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Thursday, 16 October 2008

Legal Frameworks Need Adjustments to Support Growth in Mortgage Markets

IN RECENT years the economies of many Middle East countries have expanded at a record pace. In particular, countries of the Gulf Cooperation Council such as Bahrain, Kuwait, Saudi Arabia and the United Arab Emirates, have undergone unprecedented growth. The real estate markets have been a primary growth sector within the region, which in turn has led to advances in the mortgage industry.
A stable mortgage market is a key underpinning to a healthy economy. It not only strengthens middle classes, but also has ripple effects on the economy, leading to increased demand for construction materials, appliances, consumer goods and other related services. The mortgage market also serves to bolster banking systems and spur the creation of secondary markets. In the United States, for example, banks have historically invested in mortgages and mortgage backed assets as a cornerstone of their treasury management. In addition, the availability of mortgage products led to steady increases in home ownership and real estate values.
Continued growth in the GCC real estate and mortgage markets, and overall economies, will require a broader base of market capital from private institutions and secondary market investors. Institutional interest in mortgage assets requires confidence that stable and transparent mortgage finance laws and regulations are in place to protect investor cash flows and principal investments.

A Secondary Market for Mortgage Assets

A key factor for the advancement of the mortgage industry in the GCC is the creation of stable secondary markets for the sale and trading of mortgages. As a result of the constriction of the mortgage backed securities market and the demise of bulge bracket investment banks in the United States, securitisations have come to a stand still worldwide. Nonetheless within the context of the GCC, and particularly Shari’ah compliant finance, the long term growth of secondary mortgage markets is predicated upon the successful issuance of asset backed sukuk.
When assessing the potential for sustained growth in the secondary mortgage market through sukuk or whole sales of mortgage asset portfolios, certain legal and regulatory issues are at the forefront. For example, the primary hurdle to mortgage sukuk growth in the GCC has been the uncertainties associated with the region’s developing legal framework. The legal issues that are typically analysed in any securitisation are particularly scrutinised when a transaction takes place in a developing marketplace. Investors tend to shy away from jurisdictions with untested mortgage and foreclosure laws, and where there is a lack of securitisation related precedents.
The vast majority of sukuk issued from the GCC so far have depended on full credit enhancement mechanisms. Reliance on full credit enhancements raises the question of whether a ‘true sale’ can be accomplished within a sukuk context. A genuine true sale occurs when the underlying collateral supporting a securitisation has been validly transferred to a special purpose vehicle (SPV). Further, this transfer cannot be re-characterised as a secured loan or otherwise avoided in the case of an insolvency of the originator. To date several purely asset based sukuk have been issued, but no sukuk issuances have been true sale securitisations. Most sukuk today entail credit enhancements in the form of guarantees by rated companies and purchase/buyback undertakings by the originator. Effectively, the ratings that are assigned to asset based sukuk that are not true sales will only be as good as the credit enhancements that are tied to the sukuk issuance. This means that the rating is weak linked to the supporting credit enhancement and not the underlying pool of assets as in true sale securitisations.
Recently, these sukuk credit enhancement mechanisms have also been challenged on Shariah compliance grounds. In order for an asset backed sukuk to be Shariah compliant the risk associated with the performance of the asset must be transferred to sukuk holders. Earlier this year Sheikh Taqi Usmani stated that certain sukuk were in breach of Shariah principles because they provided the issuer with an obligation to buy back the underlying assets from the sukuk holders at face value at the expiration of the sukuk or in the event of a default. In other words, similar to a true sale analysis, in order for an asset based sukuk to be Shariah compliant, risk must be tied to the underlying assets not the credit worthiness of the issuer.
In the United States, Zayan Finance has successfully established a Shariah compliant commercial mortgage origination platform that allows for a true sale securitisation of assets originated under the Musharakah Mutanaqisa (declining partnership) model of Islamic finance. The structure was created under the purview of rating agencies and is specifically designed to meet industry requirements for REMIC (Real Estate Mortgage Investment Conduit) tax treatment as well as satisfy bankruptcy laws associated with substantive consolidation while at the same time maintaining Shariah compliance. Considering the fact that western countries have well established legal frameworks to support securitisation, it is highly likely that a steady flow of true sale mortgage sukuk from outside of the GCC may precede the establishment of a local secondary mortgage market. Nonetheless, GCC capital markets would be the long term benefactors from seeing Shariah compliant true sale securitisations happen.

