In this chapter Subprime mortgages crisis is elaborated and the alternative system offered by the Islamic Financial System is presented.
A remarkable and rapid growth of capital market has successively diminished national boundaries. To meet the demand of these transactions, market has invented various ways to align financial products with their respective risks. This alignment of financial products with investor's risks and more and more appetite of return paved a way to create complex structure of financial products. The crucial refund policies, they allowed the credit rating agencies to award the investment institutions the same grade they gave the banks that backed them.These complexities made such structures difficult to be understood by the consumers using them, ultimately this lack of understanding shaped the risk of such products and their underlying assets dangerously complicated in their understanding and impacts. Everyone involved, from banks to borrowers to investors, convinced themselves that they were taking little, if any, risk. [1]
Under the brunt of rapidly growing economy and company revenues reaching their all time high the every day financial consumer engaged himself in a lot of different financial schemes to facilitate themselves, and mortgage loans were one of those methods adopted by them. From this superficial flourishing scenario of these transactions taking place in an artificial economy a point came when economic bubble bursted. This bursting of bubble effected the interest rates on mortgages by pushing them high while the value of the under lying assets decreased. This unbalance situation appeared, when supply crossed the level of demand. This consequently brought a dramatic rise in the rate of delinquency and default of Subprime-mortgage loans in the US, as borrowers were not able to make the mortgage payments required due to higher interest rates. These mortgage loan defaults gave rise to credit crisis which ultimately created panic in the credit market. [2]
2.1 What was the U.S. Subprime Mortgage financial crisis?
The U.S. mortgage market on the bases of their credit rating was divided into Prime and Subprime segments. The borrowers who were unable to meet the required prime criteria were classified as Subprime borrowers. Subprime word refers to the mortgages given to less than creditworthy borrowers. Initially the Subprime loans had low interest rates for the first two or three years and were typically granted to people with less than perfect credit scores. Through low interest rates, there was increased supply of money in the market, and additional money floating in the market the banks were in charge to lend this money in the market to earn extra revenue. [3] There were mainly two types of mortgages working in the market, fixed-rate mortgage and adjustable-rate mortgage. In fixed-rate mortgage arrangements a fixed interest payment based on the principal was due on a regular basis. In adjustable-rate mortgage arrangements interest was set to LIBOR index plus a certain margin in basis points. Until the interest rate was low these Subprime mortgage borrowers were able to pay these adjustable rate mortgages, but they were unable to pay mortgage payments on high rate of interest. The deterioration in the Subprime mortgage market for the most part is linked to the defaults on adjustable-rate mortgage arrangements by these Subprime borrowers. [4] One of these mortgages was interest only loans where for couple of years the borrowers were to pay only interest rate without the principal amount kicking in. The ability to engage in mortgage loans was dependent on the value of the underlying collateral, i.e. the house. The lenders of the primary mortgage market include mortgage banking companies, saving banks and housing finance agencies. Mortgage banking companies relied on secondary market funding in order to originate more mortgage loans. In the secondary market there were several government-sponsored enterprises that facilitated funding in order to keep interest rates low on house purchases. Fannie Mae, Freddie Mac and Ginnie Mae were that operated in the secondary market, providing primary lenders with liquidity. These enterprises bought these mortgage loans from the primary lenders and sold them to institutional investors after repacking them into securities. [5]
Their credit ratings provided guidance for lenders to evaluate a person's credit risk as it measured the borrower's probability of delinquency and default. The main aspects considered when determining credit quality were the characteristics of the borrower, of the collateral, and of the loan. [6] The refund policies, technically known as "liquidity puts," were crucial. As they allowed the credit rating agencies to bestow on the investments the same grade they gave the banks that backed them.These complexities made such structures difficult to be understood by the consumers using them and this lack of understanding shaped the risk of such underlying assets dangerously complicated in their impacts. [7] These government-sponsored enterprises also decided the criteria for lending money on these credit ratings. As the prime segment had become saturated mortgage lenders looked for alternative customers in new markets. Instead of entering new geographic markets, lenders detected a great opportunity by approaching the Subprime segment. Credit innovations done by these enterprises allowed Subprime borrowers to engage in a wider range of mortgage products, this extra risk conceded by these Subprime borrowers, resulted in a higher interest on Subprime mortgages. These Subprime mortgagers thought that there income was sufficient when it was only covering the expected interest ignoring the other expenses for instance mortgage insurance, closing fees, installments, and tax. These total expenses had tendency of going up to three times as high as the interest expenses, hence, mortgage lenders allowed loans that unfamiliar Subprime borrowers could not afford. [8]
