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Guidance Financial Group

Establishing a Fund for Shariah-compliant Investors :


Sharing Our Experience

15th September, 2006

Guidance Financial Group

Introduction to Guidance Financial Group

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

Guidance Financial Group


Shariahcompliant financial services

Financial Investments
Public and private markets investments

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

INTRODUCTION TO GUIDANCE FINANCIAL GROUP

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

Guidance Financial Group

Developing a Shariah-compliant Fund

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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)

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

Developing a Shariah-compliant 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?

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

Developing a Shariah-compliant Fund

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

Guidance Financial Group

Case Study: Development of the Guidance MBS Fixed Income Fund

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

13

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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%

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

18

Case Study: Development of the Guidance Income Fund

THE CASE FOR FIXED INCOME INVESTING

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.

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

20

Case Study: Development of the Guidance Income Fund

THE U.S. AGENCY MORTGAGE-BACKED SECURITIES MARKET

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.

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

22

Case Study: Development of the Guidance Income Fund

THE U.S. AGENCY MORTGAGE-BACKED SECURITIES MARKET

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).

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

26

Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

27

Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

28

Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

29

Case Study: Development of the Guidance Income Fund

SUMMARY OF OVERALL PROCESS

PRODUCT DEVELOPMENT & STRATEGIC ALLIANCES

ASSET ORIGINATION & UNDERWRITING & CLOSING CREDIT ENHANCEMENT & SECURITIZATION WAREHOUSE PURCHASE

PORTFOLIO CONSTRUCTION & ANALYTICS

SERVICING / TRUSTEE

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

30

Case Study: Development of the Guidance Income Fund

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

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Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

SECURITISATION STRUCTURE ISSUES

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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

Guidance Financial Group


Brunei Islamic Financial Services Forum 15 Sep 2006

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Case Study: Development of the Guidance Income Fund

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