Islamic Default

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Interest-free ‘sukak’ bonds at first withstood the economic crisis, but Dubai’s Nakheel default has hurt their reputation
By Lorne Cutler

With $25-billion in Dubai debt potentially in default, much of it on the spectacular Palm Jumeirah – the palm-shaped island off this Middle East emirate --
the ramifications of Dubai’s debt problems go far beyond the potential for global contagion. A default will also test the true nature and performance of Islamic financing under stress. This critical area to watch has never really been tested before.


Islamic financing has been growing rapidly in importance in many Muslim
countries as well as in Western countries with large Muslim
populations. With almost a trillion dollars in assets worldwide,
Islamic financing has attracted the interest of Islamic banks and
conventional banks alike, particularly in Dubai.

Dubai
World (DW) is the holding company for the business assets of the
Government of Dubai. While most of the debt incurred by DW and its
subsidiaries was conventional, a significant amount was Shariah
compliant. Of DW’s $60-billion in debt, Nakheel, one of Dubai’s largest
real estate developers, issued $5.2-billion in Islamic bonds of which
$3.5-billion is due this month. Nakheel and DW are not able to pay this
debt and are trying to reschedule.

As interest is not
allowed under Islamic law, three broad financing structures have been
developed by Islamic scholars, all involving bank purchases of the
goods that the buyer wishes to procure. The bank will then either
resell the goods to the buyer (Murabaha), lease them to the buyer
(Ijarah), or go into partnership with the buyer with the bank putting
up the money and getting a return only if the venture is profitable
(Musharaka). While lenders have modified these structures to minimize
their exposure to the underlying commercial transaction, Islamic loans
must obtain the approval of Islamic scholars. It is often controversial
as to what structures are truly Shariah compliant.

The sukuk
or Islamic bond was further developed to facilitate Islamic financing.
This instrument allows the debt to be securitized and syndicated, while
the underlying financing must follow one of the acceptable Islamic
structures. Sukuks are traded on the Nasdaq Dubai exchange. Elaborate
sukuks have been developed to mitigate risk and provide returns similar
to that of conventional interest-bearing loans.

Existing
Nakheel assets were sold to a special purpose vehicle (SPV) and the
assets were then leased back to Nakheel. The SPV raised the funds to
buy the assets by issuing lease-based sukuks. The proceeds of the sukuk
were used to fund construction of the Palm and the sukuk holders were
to be paid out of Nakheel’s lease payments to the SPV.

The
major strength of sukuks was also their major weakness. There had been
no history of sukuk defaults. While this was very reassuring to lenders
it also meant that there was no experience as to how the Dubai courts
would treat a sukuk in default.

The potential default of
Nakheel’s sukuk raises key issues for both sukuk holders and proponents
of Islamic financing. While structured according to Shariah law, sukuks
are typically governed by U.K. law and international arbitration. There
is no experience as to how the courts of Dubai will view these bonds
and whether U.K. or Shariah law will take precedence. The prospectus
warned that the Dubai courts are not bound to enforce U.K. judgments
without re-examining the merits of the case and may not consider U.K.
law as the governing law. If Islamic lenders are supposed to risk
share with the borrower, the courts may consider Islamic loans lower
priority to Nakheel’s or DW’s conventional debt. Lenders would probably
rather see these loans restructured than be pursued through the
courts. Acceptance of DW’s waiver of sovereign immunity also needs to
be watched.

Different Islamic scholars have different
interpretations of what is permissible under Shariah law. Nakheel’s
sukuk was approved by the Dubai Islamic Bank’s Shariah board. It is not
known, however, as to how the Dubai courts would react should some
other Islamic scholars come forward and make a case that the loans were
never Shariah compliant. Nakheel’s sukuks were secured by existing real
estate developments and land. Even if this security is enforceable,
with the 50% decline in real estate values in Dubai, the security is
not worth what it once was. If the sukuk structure and security cannot
stand up in court, Dubai’s ability to attract conventional and Islamic
financing will be jeopardized.

The other challenges posed by
the current situation are to the religious scholars. Islamic scholars
tend to view Islamic financing as being morally superior to
conventional financing due to its prohibitions against interest and the
taking of undue risk. As last year’s banking crisis for the most part
bypassed Islamic banks, this sense of Islamic financing’s moral
superiority was reinforced for many.

The default of Nakheel’s
sukuk clearly shows that Islamic banks are not immune to taking undue
risk and conducting insufficient due diligence. While real estate
bubbles can form anywhere, Dubai’s was more obvious than most. Islamic
lenders were no different than conventional lenders in ignoring the
growing real estate bubble and will now have to re-evaluate their
perception of risk the same as conventional lenders. Such reflection
may result in a shift to musharaka financing structures which are often
considered to be more acceptable by Islamic scholars. The risk of
default is lessened as debt payments are only due if the venture is
profitable but the risk of loss is higher. If this reduces the use of
less risky murahabas and ijarahs, Islamic banks could lend less and be
less profitable.

Regardless of the outcome of the Dubai debt
crisis, this crisis will force changes in how both conventional and
Islamic banks consider risk in Shariah financing.

Financial Post
lacutler1@hotmail.com
Lorne Cutler is an Ottawa-based independent financial consultant.


Photo: The Burj Dubai, man’s tallest structure: There’s never been a default of interest-free debt. Which means there’s no precedent. (Getty Images)

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