Subprime Crisis 2008 and Islamic Solutions. By: Amiera Zulkifli. Msc Islamic Finance and Management, Durham University, UK.

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1 Subprime Crisis 2008 and Islamic Solutions By: Amiera Zulkifli Msc Islamic Finance and Management, Durham University, UK. The subprime crisis of 2008 ravaged the real and financial sectors of the global economy. Trace the economic links between the subprime mortgages and the devastation which ensued from their defaults. Would this devastation been averted if Islamic principles were applied to finance the homes of the underprivileged? Generally, there was a calm period of the economy known as the Great Moderation where Central banks around the world claimed that it was due to increasingly competent use of interest rate policy (Garnaut, 2009). However, it was not long until the market failure makes its way into the economy in The period was known as the Great Crash where combination of several failures in the economy contributed to the collapse. The Great Crash Real estate had significantly grown in popularity because it is considered as a good consumption as well as investment (Malpezzi, 1990). Financial institutions start to offer easy credit to many, including the non-credit worthy ones, mainly the underprivileged. Credit history, financial ability and backgrounds of borrowers are not thoroughly checked prior to credit approval creating what economic called subprime mortgage. Exploding adjustable rate mortgage (ARMs), balloon payments loan and reverse mortgages (Engel & McCoy, 2010) are among examples of over the night products that were offered in the market. Bankers later find ways to qualify the subprime borrowers using law underwriting standards which have unusually low teaser rate in the ARMs and which will reset to higher rates after initial ones (Ebrahim, 2009). This was to create a credit history to able them to qualify for future refinancing with fixed rate mortgage (Ebrahim, 2009). There were assumptions that the

2 house will increase in value and the subprime borrower are able to refinance prior to expiration of teaser rates (Ebrahim, 2009). Unfortunately, the opposite happens, where payments increase sharply coupled with decrease house value leaving the subprime borrower in dire position to meet monthly payments (Ebrahim, 2009). Thus, due to negative equity, many defaulted as they do not have any option causing a domino effect in the economy (Ebrahim, 2009). The property became an underwater investment triggering further strategic default (Foote, et. al., 2008) mainly by the prime borrowers. The house value became lower than the loan value at this time of the economy, spreading more defaults as borrower felt that it is not worth to continue payment. [Figure 1] The Economic Collapse The effects of subprime mortgage were horrendous, as it causes domino effect in the entire chain. The risky ARMs loan had become a toxic debt, causing financial fragility (Ebrahim, et. al., 2014) which leads to economic collapse. There were too many debt in the economy and financial institutions starts to fall out. Large financial institutions in the United States like Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and Lehman Brothers, were either taken over, bailed out by the government or went bankrupt (Wikipedia, 2015). The collapse of Lehman Brothers and government s refusal to bail-out had been the starting point for extraordinary downturn in global economy (Garnaut, 2009). Stemming from that, financial institutions now believe that no one is safe. Government may no longer be their safety net in the event of crisis, leading to credit tightens. The burst of housing bubble also caused securities that were tied to the United States real estate dropped sharply, damaging the entire chain of global institutions (Wikipedia, 2015). The Great Crash has now turned into Great Recession in world output and trade (Garnaut, 2009). Output started to decline in end 2007 for Japan and European countries while the United States only suffers such decline in first quarter of Due to tightening of credits, business funding stopped everywhere, as exporters could not get their usual banks to honour

3 their usual credit letters to usual customers (Garnaut, 2009). This has subsequently reduced consumer spending and business investment everywhere (Garnaut, 2009). For China, factories began to receive s from overseas customers cancelling orders causing massive flouting of products from cars, household items and others (Granaut, 2009). It is sadden to see businesses in Japan, Korea, and Taiwan liquidated followed by China leaving hundred thousands of people unemployed. Commodity crash on oil, copper occurred and decline in trade quickly spread worldwide (Granaut, 2009). In short, the repercussions of subprime woes were felt in the real sector as well as the financial sector (Ebrahim, 2009) which have given great impact on the economy today. The Solution The post-crisis of 2008 have forced many to find ways to deleverage their financial sectors (Financial Times, 2014). Perhaps it best to solve the root problem of such crisis by looking into the financial mechanism that can affect the market. Ebrahim (2009) in his paper suggested a Cooperative Home Mortgage Scheme specially designed to serve the underprivileged and avert subprime crisis. The financial cooperative based its model on the Security (Mortgage) Design and the financial cooperative namely the Accumulating Savings and Credit Associations (ASCRAs) which are inter-related with Rotating Savings and Credit Associations (ROSCAs) (Ebrahim, 2009). The housing financial cooperative consists of a group of people whom raised funds to purchase large priced goods like a house for the other members (Ebrahim, 2009). Here, the member whom house being purchased repays the principal together with extra amount in lieu of the interest rate to the cooperative (Ebrahim, 2009). The member then offset the cost of borrowing with the benefit of lending thus creating a zero or interest-free rates (Ebrahim, 2009). The cooperative will also ensure that there was no risk shifting which mitigate the issues of agency cost of debt (Ebrahim, 2014).

