Financial Crisis and Islamic Finance

Graduate Thesis: Jasmin Jusufovi Mentor: Mehmet Can

Outline
Introduction Explanation of the instrument in conventional finance which are blamed for the financial crisis. Inquiry into the crisis and its timeline Explanation of the comparable financial tools in Islamic Finance. Conclusion

Introduction
Everyday panic over a financial crisis seeks for some investigation. The thesis has worked on theoretical basis, to present, i.e. to understand the conventional finance and its alternative in Islamic finance Theoretical approach is justified by the lack of data in Islamic finance.

Our attention goes to...

Mortgage loans (mortgages)
How they work, and Characteristics.

Prime and subprime mortgages NINJA loans

Mortgage loans - recollection

Mortgage means a backup for the financier in real asset provided by the borrower, in case the latter defaults. Differed payment Price - interest

Mortgages properties
It is a contract involving two parties financier and borrower. Attention to clients creditworthiness. Good creditworthiness prime Poor creditworthiness

subprime.

Subprime mortgages
They are the result of loosening the mortgage standards. Initially aimed at exploiting the market demand for housing credits. Further geneaology gave birth to NINJA loans.

NINJA loans
Stands for No Income No Job or Asset. It essentially means that EVERYONE could be given loan. Market demand exploited to its maximum High risk involved backup needed

Securitization the inventive backup

Process of transfering illiquid or other assets into a marketable legal documents securities. For banks the clients liability (in form of a mortgage) is an asset and therefore the security created from it is Mortgage-based security.

Hedging further insurance

Too much outstanding loans and loan-based securities mean to much exposition to risk. Hedging is an inventive tool of selling an excessive risk upon another client, and therefore diluting the risk through the market. Most common hedging is Credit Default Swap

Credit Default Swap (CDS)

Rapackaging the risk in loans into a hegde to be sold to another entity in the market. Lender faces credit risk another party agrees to insure the risk in exchange for regular periodic payments. If the loan defaults, insurer pays the remaining debt to the lender.

Speculation
CDSs open door to speculation It is an influence on prices in the market with suspicious actions, thus driving the prices up and down drastically

So, what went wrong?!

The financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail. Because derivatives are entirely unregulated and trade on no public exchanges, their originators can deliberately hide their vulnerabilities.

 Soaring profits in securitization market invited everyone to take part in it. Banks loaned more and more, to have an excuse to securitize. Running out of primes, the banks turned to the risky, poor clients.

 Huge risks were taken, so other parties were involved to insure the risk. People started realizing what is happening; a cycle of defaults occured, and it all started to crumble. There was no money to sustain the derivatives created, and many market participants filed for bankruptcy.

Major events in the crisis timeline

1938: The Federal National Mortgage Association, commonly known as Fannie Mae, is established to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers.
1970: Federal Home Loan Mortgage Corporation (Freddie Mac) is created by an act of Congress, as a government sponsored enterprise, to buy mortgages on the secondary market, pool them, and sell them as mortgage-backed securities to investors on the open market;

 1992: Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required Fannie Mae and Freddie Mac to devote a percentage of their lending to support affordable housing increasing their pooling and selling of such loans as securities; Office of Federal Housing Enterprise Oversight (OFHEO) created to oversee them.
1993: The Federal Reserve Bank of Boston published "Closing the Gap: A Guide to Equal Opportunity Lending" which recommended a series of measures to better serve low-income and minority households, including loosening income thresholds for receiving a mortgage, influencing government policy and housing activist demands on banks thereafter.

 19952001: Dot-com bubble and collapse

1998-2008: With increase in sales of mortgage-backed securities, companies buy more Credit default swaps, unregulated insurance contracts used to protect debt holders; these increased 100-fold from, with estimates of the debt covered by such contracts, as of November 2008, ranging from $33 to $47 trillion.

 2000-2001: US Federal Reserve

lowers Federal funds rate 11 times, from 6.5% (May 2000) to 1.75% (December 2001), creating an easy-credit environment that fueled the growth of US subprime mortgages. combined purchases of incorrectly rated AAA subprime mortgage-backed securities rise from $38 billion to $90 billion per year.
Lenders began to offer loans to higher-risk borrowers, including illegal immigrants. Speculation in residential real estate rose.

2002-2006: Fannie Mae and Freddie Mac

 2004-2007: Many financial institutions issued large amounts of debt and invested in mortgage-backed securities (MBS), believing that house prices would continue to rise and that households would keep up on mortgage payments.
Fall 2005: Booming housing market halts abruptly

 Throughout 2007 and 2008 home sales continue to fall. Stock market experiences downturns September 2008

September 7: Federal takeover of Fannie Mae

The crisis spreads to Europe in the ending of 2008.

and Freddie Mac. This causes panic because almost every home mortgage lender and Wall Street bank relied on them to facilitate the mortgage market and investors worldwide. September 17: The US Federal Reserve lends $85 billion to American International Group (AIG) to avoid bankruptcy.

