Subprime Mortgages and the Shari'a
Though I've blogged about it in the past, I tend to be more bemused than interested in the perpetual patting on the backs among many in the Islamic finance sector for avoiding the financial crisis. Part of this is because those I respect who defend the industry--Vogel, Nick Foster, rising up and comer Jonathan Ercanbrack, even Sh. Yusuf DeLorenzo--don't really take it seriously. At a conference at Fordham I was on a panel with Sh Yusuf when he described the industry as having "dodged a bullet", not the language you use when you claim your skills helped you avoid something. My biggest disagreement with Vogel and Foster on this is they don't think the industry is self congratulatory, and I think they're oozing in self-congratulation. Probably depends who you speak to I suppose. Clearly DeLorenzo is not, but Umer Chapra is. Maybe that's why I've always had a bit of a soft spot for Sh Yusuf I suppose . . . .
The other reason I tend to ignore it is because the reasoning is usually so specious, it's not worth paying attention to. Usually, it runs something along the lines of "Financial institutions were hit hard by the crisis, but Islamic financial institutions did relatively fine, therefore Islamic finance is better suited to avoid crises like the one we just suffered." Exactly, as Colbert would say. The other day, a whole bunch of people had the flu, but my wife and I didn't get it. Therefore, an Islamic lifestyle prevents you from getting sick. And then a week ago, I sneezed, and then it rained. So I figured it out, Muslim sneezing causes rain. Anyway, the fallacy is obvious enough. Correlation is not causation, you can't just show two things happened, you have to show how one relates to the other.
But the other day wandering through law review notes and internet sites for a recent paper I'm trying to put together, I came across across a law review note and a report, quoting the same "senior financial analyst" at the premier standard setting body in Islamic Finance, AAOIFI, located in Manama. (That's another thing while I'm at it. Taking a mortgage and paying a fixed 3.770% on the loan--absolutely forbidden, you may end up in hell. Placing your institution in a country protected by guns that are turned on unarmed civilians demanding better treatment, using a judiciary that is mostly good at prosecuting doctors for healing the sick--nobody's perfect!) Anyway, this fellow at least has the temerity to attempt to link Islamic finance to avoidance of the crisis through practice. Though of course that's his downfall, because it's so easily demonstrably false, and actually to some extent disingenuous.
Here's what the note has the analyst saying:
Islamic financial institutions would be prohibited from dealing in subprime mortgages for multiple reasons: first, a traditional mortgage in itself is based on lending at interest and would thus be prohibited for containing riba; second, a subprime mortgage could arguably be prohibited as gharar or maysir, because it could be viewed as uncertain or excessively risky
I guess that's "multiple" reasons, though most people would say "two". But more importantly, both are pretty ridiculous. The first is disingenuous. Yes, Islamic finance institutions don't offer regular mortgages. What they do offer, however, is to buy the house for you, at market price, sell it to you immediately, at a higher price reflecting a prevailing interest rate, for you to pay in monthly installments over 30 years. It's the same thing, and in fact the practice is permitted in the US under OCC interpretive letters on the assumption that it's the same thing. And if you can do that for a regular mortgage, you can do it for a subprime, just raise the price of resale. That's perfectly acceptable in Islamic finance. So it is highly misleading, deeply deceptive to argue that Islamic finance avoided subprime mortgages because of the problems in riba. Its workarounds work fine for that.
Now as to the second, I don't know, either it's also disingenuous, or it's reflective of a general ignorance respecting what gharar means. Just because there is a business risk does not mean there is impermissible gharar. Not being sure whether a business is going to succeed is not gharar. I can fund a business as a silent partner with someone whose business plan is a risk, a big one. Business can't get done otherwise. Gharar refers to deeper structural forms of uncertainty--selling something not yet in existence, for example, like the fetus of a camel, or fish in the sea. If all of a sudden the fact that the venture might fail, that the numbers might not come through, counts as gharar, then they are proposing an incredible stricture on business. And absent that, it's not at all obvious how subprime mortgages are gharar. If Islamic banks didn't invest subprime, it wasn't because of any prohibitions.
Here's more from the article
The exposure to the subprime market in the US is probably non-existent among the Islamic banks because mortgages are not supposed to be traded on Islamic principles.
Really? Someone better tell the banks here, Fannie Mac and Freddie Mac owned a pretty healthy percentage of Islamic home mortgages, tens perhaps hundreds of millions of dollars of them, bought from the original banks themselves. (I have the numbers somewhere, too lazy too look it up for now, suffice it to say it was large). Not sure how that gets done without trading them. And let's be frank, there is much literature out there on the secondary market for Islamic home mortgages, which refers of course to the securitization and trading of those mortgages to earn the Islamic bank more capital to make yet more mortgages. The major problem discussed in that literature prior to the crash? Not permissibility, but rather that the market was thin. Essentially nobody knew what the hell these products were and so they didn't want to buy too many of them. It is admittedly one way to avoid a bubble--sell stuff people aren't interested in, and there's likely not a bubble.
