMBS.
The focus in this paper is to lay-out a detailed framework for the rights and obligations of
both the home-owner and the investor. The home-owner as the active partner enjoys certain
privileges but at the same time effort is made to entertain the principal appreciation rights of
the investor. The rights and obligations of the home-owner and investor are discussed with
respect to: house value appreciation / depreciation, home-owner default, voluntary
prepayments by the home-owner and the term of the Ijarah.
A stable and well-financed primary market would result in a thriving Secondary market for
securities backed by the Housing market; trading according to their credit profile (Credit
losses and severities), voluntary prepayments, borrower profile, region and idiosyncratic
characteristics. By keeping the structure leverage-free, it would be made sure that the
mistakes of the Securitization in the Western world are avoided. Once the structure is shown
to work seamlessly for both the home-owner as well as the investor, it can help draw
investors to securely invest in the housing market. This will result in raising cheaper
financing, increase transparency and eventually increase home-ownership.
Table of Contents
1
2
INTRODUCTION ………………………………………………………………… 1
SUKUK STRUCTURE …………………………………………………………… 2
2.1
Formation of the Contract ……………………………………………….… 2
2.2
Securitization of Contracts into a Master Trust …………………………… 4
3
SUKUK CHARACTERISTICS …………………………………………………... 7
3.1
Property Value Appreciation ….…………………………………................ 7
3.2
Property Value Depreciation ……………………………………................. 7
3.3
Home-Owner Default ………………………………………………..……. 7
3.4
Voluntary Prepayments by the Home-Owner ………..……………….…… 9
3.5
Term of the Ijarah ………………………………………...…………….…. 9
4
COMPARSION TO SECURITIZATION STRUCTURES IN US ………………. 10
5
SECURITIZATION FOR DEVELOPING COUNTRIES ……………………….. 13
6
LESSONS LEARNED FROM THE MORTGAGE CRISIS IN THE US ….……..14
6.1
Un-levered Structure ………………………………………….…...………. 14
6.2
Skin in the game for the Issuer…………………………….……………….. 16
6.3
Symmetrical Risk/Return Profiles ………………………………………… 16
6.4
Incentives for the End-Investors ………………………………………...… 17
7
SECONDARY TRADING OF SUKUK SECURITIES ………………………… 18
7.1
Historical Credit profile (Credit losses and severities) ……………….…… 18
7.2
Voluntary Prepayments………………..…………………….…………..…. 18
7.3
Home-Owner Profile ………………………….…………………………… 18
7.4
Region ……………………..……………………….……………………... 18
7.5
Vintage ……………………….…………………….……………………… 19
8
CONCLUSION ……………………………………………………...…………… 20
GLOSSARY …………………………………………………………………………..... 21
BIBLIOGRAPHY …………………………………………………………………….... 23
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
1 INTRODUCTION
The Securitization structure proposed in this paper has been developed keeping in mind the
needs of both the Home-Owners and the End-Investors. The Home-Owners require
reasonable financing and a suitable partner whereas the End-Investors require to make
Shariah-Compliant investment yielding stable returns and a potential for principal gains. This
structure is able to achieve these goals while at the same time providing End-Investors with
an investment opportunity to get exposure to an illiquid market using a Sukuk instrument that
has ample liquidity.
The next section describes the process for formation of an individual “Contract” which forms
the basic unit of the Securitization vehicle. Section 3 describes the behavior of the Sukuk
under various scenarios. In later sections comparison is made between the proposed structure
and the structures currently in place in the United States. This paper includes lessons that
were learned from the housing market debacle in the US. Section 5 is dedicated to illustrate
the benefits of this Securitization structure for implementation in the developing countries.
Lastly, section 7 describes the development of the Secondary market for Sukuk instruments
backed by the proposed Securitization structure.
1
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
2 SUKUK STRUCTURE
This section will describe the formation of the Contract which is the basic unit of the
Securitization structure proposed in this paper.
2.1 Formation of the Contract
A combination of a Musharakah and an Ijarah make up a single unit of a "Contract". This
concept is elaborated using an example. Person A is interested in purchasing a house
("Home-Owner") but does not have enough Cash to make the purchase. Person A then goes
to an Originator, who gets into a Musharakah with the Home-Owner to purchase the house.
