Friday, May 27, 2005

Muslim middle classes and the truly needed Sukuk

Yesterday on, the structure of a new "Sukuk" issuance (Sukuk is the plural of Sakk, meaning "bond" or "certificate", a synonym of the Arabic word "sanad", which is commonly used for conventional bonds) was shown as follows (almost all of those lease-based structures look alike -- one can discuss juristic problems with those structures, but that is not my purpose in this blog):

Now one can see a benefit in issuing only bonds that are secured by some underlying assets. This would ensure that the issuing agency can only borrow up to the current market value of its assets, which reduces the chances of bankruptcy. Moreover, the lease structure may in fact impose a "marking to market" discipline, by linking the interest rate paid on those bonds to the actual rental cost of comparable properties, thus ensuring fairness and economic sense of all completed transactions of this form.

In reality, however, many governments and corporations that issue those sukuk also issue regular bonds, thus being exposed to potential bankruptcy. Moreover, the interest rate masked as lease payments is benchmarked to LIBOR, with a risk-premium based on the issuing country or agency's credit rating (betraying domination of "Islamic finance" by a group of London bankers, who think of everything in terms of the opportunity cost via London inter-bank loans). Thus, the solvency and marking to market advantages of having a real economic transaction (lease) underlying the bond issuance are in fact squandered.

It is very instructive in this regard to read S&P's analysis of the Qatar Global Sukuk (available on the S&P website), which were also lease based. The S&P analysts showed that the risk structure of the Sukuk is identical to that of conventional bonds -- even destruction of the leased property thorugh an act of God would be a dissolution event requiring the lessee to make the rest of its payments as promised! In other words, there is no lease at all: it's a charade, the only beneficials from which are the lawyers who structured the deal, the investment bankers who collected its fees, and the jurists who gave it its stamp of approval.

This brings me to a much more serious problem with Islamic finance: Are there any deals done in that industry that couldn't have been done otherwise? It seems that everytime one inspects any Islamic finance deal in some detail, one discovers that it merely replicates an already existing financial product or service at a higher cost. Is that all Islamic finance can offer?

Let's look at Muslim societies: Their biggest problem is the striking absence of a thriving middle class (in some countries, no indigenous middle class ever developed, and in others, it has been eroding very quickly). The vast majority of Muslims who can form the middle classes of those countries are in dire need for credit to avoid falling into (or staying in) poverty, and yet banks that are swimming in excess liquidity can't think of any better role to play than investing in various high-yielding bonds... And if the bank is called "Islamic", then let's just create an "Islamic bond" for it, mimicking the same risk and yield structure of conventional bonds... In other words, there is a fundamental crisis of financial disintermediation in Islamic societies, and "Islamic finance" has not -- to date -- done much to solve this problem.

The bond/Sakk needed in those societies is a different one: a new social contract that allows banks not only to serve as depositaries of funds, but also to extend credit to the shrinking and potential middle classes of their respective societies. Micro-lending is not the solution (I'll have to get to that in a separate posting), it is only a stop-gap measure for immediate poverty alleviation. What are needed are networks of intermediary credit institutions to fill the gaps between banks (be they Islamic or conventional) and the general public. I am proposing the use of mutual savings banks and credit unions to fill that gap in my paper under construction: "Mutuality as an Anti-dote to Rent-Seeking Shari`a-Arbitrage in Islamic Finance".

Before anyone objects to this proposal, note that all Islamic banks do at any rate is serve as intermediaries between conventional multinational financial institutions (be they mother banks, as in the case of HSBC, or otherwise) and "Islamic" structures offered to various customers. A similar or better structure can be built to appeal to the increasing religiousity of potential or barely surviving Muslim middle classes, to channel credit to them in Islamically accepted ways (which would also make economic sense by ensuring solvency and fairness through marking to market).

