Monday, April 16, 2012

Islamic mortgages: Is there anything new?

An article I read tonight raised an old question about Islamic mortgages that I think is interesting, specifically, whether they offer anything different from conventional mortgages.  The answer (both yes and no) is a bit complicated for the basic question asked. The context is the UK market, but it applies in any market and has less to do with the specific regulatory requirements for companies offering home financing.  The article describes:
Risk sharing, not profiting unjustly or unfairly, not charging excessive charges; in a residential purchase context, allowing part rent, part purchase, sharing equity upside, sharing downside property risks. These characteristics apply equally to an approved Islamic home finance plan as they do to a new conventional purchase plan designed for a housing association in the north east of England.
There are a few different themes expressed here which affect Islamic mortgage financing.  The first comes up in the first two words: "risk sharing".  This is often used as the big difference between conventional finance and Islamic finance, in many cases erroneously (disclaimer: if you reverse the two words you come up with the brand I operate under).  There is nothing in Islamic finance that requires sharing risk any more than conventional finance.  It would be perfectly acceptable for a business to structure its contracts so that they are Shari'ah-compliant and where one party accepts only minimal risk beyond the credit risk that conventional banks specialize in dealing with. For example, an Islamic bank may only offer financing using murabaha, which is the most commonly used structure for assets on Islamic banks' balance sheet .

The next part is, in my opinion, more important for what Islamic finance is designed to do: "not profiting unjustly or unfairly, not charging excessive charges".  In the modern concept of finance, this is where Islamic financial institutions should be cleaning up and taking business from conventional banks (for both Muslim and non-Muslim consumers).  However it has not happened and there have been failures of business models (e.g. Arcapita and Gulf Finance House) and institutions themselves (e.g. UM Financial) where ethical behavior has converged with the conventional industry or even dropped below the (low) industry standard. 

This is more a problem of regulation.  The Islamic investment bank models practiced in the GCC where the banks would invest and then sell on to investors at a premium with minimal disclosure (I am speaking here more of GFH where there is more evidence of the practice) would have not been allowed in more strictly regulated markets.  In the case of companies like UM Financial, which escaped regulations almost entirely, had they been subject to even minimal standards of regulation in the industries they operated, they would have been shut down far earlier than they were. 

More than any other financial sub-industry, Islamic finance should welcome regulation (both in the traditional sense and in the additional Shari'ah regulation).  There are issues with how the industry imperfectly self-regulates today (on the Shari'ah side), with egregious abuses in conflict of interest have occurred in both Chicago (Sunrise Equities) and Toronto (UM Financial) where the companies' founders were excessively connected with the heads of their respective (supposedly independent) Shari'ah boards rendering them in practice as non-independent. One hopes that other regions have better standards, but I am not encouraged by the fact that UM Financial is still listed as a member of AAOIFI. 

Regulation to prevent bad actors is necessary to maintain the credibility of the industry as a whole, especially in overly politicized environments (like the US and Canada) where any wrongdoing (or even right-doing) by an Islamic financial institution is seized upon as "evidence of a plot to impose Shari'ah". 

But I have become distracted from the main point of this post, which is to address the description of Islamic mortgages: "allowing part rent, part purchase, sharing equity upside, sharing downside property risks".  This was the point that inspired the post and I think is the most interesting about how Islamic finance works in practice: it is much easier for Islamic mortgage companies in the US to share in the upside of transactions than it is in the downside, but it almost never happens. 

Banking regulations in the US are extremely hesitant to allow a depositor to lose money and most of the potential uses of deposits for an Islamic bank would be in mortgage financing.  However, the discussion always revolves around the banking side of the equation: why do Islamic mortgage providers use Freddie Mac to provide much of the liquidity to fund Islamic mortgages?  Why don't Islamic financial institutions use more of a profit-and-loss sharing method of mortgage finance?

The answer may not necessarily be the financial institutions' fault (they do have to fit within the US' financial regulations, but there are many forms they could take to serve the market if profit-and-loss sharing were demanded).  It may be that most potential customers demand a Shari'ah-compliant product that leaves them with the upside.  Given the evidence of the industry's roughly 40 year history, it appears that when presented with the costs and benefits most consumers prefer to keep the upside, and use more debt-based financing models for home finance. 

The present form for Islamic finance is, of course, not where it will be in 10 or 20 years and it will (should) change substantially over that time period, but the key for that change in the mortgage market will be consumers themselves giving up their monopoly on the upside gain.  Are financial consumers willing to give up a portion of the appreciation of their house's value to be able to pass along some of the loss if home prices fall, especially when Islamic mortgage companies are offering non-recourse Shari'ah-compliant loans?  I am not sure of the answer today.


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MortgagesForMuslims said...

Interesting article

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