International Investing Guide - Don't Call It Interest
Richard C. Morais

July 23, 2007

How does a God-fearing Muslim finance a gas well? With sort of a sale-leaseback.

If you are a devout Muslim, you can't invest in a company that produces alcohol or pork. The Koran forbids interest, so a conventional home mortgage is verboten. So would be a debt-financed business asset. You can't use derivatives or buy into conventional hedge funds.

It's a tricky business to participate in a modern economy without running afoul of sharia, or Islamic law. But it can be done. For a fee you can get a consultant to arrange financial transactions that would pass muster with Allah. There may be extra steps or additional paperwork, but sometimes the outcome is the same as you'd get without sharia.

Big money is at stake. Moody's says $800 billion is available for investing in sharia-compliant assets. UBS, HSBC, Barclays, Deutsche Bank, Standard Chartered, AIG, Lloyds TSB, Morgan Stanley and Swiss Re are some of the Western financial institutions rushing sharia-compliant financial products to market.

How does one put that kind of money to work without breaking the rule on usury, given how ubiquitous interest is? A little creativity helps. Almost any hedge fund is off-limits, because of the genre's anything-goes investing style. So you don't buy a hedge fund, you buy a "structured note," whose return is tied to an index of hedge funds. Just such a product was introduced in June by Dubai Islamic Bank, Deutsche Bank and Goldman Sachs Asset Management (minimum investment $10,000). "The notes will reflect the performance of the index, so the customer's money will never go into the actual hedge fund," said Naveed Ahmad, head of investments at Dubai Islamic Bank, at the product's unveiling.

Such blue-chip financial institutions rely largely on 20 or so rock-star sharia scholars to certify that their financial products are in accord with the Koran and the Prophet's teachings. These elite Islamic scholars may sit on 40 or 50 sharia boards each, typically at between $20,000 and $30,000 a seat annually.

Sheikh Yusuf Talal DeLorenzo, 59, is one such top scholar and works from a Toll Brothers mansion in the suburbs of Washington, D.C. The sheikh tells us he is a "consumer advocate" for Muslims buying investment products. He cautions his colleagues in the Gulf to resist "black boxes" meant to "wrap a non-sharia-compliant underlying [investment] in a sharia-compliant structure." He is, in fact, deeply skeptical of Dubai Islamic Bank's hedge fund note; he has his own hedge fund platform (see below) that he says is strictly compliant. But the bank's elite scholar, Hussain Hamed Hassan, gave the note a blessing.

In June Saudi Arabia's Prince Mishaal bin Abdullah bin Turki al-Saud joined forces with Bear Stearns to create an asset management firm to guide wealthy Saudi families. As Eric Meyer, a Connecticut hedge fund executive and founder of his own Shariah Capital, explains, Western financial institutions are all eager to relieve the Gulf's "constipation of liquidity."

Mahmoud Amin El-Gamal, who holds the Islamic Finance Chair at Rice University in Houston, claims the sharia finance industry is selling overpriced products to the religiously naive. Indeed, some of the product specifications seem like hairsplitting. "Both the sophisticated investors and the ultrapuritans will see through this," says El-Gamal. "So you're left with the gullible who don't really understand the structure. You're feeling good for paying $500 to top law firms and 'religious' scholars? I think that's misplaced. Muslims around the world have among the worst rates of literacy and mortality. Take that same money and give it to charity."

Sheikh Yusuf disagrees. "Most of Islamic finance has been arranged for institutional and high-net-worth investors, all of whom represent the most knowledgeable investor."

So how do you make a mortgage or a leveraged buyout compliant? "The fundamental philosophical difference between Islamic finance and conventional finance is that risk must be shared and the counterparties must have an active stake in the business," the sheikh explains. So, the bank helping you buy a house is not exactly lending the money. Rather, you're buying the house together.

Guidance Financial Group of Reston, Va. creates a partnership with a home buyer to purchase a house, in a transaction called musharaka. Over time the homeowner buys more and more equity in the partnership until he buys out Guidance and owns the house outright. Devon Bank of Chicago, meanwhile, relies mostly on a transaction called murahaba. The bank buys the house, then sells it to the buyer at cost plus a pre-agreed-upon profit, paid in installments. In either case--even if interest rates are used to price the product--the act of paying interest is technically sidestepped.

"We have a higher documentation fee because documents are not spit out of some loan production package," says David Loundy, vice president at Devon Bank. "But we price an Islamic financing transaction same as we would a conventional loan." In other words the interest rate--if there were an interest rate--would be about the same, but the closing costs will run a few hundred dollars extra. God forbid you borrow for the extra costs. This is how one mortgage banker analyzes such deals: "The price for getting into heaven is about 50 basis points."

For business borrowings--excuse us, financings--there is the sukuk, an asset-backed security. The investor holding the sukuk is not exactly collecting interest. Rather, he is sharing in an asset's income stream. It just happens that in well-structured sukuks his claim on the asset is senior to that of the issuer. Islamic law doesn't necessarily prohibit preferred stock.

Created in the 1990s by innovative financiers in Malaysia to provide $30 million for a Shell subsidiary, sukuks have blossomed into a fast-growing industry, with $70 billion in issue last year. The U.K. Treasury is overhauling regulations so London can take the lead in developing a secondary market. One little problem, for the many sukuks created in London but involving assets in the Gulf, is that it's not clear, in the case of a bankruptcy, which country's laws would apply. Moody's views many sukuks as unsecured loans.

East Cameron Partners is a wildcatter that acquired some offshore oil and gas leases in the Gulf of Mexico. ECP originally financed its speculative exploration by doing a deal with the pioneering Australian bank Macquarie. In a complex transaction Macquarie issued debt and grabbed a 50% stake in the ultimately nicely producing offshore gas wells. With gas prices high, ECP's management wanted this equity back. Enter Ibrahim Mardam-Bey, now chief executive of Siraj Capital but then an adviser to Lebanon's BSEC, an investment bank specializing in sharia-compliant structures. Mardam-Bey and Dubai lawyers created a Delaware limited liability company that owns the royalty-producing well and linked it to a Cayman Islands fund that issued sharia-compliant certificates. The legal structure is akin to a sale-leaseback. The $166 million issue had a 11.25% "coupon" and was rated CCC+ by Standard & Poor's. Islamic investors picked up half the issue last July--hedge funds, the rest.

Siraj Capital Ltd is an investment company specializing in developing, sponsoring, seeding and launching innovative investment funds and investment opportunities in the Gulf Cooperation Council (GCC), Middle East and North Africa (MENA). Siraj Capital Ltd has recently co-launched RAHALA, a $ 500 Million regional hospitality investment company.