2.2 Key features of the financial crisis
Under U.S. mortgage market the underlying asset was ring-fenced, i.e. the house was the only collateral backing the mortgage, therefore, a borrower who faced default on the payment could only offer the underlying house to the lender, while, the foreclosure of the property canceling the borrower's debt, even if the value of the asset doesn't correspond to the outstanding debt of the lender. So U.S. mortgage borrowers made deals by turning in houses of less value than their loans. This system supported the speculative house ownership, since the borrower may transfer the ownership to the bank and move if the value of one property is reduced. [9] While under Islamic financial system debt payment is the agreed payment between borrower and lender which was agreed when terms of debts were being initialised, there is no concept of compounding interest. But on extreme levels if a borrower defaults on the payments, the individual is personally responsible for the whole debt, if the foreclosed value of the asset doesn't correspond to the outstanding debt of the lender, other assets of the borrower may be confiscated, This consequently results in individual loss instead of institutional and systematic damage of the system as a whole.
Another very important aspect of the U.S. mortgage market was that it offered high loan-to-value (LTV) ratios to borrowers. There was no regulation regarding LTV ratios, meaning that the loans may exceed the value of the underlying collateral like there were few loans that were allowing a LTV of 125 percent. [10]
2.3 The Worst Crisis since the 1930s
The present worldwide financial crisis that began with the crisis in the mortgage markets in the United States is categorised as the worst financial crisis since 1930s. This Fiscal tightening momentum and tremendous losses during this crisis turned investment managers to focus on "Return of Capital" rather then "Return on Capital". Investors began to realise the riskier nature of these securities. The insurance for covering default risk became very costly as asset backed securities were difficult to sell in turn. The financial institutions that depended on the markets for funding also got adversely affected. Commercial banks lacked necessary funds to provide new loans as they depended on short-term commercial paper which they could no longer obtain and Investment banks that needed short-term paper in order to buy asset-backed securities defaulted on their payments. [11] Financial system witnessed a jargon of problems that trigger a deeper session of turmoil like companies that needed credit to survive being shut down, rise of number of bankruptcies, no new businesses or jobs openings, leaving many people without jobs and growing up unemployment rates. In the US there was 25,000 increase in jobless claims to 471,000 in the week ending May 15. [12] All that made it harder to borrow money to buy a house hard to find the funding to build a factory or renovate and buy new equipment for an existing one.
This recent crisis that began in the financial sector and moved to the real economy is the result of motives to achieve economic stability in short-run. This motive indeed causes instability in the long-run since debt mount up to unsustainable levels causing rise of interest rate in future. [13] As stated earlier, the subprime mortgage crisis refers to real estate crisis triggered by a dramatic rise in mortgage delinquencies with major adverse consequences for banks and financial markets around the globe and in USA. This crisis was fuelled by Subprime lending, a phenomenon that eventually led to the exporting of the crisis to markets in Europe and Asia. Voracious bank executives, dishonest mortgage brokers and many other structural conditions have been blamed for the present financial meltdown. Impact of ignoring the account of "Systematic Risk" on the part of Credit rating agencies by blessing the apparently low risk securities with AAA rating can't be ignored, as in principal the securitisation of these mortgages did not provide any protection against the systematic risk. [14] A brief over view of that mortgage structure is as follow:
In first step an individual got a mortgage from a broker, who sold that mortgage to a bank,
The banks in turn sold that mortgage to an investment firm on Wall Street. Thousands of such mortgages were collected in one big pool by these firms, which were receiving a monthly income that was supposed to continue for the life of these mortgages. These were security backed mortgages and seemed as safe investments by both US and global investors. These Subprime mortgages were pooled together and often were broken into pieces and grouped and packaged with other mortgages of the same type. So as a last step these firms pooled together these mortgages as securities and sold/resold the shares of that income to willing investors. Features of diversification, liquidity and smoothing out of particular risk of defaulting or bankruptcy crafted them as wonderful low risked financial vehicles. In presence of huge demand of these financial assets and absence of not many who could actually provide such assets, speculative bubbles came on the stage and became a part of the supply response of these financial assets. 80 % of security based US market and excess of capital, globally pushed an enormous amount of money into the US mortgage market. [15] Global and US based banks and investors bought such securities thinking that they are safe ultimately leveraging them (Invested more capital than they actually had).
