The subprime crisis was caused by irresponsible lenders providing housing finance that was unsustainable. Islamic home finance has been provided more responsibly and there have been few repayment problems. However, the Islamic finance industry should not be complacent, and there are lessons to be learnt from the subprime crisis. Providing clients with mortgages for over 100% of the value of the property being acquired is a mistake; indeed, clients should pay a deposit of at least 10% of the property value. With diminishing Musharakah home finance, the bank usually provides a maximum 90% of the partnership capital, the client provides the remainder. Conventional banks lending to subprime clients often provide financial ‘sweeteners’, with low or interest-only payments for two years or more, after which payments were scheduled to increase substantially. While providers of Islamic home finance can allow clients to make more repayments as their careers progress and income increases, it is important to check carefully the references from the clients’ employer to ensure this assumption is reasonable. Finally, members of the Shariah board should question the up-front fees charged for Islamic home finance. Arrangement fees to cover set-up costs are permissible, but these were abused by conventional lenders that charged high fees, much of which was paid in commission to mortgage brokers. Consequently, the brokers had a strong incentive to sell mortgages to subprime clients who they know were unlikely to honor future repayments. This was unfair and unethical. It involved the exploitation of clients and the resultant homelessness and family misery which we now see in the US.
PROFESSOR RODNEY WILSON:
There are many different parties affected by this crisis: home owners, finance providers, banks etc, and I think such statement needs more clarification to assess agreement as it is very broad. One would need to know which problems in particular would have been prevented by which Islamic principles? Delinquent homeowners? Bankrupt financiers? Lack of liquidity? However, I still think it’s very risky to presume such a crisis could not happen to the housing market dominated by Islamic finance providers. As the home finance market becomes more competitive and financing liquidity stays high, even Islamic companies may be tempted to offer financing to individuals who cannot afford the lease payments, or decided not to pay, in a stressed housing market. Hopefully, all parties can learn from the mistakes in the US. The decision to provide finance to low-income buyers can be an important and a socially beneficial phenomenon that allows such people to benefit from rising prices, rather than being left behind. However, the risk of such financing versus the profit made must be assessed correctly by the finance provider and the consequences of non-payment have to be such that buyers/tenants are encouraged to live within their means. In my opinion, these last concepts are universal and apply equally to both conventional and Islamic home finance providers.
KHALID F HOWLADAR: Senior credit officer, asset backed and Sukuk finance, Moody’s Middle East
I think that the question is more textured. We are almost certainly watching Islamic institutions finance asset bubbles in a number of countries. But, the nature and quantity of leverage that an Islamic institution is able to achieve is different. So, I do not know if such a crisis could be prevented. But I think that it might be less severe. ABDULKADER THOMAS: President and CEO, SHAPE — Financial Corp
I would agree with the suggestion. The idea of creating assets just because you can sell them to someone else, whatever the quality, does not seem to fit well with the Shariah concept of fairness. Similarly, many of the excesses could have been avoided if, through a higher degree of transparency and understanding of the underlying use of the cash, investors had a better understanding of what they were buying.
VINCE COOK:
So far, the subprime crisis has wiped out more than US$750 billion from the balance sheets of conventional financial institutions. Hardly anyone seems to realize that this is more than the combined assets of the top 500 biggest Islamic financial institutions worldwide. At the same time, the Islamic finance industry stays untouched. At this stage, it therefore is easier to point fingers than to learn lessons. Bad risk management, greed and reckless securitization in a blind ambition for growth were the origins of these happenings. Every market lives in cycles, so the Islamic finance and/or real economy will one day take a hit. Though the specific and direct issues of the subprime crisis look distant, the basic reasons that it originated from could also harm Islamic finance. Not only do the compliancy of the Islamic products (that get a lot of Shariah attention and screening) deserve to be properly addressed, but the governance, organization and ethical standards also deserve careful follow-up. The nature of the products is important, as is the way they are structured. Also what they are used for and where they could lead to should remain the focus.
