Rasameel Structured Finance views on securitization on wake of financial meltdown

To understand better the solutions brought up the press conference started with a recap of the causes and effects of the current financial problems which are afflicting capital markets throughout the world: High Debt Levels; Asset-Liability Maturity Mismatch; Fraud; Complex; mispriced investments (Credit Default Swaps, Collateralized Debt Obligations, Subprime Mortgage Securitizations); Speculation Resulting in Asset Price Bubbles; "Originate to Distribute" Model, take a fee and then sell out; Inept Credit Rating Agencies; Mispricing of Risk; "Mark to Model" Pricing, over-reliance on financial models instead of the market.

Our current financial crisis is the latest and the worst of a series of financial crises over the last thirty years.

List of financial crises:

1982: Mexican, Brazilian and Argentinean debt crisis
1987: Stock Market Crash
1989: United States Savings & Loan crisis
1989: Collapse of the Japanese asset price bubble
1992: Speculative attacks on European Exchange Rate Mechanism currencies
1994: Speculative attack and default of Mexican debt
1997: Devaluations and banking crises across Asia
1998: Russian financial crisis, devaluation of the rubble and default on debt
2000: Dot.com crash
2001: Breakdown of Argentine banking system
2007: Spread of the U.S. subprime mortgage crisis to worldwide capital markets

Every one of these crises was preceded by speculative excesses and greed carried out by short-sighted, get-rich-quick opportunists in the major financial centers.

It seems the "nature" of Wall Street, City of London and other various money centers to act in a way that results in these cyclical disasters both for themselves and their clients.

Benjamin Graham, the great stock analyst of the mid 20th century who was the mentor to a young Warren Buffet, observed that every generation on Wall Street must make the same mistakes. But why do investors need to learn over and over again that you should never swim across a river with a scorpion on your back? This volatility, this boom-and-bust cycle, is prevalent throughout conventional finance. Wide swings in the economic cycle, in company earnings, and in asset prices seem to be the rule.

It is a well known principle that Fear and Greed are the dominant emotions in conventional finance. Gambling, speculation, leverage, panic and crashes are the result of these emotions being acted upon.

The odd thing is that conventional finance prefers steady returns to volatile returns.

A company with steady earnings will have a higher price earnings multiplier than a volatile company. Although companies with steady earnings are rewarded with higher valuations, the temptation to gamble, speculate, and bet on uncertainty is often too hard, if not impossible, to resist.

A principle of fixed income is that to increase return, you must increase either maturity risk or credit risk. In the last ten years, there has been an additional method. Return is increased by increasing complexity. However, complex financial instruments and derivatives are very often used to hide risky assumptions and unpleasant possible consequences. Warren Buffet said that "The only reason that one may not understand a financial statement is because the writer does not want you to understand it." The same can be said for complex financial instruments and derivatives.

Conventional finance is a zero sum game. One investor gains at the expense of another. And even that unhappy state gets worse when greedy, unscrupulous third parties get involved. Far too often, this competitive antagonism in conventional finance produces a lack of alignment of interest among investors even within the same company. In a highly leveraged company, risky, high-payoff speculative transactions are attractive to equity investors who have little to lose but these transactions can devastate the senior debt holders if they go bad. Within a single Collateralized Debt Obligations transaction, one of the security types that brought on the current financial crisis, investments that benefit the equity class can be damaging to the senior classes and vice versa.

A French anthropologist once described the evolution of man-made tools as progressing from the Useful to the Beautiful to the Decadent. I believe that a great number of conventional financial tools have moved far from the Useful and the Beautiful.

However, despite these problems, despite these contradictions, despite these structural flaws, conventional finance is still the dominant force in the world's capital markets.

Even with our wealth here in the GCC, even with our culture and our traditions, in order to participate in the world's capital markets either as borrowers or lenders, we must interact in some manner with conventional finance.

Issam Z. Al-Tawari, Vice Chairman and CEO of Rasameel, explained what is the solution? How do we integrate the GCC capital markets with the world's dominant financial system while retaining our traditions and investing in accordance with our religion and making certain that "it does not happen here"?

Rasameel Structured Finance is dedicated to Shariah compliant securitization, or "Tasneed".

Shariah compliant finance is the system of banking and finance that is consistent with the principles of Islamic Law. With this requirement, Shariah finance provides funding and investment opportunities for capital markets but in accordance with moral, ethical and principled directives. Moral, ethical, and principled directives are alien to conventional finance.

Sheikh/ AbdulSattar Al-Qattan - Shariah Board Member added some of the fundamental concepts of Shariah finance are:

1) No money for money return.
Pure interest, riba, is prohibited but you can make a profit from a gainful undertaking as long as there is a sharing of risk

2) No gambling
Profits must not be guaranteed based on assumptions and can only accrue if the investment itself yields income.

3) No excessive risk/uncertainty
Shariah finance does not forbid risk taking but does not permit risk that allows one party to reap all of the benefits at the expense of another

4) Ownership of tangible assets
Investors should be the "owners of the business" so investors focus on the underlying soundness of business.

5) Shariah finance relates assets to funding
There must be a real economic purpose to the undertaking, funding of trade or production of real assets.

6) There must not be sales of non-existent asset or sales of assets that the seller does not own.

7) The promise to buy or sell something cannot itself be an object of sale or purchase.

8) No return without risk
Shariah finance requires that investors should share in risk and rewards and not guarantee some investors a return that will be at the expense of other investors.

Shariah finance, by its fundamental nature, discourages or prohibits those speculative excesses that are the root cause of the current global financial crisis.

