Haresham Baharum

Guidance Financial Group
Establishing a Fund for Shariah-compliant Investors :

Sharing Our Experience
15th September, 2006
Introduction to Guidance Financial Group

Brunei Islamic Financial Services Forum 15 Sep 2006
INTRODUCTION TO GUIDANCE FINANCIAL GROUP
Capital Guidance
Commercial Distribution Network

Chemicals Industrial safety Ceramic tiles Bathroom equipment China & gift ware
Madison Marquette
Real estate investment, development, and management

Shariahcompliant financial services
Financial Investments
Public and private markets investments

INTRODUCTION TO GUIDANCE FINANCIAL GROUP
Retail (Mortgage Banking)

Sales, distribution underwriting, processing
Capital Markets
Investments
Structuring and asset-backed securitisation
Islamic private equity, real estate and fixed income funds
Developing a Shariah-compliant Fund

GUIDANCE FINANCIAL GROUP: INVESTMENT FUNDS
Varied Fund Types Guidance Hotel Investment Company (Shaza Hotels Fund) 1st Shariah-compliant private equity fund for Asia 1st Shariah-compliant China residential development fund Development of 1st Shariah-compliant mortgagebacked securities (MBS) fund (a fixed income fund)

CREATING A NEW FUND
Some Pertinent Issues to Consider: Is there a vacuum in the market? What do potential investors look for? Level of Shariah compliance Distribution: Retail or Institutional?

CREATING A NEW FUND
Some Pertinent Issues to Consider (contd): Partnership with Experts Fund Structure: Quick-to-Market approaches
Feeder & Parallel Structures
Investment Assets: Readily available or To be Created
Case Study: Development of the Guidance MBS Fixed Income Fund

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Case Study: Development of the Guidance Income Fund
THE US$ FIXED INCOME MARKET
Market Size In 2005, the size of the US Dollar Fixed Income Market is approximately $25.3 Trillion. This is larger than the more widely discussed US Equities market of about $18.2 Trillion
U.S. Equity vs. Fixed Income Market Capitalization
Equities $18.2 Trillion Fixed Income $25.3 Trillion
Sources: Bond Market Association, The Financial Services Fact Book 2006, NASDAQ, NYSE, Amex

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THE U.S. DOLLAR FIXED INCOME MARKET
A Very Liquid Market The US Dollar Fixed Income market is very actively traded: in 2005, $555 billion Treasury and $252 billion Mortgage securities traded daily, compared to about $80 billion of stocks traded daily amongst the three major US equities market. Offers investors tremendous liquidity.
600 500 $ Billions 400 300 200 100 0
Source: Bond Market Association
Municipal Agency Mortgage Treasury
2000
2001
2002
2003
2004
2005 Jun-06

12
THE CASE FOR FIXED INCOME INVESTING
Asset Allocation is a Primary Determinant of Long-Term Returns Fixed Income assets offer investors the ability to achieve stability of returns while preserving capital. This makes fixed income a necessary component of any balanced investment portfolio. Studies show that types and size of asset classes significantly affect a portfolios long-term performance Tactical Asset
Security Allocation Selection Other Factors
Sources of Long Term Performance
Source: Brinson, Hood & Beebower. Determinants of Portfolio Performance Financial Analysts Journal. May/June 1991
Strategic Asset Allocation

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Portfolio Contribution of Fixed-Income Asset Class Comparison of a Shariah-compliant portfolio with no fixed income investments vs. an unrestricted portfolio
Fixed Income Investments
Asset Class
Unrestricted Portfolio Restricted ShariahCompliant Portfolio
Cash Equivalents
World Equities
Real Estate

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Efficient Frontier Analysis Fixed-income assets are a core investment for an intermediate risk portfolio - they reduce risk for any given target return.
13% 12% REITs 11% Annual Return 10% 9% 8% 7% 6% Cash 5% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Annual Standard Deviation Fixed Income Global Equities
Unrestricted Portfolio Existing Shariah Portfolio w/o Fixed Income Individual Assets
For a given return the constrained Shariahcompliant portfolio has up to 25% more risk
Note: Analysis performed using Wilshire Associates forecast return data

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Fixed Income Reduces Risk to Achieve a Given Return

Fixed Income Allocation
80% 70% 60% 50% 40% 30% 20% 10% 0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% Target Return 0% 10% 20% 30%
Reduction in Risk
40%
Fixed Income Allocation as % of Total Portfolio Reduction in Risk by Allocating Fixed Income
Note: Analysis performed using Wilshire Associates forecast return data