In this example, both parties have ownership of the property that has been purchased. Both
parties have risk to the depreciation of the house price and also chance to profit from
potential appreciation in the value of the purchase property. The ratio of ownership in the
property is equivalent to the ratio of the Initial Contribution Percentage, Initial Contribution
of the Originator is the amount of contribution made by the Originator as a percentage of the
total purchase price and similarly for the Home-owner. The result of the Musharakah is a
symbiotic relationship between the Home-Owner and the Originator. Musharakah allows the
Home-owner to purchase a property which he/she would not have been able to do without the
partnership of the Originator. Musharakah allows the Originator to serve as an Investor, we
will describe in more detail later on how the Originator benefits from the partnership.
Z = Total Purchase value of the house
X = Initial Contribution of the Home-Owner
Y = Initial Contribution of the Originator
Z=X+Y
2
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Initial Contribution of
Home-Owner
Home-Owner
(X)
Home-Owner
Ownership Share
Initial Contribution of
Originator
Originator
(Y)
Purchase Price of
the Property
(Z)
Originator Ownership
Share
Z=X+Y
Figure 1: Home-Owner and Originator enter into a Musharakah to Purchase property
The second leg of the Contract involves an Ijarah between the Home-Owner and the
Originator. In this lease, the Home-Owner acts as the Lessee and pays the Originator (Lessor)
for the Usufruct of Originator's share of the property. The rental rate used to form the Ijarah
is derived from the market rates, which in turn are a product of a number of macro-economic
factors. The Home-Owner has the option to make payments to partially purchase the
Ownership of the Property from the Originator, it should be noted that it is an option not an
obligation for the Home-Owner.
3
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Usufruct of Originator’s
Ownership Share
Originator’s
Ownership
Share
Rental Payments*
Home-Owner
(X)
* Home-Owner has the option to make voluntary payments to
partially buy Originator’s Ownership Share
Figure 2: Rental payments paid by the Home-Owner to the Originator for the usufruct of the
Originator’s Ownership Share of the property
Since the lessor in Ijarah owns the leased assets, he can sell the asset, in whole or in part, to
a third party who may purchase it and may replace the seller in the rights and obligations of
the lessor with regard to the purchased part of the asset.1Next we show how the Ijarah is
placed into a Securitization vehicle.
2.2 Securitization of Contracts into a Master Trust
Musharakah and Ijarah are combined to form an individual Contract. These Contracts are
then placed into a Bankruptcy-remote entity i.e. the Master Trust. Figure 3 below shows the
schematic showing a number of Contracts combined to form a Master Trust. Servicer acts as
an Agent on behalf of the End-Investors and Issuer to collect rent and principal payments
from the Home-Owners. In return the Servicer charges a nominal fee which is paid from the
rental payments made by the Home-Owners.
1
Muhammad Taqi Usmani, An Introduction to Islamic Finance, 125
4
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Contract 1
Contract 2
SERVICER
MASTER TRUST
Contract 3
Contract 4
Contract n
Securities Offered
to End-Investors
Issuer’s
Share
Figure 3: Securitization of Contracts into the Master Trust
Once the Master Trust has been formed, it issues a number of Securities to End-Investors.
The Securities that are issued by the Master Trust form the Sukuk. Sukuk is backed by the
ownership interest in the properties and the rental income is the periodic profit that is
received by the Sukuk-Holders. The Issuer, which can be a Bank or a Finance Company is
responsible for originating the Contracts. The Issuer also keeps a share of the Master Trust, in
order to make sure that the Issuer and the End-Investors do not have any conflict of interest.
Having the Issuer's share in the Master Trust makes sure that the interests of Issuer and the
End-Investors are aligned.
Figure 4 below shows the complete frame-work of the proposed Securitization structure. It
begins with the Originator (Issuer) working with individual Home-Owners to originate the
Contracts. These contracts are then placed into a Master Trust which has ownership stakes in
the purchased properties and receives periodic income from the Home-Owners. The Servicer
is responsible for servicing all the payments in this structure and can be the same entity as the
Issuer. The Master Trust issues Sukuk securities which represent ownership stakes in the
purchased properties and the rental income for the usufruct by the Home-Owners.
