securitization – Alyssa A. Lappen

by Dr. Rachel Ehrenfeld and Alyssa A. Lappen
Human Events | Jan. 23, 2008

All presidential candidates promise to fix our economy, but no one discusses the need to better safeguard our financial markets. The Committee on Foreign Investment in the U.S. (CFIUS), approved Bourse Dubai’s purchase of 20% of the America’s largest electronic exchange, New York-based Nasdaq, on Dec. 31, 2007.

This may soon give Dubai access to the troubled Boston Stock Exchange (BSE), through Nasdaq’s proposed BSE acquisition, which is now pending before the Securities and Exchange Commission (SEC).

“Foreign ownership of our capital markets may make it more difficult for shareholders to obtain information about the inner workings of the stock market,” notes Brent Baker, a former SEC Special Counsel. Nasdaq, like most U.S. exchanges, 5,100 brokerage houses and registered securities representatives, is regulated by the Washington, D.C.-based Financial Industry Regulatory Authority (FINRA). The Philadelphia Stock Exchange (PHLX), however, and the problematic BSE with its rather murky track record of non-compliance, retained their independent self-regulatory organization (SRO) status. Now, Nasdaq plans to purchase both.

“What do the regulators currently do to monitor the BSE, which up until now had been sanctioned several times for failure to regulate itself?” Baker wonders. Indeed, the SEC sanctioned the BSE in 1999 and 2007 for illegal practices. The September 5, 2007 sanction was for the BSE failure to enforce its own rules or comply with a 1999 SEC directive, and for illegal trading activities – including forward trading, from 1999 through 2004. On the same day, the U.S. District Court for the District of Massachusetts ordered former BSE President James Crofwell, to pay a $75,000 penalty “for aiding and abetting the Exchange’s failure to enforce its rules.”

The BSE history raises especially thorny questions about market manipulation and the possibility that unsupervised foreigner investors and securities firms may borrow or manipulate U.S. company stocks, adversely affecting domestic markets and further eroding investor confidence.

Since Bourse Dubai promotes its status as the world’s first and leading Islamic securities exchange, its influence could affect the listings on Nasdaq. Dubai might leverage the “sovereign immunity” of both the BSE and PHLX to list and delist companies on Nasdaq. SEC rules in that case could be irrelevant, and the effects on the U.S. capital markets and economy could be enormous. For example, pharmaceutical companies producing Viagra and contraceptives could be delisted, as could companies based in or doing business with Israel.

“This is a slippery slope,” says Baker, “if the SEC approves the Nasdaq’s purchase of the BSE and PHLX, and they both keep their SRO licenses.”

American regulators “believe in honest and complete disclosure and people invest with the understanding that they will make or loose money depending on their judgment, the markets and the economy,” says John W. Moscow, former Assistant District Attorney and Deputy Chief of Investigations under New York District Attorney Robert Morgenthau.

“In England,” where Dubai will shortly acquire Nasdaq’s 28% stake in the London Stock Exchange, he says, “the governing philosophy is that if God did not want [investors] shorn, he would not have made them sheep.”

The integrity of regulations in Dubai is a more important problem. To attract business, “they are willing to omit the costs of regulation and compliance that exist elsewhere.” Dubai traders deal in arms, women, drugs, and money laundering. “As long as [traders] deliver the money, and so long as the market does what it is supposed to do, it is sufficient,” says Moscow.

The U.S. markets are already in big trouble, says Moscow, given the high trading volume between U.S. and foreign exchanges through shadow accounts to the Federal Reserve Board’s Depository Trust Corporation (DTC), Euroclear and other clearing systems. Nasdaq’s acquisition of the BSE only worsens the problem.

The same owner, through many different foreign corporate entities, can buy majority stakes in many companies and manipulate the market. With no regulation of these trades, no one would be the wiser. “The bad guys are going to eat us alive,” Moscow says.

Indeed, SEC chairman Christopher Cox has now proposed allowing foreign exchanges to sell directly to U.S. investors through U.S.-based brokerage firms. Exchanges with “comparable” regulatory oversight would no longer need to register with the SEC, under the new proposal. But of course, having comparable regulations alone in no way ensures that foreign exchanges enforce their regulations with the same rigor as the SEC.

The U.S. markets remain the most highly and efficiently regulated in the world, according to Moscow. Clearly, that is still not good enough.

— Rachel Ehrenfeld, author of Funding Evil, is director of the American Center of Democracy, and a member of the board of the Committee for the Present Danger. Alyssa A. Lappen, a senior fellow at ACD, is a former editor of Institutional Investor, Working Woman , Corporate Finance and Forbes.