16
Portfolio Allocation of U.S. Institutional Investors

100% 80% 60% 40% 20% 0%
Colleges and University Endowments Private Pension Funds Public Pension Funds Commercial Banks Life/Health Insurers
Fixed Income
Total Fixed Income Allocation
Equities
Other
21.5%
22.6%
33.2%
98.1%
83.7%
Note: Allocations are percentage of securities and other investment assets excluding cash; Other includes real estate and other marketable assets Source: The Federal Reserve; FDIC; Wilshire; Pioneering Portfolio Management, Swenson, 2000

17
TYPICAL FIXED INCOME ASSET CLASSES
The Fixed income class comprises various investment types, best illustrated by examination of the Lehman Aggregate Bond Index.
Agencies 11.7% Asset Backed 1.6%
Corporate Bonds 26.1%
Mortgage Backed Securities 38.1%
U.S. Treasuries 22.5%

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One Month CD Annualized Mean Return Return Above Cash Volatility Additional Return Per 1% of Volatility 6.24%
1-3 Year Treasury 7.83%
Intermediate Treasury 8.68%
Freddie Mac Mortgage 10.05%
Corp. Invest Grade 10.16%
High Yield 9.08%
30 Year Treasury 8.83%
1.60% 2.2% 3.41%
2.45% 4.91%
3.82% 6.17%
3.92% 7.17%
2.85% 12.77%
2.59% 13.27%
0.47%
0.50%
0.62%
0.55%
0.22%
0.20%
Source: Wilshire; Data from 20-year period from 1983-2002. Freddie Mac MBS is used as a benchmark; its performance is comparable to the MBS issued by other agencies.

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THE U.S. AGENCY MORTGAGE-BACKED SECURITIES MARKET
MBS: A Large Well-Traded Product

300 250
Average Daily Trading Volume of Agency MBS 1998 - 2005

$252 $206 $207
$Billions
200
$155
150
$112
100 50 0 1998 1999 2000 2001 2002 2003 2004 2005
$71
$67
$70
Source: Bond Market Association

20
MBS: A Large Proportion of Fixed Income Investments for Commercial Banks and Savings Institutions
MBS as a Proportion of Fixed Income Securities
80% 70% 60% 50% 40% 30% 20% 10% 0% Life/Health Insurers Commercial Banks Savings Institutions
67.7% 53.9%
13.5%
Source: Financial services Fact Book 2003. Individual sources are Life/heath insurers: AM Best Company; Commercial banks: FDIC; Savings Institutions: FDIC. Note: Fixed Income Securities includes government, municipal, and corporate bonds and asset backed securities.

21
STATE OF THE SHARIAH-COMPLIANT FIXED INCOME MARKET
Shariah-compliant investors have relatively limited access to liquid, high credit, fixed-income investments Several pioneering emerging-markets sovereign sukuks issued recently have made some strides to bridge the gap, but some issues persist:

Limited liquidity High volatility of emerging-markets debt Need for credit diversification Relative scarcity despite recent issues

22
Agency Securitization of Residential Mortgages Two main players: Freddie Mac and Fannie Mae (privatelyowned Government Sponsored Enterprises, or GSEs) GSEs purchase residential mortgage loans from primary mortgage lenders across the U.S. GSEs pool mortgages and issue GSE-guaranteed mortgagebacked securities (MBS). The market perceives an implicit guarantee of the US government stemming from lines of credit that enable both entities to borrow directly from the US Treasury. MBS investors include retail funds, pension funds, insurance companies and banks (20% risk weighting under the Basle Accord).

23
DECLINING BALANCE CO-OWNERSHIP PROGRAM
Declining Balance Co-Ownership Program

Pioneered the use of diminishing musyarakah structures in residential financing. Shariah-compliance from A to Z
Organizing world class Shariah Board Three years product development effort 18 law firms addressing legal complexities Freddie Mac and other strategic alliances, to create the first program to securitize Islamic mortgages in Wall Street. Covering the full cycle of product development, marketing/sales, processing/underwriting, and secondary marketing/ securitization To date, originated and securitized more than US$ 700 million

24
SUMMARY OF OVERALL PROCESS
PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES
ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE
PORTFOLIO CONSTRUCTION & ANALYTICS
SERVICING / TRUSTEE

25
SERVICING / TRUSTEE

26
SERVICING / TRUSTEE

27
SERVICING / TRUSTEE

28
SERVICING / TRUSTEE

29
SERVICING / TRUSTEE

30
ASSET ORIGINATION TO INVESTMENT PROCESS
Consumer
Single-family Home Title
Investors
Asset Originator
Guidance
Beneficial Co-Ownership Interests
Freddie Mac
Freddie Guaranteed PC
Guidance MBS Income Fund
Servicing Rights
30