5
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Servicer
Contract
(consisting of
Ijarah and
Musharakah)
Individual
Contracts
Servicing of
Contracts
Periodic Rental
payments and
Principal payments
Sukuk Notes
(EndInvestors)
Master Trust
Initial
Contribution of
the Originator
to purchase
property
Note Proceeds
Issuer’s Share
in Master Trust
Issuer
(Originator
of Contracts)
Figure 4: Frame-work for the Securitization structure
6
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
3 SUKUK CHARACTERISTICS
3.1 Property Value Appreciation
In a conventional mortgage, the lender does not benefit from Home-Value Appreciation. In
the Sukuk proposed in this paper, the End-Investor benefits from appreciation of the property
prices backing the Master Trust Contracts. The Sukuk holders have the opportunity to get
more than Par for their Initial Par investment. At the end of the Ijarah, the Home-Owner can
either pay the remaining principal outstanding or refinance. If the Home-Owner pays all of
the Principal back before maturity then the Master Trust would get Par back for that Contract.
If the Home-Owner refinances then the Master Trust would get more than Par for their share
of the property ownership.
3.2 Property Value Depreciation
In a conventional mortgage, the Home-Owner is solely responsible for any depreciation in the
house price. The proposed Sukuk structure is based on sharing of any losses due to Property
Value Depreciation among the End-Investors and the Home-Owners.
3.3 Home-Owner default:
There are two basic types of defaults to be discussed. First is the Term Default, which occurs
due to the Home-Owner defaulting on one of the Ijarah payments. Second type of default is
the Maturity Default, this happens due to the Home-Owner being unable to either pay full
principal (full initial purchase price of the property) or refinance at maturity.
Term defaults can occur due to the Home-Owner being unable to pay the monthly Ijarah
payments. If 3 payments are missed, it results in the Home-Owner to be in default. This
results in the property being transferred to the Master Trust. At this time it becomes the duty
of the Issuer to act as a fiduciary and maximize the Recovery for the Master Trust and the
Home-Owner. The Recovery is achieved by selling the property through a process of a public
auction. Given that the Issuer also owns a piece of the Master Trust, it is assured that the
interests of the Issuer are aligned with that of the Home-Owner and End-Investors in order to
maximize the recovery. Figure 5 below shows the time-line of a Term Default and auction of
the property to get Recovery value.
7
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Recovery paid to
Home-Owner and
Master Trust
Regular periodic
Ijarah payments
3 missed periodic
payments
Sale of Property
Figure 5: Time-line showing a case of Term Default
Maturity default takes place at the end of the term for Ijarah. At this point if the Home-Owner
has not been able to fully pay-off the remaining balance of the Purchase Price of the property,
he/she has the option to refinance into a new Contract. In case the Home-Owner is unable to
do either of the two, it results in a Maturity default. Figure 6 below shows a graphical
illustration of the options available to the Home-Owner at Maturity of the Ijarah.
Maturity of Ijarah
Pay-off full
property
Purchase Price
Refinance
If not able to Pay-off the
full Purchase price nor
Refinance
Maturity Default
Figure 6: Illustration of Maturity Default at the end of the Ijarah term
8
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
3.4 Voluntary Prepayments by the Home-Owner
This section deals with the very important aspect of any housing based Sukuk, which is the
payment of Principal. Comparison will be made with various other principal repayment
structures that are currently in place. Unlike most other home mortgages, the Home-Owner is
under no obligation to pay back any part of the principal during the term of the Ijarah. In the
United States, residential mortgages are paid back using an amortization schedule but the
Home-Owner has an option to pay back more than the scheduled principal payment during
any period. This leads to a lot of speculation based on interest rates. If interest rates go up,
this leads to less people making any voluntary prepayments and if the interest rates go down,
this leads to more prepayments as borrowers refinance into lower rates.
There is a valid argument that by having no scheduled principal prepayment in this Sukuk
structure will result in very few Home-Owners making principal payments. This is not
entirely correct, as Home-Owners are incentivized to pay-back the full principal within the
term of the Ijarah. As long as the Contract is outstanding, the Home-Owner will be
responsible for making the Ijarah payments as well as the Servicing fee. Both the Ijarah and
the Servicing fee are based on the Outstanding notional of the Ijarah hence it is in the interest
of the Home-Owner to reduce the size of the Ijarah by making principal payments. In case the
Home-Owner is not able to pay-back the principal within the term of the Ijarah, the HomeOwner will incur more fees associated with Refinancing. To summarize, the Home-Owner
has an option but no obligation to make Principal payments during the term of the Ijarah.