The qualification guide lines adopted by the banks to lend money were pretty tight in past. They refused to those who have no income or poor credit history. But new development in economic sector caused the instigation of generating higher returns and created a corridor for high risk borrowers to mortgage at the significantly higher mortgage rates.
Thus, on one hand these financial instruments and vehicles were serving as a great solution to meet the demand of assets in the market but on the other hand the yield on such securitised Subprime mortgages was also higher. Ultimately the markets absorbed enormous amounts of these securities and as a result this Subprime lending by banks caused 5 million people to become homeowners from tenants, resulting low rents and high house prices till they reached unsustainable heights relative to rents in contrast to the stock market, where in the real estate market when the asset prices rose, more assets were created through construction. By 2006, between 63 and 81 per cent of Subprime loans were originated from mortgage brokers and other wholesale lenders. [16] But this designed plan Collapsed.
In reality the fact was that this boom was not based on a real economic activity but on a series of inflated debts. The banking institutions had employed increasingly sophisticated financial engineering techniques to repackage mortgages into complex structured securities; such financial innovations were not supported by proportionate development to their governance processes and risk management infrastructure and practices. [17]
The halt in rise of housing prices and no increase in average household income in 2006 made this housing bubble more evident as many Subprime mortgage lenders began declaring bankruptcy around March 2007. Because of the losses in the Subprime mortgage markets international financial system witnessed a triggered surprising turmoil with amazing speed even to those financial institutions that had no direct exposure to the Subprime mortgage market and shake in confidence of many financial institutions and the stock market grounding systemic weakness across financial sectors. The share prices for large, small, and investment banks all significantly dropped and lost about a third of their value creating distrust among the banks and as a consequence interbank lending was disrupted. This catastrophe that struck the heart of the macro economy is the result of unruly desires of ravenous capitalists. [18]
At this point the Subprime crisis turned into a credit crisis. A credit crunch, credit squeeze or credit crisis is a reduction in the general availability of loans or credit or a sudden tightening of the conditions required to obtain a loan from the banks. The "credit crunch" of 2007-2008 can be seen as a product of the explosive modification of debt that has occurred in recent years. This modification has, moreover, combined with a globalisation of the credit markets to produce not only a lending crisis but also a set of daunting challenges for those concerned with corporate rescue. [19]
2.4 Islamic Mortgage System
The World Economic Forum's Financial Development Report 2008 has endorsed a view that: "These crises [currency crises, sovereign debt crises, systemic banking or financial crises, systemic corporate crises, systemic household debt crises] are often preceded by asset bubbles and the credit bubbles that feed them… However, many asset bubbles have been associated with episodes of easy monetary policy and excessive credit growth. The perverse interaction between easy money, asset bubbles, credit growth, and leveraging that feed asset bubbles has been observed in many episodes. The initial trigger for a bubble may (but not necessarily) be a period of easy money with relatively low real interest rates. Such a low cost of capital and easy liquidity may lead to an initial increase in the asset price above its fundamental value. Since asset purchases are often financed by credit, the initial increase in the asset prices allows borrowers to borrow more as the asset price rise increases the value of collateral that can be used to increase leverage. With higher asset prices, the collateral value of borrowing to finance further asset purchases is higher, with increased leverage allowing additional asset purchases that further increases the collateral that then allows further borrowing and leveraging, entering into a vicious circle… Thus, easy money and easy credit may be an initial trigger of a process of asset bubbles and excessive leveraging of the financial system and of the private non-financial sector (Roubini, 2008, pp. 34-35)." [20]
As a result of bad bets on" risky Subprime loans" on July 17, 2007, two hedge funds of Bear Stearns collapsed. [21] The following news was the start of a sequence of devastating declarations by banks and mortgage investment companies about losses associated to Subprime mortgages. [22] The declining U.S. housing prices, unprecedented foreclosures, and unexpected performance of complex financial products backed by Subprime loans ended up in a global credit crunch and in order to defuse the effects of economic meltdown, several Central Banks overnight slit the lending rates and injected in extra cash into the economy. [23]