The Islamic alternative

Our attention will be on:
Musharakah (Partnership)
Regular and deminishing

Mudarabah (Commerce with agents) Murabahah (cost-plus sale)

Constracts / Instruments in Islamic Finance

Contracts / Instruments
Transactional Contracts Financing Contracts Intermediation contracts Social welfare contracts

Bay' (Sale)

Trade financing (Murabahah)

Parthership

Fee-Based Services

Insurance (Takaful)

Gratuitous Loans (Qard-e-Hasna)

Sarf (Exchange) Sale of Rights to Use (Ijarah, Istisna)

Asset-backed (Ijara / Istisna) Equity partnership (Musharakah)

Mudarabah

Guarantee (Kifala) Fee-based service (Jo'ala) Custody (Amanah)

Trust (Waqf)

Musharakah

Representation (Wikala)

Shariah as a source of economic philosophy...

It stems from Quran, Sunnah and the interpretations and oppinions of learned jurists (Ijtihad). It manifests the faith into dayto-day actions. Divided into two components:
Ibadat (defining rituals and rites) Muamalat (defining social, economic framework and practicality of day-to-day life.

Notions in Islamic economic system

Justice Property rights Property obligations Contracts Trust Personal obligations, rights and self-interest. Work Wealth Risk sharing

Islamic prohibitions
Islam prohibits the following notions know to conventional economists:
Interest (Riba) Gambling (Qimar) Ambiguity, uncertainty (Gharar)

Interest in Islamic philosophy

Wide scholar debate exists on what Arabic Riba means in conventional terms. General agreement is that Riba is interest per se, and any add-ups, swelling in value, over certain initial value. There are:

Riba al-Nasiah (excess in money-tomoney exhange) Riba al-Fadl (deals with hand-to-hand goods exchange)

Musharakah (partnership)
Comes from Arabih Shirakah which means sharing and participating together in certain activity, project, etc. Branches into
Shirakatu l-milk Shirakatu l-aqd
Shirakatu l-emval Shirakatu l-amal Shirakatu l-wujuh.

 Two parties combine their capital to share the generated profit. Proportions for profit sharing are predetermined before entering the contract. Losses are borne proportionally to the portion in partnership.

Diminishing Musharakah
Designed to meet the housing financing demand. The bank (the owner of the major part) rents its portion to the client. Clients installments include rent and amount to buy portion of owners equity. Rent is adjusted according to the deminishing equity.

Musharakah in financial market

Musharakah loans are marketable. The important prerequisite to be met is that the certificates (or securities) must represent the real asset, i.e. house, factory, etc.

Mudarabah (Commerce with agents)

Contract that includes financier and the agent (mudarib) who invests the financiers capital on his behalf. The profits generated by the project into which the capital was invested is shared among financier and mudarib.

Features of Mudarabah
Control Profit and loss sharing Profit distribution Multiple tiers Credit risks and defaults It cannot be traded in the financial market.

Murabahah (cost-plus sale)

The basis for this model is the trade. The financier is the seller of the good, who can sell the good on deffered payement. Since it is a trade, the seller can charge a profit margin.

Prospects of the trade in Islamic teaching...

The item in subject must be tangible in the moment of sale. The item must be owned by the seller. It must be in a physical or construtctive ownership. Purchase must be on the spot and immediate. Item must be a real value. It cannot be used for haram. The item must be known to either party. Delivery must be evident and unconditioned. The price, and markup, must be evident, clear and well understood.

Murabahah, further notions

Includes three parties:
Borrower - client Bank (financier - seller) The innitial seller.

Ordinarily today, the model is combined with mudarabah, whereby the client is hired by the bank to accept the delivery once the item is purchased, namely, creating no need for banks inventory. It is not marketable.

As we approach the ending...

Islamic economic philosophy recognizes the importance of financial markets, but raises many issues to be resolved. The debate is ongoing.
Notion of limited liability Tradability and negotiability Speculative trading Short selling.

So... What?! (or conclusion)

Are the unbound innovations beneficial? Could an event such as the current financial crisis with its properties, happen in the environment of Islamic Finance? How can Islamic Finance be an alternative or a remedy for the crisis?

Now, YOU!!!

Questions? Remarks? Comments?

YOUR ATTENTION WAS APPRECIATED...

Have a nice day!