3.5 Term of the Ijarah
Ijarah leg of the Contract is set for a limited number of the years e.g. 3-5 years in order to
mitigate the risk due to the Monetary Policy adapted by the Central Bank. As an illustration
let's say that the Ijarah is set to have a rental yield of 10% for the Originator. Now, a few
years later if the inflation rate rises drastically, this will have a detrimental effect for the
Originator and hence the End-Investor. Higher inflation rate would result in the Home-Owner
making principal prepayments to purchase the property before maturity of the Contract. In
order to mitigate this risk, the duration of the Ijarah contract is to be kept within a certain
time period. At the end of such period, the Contract (Musharakah and the Ijarah) can be renegotiated based on the prevailing market rates at that time.
9
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
4 COMPARISON TO SECURITIZATION STRUCTURES IN
US
The development of innovative financial solutions in the Muslim world has been dormant for
centuries. It is only recently, since the early 1970s that significant work that has been done in
the field of Islamic Finance. In the Dark ages, it were the muslim scholars who kept the
tradition of learning and civilization alive and the West benefited from the Muslim
knowledge. Now time has come for muslims to benefit from the knowledge that has been
created in the West. In order to take benefit from Western financial structures, care must be
taken to make sure that the concepts are acceptable by Shariah. The West has had significant
success in linking the End-Investor (Excess Capital) with the most optimal user of this Excess
Capital; be it the Stock Market, Debt Market or the Securitization structures, they all serve
the purpose of linking Capital with its most optimal (on a risk-adjusted basis) user. It must be
kept in mind, that even though the West has had more success than the Muslim world in
implementation of a financial system, it has been plagued with constant cycles of boom and
bust. The most recent financial markets crisis has again opened the discussion for the need of
structural changes to the current financial models/instruments in place. Most commentators
have stressed for the need of more regulation whereas the stress should be on making changes
to the structural features of the financial instruments. An in-depth discussion of the financial
system is beyond the scope of this paper and for now the focus will only be on the
Securitization structures for the housing market. Now that the theoretical reasoning for
benefiting from Western knowledge regarding financial structures has been discussed, indepth discussion on Securitization comparison will follow.
The Housing Securitization market in the United States comprises of generically two types of
structures:
a) Agency RMBS ("Residential Mortgage-Backed Securities")
b) Non-Agency RMBS ("Residential Mortgage-Backed Securities")
Agency RMBS:
Agency RMBS consists of mortgage loans that are guaranteed by a US Government Agency
(eg. Fannie Mae, Freddie Mac, Gannie Mae). The home loans backing Agency mortgages
consists of loans that meet certain criteria set by these agencies; they are referred to as
"Conforming Loans". Number of individual Conforming Loans are pooled together to create
an Agency RMBS which in turn is sold to End-Investors. It is a form of "Vertical Tranching"
as each individual investor has a Pro-Rata share of the underlying loans, hence each investor
shares equally (based on their percentage share) in prepayments. Given that these securities
are backed by a US Government agency, they are considered to carry no credit risk. The
major risks involved are Interest Rate risk and Prepayment Risk. Figure 7 below shows
Principal and Interest distributions being applied Pro-Rata to all the vertical slices. Principal
payments are further of two types; Voluntary and involuntary prepayments. Voluntary
prepayments are due to principal payments made by the Home-Owners backing the
10
Sukuk-based
based Securitization for Development of a Stable and Thriving Housing Market
mortgages in the respective loans. Involuntary prepayments are due to principal payment
made by the Agencies in case of default by individual Home-Owner(s).