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By Alyssa A. Lappen
FrontPageMagazine | Jan 21, 2008

The very expectations of glittering shari’a finance (Islamic banking) profits hypnotize financial institutions, securities exchanges, and banks–and there are few regulatory or monitoring protections against abuses. So why did United Arab Emirates (UAE) government IP address 92.97.131.110 send some 30,000 to 40,0000 spam messages on December 8, 2007, soliciting Islamic finance clients among U.S. citizens and small businesses?

“Need assistance,” the spam asks, soliciting inquiries to , registered to Emirates Telecommunications Corporation at UAE’s federal domain authority.

Maybe gorging on U.S. strategic assets increases UAE appetite–even though, the lower stocks go, the more prime U.S. investment companies Middle East investors scoop up. Maybe UAE spammers may want to lasso U.S. credit crunch victims desperate for cheaper home or small business loans.

Let’s hope U.S. consumers and U.S. presidential candidates–unlike those U.S. financiers falling like flies before UAE sheiks–will carefully scrutinize the entire Islamic banking scam.

The UAE email solicitation purports that Islamic finance provides four “attractions:”

* Good alternative source of funds

* Risk perceptions of Islamic financiers

* Off-balance sheet financing

* Preferred mode of financing for certain corporate (sic) and individuals

Many grave secular risks accompany shari’a‘s growing foothold in Western markets.

With wife-beating, stoning women, dismembering thieves, hanging homosexuals, supremacist ideology and an annual head tax (jizya) on non-Muslim subjects–shari’a also orders Muslims to fund jihad (financial jihad—al Jihad bi-al-Mal). As in Qur’an 61:10-11, “strive for the cause of Allah with your wealth and your lives.” and Qur’an 49:15. “Financial Jihad [is]…more important…than self-sacrificing,” says Saudi cleric and Muslim Brother Hamud bin Uqla al-Shuaibi.

Consider the four purported advantages.

First, the Saudi-favored shari’a finance “alternative,” as noted in FrontPageMagazine earlier, is a 20th century construct without basis in Islamic history–and often funds destruction. It’s an “invented tradition” empowering Islamic radicals, writes USC King Faisal Professor of Islamic Thought, Timur Kuran, in Islam and Mammon: “Neither classical nor medieval Islamic civilization featured banks in the modern sense, let alone ‘Islamic banks’.”

Muslims expect “humanitarian” Islamic finance to buy their “reward in the Hereafter.”

Conversely, Americans expect alternative “ethical” and “socially responsible” investing to build human rights in southern Sudan, common shareholder rights, and good corporate governance and transparency–terms not in the shari’a finance lexicon.

Then take “risk perceptions of Islamic financiers.”

Evidently bankers have forgotten to whom the advantage of this second bogus UAE-invoked “attraction” accrues: Citibank’s Islamic financiers in 1955 launched its Saudi American Bank subsidiary in Jeddah and in 1966 opened a Riyadh branch–without presenting due diligence on the risks of operating under shari’a law, which include sudden confiscation. So Citibank discovered in 1980, when the Saudis seized SAB by royal decree, denied Citi any future profits, and ordered the bank to train Saudis staffers.

Likewise, the “risk perceptions of Islamic financiers” apparently aided criminals at the Bank of Credit and Commerce International (BCCI), which was founded as an Islamic bank. BCCI perpetrated the largest fraud in banking history, costing depositors and investors at least $21 billion before U.S. prosecutors closed it in 1991. BCCI was also established “to help the world of Islam, and [as] the best way to fight the evil influence of the Zionists,” as Rachel Ehrenfeld noted in Evil Money (Harper Collins, 1992, pp. 160, 164-5, 169-70). Thus under UAE president Sheikh Khalifa Bin Zayed Bin Sultan Al-Nahayan’s late, terror-financier father, BCCI funded such “alternative” organizations, states and projects as Hezbollah, al Qaeda, Syria, Iran and Pakistan’s nuclear bomb manufacturing.

And Islamic banking’s third “advantage”–its off-balance sheet financing–most readily explains its fourth: the domain’s preference by “certain corporate (sic) and individuals.”

But even the Finance and Accounting Standards Board (FASB), which sets standards for the self-regulated accounting industry, would agree with a Government Accountability Office (GAO) report released in December 2007, calling for more and better market and banking oversight–not less.

And that includes leashing the downside risks in off-the-books financing. Hundreds of billions of dollars in subprime mortgages caused the current global credit crisis, which is ravaging global equities and bond markets, and could slice $6 trillion from U.S. home values and take years to resolve.

In the 30 years since Bank of America technology and an 8.5% BOA mortgage-backed “pass-through” spawned a landmark market innovation–securitization–underwriters transformed trillions of dollars in claimed cash flows on illiquid assets into increasingly liquid, traceable securities. Collateralized debt obligations (CDOs) made mortgage-backed and other complex lending securities so liquid that in the 1980s, U.S. brokerage firms practically sold them on street corners.

