Today there was a flurry of activity on Nasdaq Dubai around IIG.
First, the Exchange suspended IIG's US$200 million sukuk.
Then, IIG Funding issued an announcement on the default on the Periodic Distribution Payment ("interest") on its Sukuk along with the canonical words that a payment default of more than three business days constitutes a Dissolution Event. That gives the certificateholders the right to vote and if enough of them vote positively (at least 25%), the maturity of the issue is accelerated.
You will notice that IIG Funding's announcement neatly skirts another potential Dissolution Event from Section 13 (e) of the Offering Memorandum. I've highlighted the relevant section in blue italics.
either (i) the Issuer becomes insolvent or is unable to pay its debts as they fall due; (ii) an administrator or liquidator of the whole or substantially the whole of the undertaking, assets and revenues of the Issuer is appointed (or application for any such appointment is made); (iii) the Issuer takes any action for a readjustment or deferment of any of its obligations or makes a general assignment or an arrangement or composition with or for the benefit of its creditors or declares a moratorium in respect of any of its indebtedness or any guarantee of any indebtedness given by it; (iv) the Issuer ceases or threatens to cease to carry on all or substantially the whole of its business (otherwise than for the purposes of or pursuant to an amalgamation, reorganisation or restructuring whilst solvent); or
A glance at IIG's 30 September 2009 summary financials (the latest issued) suggests that the Sukuk represents roughly 85% of IIG's borrowings.
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4 comments:
I just had a chance to flip through the offering circular for this sukuk and saw your post about the IIG conditions of the dissolution event.
I had a few thoughts when I was reading the offering circular; I'd be interested to hear if you had thoughts as well.
1) When the sukuk was issued for $200 million (KWD 58 million), the company's balance sheet contained only KWD 144 million and generated profits of $79 million (KWD 23 million), compared to about $12.9 million in annual periodic distribution amounts.
2) The projects that were being financed were real estate and other relatively speculative investments. Yet the coupon was only 6.45% (pre-financial crisis search for yield).
With the initial notice of default occurring in January 2010 (the company made a late payment of a periodic distribution amount) occurring after an adverse judgment against the company combined with fallout from the financial crisis, the company's equity and cash was largely depleted.
In addition, the sukuk contained a share pledge of shares greater than the value of the sukuk which IIG could trade (as long as the value didn't fall below 105% of the sukuk value). This seems to be a "heads I win, tails you lose" situation. They could make bets; even day trade (up to 10% of the portfolio daily). If the value collapses, they can no longer trade it, but if it rises, they would presumably receive the profits.
This seems to be an ill-conceived sukuk structured for the benefit of the IIG with payout for investors if things went well with all the burden on them if it didn't. The share pledge loses value, the certificate holders become unsecured creditors and the case goes to court. Given that it was issued months before the financial crisis began in the US (issued June 2007), it doesn't seem to have any bearing on the Islamic finance industry in general; just another example of projecting history into the future and a 'go-go' attitude towards risk.
Blake
Thanks for your post.
You raise some interesting questions.
By way of intro, I would consider IIG's offering to be non investment grade for a variety of reasons, including those you mention.
And also my answer contains a lot more detail than required for a discussion with you. That's intended for anyone else who may stumble upon this post. (Which statement in itself may be an indication of some irrational exuberance on my part).
Let's start where I usually prefer to - the macro picture.
At the time IIG's sukuk was issued HY spreads were extremely low. In fact June 2007 was one of the lowest on record. One might say irrationally low. Depending on the source, one gets figures of 240 to 260 basis points.
The typical "historical" average of HY spreads usually cited are Altman with 525 bp and others closer to 600.
Altman I believe prices over the 10 year Treasury. Some others use constant maturities for the average life of the security (principal only considered).
Right there it's clear that the market has fundamentally mispriced risk on a macro level.
Within that context what can we say about IIG's pricing?
Again some macro comments ignoring the deal specifics to see if the deal was in the "ballpark".
When IIG's issue was priced there was a 7 to 8 bp spread between the 5 and 10 year - which I will conveniently ignore -using the 5 year of about 460bps - another "convenient" rounding of mid month levels when I assume (but don't know) the deal was priced.
That would make an average HY coupon of 710 bps (using the mid point of the range for June 2007 HY spread). IIG came in at 675 - more or less 35 bps under the theoretical average level.
Besides the obvious comment that deals are specific not average - what could account for the pricing?
IIG's issue wasn't a straight bond.
Several features which affected the yield.
(1) Collateral (more on that later).
(2) Embedded options: convertible to common equity at US$1.73 share, putable (one year prior to maturity) and callable.
Other factors:
(1)first time issuer premium,
(2) market exuberance at an "Islamic" deal.
So for the market of the day, IIG appears not to have been mispriced - at a macro level.
Now to the micro.