But let's go one more step, how about credit default swaps, "insurance" of a sort against a falling mortgage backed security. Surely Islamic finance wouldn't allow that, would it? Generally no, you cannot guarantee against a loss. But there was definite movement in the other direction, the shari'a desk at the Malaysian National Bank (BNM) did indicate you could offer a kafala, a guarantee, with fees, to insure an obligation. (Very interesting piece on that here) They were thinking more about being able to guarantee bank deposits, a real issue for Islamic banks, but the reasoning isn't hard to encompass. Just then authorize trading those guarantees, as you can trade mortgage securities, and you're all the way there, completely exposed. One last, little step, not hard to take, was all that would be left.
HAH
The other reason I tend to ignore it is because the reasoning is usually so specious, it's not worth paying attention to. Usually, it runs something along the lines of "Financial institutions were hit hard by the crisis, but Islamic financial institutions did relatively fine, therefore Islamic finance is better suited to avoid crises like the one we just suffered." Exactly, as Colbert would say. The other day, a whole bunch of people had the flu, but my wife and I didn't get it. Therefore, an Islamic lifestyle prevents you from getting sick. And then a week ago, I sneezed, and then it rained. So I figured it out, Muslim sneezing causes rain. Anyway, the fallacy is obvious enough. Correlation is not causation, you can't just show two things happened, you have to show how one relates to the other.
But the other day wandering through law review notes and internet sites for a recent paper I'm trying to put together, I came across across a law review note and a report, quoting the same "senior financial analyst" at the premier standard setting body in Islamic Finance, AAOIFI, located in Manama. (That's another thing while I'm at it. Taking a mortgage and paying a fixed 3.770% on the loan--absolutely forbidden, you may end up in hell. Placing your institution in a country protected by guns that are turned on unarmed civilians demanding better treatment, using a judiciary that is mostly good at prosecuting doctors for healing the sick--nobody's perfect!) Anyway, this fellow at least has the temerity to attempt to link Islamic finance to avoidance of the crisis through practice. Though of course that's his downfall, because it's so easily demonstrably false, and actually to some extent disingenuous.
Here's what the note has the analyst saying:
Islamic financial institutions would be prohibited from dealing in subprime mortgages for multiple reasons: first, a traditional mortgage in itself is based on lending at interest and would thus be prohibited for containing riba; second, a subprime mortgage could arguably be prohibited as gharar or maysir, because it could be viewed as uncertain or excessively risky
I guess that's "multiple" reasons, though most people would say "two". But more importantly, both are pretty ridiculous. The first is disingenuous. Yes, Islamic finance institutions don't offer regular mortgages. What they do offer, however, is to buy the house for you, at market price, sell it to you immediately, at a higher price reflecting a prevailing interest rate, for you to pay in monthly installments over 30 years. It's the same thing, and in fact the practice is permitted in the US under OCC interpretive letters on the assumption that it's the same thing. And if you can do that for a regular mortgage, you can do it for a subprime, just raise the price of resale. That's perfectly acceptable in Islamic finance. So it is highly misleading, deeply deceptive to argue that Islamic finance avoided subprime mortgages because of the problems in riba. Its workarounds work fine for that.
Now as to the second, I don't know, either it's also disingenuous, or it's reflective of a general ignorance respecting what gharar means. Just because there is a business risk does not mean there is impermissible gharar. Not being sure whether a business is going to succeed is not gharar. I can fund a business as a silent partner with someone whose business plan is a risk, a big one. Business can't get done otherwise. Gharar refers to deeper structural forms of uncertainty--selling something not yet in existence, for example, like the fetus of a camel, or fish in the sea. If all of a sudden the fact that the venture might fail, that the numbers might not come through, counts as gharar, then they are proposing an incredible stricture on business. And absent that, it's not at all obvious how subprime mortgages are gharar. If Islamic banks didn't invest subprime, it wasn't because of any prohibitions.
Here's more from the article
The exposure to the subprime market in the US is probably non-existent among the Islamic banks because mortgages are not supposed to be traded on Islamic principles.
Really? Someone better tell the banks here, Fannie Mac and Freddie Mac owned a pretty healthy percentage of Islamic home mortgages, tens perhaps hundreds of millions of dollars of them, bought from the original banks themselves. (I have the numbers somewhere, too lazy too look it up for now, suffice it to say it was large). Not sure how that gets done without trading them. And let's be frank, there is much literature out there on the secondary market for Islamic home mortgages, which refers of course to the securitization and trading of those mortgages to earn the Islamic bank more capital to make yet more mortgages. The major problem discussed in that literature prior to the crash? Not permissibility, but rather that the market was thin. Essentially nobody knew what the hell these products were and so they didn't want to buy too many of them. It is admittedly one way to avoid a bubble--sell stuff people aren't interested in, and there's likely not a bubble.
But let's go one more step, how about credit default swaps, "insurance" of a sort against a falling mortgage backed security. Surely Islamic finance wouldn't allow that, would it? Generally no, you cannot guarantee against a loss. But there was definite movement in the other direction, the shari'a desk at the Malaysian National Bank (BNM) did indicate you could offer a kafala, a guarantee, with fees, to insure an obligation. (Very interesting piece on that here) They were thinking more about being able to guarantee bank deposits, a real issue for Islamic banks, but the reasoning isn't hard to encompass. Just then authorize trading those guarantees, as you can trade mortgage securities, and you're all the way there, completely exposed. One last, little step, not hard to take, was all that would be left.
HAH
Nizam has since moved up to become Deputy Secretary General of AAOIFI.
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Thanks for the update, and sorry it took me so long to post the comment. I've been out on vacation.
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