The prohibition of interest, pure money for money transaction, requires Shariah compliant finance to engage in actual, productive activities like funding trade or purchasing assets, not providing cash for unsecured speculative activities.

The prohibitions of Maysir (gambling) and Gharar (excessive uncertainty) require that Shariah finance avoid most financial derivatives and those financial transactions that are little more than a game of chance.

The requirement that an asset must exist prohibits unsecured debt and speculation. When all investors share equally in the risks and rewards of a transaction and when guarantees to some investors that will come at the expense of others are prohibited, there is little interest in unsecured debt and speculation. When an asset does not exist, when an asset is not yet in the possession of the seller, when an asset is not tangible but is only a promise to buy, sell or pay, a transaction is not an investment, it is a speculation.

All of these features of Shariah finance require a much higher level of financial prudence, caution, and good sense. The opportunity to indulge in the scorpion's nature for greed and volatility is removed.

Rasameel Structured Finance specializes in Shariah compliant securitization or "Tasneed". Conventional securitization is the process of turning cash producing assets into securities. Since the earliest mortgage pass-through transactions in the 1970's, securitization has become a major component of capital markets. Securitization has provided lower rates to borrowers, better security for lenders, increased liquidity and provided alternative funding sources in the capital markets.

Recently, some have stated that securitization is the cause of the current financial calamity and that securitization is itself risky. This is not true. If someone thinks a securitization transaction is risky, wait until they see the result of a comparable unsecured transaction?

But, there have been several recent problems involving securitizations. These problems do not affect the entire securitization sector or the securitization process. These problems are in several specific areas into which abuses and fraudulent manipulations have crept:

- Collateralized Debt Obligations, in which a number of already existing debt securities are pooled together, various levels of risk and return are allocated to a number of new securities according to a set of cash flow rules.

- Subprime mortgages transactions containing mortgages issued to poor credit risk homeowners and using unrealistic assumptions for expected defaults and loss and prepayments.

- Credit Default Swaps which are derivative contracts whose value depends on the price movements of a real, underlying fixed income cash security. One real security can be the basis of several tens to several hundred times the amount of credit default swaps. (Recently, the credit default swap market was estimated to be $33 trillion. Even this number has been criticized as being 25% too low. No one knows the actual outstanding amount.)

In addition, in all problem securitizations there are always two more features:

- Excessive levels of debt and leverage.
- Participants who take fees and then remove themselves from any further involvement.

The basic nature of securitization is Shariah compliant. But when these abuses are present, there can be problems.

That is why Rasameel encourages and promotes Shariah compliant securitization or "Tasneed".

In both securitizations and Tasneed, the investors own the profit generating assets and the investors' profit is derived from the cash flow of real assets.

But in a Tasneed, all investors must be subjected to the risk of the assets that generate the return. Certain parties are not permitted to earn returns with no risk. In a Tasneed, the transaction is used to fund productive activities, to finance the purchase and sale of real assets, and generally to produce socially useful financing opportunities. A Tasneed transaction will not contain excessive levels of leverage nor will it contain a promise-to-pay asset or other type of synthetic asset like a Credit Default Swap.

The ethical and moral requirements of Tasneed prohibit those features of conventional securitization that have resulted in so many problems. A Tasneed transaction will not attract short sighted, irresponsible speculators who are alternately driven by greed and fear. Tasneed will not appeal to get-rich-quick hedge funds. Tasneed will not be used to finance assets that have no real purpose or even a real existence. And Tasneed will not be a cause of these repetitive cyclical financial crises.

Even though securitization could provide enormous advantages to the capital markets in the GCC, even though securitization and especially Tasneed presents opportunities to invest in accordance with Shariah directives, and even though Tasneed can help ensure that "it will not happen here", securitization is not a visible part of the GCC capital markets.

Even the latest proposed rescue package for investment companies here in Kuwait would present a perfect opportunity for the Kuwaiti government to pool these assets into securities and sell them as rated, tradable sukuk.

The reason Tasneed or even conventional securitization is not common in the capital markets of the GCC is due to the lack of legal infrastructure. Securitization requires a careful, precise and thorough set of laws to provide the safety and protection to investors. There are several legal requirements that are necessary:

1) Security interest of assets must be transferred to the investors.
2) Security interest in the assets must be enforced.
3) There must be a Special Purpose Vehicle (SPV) legal entity.
4) There must be a "True Sale" of assets to the SPV.
5) There must be bankruptcy remoteness of the SPV from the asset originator.

The legal infrastructure that provides for these requirements is either missing or imperfect. The legal infrastructure of the GCC can no longer remain ambiguous and hazy in this area.

These legal principles are necessary to improve the capital markets in the GCC. They are required for both Shariah and conventional finance to grow.

These principles are no doubt more important for Shariah finance but they are in no way meant to favor Shariah finance over conventional finance. It is the simplicity and transparency that makes Shariah finance competitive with conventional finance. But the reason that Rasameel believes that Shariah finance will play are larger role in the future of the GCC capital markets is:

"The corner stone of conventional finance is the interest rate, the cornerstone of Shariah finance is fairness."

A wide range of capital market instruments with various characteristics is essential in meeting the demands and requirements of investors and businesses. The GCC is missing many of these capital market instruments. Thus, Rasameel Structured Finance is announcing the formation of a committee to propose and recommend improvements in the capital markets legislation in Kuwait. We call upon all parties, representatives of commercial, industrial, and investor interests as well as government regulators, Parliament members and members of the financial community to join us. The result of our collective efforts will be capital market legislation that will provide a sound, strong foundation for the financial growth of Kuwait and the GCC and to ensure that "it won't happen here".