Home
Figure 7:
7 Waterfall for Agency RMBS Structure
Non-Agency RMBS:
Loans that do not fall into the ‘Conforming Loan’ category are not eligible to be part of
Agency Mortgages. The ‘Non-conforming’
‘Non conforming’ loans are securitized into Private-label
Private
NonAgency RMBS structures which do not have any Government Agency backing. Non-Agency
Non
RMBS structure involves tranching of the liabilities into a number
number of priority tranches. Figure
8 below shows the Waterfall for distribution of interest/principal distributions as well as
losses. Interest and Principal payments are first paid out to the Senior tranche and the lastly to
the Junior tranche. Any Losses are first applied to the Junior tranche
tranche and lastly to the Senior
tranche. The major risk for Non-Agency
Non
RMBS is the Credit Risk.
11
Sukuk-based
based Securitization for Development of a Stable and Thriving Housing Market
Figure 8: Waterfall for Non-Agency
Non
RMBS Structure
The Securitization structure proposed in this paper behaves like a Hybrid of Agency and
Non-Agency mortgages. It carrries credit risk similar to Non-Agency mortggage but behaves
like an Agency mortgage in teerms of the vertical tranching.
12
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
5 SECURITIZATION FOR DEVELOPING COUNTRIES
A lot of the third world countries are plagued with the land mafia which makes investing in
the real-estate sector a difficult and risky proposition. For End-Investors who take part in the
Master Trust, it will minimize this risk. Investors are able mitigate the risk of losing
investment to the land mafia due to being part of a much larger stake-holder i.e. the Master
Trust. Master Trust will be much harder target for the land mafia due to the sheer size of the
structure, political and regulatory backing.
Once a vibrant Secondary Market for the securities backed by the Master Trust is formed, it
will allow investors to easily trade in and out of the housing market. Increased liquidity to the
Housing Sector will be beneficial for the both the Home-Owners as well as the EndInvestors.
Having a well-oiled Securitization market will attract Foreign Investment. Hedge funds,
Sovereign Wealth Funds, Pensions Funds etc. are not in a position to do the due diligence on
small investments and in order for them to make investments into the housing market, the
need to have Securitization is very pivotal. Given that the Master Trust is responsible for
dealing with all the tasks relating to the servicing of the individual loans and taking care of all
the local regulatory and legal requirements, the investment becomes a very seamless process
from the perspective of the Foreign Investor.
Another suggestion is to make a make regulation which requires a certain portion of the
Master Trust to be consisting of Contracts made to support low-income housing. In
developing countries the poor have very little or no access to financing in order to purchase a
home. Mandating low-income housing to be part of the structure would be beneficial to both
the End-Investor as well as the Home-Owners. End-Investors would benefit from the
diversity accomplished from having low-income housing Contracts. Low income HomeOwners would benefit from having access to financing in order to purchase their homes. It is
hoped that this suggestion would help reduce the widening gap between the rich and the poor
in the developing countries.
13
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
6 LESSONS LEARNED FROM THE MORTGAGE CRISIS IN
THE US
This section highlights some of the features of the proposed structure that make it more
reliable and robust than the prevalent securitization structures in the United States of
America. Recent housing market crisis in the US is used as a bench-mark to compare and
stress-test the Securitization structure proposed in this paper.
6.1 Un-levered structure
The proposed Sukuk-based Securitization structure illustrated in this paper refrains from
applying financial leverage. Both the Home-Buyer as well as the End-Investor(s) are
essentially making Equity investments. The Home-Buyer is able to purchase the property
without putting up the whole purchase price whereas the End-Investor is able to find a way to
get exposure to the Housing Market at the same time investing in a security which is very
liquid.
In US Home-Buyers were able to purchase properties with as low as 0% down-payment. This
meant that excessive leverage was put to work. This led to a classic boom-bust cycle.
Initially, the low interest rates lead to a steep rise in the value of property prices across United
States. This resulted in home-owner selling or refinancing their mortgages to double or triple
their initial investments. This is shown through a simple example.
Initial Property Price = USD $100,000
Initial Home-Buyer Investment = USD $10,000
Initial Mortgage Size = USD $90,000
Rate of Interest charged by the Bank = 5%
The above example shows the use of 10x leverage used by the home-owner to purchase the
property. The low interest rates allowed more people to purchase houses using a high level of
leverage which resulted in a sudden steep rise in property prices. The same property within
12 months was worth USD $30,000 more. At this time, the original Home-buyer was able to
either Sell of Refinance his/her original mortgage in order lock-in the profit.
