Monday, July 13, 2009

Asset Based vs. Asset Backed

A brief definition of the two forms of financing:

Asset Based:
Methods of financing in which investors look to the cash flow from an asset or a pool of assets for a return on, and the return of their investment.

Asset Backed:
A term used to describe a security which is backed or secured by a pool of assets such as leases or receivables, but not real estate. The security shall be serviced by the cash flow derived from the pool of assets.

Given the definitions, which would be the preferred structure for Shariah based financing?

The important thing to consider is the ownership of the (real) asset and not just the rights to the earnings or cash flow. For example, an Ijarah structure requires full ownership before one can lease out and earn lease rental from an asset. Therefore, in order to make it comply with Shariah, the structure must define the ownership of the asset as well as the rights and responsibilities of the owners and the counterparties.

There is nothing wrong with a security that derives its cashflow or income from a pool of assets. But in a partnership based structure, the rights to income from an asset is derived from the ownership of the asset and full ownership means legal ownership and not merely beneficial ownership. There must be a true sale of the assets and not merely an artificial beneficial sale.

Whether we call it asset based or asset backed, we must ensure that the assets and the rights associated with ownership belong to the rightful parties.

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