PAUL WOUTERS: Partner, Bener Law Office
As to the issue whether the US subprime crisis could have been prevented if Islamic principles had been applied in the international financial markets, we do agree with the view of the relevant scholar on this point. One of the main causes for the subprime crisis is that financial institutions have been providing (interest-only) mortgages to risky/non-solvent borrowers. These borrowers were the first to feel the blows of the whip when the US Federal Reserve increased the benchmark interest rate used for mortgage loans. If we look at Islamic mortgages, which are, of course, based on Islamic principles, we can argue that the subprime crisis could have been prevented at an early stage. The commonly used structures for Islamic mortgages are diminishing Musharakah (partnership) or an Ijarah (lease). In the case of diminishing Musharakah, as the mortgagee makes monthly payments to the mortgagor, the equity stake of the mortgagee increases while the beneficial interest of the mortgagor diminishes. In case of Ijarah, the lessee will make payments to the lessor until the expiry of the lease, at which time the lessor will transfer ownership of the property to the lessee. In both structures, the bank has an equity stake in the property and risks are borne pro rata between the mortgagor and the mortgagee. Therefore, the Islamic bank will be more discerning with whom it forms a partnership and ensures that the parties with whom it enters into an agreement are highly suitable in order to reduce the chances of default. This means that in an ideal Islamic structure, it is highly unlikely that risky borrowers would be granted a mortgage to such an extent as seen in the conventional market. It follows from the above that the only effective measure, either in an Islamic contractual setting or in a conventional setting, is the performance of a certain level of due diligence by the financial institution to determine the creditworthiness/solvability of its borrower/contract party.
KHALILA MEGGOUH: Legal consultant, finance/Islamic finance, DLA Piper Middle East
The US subprime crisis is the direct result of the sale of mortgages to clients in the knowledge that it would be unlikely that they would be able to meet monthly repayments beyond the fixed rate period and without any proper underlying collateral. Although remortgaging is not necessarily against Shariah principles, the added promise of ‘Don’t worry about meeting the significantly higher payments after the fixed rate period has finished, you can always remortgage’ constitutes gharar. It is not only to the benefit of one party (the seller gains commission), it is also purposely putting someone in jeopardy, since it was not at all certain if remortgaging would be an option. Shariah compliant banks, for whom gharar is one of the prohibitions, should not be in a situation like this. The problem is complicated further when all the low credit rated mortgages were packaged up and sold on as MBS (mortgage-backed securities). Although it led to diversification, the packaging and repackaging also resulted in a situation where it was no longer clear what the exact underlying asset of the transaction was. Gharar and not having a clear underlying asset violates two main principles of Islamic finance and should therefore not occur. However, this does not mean that banks should not lean back and let things go by. It is certainly the responsibility of the bank to ensure that the prohibitions are not violated and that unscrupulous salesmanship does not occur. Strong internal control and management procedures should at all times apply.
DR NATALIE SCHOON: Head of product management, Bank of London and The Middle East
Islamic principles assuredly would have prevented the sort of over-leveraging we’ve seen in some segments of the US housing market. There also would have been clear benefits to risk sharing, rather than packaging mortgage risk and selling it off the balance sheet. Still, the Islamic banking industry should be measured in its criticism. The rapid growth we’ve seen sector-wide has yet to be fully tested in a down-market cycle. Moreover, the fractured nature of the business across multiple geographies suggests that any weaknesses have yet to be revealed over time. As with the subprime crisis, such weakness may become apparent only after the fact. Banking executives and regulatory officials in the US have much to be embarrassed about. Financial systems and capital-market structures do short-circuit from time to time, reflecting human fallibility. The strength of a banking system lies in its ability to recover quickly, and to ensure that the lessons learnt are ingrained in new operating approaches. Depending on the way the subprime crisis shakes out, the Islamic banking industry may find itself a useful case study, as well as an object for censure.
DOUGLAS CLARK JOHNSON: CEO, Calyx Financial
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