Property Price After 12 Months = USD $130,000
Interest payment to Bank = USD $90,000 * 5% = USD $4,500
Principal payment to Bank = USD $90,000
Net Profit for Home-Buyer = USD $130,000 - USD $90,000 - USD $4,500 - USD $10,000 =
USD $25,500
14
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Note that for the purposes of simplicity closing costs, taxes and other related transactional
costs are not listed. This exceptionally high rate of profit in this transaction was largely
driven by the excess amount of leverage that was made available to the Home-buyers.
This Boom cycle went on for a while but as it was unsustainable it had to come to an end.
Once the Housing Market came crashing, it led to a vicious cycle. The steep house prices had
lead Home-Owners that had a very high leverage to owe higher interest payments.
The high interest payments lead to more Home-Owners defaulting on their mortgage
interest payments. Housing Market crash resulted in Home-Owners to either have a very low
or Negative Equity in their homes. Once the Home-owners had Negative Equity in their
property, there was no incentive for them to service the mortgage. Negative-Equity was the
driving force for Home-Owners to stop paying interest on their mortgages and simply vacate
the property. Home-Owner defaults lead to Banks taking over the property in a Foreclosure
and then tried to sell them. Given the lack of credit/leverage available to new Home-Owners
after the market crash, meant that there was very little appetite to purchase properties that
were sitting in the Bank portfolios. This in turn led to further depressed House Prices.
Eventually, the bank losses due to the housing market lead to massive write-downs across the
banking sector and things only stabilized once the banks were bailed out by the
government. Case-Shiller index shown in Figure 6 below illustrates the sharp rise and fall of
the home property prices in the US.
Figure 6: Case-Shiller Index2
2
"Case-Shiller index." December 2009. Wikipedia. 2 December 2009.
<http://en.wikipedia.org/wiki/File:Case-shiller-index-values.jpg>
15
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
The use of leverage is forbidden according to Islamic Shariah. During the Boom and the Bust
one of the two parties involved in a levered transaction was abused. During the Boom period,
the End-Investor was not able to share the gains in the Housing Market and was only paid
back its principal investment along with meager interest. In the Bust cycle, the Home-Owner
lost all of its investment due to Negative-Equity in their houses. The use of the unlevered
structure shown in this paper never results in a case where the Home-Owner has a NegativeEquity in the property, hence the interests of the Home-owner and the End-Investor(s) are
always aligned.
6.2 Skin in the game for the Issuer
It is important to make sure that the interests of all the parties involved in this Sukuk structure
are aligned. In order to make this happen, the Issuer is required to own a certain portion of the
Master Trust. This will ensure that it is in the interest of the Issuer to maximize the value of
the Contracts in the Master Trust. The portion of the Issuer's Share could be anywhere
between 5%-10% dependent on the regulatory environment.
The Issuer in its role as an Originator is able to extract fees related with each Contract in
terms of closing fees. Also, if the Issuer is same as the Servicer then the Issuer will also get
the Servicing fees as well. The fees incentivize the Issuer to ramp-up as many deals as
possible in order to maximize the amount of fees that it will receive. By forcing the Issuer to
take the Issuer's Share in each deal, it is assured that the Issuer does not compromise on the
collateral quality in order to receive more fees.
The residential mortgage model that lead to the Mortgage Crisis in the US followed the
framework where the Issuer did not have any interest in the quality of the RMBS
transactions. Loans were originated by an Originator (usually a different party than the
Issuer) who simply passed the loan onto the Issuer and received its fee for originating the
loan. The Issuer kept the loans in a Warehouse until it had enough loans to ramp-up a privatelabel RMBS deal and then securitized all the loans and sold it to investors. In this model, the
Originator and the Issuer both had an incentive to maximize the amount of loans that were
securitized and in the process the quality of loans originated was compromised. This led to
RMBS deals that had poor-quality loans backing the structure, which lead to the massive
defaults. This problem can be tackled by forcing the Issuer to own a significant stake in the
Master Trust, as has been recommended in this paper.
6.3 Symmetrical Risk/Return Profiles
The proposed frame-work in this paper is based on the rules laid down by Islamic Finance.