During that 1980s securitization boom, the Muslim Brotherhood heavily used the new Western financial technology to develop MB founder Hassan al-Banna’s shari’a banking invention. Today, Islamic financial institutions also manufacture “special purpose entities” (SPEs)–the same kind that coincidentally helped destroy Enron. Naturally, Islamic financial engineers renamed the prickly SPEs “special-purpose vehicles (SPVs)”–legal devices to “restructure interest-bearing debt, collecting interest [as] rent or [a] price mark-up.”

So-called sukuk al-ijara (shari’a bond) issuers sell real estate or assets to SPVs, which capitalize their investment by selling share certificates. In turn, the SPVs then lease back the assets they purchased to the sukuk issuers, collecting principal plus interest, which they pass on to sukuk investors as “rent.” When the sukuk matures, the SPVs sell or return the property to the sukuk issuers.

In short, the supposed “alternative” Islamic finance instruments, which claim to avoid usury, use Western structured finance tools–“some of the most complex ever created.” You got it. Shari’a bankers transform liquid, traceable cash flows from interest-bearing debt into illiquid assets.

How is that more secure for the financial markets?

Actually, financial innovation has sometimes caused market dislocations. Often, the bigger the innovation, the greater the unforeseen consequences–and market declines. Take the role of “portfolio insurance” in the 1987 crash. Or the 1994 bust of mortgage-backed bonds, which wiped out $1 trillion in value–then roughly 10% of the U.S. bond market. That free-fall took down (by several notches) many huge pension funds, municipalities and institutional investors–and also beached a few hedge funds like dead whales.

So how does the complex purported shari’a finance alternative create more security for Western financial markets?

It doesn’t. Under “complexities,” the December UAE solicitation for Islamic finance clients admitted, “Shari’a regulations can override commercial decisions.”

The email also noted two other major shari’a finance problems:

* Documentation is not standardized

* Inter-creditor agreements can be complex (emphasis added)

Taking monumental risks does not even eliminate usury. All “Islamic finance today is interest based,” complains Rice University Islamic economics, finance and management chairman, Mahmoud el-Gamal, in the Financial Times. Disparaging Islamic banking as “shari’a arbitrage,” el-Gamal calls it “first and foremost about religious identity.” And the “forefathers” of so-called “political Islam” intended precisely that in their conception of this 20th century financial concoction.

In reality, “innovative” Islamic financial securities involve enormous risks, which may be an intended prong of the Muslim Brotherhood’s strategic financial jihad.

Sukuk issues entice investors with yields much higher than Western bonds. While central Western banks orchestrate historic, simultaneous rate reductions to contain losses feared to equal those of the 1986 to 1995 savings and loan crisis, a sukuk index with a mere 3.8 year duration sported 6.2% “coupon” on Nov. 30, 2007. Meanwhile, in mid January, yields were only 2.89% on intermediate Treasuries–and just 5.25% on the Lehman Brothers intermediate U.S. corporate bond index. Only long term U.S. corporate debt yielded more than 6.5%. No wonder sukuk issues have been fully subscribed.

But two key determinants of bond quality remain–the surety of payments for the scheduled life of the loan, and the certainty that, on maturity, investors will recover 100% of their principal.

Simply believing Islamic sukuk to be inherently safer than Western bonds doesn’t improve their quality of their higher interest rates–oops–“rent.” Islamic or not, buying a sukuk makes its purchaser a creditor. And for the same reasons “junk” is synonymous with high-yield bonds, larger returns carry greater risks.

Which says nothing of the dubious underlying “profit and loss sharing” Islamic finance philosophy. Investors should look doubly hard at whether to expect profit or loss when a sukuk matures–that is, whether recouping the loan’s entire “face value” is even in the cards. That might depend on the values of underlying properties or assets at maturity. But then, “Shari’a regulations can override commercial decisions,” and so on.

In 1983, my esteemed colleague, former Forbes senior editor Howard Rudnitsky, warned in a booming real estate tax-shelter market, “heavy leverage involves risks, and if the market turns bad, the top-heavy financing could wipe out the equity. The creditors would get the property back, the syndicator would keep his fees and the investor would get the shaft.” Not to mention the back taxes, interest and penalties if the Internal Revenue Service ruled the enterprise “uneconomic.”

The same principles apply here. With or without spam, better, safer and fairer for government and IRS regulators, banks, markets–and investors–to take all finance, unIslamic.

Alyssa A. Lappen, a senior fellow at the American Center for Democracy, is a former senior editor of Institutional Investor, Working Woman and Corporate Finance and a former associate editor of Forbes.

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