The structure is not yet very clear (more research is needed) but a model of Islamic Credit Unions at syndicates, labor unions, and other structures that are currently dominated by incresingly religious Muslim memberships, seems workable. It would help to formalize the existing informal credit structures used only in emergency situations, and allow the Muslim middle classes to develop a culture of thrift and investment that can make them economically sustainable. In the meantime, larger banks (Islamic or otherwise) can serve as wholesalers for those networks of credit unions, and we have seen how trivial it is to "Islamize" that securitization part of finance... First, however, we need to develop a useful Islamic finance for the betterment of Muslim societies.

Thursday, May 26, 2005

Near-fraudulent marketing of "Islamic Hedge Funds"

On 28 October 2004, Mr. Yusuf Talal DeLorenzo (identified as "Shariah Supervisor and Director, Yasaar Ltd., London, and Executive Representative to the Shariah Board of the Shariah Equity Opportunity Fund Ltd.") wrote a thinly veiled advertisement piece for the "Islamic hedge fund" that retains his services. In that article/ad, published on, he wrote:

In the hedge fund industry, the preservation of capital is rule number one. It is unfortunate that many people have the impression that hedge funds are about speculation and wild rides on Wall Street. Nothing could be further from the truth. The fundamental principle of hedge funds is that every trade, every move is calculated to preserve capital. The name itself, hedge, is indicative of this fundamental principle. (The Arabic word for the same, tahawwut, is equally indicative of this fact.) In most cases, there is more risk in an ordinary mutual fund than in any hedge fund. For most hedge funds, slow and steady wins the race. Typically, however, it is not the slow and steady horses that catch the eye of the public! Finally, the true nature of a hedge fund is to protect against gambling and speculation, even when others in the marketplace are doing so. So, to equate hedging with gharar is clearly a mistake.

At first, I assumed that this verbal confusion of "hege fund" vs. "hedging" was a function of Mr. Delorenzo's limited financial sophistication. However, I was surprised at a conference in Manama, Bahrain, when Dr. M. Daud Bakar, also retained by the "Islamic hedge fund", continued to play on this verbal confusion. I was on the same panel, and tried repeatedly to explain that while hedge funds have their place in the portfolios of high net worth individuals and institutional investors, they must be understood for what they are: high-risk high-return vehicles that rely on leverage to produce high expected returns. However, Dr. Bakar continued to claim that "hedge funds" are hedging mechanisms. To my surprise, one member of the audience (who represented some investors) said afterwards that he was confused by my remarks: "How could hedge funds be about anything other than hedging?", he asked. Given the repeated attempt to explain the reality of hedge funds, and the repeated insistance on confusing the issue by "Shari`a scholars", I have no choice but to suspect that this is a case of willful fraudulent advertisement to unsophisticated investors: something that would not be tolerated in the developed world.

Interestingly, I also saw a presentation in Istanbul by the actual provider of this hedge fund, Mr. Eric Meyer. He was more careful not to say anything that could get him into legal trouble. However, he did manage to show a slide that claimed historical "higher returns with lower risk". Of course, he did not point out the well-documented reporting/selectivity bias in hedge fund returns and risks (those that fail are dropped from the sample). For more information on this and related issues, see my presentation at the aforementioned Bahrain conference: "Hedge funds: Regulatory (including Shari`a) issues".

Piety vs. bias

This is my first posting to initiate this blog, containing my thoughts on Islam, Muslims and economics. The main problem I have seen in other Muslims' approaches to this class of topics is confusion between piety and bias. While many Muslims can make perfect sense to non-Muslims when they speak "from a secular viewpoint", they make much less sense once they talk about Islam, Muslim societies, and issues related to economics and finance. I do not accept the paradigm that piety precludes making sense to others.

Since I am an economist by training and profession, I shall post periodic thoughts to this blog, mainly as responses to news about latest developments in Muslim societies, and especially in the area of Islamic finance -- where much fanfare has become the norm. This blog clearly cannot be a substitute for serious academic research on the topic. For my academic writings, consult my CV, posted to my website. A number of papers and powerpoint presentations are also posted on the website.