This means that the Home-Owner and the End-Investor(s) have Symmetrical Risk/Return
Profiles. In Conventional mortgages, the borrower (Home-Owner) bears the maximum risk as
well as the opportunity of maximum return. In case the property prices increase, the borrower
is able to refinance and take out any positive equity. Similarly, if the property price decreases,
the borrower is the first one to bear the risk.
16
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
The relationship of Home-Owner and the End-Investor specified in this paper leads to
equitable sharing of any increase or decrease of the property values.
6.4 Incentives for the End-Investor
The proposed structure for the Sukuk is beneficial for both the Home-Owner as well as the
End-Investor. The End-Investor is able to take an Equity position in the Housing Market
without having to deal with the day-to-day issues related to owning a set of properties. In the
US, RMBS market is able to only provide investors with a debt investment with limited
upside. The focus is more on gaining principal protection with limited interest income and no
principal growth. The focus in the Sukuk structure is to provide investors with a potential for
principal growth and also a stable investment income. There is also a greater chance for a
potential principal loss as there is no credit enhancement for End-Investment. This is
necessary in order to make the structure Shariah-Compliant.
17
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
7 SECONDARY TRADING OF SUKUK SECURITIES
A well-financed and thriving Housing Market requires that there is an active market for
Securities backed by the Housing Market. Once there has been a significant Primary Market
issuance the next step would be to create an active Secondary Market. A liquid Secondary
Market for Sukuk securities would create confidence among the investors. Each Sukuk
security would trade according to the collateral characteristics backing the Master Trust
corresponding to the Sukuk. In this section salient features of the Master Trust collateral will
be discussed, that will determine the Secondary Market pricing of the Sukuks.
7.1 Historical Credit profile (Credit losses and severities)
For each Master Trust, once the collateral has seasoned it will have historical credit
information. Credit information will include historical credit defaults as well as historical loss
severities. Losses will occur in the portfolio if the property liquidation post-default results in
proceeds that are less than the original Purchase price of the property. Sukuk that have
historically less losses and lower severities would trade higher than others.
7.2 Voluntary Prepayments
Historical data regarding Voluntary Prepayments can be used as a good indicator regarding
the quality of the originated Contracts. A higher Prepayment rate would generally indicate
that property prices backing the Master Trust have rallied since origination. Secondary
trading of the Sukuk securities will take into effect the historical Voluntary Prepayments.
Depending on the market rates, the voluntary prepayments information would determine the
Sukuk pricing.
7.3 Home-Owner Profile
Most of the other factors mentioned above deal with the collateral backing the Master Trust
whereas the Borrower Profile deals with the quality of the Home-Owners. It shows the ability
of the Home-Owner to service the Ijarah and also its ability to Refinance at maturity of the
Contract. It is the responsibility of the Originator to do due-diligence in order to make sure
that the Home-Owner has a stable job/income. In the US, credit scores are used as the
primary tool for determining the quality of the Home-Owners. In developing countries where
such information is not available, stable job/income could be used as a measure for
determining the quality of the Home-Owners. Sukuks backed by Contracts with better quality
Home-Owners would trade at a premium.
7.4 Region
18
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Investors looking to buy the Sukuk securities would be interested getting an exposure to
certain type of properties located within a specified geographical region. Investors are able to
take advantage of the diversification offered by the Master Trust as it will own a number of
properties located across various regions. Geographical diversification will make sure that the
correlation between the various properties is minimal. Low correlation within the collateral
would attract conservative investors. Depending upon the Geographical make-up of the
collateral, it would attract certain types of End-Investors.
7.5 Vintage
Each Master Trust will own Contracts originated between certain time periods. This will
allow investors to pick-up Sukuks backed by collateral from a certain Vintage. Two Master
Trusts may perform completely differently dependent on which part of the Housing Market
cycle were the Contracts originated. Allowing the investors to choose Contracts from their
preferred Vintage will create more demand for the Sukuks leading to better financing for the
Home-Owners.
19
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
8 CONCLUSION
In this paper, a frame-work has been laid out for developing a Securitization structure in
order to finance the Home Mortgage Market. Effort has been made to address all the
plausible issues relating to development of a housing market securitization vehicle. The
structure is made to be completely in compliance with the injunctions of Islamic Shariah
while at the same time taking advantage of the progress made in the Western world in
developing a Securitization market.