Foreclosure Laws and Principles for Mitigating Delinquencies

The advancement of foreclosure laws and the enhancement of delinquency related penalties will also serve to bolster secondary markets for the GCC mortgage industry. Two primary concerns for secondary market investors, whether in the context of securitisation or through whole sales of mortgage assets, are recourse in the event of default, and the likelihood of receiving a consistent and timely payment stream from the underlying assets. Although large scale write downs of mortgage assets linked to payment defaults have recently caused unprecedented upheaval in the U.S. and other economies, the ability of lenders to foreclose on distressed assets has been routine and, in most cases, has allowed lenders to recover at least some portion of their losses.
Having a clear and predictable course of action in cases of default allows financiers to adequately assess investment risk. When a foreclosed property sells for less than what is owed, the financier suffers a loss. The amount of that loss is known as the “loss severity.” Loss severity determinations are a critical component in secondary market investor analyses. Key elements affecting loss severity are the cost of foreclosure proceedings and the time required to gain possession and liquidate defaulted assets. Lengthy foreclosure proceedings are detrimental to financiers since debt coverage payments are not received during the foreclosure process and because in most instances the value of the property will diminish with the passing of time. Accordingly, the speed and efficiency with which the mortgaged real estate is liquidated has a direct bearing on mitigating losses and decreasing the loss severity. In the United States each state has its own foreclosure laws. A particular state’s foreclosure laws fall into one of two categories: judicial foreclosure or non-judicial foreclosure. Judicial foreclosure often involves a lengthy process in which courts oversee the foreclosure process. On the other hand, non-judicial foreclosure proceedings allow the creditor to initiate foreclosure through a power of sale clause contained within the mortgage documents without initiating judicial proceedings. Historically mortgage lenders have experienced lower loan losses in states with non judicial foreclosure laws than in states with judicial foreclosure laws because of the ability to liquidate foreclosed properties in a more timely fashion.
The absence of clear and efficient foreclosure laws will adversely effect the development of mortgage markets in the GCC. The current legal frameworks in GCC countries offer considerable leniency towards consumers in loan default scenarios and very little by way of protection for creditors. In Bahrain for example, which is generally considered one of the leading financial centers in the GCC, the concept of a mortgage security is recognised and there is a reliable system in place for recording security instruments adding a level of protection for financiers. Bahrain’s laws outline the legal framework for the creation of mortgages and give mortgage financiers priority in recovering payment over other creditors. The procedure for foreclosure, however, is not well established. Currently, Bahraini law does not address a financier’s right to repossess a property in the case of default for nonpayment.
The most effective way for GCC financiers to curtail mortgage default losses will be through the enactment of clear legislation that: 1) enforces the application of contractually created power of sale clauses in mortgage documents, 2) crystallises the right of financiers to foreclose on defaulted mortgages, and 3) lays out a detailed and objective process of effectuating a foreclosure through either judicial or non-judicial proceedings.
Mortgage delinquency is also a key concern for secondary market investors. In most cases payment delinquency is a precursor to an eventual default. However in the GCC this is not always the case. In Saudi Arabia, for example, the lack of specific delinquency deterrents and reluctance by courts to allow property foreclosures has resulted in consumer neglect in making timely payments. Saudi Arabia recently enacted a number of mortgage related legislation reforms to support the growing mortgage market and to establish a systematic application of judicial authority. Whether or not the newly enacted legislation will provide adequate attention to foreclosure policies and procedures remains to be seen. Also, the recent establishment of the Saudi Credit Bureau (SIMAH) stands to mitigate the instances of delinquency and default by aggregating credit related information to provide financiers with an objective risk profile of customers, which should have a positive effect on consumer payment habits.
In the context of Shariah based transactions certain contractual provisions may be put in place to deter delinquencies. It is a well settled Shariah principle that late payment penalties which serve to create additional revenue for financiers are tantamount to riba and are therefore prohibited. However, certain Shariah scholars have approved delinquency deterrence mechanisms which trigger the payment of a fee in the event instalment payments are not received by a specific date. The financier, however, must expunge the late payment fee it receives (after deducting its actual costs incurred as a result of the late payment) by donating it to charity on behalf of the consumer. Another Shariah compliant delinquency deterrent, developed by Zayan Finance in the U.S. in the context of commercial mortgages, is the creation of a default fund which is held by the financier for the benefit of the consumer.
In the event the consumer fails to make timely payments or is otherwise in default under the terms of the financing, a fee is charged to the consumer and when collected is placed into an escrow account.
Once the consumer cures the default the escrowed amounts are returned. If the consumer fails to cure the default, the amounts charged (to the extent they are collected) are donated to charity. By adopting deterrent based delinquency provisions in financing contracts that are substantive and are likely to be enforced by the courts, GCC mortgage originators will serve to curtail lax attitudes towards payment in consumers, which will in turn foster more direct investment by secondary market investors.
In recent years, legal systems in many GCC countries have experienced progressive change and development. The trend has been to enact legislation and increase regulation in order to create stability in the mortgage market and to replace disparate and discretionary judicial authority with more predictable legal outcomes.
It is critical for the development of the GCC mortgage industry that this trend continues. An aggressive yet methodical expansion of mortgage laws and regulations will serve to broaden secondary market activities particularly by foreign investors who will perceive these changes as decreasing risk and unpredictability and increasing more systematic legal protections for investors.
This report was prepared and contributed by Maksudul Islam, Nasser Nubani, Wahid Sarij and Farrukh Siddiqui of Capitas Group LLC, a New York headquartered firm with a track record of successfully establishing Shari’ah compliant specialty finance businesses and is the parent company of Zayan Finance LLC.

(Khaleej Times)

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