Part 1 of 2
(1) IIG Financials: Taking assets at face value, the leverage doesn’t seem unreasonable. What caught my eye is the bulk of income was non cash fair value changes. There's no real cash flow from operations in 2006 or 2007. But real cash expenses are being incurred – including the now heavier interest burden. Other cash outflows are cash dividends. And the company is merrily trading its own (treasury) stock. It's hard to see what economic purpose the latter serves - except to prop up its price.
Future earnings and ability to service debt seems to be predicated on increasing asset values in a market known for its volatility in both valuation and liquidity. That leaves asset sales (where the same two considerations apply) or rotation of creditors.
(2) Indeed, these activities are risky. Their nature and IIG’s financial profile (Point #1 above) suggest some structural changes to the transaction (chiefly a lower borrowing base) assuming that the transaction could pass market and management screens.
Unlike many Sukuk, this one actually had pledged collateral. It’s unclear if that was motivated by credit concerns or a desire to “fit” the transaction into an “Islamic” framework.
On the collateral, there are two main sorts of issues.
The first of these is legal risks. The Offering Circular lays these out pretty nicely. Page 21 re title to real estate. Page 29 re the securities pledge. Page 29 re bankruptcy. One only has to think of the saga of the Commercial Bank of Kuwait and its attempt to take unclouded ownership of the Boubyan Bank shares (from the failed TID repo) to realize that realizing collateral isn’t particularly easy. During a legally prolonged wait to dispose marketable securities, prices may move dramatically and not always upwards.
Another concern should be the integrity of collateral values. There is a lot of froth in the KSE. And regulation/supervision of the market is considered inadequate. Hence, the recent capital markets supervision law. It’s pretty well known that there are investment “blocs” that co-ordinate buying and selling among their members to influence market prices. Often they “invest” in each other’s shares – an activity that can at times be used to influence their security prices. Kuwaiti banks are by and large asset based lenders not cashflow. As paper values increase, their real loans often do: “There’s more collateral”.
The problem is that if such a group hits a wall, they’re no longer able to maintain these market interventions. Unsupported asset prices can collapse rather quickly – leaving the erstwhile “secured” lender particularly insecure.
(3) Structure: As to structure, at least on a contractual promise basis, the issuer (really the obligor when one strips away the façade) has agreed to absorb 100% of the downside in return for 100% of the upside above the contractual interest payment. The investors have willing given away that share of the upside to opt out of the downside – in effect selling a call and buying a put.
While there are situations where the investors are left holding the bag, there are also a whole range of outcomes where the portfolio can lose money and they remain whole. If income is zero (the portfolio’s value remains stable - no dividends), the obligor will pay the “interest”. If the portfolio drops a certain percentage (say 10%), the obligor would probably pay “interest” and the “principal”. It’s only when the loss is too deep that he defaults on his obligation. At that point, the collateral serves – at least it’s hoped – to put a floor under that loss.
Part 2 of 2
Looks like a duck, walks like a duck, quacks like a duck. It’s a debt instrument. Money on money return. Credit risk substituted for business risk (on a contractual basis). That I believe was Sh. Usmani’s point.
In the non Shari’ah world, loans to support stock market portfolios are not uncommon. In these cases, the lender gets none of the upside. If the market crashes, the lender may be left holding stocks worth less than his loan. And in some dire cases worthless. I don’t see a real difference to the IIG Sukuk.
However, these non Shari’ah structures are generally tighter. At one end are margin loans for individuals. Short tenors. Lower borrowing base. Strict limitations on permitted investments. Daily marks. Margin calls and prompt liquidation for failure to cover. Then there less tight structures for larger legal entity borrowers. But ideally calibrated to market volatility, liquidity of holdings with a safety margin built in.
For the Kuwait, KSE and IIG, the IIG Sukuk structure seem less than robust. Maybe the unspoken element here was an acceptance of a good deal of unsecured risk with the collateral structure a conveniently “Islamic” structure.
One might have thought then that the mudarabah would be a separate legal entity holding the assets (a trust arrangement) with IIG as a fund manager – not part of IIG’s estate.
(4) Islamic Finance: In one sense, there is no reason of course why a distressed transaction necessarily reflects badly on “Islamic” finance. Muslims are not innately superior in conducting business to other groups. So there will be losses.
However, as distress occurs, transactions are scrutinized in more detail. This is where the problem has occurred. If transactions seem at variance with Shari’ah -- more Abu Yusuf tricks than legitimate structures-- questions and criticism will arise.
Individual devices like the reverse engineering of the periodic profit distribution on Golden Belt with no reference to the economic value of the property. More importantly structures which eliminate contractually the investor/lender’s exposure to the left hand side of the returns distribution. And perhaps even those which limit his share of the right hand side to a percentage independent of business performance.
In this transaction, the original share of profit is 99% to the rabb al mal (investors) and 1% to the mudarib. But once the funds allocated to the rabb al mal have paid the periodic distribution amount, anything remaining goes back to the mudarib.
One doesn’t have to strain one’s eyes to see two legs of the contractum trinius. With the third leg the repurchase obligation.
والله اعلم
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