There are still some factors that require more work. In case of significant appreciation of the
property prices, it would always be in the interest of the Home-Owner to pay back the
complete principal rather than refinance. Refinancing would entail sharing the property gains
with the Master Trust. This issue can be addressed by limiting the amount of prepayment to a
certain percent for each year without the option of carrying it forward to next year. As an
example, if the term of the Ijarah is 5 years, then the maximum prepayment could be set at
20% per year. This would make sure that both the Home-Owner as well as the End-Investor
both share in the appreciation of the property price.
Development of a stable securitization structure for the housing market would immensely
benefit both the home-buyers and property investors. It would provide home-buyers access to
a reasonable and interest-free financing in order to purchase their homes. Having a Master
Trust as their Musharakah partner would provide additional security against land mafia and
other bureaucratic hindrances. For the property investors it would allow them to make an
investment into a relatively liquid product. It allows the investors to share in potential upside
in property prices and at the same time provide stable periodic cash flows through the Ijarah.
A well refined housing market would attract global investors looking to make Shariahcompliant interest-free investments.
A basic framework has been provided in this paper, which can further be advanced to make it
adaptable to the requirements of a certain country or region.
20
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
GLOSSARY
Down-Payment
It is the initial upfront portion of the total amount due in order to purchase the property.
End-Investor
The Investor buying the Sukuks issued by the Master Trust, in order to gain exposure to the
housing market.
Home-Owner
The resident of the purchased property, responsible for paying rent for the usufruct of the
property. Home-Owner also makes an initial Down-Payment for the purchase of the property.
Refinance
Refinancing means the replacement of the initial Contract (Musharakah and Ijarah) with a
new Contract bearing different terms.
Negative-Equity
Negative-Equity is a situation where the value of the asset securing a loan is worth less than
the outstanding balance of the loan.
Originator
The Bank or the Finance Company that originates the Contracts and then places them into a
Master Trust. For the sake of this paper Originator and the Issuer are the same.
Musharakah
An Islamic finance structure which is used instead of an interest-bearing loan. It is a
partnership in which both gains and losses are shared.
Initial Contribution Percentage
Initial Contribution Percentage for the Home-Owner refers to the total amount of Principal
contribution made by the Home-Owner as a percentage of the total purchase price of the
property.
Issuer
Refers to the party that issues the Sukuk securities from the Master Trust to the EndInvestors. For the purpose of this paper, the Originator and the Issuer is the same entity.
21
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
Secondary Market
Refers to the marketplace where previously issued Sukuk Securities trade.
Securitization
It is the process through which Contracts are placed into a Master Trust which in turn issues
Sukuk securities in order to finance these Contracts.
Servicing Fee
The fee that is received by the Servicer in order to service the Contract payments. It includes
the payments for Ijarah and any principal payments made by the Home-Owner.
Master Trust
Master Trust is a bankruptcy remote entity, individual Contracts are transferred to the Master
Trust through a true sale.
RMBS
It is a Mortgage-Backed Security that is backed by mortgages on residential real estate.
Prepayment Risk
The risk associated with the early unscheduled return of principal on a loan.
Primary Market
Part of the Capital markets that deal with the issuance of new securities.
22
Sukuk-based Securitization for Development of a Stable and Thriving Housing Market
BIBLIOGRAPHY
Usmani, Muhammad Taqi (1998). An Introduction to Islamic Finance. Karachi, Pakistan:
Idaratul Ma'arif.
Usmani, Muhammad Taqi. "Sukuk and Their Contemporary Applications."
Darrell Wheeler, Ratul Roy, Rahul Parulekar (2007). “A Simple Guide to Subprime,
Mortgages, CDO and securitization.” Citi Fixed Income Strategy & Analysis, NewYork,
USA
Ivan M.Gjaja, Mary E.Kane, Marc Carnahan (2005). “Introducation to the Home Equity Loan
Market.” Citigroup Fixed Income Strategy & Analysis, NewYork, USA
Darrell Wheeler, Ratul Roy, Mary E.Kane (2008). “Does the World Need Securitization?”
Citi Fixed Income Strategy & Analysis, NewYork, USA
23