Under the same effects as a consequence of drying up of money market, the European Central Bank added 94.8 billion euros of one-day funds to money markets on August 9, 2007. In September 2007, the Bank of England, gave an emergency monetary support to British mortgage lender Northern Rock, that was flickered by a classic bank run and by March 2008, major banks and insurers across the globe forecasted over $150 billion of write-downs and losses as a result of Subprime mortgage loans. [24]
According to the senior financial analyst Khairul Nizam of Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in this chaos, one area of the global financial market has remained intact. "Islamic finance institutions have been protected from the global 'credit crunch." The reason: because the trading of Subprime mortgages is against the principles of Islamic Financial System. [25] According to Khairul Nizam, as the Subprime mortgages are not traded on the principals of Islamic financing their exposure in the Islamic financial market was non existent. So rather than credit issues, because of Shariah issues the Islamic banks have to stay away from these kind of transactions.
Thus, Islamic financial institutions escaped the credit crunch by managing to entirely avoid the Subprime lending market as a result of fundamental differences between the two systems. Islamic financial institutions were and are forbidden from dealing in Subprime mortgages for various reasons: first, a traditional mortgage in itself is based on lending at interest and would thus be barred for containing interest or Riba; second, because there is a huge uncertainty or excessively risky elements involved, a Subprime mortgage is prohibited because of the involvement of Gharar (Ambiguity) or Maysir (Gambling). [26] Risk management is one of the fundamentals of Islamic financial system. Under this system on one hand there is no profit allowed unless equivalent liability of loss is taken into consideration and on the other exposing one's wealth to unnecessary risk without bring real economic activity in motion is also prohibited.
In alternate to conventional mortgage system Islamic finance adopts a system which signifies the mechanism of three contracts:
A Partnership contract between the bank and the client in buying the said commodity for example a House.
The Ijara (Lease) contract, where bank earns profit by renting or leasing the said house to the client, and
The third contract is where client or partner will buy bank's share or unit in the partnership on predetermined price and contract between the parties. The working mechanism of this system is as follows:
In the following example:
B stands for the bank and
P stands for the person who wants to buy a House or partner of the bank in the said transaction
Step 1: B and P jointly buy a house, or only B buys a house and becomes the joint owner and sole owner of the house respectively.
Step 2: Then a term is agreed let us say 30 years. Now for that term P who is joint owner of property with B will live in that house and will pay rent to B for his part of share in house. For example if B's share of money was 70% in buying that house then P will pay for that 70% of the share to B and not for the 30% i.e. his ownership. With this rent that P will pay to B, P will pay B an amount/equity to buy the share of the house. By this way B's equity will keep decreasing and P's ownership in the house will keep increasing. Through this variable shared equity plan, steadily as the payments are made, the proportion of the house owned by B will shift completely to P. Briefly house is bought on installment from the bank on a mark up determined by the bank and the purchaser, until the purchaser pays off. The difference between the transaction made by the conventional bank and this transaction is that bank buys house for you and you pay the bank for it, but in a loan transaction under conventional banking you take loan from bank and you pay back money to the bank on some interest rate. Summarizing the above description, mortgage financing under Islamic Financial System basically involves three contracts namely:
Partnership Contract (Musharaka)
Two partners share the capital and buy a house or any commodity they want to buy
Lease or Rent Contract (Ijara)
As bank is not living in the house, so partner living in the house will be paying the rent. Or in other words the bank will lease the property to the partner or client.
Buying Of the Share (Baye)
The partner or client will be having an option of buying pre determined share portion from the bank's portion every month, until the client buys all the shares of the house. In this kind of financing there is no involvement of Interest, Gharar or any other element which is prohibited under Islamic Shariah.
