Workshop Securitization: The Islamic Way May 11-15, 2008 Dubai Talal Abu-Ghazaleh Professional Training Group (TAGITraining) Presents A to Z of the Securitization: The Islamic Way Ghassem A. Homaifar Professor of Financial Economics Middle Tennessee State University & Mahmoud Haddad Professor of Finance University of Tennessee at Martin

A to Z of The Securitization in Islamic Countries Introduction Major Players Rating Agency’s Function in a Typical Securitization Credit Enhancement External Credit Enhancements Internal Credit Enhancements Over- collateralization Senior/Subordinated Structure Dynamics of Underwriting Process Requirements for Successful Securitization Secondary Market Provider Benefits of Securitization Cost of Securitization Fixed and Variable Costs of Securitization Case Study

Financial Engineering Process Characteristics of Assets to Be Securitized Structure of the Assets Created in a Securitization Process Residential Mortgage Backed Securities RMBS Commercial Mortgage Backed Securities CMBS Legal and Structural Issues Sale Accounting Sales of Loan Assignment Participation Case Study

Algorithm of Securitization Legal Framework Macro Economics of Securitization Implications Construction of Monthly Cash Flow for Pass-through Securities Multi Class Sequential-Pay Pass-through Creating Floater and Inverse Floater Creating Commodity based Accrual Bonds (zero coupon) Cross Border Securitization Case Study

Future Flow Securitization Characteristics of Future Flow Securitization Mitigating Risk in Future Flow Securitization Transactions: Performance risk Product risk Sovereign risk Diversion risk High Inflation Lost Purchasing Power Sharp Currency Depreciation Loan Performance Deterioration Case Study

Synthetic Securitization Credit-Linked Notes Synthetic Collateralized Loan Obligations Objectives of Structuring CLO Synthetic CLO Synthetic Arbitrage CLO Synthetic Balance Sheet CLO Capital Adequacy Requirements Credit Exposure Method Total Return Swaps Leverage Impact of Capital Structure on Bank Balance Sheet Case Study

Islamic Financial Instruments Islamic CDs Preserves purchasing power Risk free Does not require partnership in the spirit of Sukuk Provides returns in excess of inflation premium It is close cousin to TIPs issued by U.S. Treasury

Islamic Certificate of Deposit (ICD) Investors have to be compensated: 1. For the loss of purchasing power 2. For the time value of money Therefore, in an Islamic setting where interest (Reba) is forbidden, conventional CDs can not be offered by an Islamic bank. Islamic CDs of varying maturities can mitigate problems embedded in the conventional CDs.

Pay off of ICD Investors will be compensated investing in the ICD in the following two ways: 1. NP(CPI t /CPI t-1 ), where CPI is the consumer price index at time t and t-1, NP is the notional principal invested. 2. Max (NP*w t * (P t - P t-1 )/P t-1, 0) Where P is the price of a commodity at time t and t-1, i.e., oil price, gold price, stock price…. and w t is the percentage that is an increasing function of time t taking values of up to 100 percent at the limit.

Continued Criteria # 1 insures that investors purchasing power is maintained, consistent with the Islamic Sharia (Al-kailabo bel kail), Criteria 2 insures that investors pay off is either zero or positive in excess of the loss of purchasing power.

Example Consider an Islamic investor in SA who invests 20,000 Dinnar over one year horizon in a 1- year ICD. Assume that consumer price index is equal to 175 at the time of investment and after one year. Furthermore assume that the SA stock index is at 715 at the time of investment and by the end of the year. The pay-off of the ISD for our hypothetical investors is as follows: 20000(185.5/175)=D 21, *.15*.10 = D Total pay-off= D 21,500.00

Example continued Realized return=.075 6% for the loss of purchasing power 1.5 percent in the form of appreciation in the price of commodity assuming bank passed 15 percent of the appreciation to the investor in a completely riskless transaction.

2-Year ISD Likewise in a 2-year ICD, in the same example assuming CPI increased by 4 percent in the second year, while stock index retreated to 860 by the end of the second year. The pay-off of 2-year ISD will be as follows assuming the bank funnels 20 percent of the increase in the price of the commodity to investors. 1. Year 1 pay-off= D D1200 for the loss of PP D300 for the appreciation of the commodity price 2. Year 2 Pay-off = D 800 for the loss of PP Zero for the decrease in the price of commodity Plus initial investment of D20,000. Total pay of 2-y ICD= D22, Total return = 11.5 percent over 2-year investment horizon