31
WHAT WE LEARNT
A challenge to strike an equilibrium between Syariah, legal and regulatory requirements using creative structuring Principle challenge arise from the beneficial ownership position that the financier takes in the property a position absent in present murabahah-based or conventional residential finance products. Special regulatory rulings or exemptions can play a significant role in creating an efficient and robust program

32
FINANCING STRUCTURE ISSUES
Beneficial Ownership

Financier is the beneficial owner of property in an Ijarah model; Financier is beneficial co-owner of the property in the Musyarakah model that Guidance has adopted; Syariah percepts dictate that ownership rights and obligations, associated with a typical property-owner, are assigned to financier Some typical owner obligations include paying for: insurance certain taxes and assessments structural maintenance and improvements Exposure to property casualty risks and benefits from insurance and condemnation proceeds

33
FINANCING STRUCTURE ISSUES (CONT D)
From Guidances experience, such requirements can be addressed through creative structuring, creating financing cash flows that mimic those of conventional loans Certain residual risks associated with ownership will persist These are however, immaterial and mostly theoretical and highly improbable.
Late Payments

Shariah principles strictly prohibit the financier to require an increase in late payments due Several approaches exist to incentivise consumer to make timely payments and allow the compensation of servicers for managing late payments and defaults

34
FINANCING STRUCTURE ISSUES (CONT D)
Legal and Regulatory Considerations Issues that arise from the financiers beneficial ownership position: Additional transfer taxes, stamp duties at the beginning of the acquisition or refinance transactions Compared to conventional loans, the personal tax treatment for the consumer and the corporate tax treatment for the investor of ownership-based financing contracts Any regulatory restriction on banks, finance companies or Sukuk issuer relating to real estate ownership Legal status of relationship between the financier and consumer it has to be that of a financing relationship, and not tenant-landlord Possibility of foreclosure and perfection of security instrument

35
SECURITISATION STRUCTURE ISSUES
The main challenges arise from the: Assignment of beneficial ownership through the securitisation chain Provision of guarantees

36
SECURITISATION STRUCTURE ISSUES (CONT D)
Assignment of Ownership

Shariah does not permit the securitisation of mere cash flows from the financing contracts Rights and duties of ownership must be assigned as well This exposes deep-pocketed financial institutions, as beneficial owners, to potential third party liabilities With assistance from regulatory authorities, Guidance recommends the use of a special legal entity acting as the initial owner or coowner of the property that is being financed This addresses the management of the ownership liability

37
SECURITISATION STRUCTURE ISSUES (CONT D)
Issuer Guarantee The following are key potential issues that need to be addressed in the structuring of the legal documents: Shariah prohibits Issuer from being compensated for providing its guarantee The object of guarantee is restricted to the consumer debt obligation but not the consumers promise to acquire the property The issuers sale of the asset pool to the certificate holder may not be contingent on the provision of a guarantee A manager/ administrator of the sukuk may not provide a guarantee on the underlying payment obligations Issuer may not be simultaneously a guarantor and investor in the sukuk
Thank You

Haresham Baharum

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Guidance Financial Group

Establishing a Fund for Shariah-compliant Investors :

15th September, 2006

Guidance Financial Group

Introduction to Guidance Financial Group

Guidance Financial Group

INTRODUCTION TO GUIDANCE FINANCIAL GROUP

Commercial Distribution Network

Guidance Financial Group

Guidance Financial Group

INTRODUCTION TO GUIDANCE FINANCIAL GROUP

Guidance Financial Group

Retail (Mortgage Banking)

Structuring and asset-backed securitisation

Islamic private equity, real estate and fixed income funds

Guidance Financial Group

Developing a Shariah-compliant Fund

Guidance Financial Group

GUIDANCE FINANCIAL GROUP: INVESTMENT FUNDS

Guidance Financial Group

Developing a Shariah-compliant Fund

CREATING A NEW FUND

Guidance Financial Group

Developing a Shariah-compliant Fund

CREATING A NEW FUND

Investment Assets: Readily available or To be Created

Guidance Financial Group

Case Study: Development of the Guidance MBS Fixed Income Fund

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE US$ FIXED INCOME MARKET

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE U.S. DOLLAR FIXED INCOME MARKET

Municipal Agency Mortgage Treasury

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

Sources of Long Term Performance

Strategic Asset Allocation

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

Note: Analysis performed using Wilshire Associates forecast return data

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

Fixed Income Reduces Risk to Achieve a Given Return

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

Portfolio Allocation of U.S. Institutional Investors

Guidance Financial Group

Case Study: Development of the Guidance Income Fund

TYPICAL FIXED INCOME ASSET CLASSES

Corporate Bonds 26.1%

Mortgage Backed Securities 38.1%

U.S. Treasuries 22.5%

Guidance Financial Group

Case Study: Development of the Guidance Income Fund