4 The Result First, pricing of such formal and cooperative mortgages were done and it includes not only interest in the usual mortgage, but loan-to-value and the tenure of facility using more specific pricing algorithm (Ebrahim, 2009). Results then showed that the financing cooperative are more efficient than the formal ones as the loan amount is marginally higher (Ebrahim, 2009). Borrowers are only subject to the payment of principal and not principal plus interest amount. Further, the cooperative has marginally lower monthly payment with lesser tenure (Ebrahim, 2009). Thus, less monthly payments together with lower tenure can provide the opportunity to the underprivileged to be a home owner. The second result revolves around the issue of equity. The formal mortgages showed a concave line profile of mortgage while the housing finance cooperative showed a linear line (Ebrahim, 2009). In case of cooperative, the equity cushion (Ebrahim, 2009) can be built faster when payment are made as the borrower are paying off the principal and not the interest. Further, the tenure for such mortgage can be reduced as there is lower amount of loan due to zero interest (Ebrahim, 2009). Bigger gap are generated quickly in cooperative which eventually increase the value of equity and makes the cooperative lien less likely to intersect the asset line value over time (Ebrahim, 2009). Homeowners also enjoy equity faster and financial institutions reduce its risk quicker. These causes less default prone and at the same time reduce the possibility for negative equity. In contrast, the formal mortgage generate slow equity cushion generating lesser gap with higher possibility of default as the borrower have to serve the interest first. [Figure 2] [Figure 3] Thirdly, interest rate can be controlled effectively using this model as the endogenous use of leverage helps to offset the cost of borrowing (Ebrahim, 2009). At times of inflation, the loanto-value and tenure of cooperative facility can be affected in contrast to formal mortgage

5 which will price out the borrower due to increase in affordability (Ebrahim, 2009). Lastly, it is believe that the model had proved to be pareto-superior than the formal mortgage depending on the characteristic of a home which borrower and underwriting adopted (Ebrahim, 2009). In short, the model proposed have shown positive impact on the economy when formal mortgage were mixed with the underlying concept of cooperative finance mechanism namely the ASCRAs. The Shari ah Here, it can be said that the housing financing cooperative proposed depicts the spirit of khilafah in Shariah as it involves brotherhood for cooperation, unity and helping out each other. Since the model did not adopt interest in its principal, it is in line with the prohibition of riba in Quran 4:161. With no interest in the cooperative, the issue of expropriation of wealth that can lead to agency cost of debt can be avoided (Ebrahim, 2014). Issues of gharar or non-disclosure of asymmetric information (Thomas, 1995) that can convey risk to the underprivileged are of no concern since the cooperative are made between people in a group having the same interest with no aim at profit maximisations. They based their cooperation on trust and amanah to help each other. Stemming from non-involvement of interest can help avoid financial fragility and financial exclusion which can alleviate poverty in poor countries. A resemblance of interest free instrument which can be compared to the cooperative is the qard hassan (interest free loan). Thus, it is strongly believed that the housing finance cooperative model proposed by Ebrahim (2009) is efficient in nature as well as Shariah compliant as compared to the formal mortgage. Adoption of such model should be done globally to help alleviate poverty and build robust economic system in countries where there were mainly populated by the underprivileged.

6 State of economy Property price Loan 0 T t Figure 1: Underwater Investment Negative cushion, Loan > asset value period of underinvestment, lead to strategic default Formal Mortgage Asset/Lien Value Asset/Lien Value Over Time Formal Mortgage P1 Q1 Equity cushion slower, lesser gap, higher possibility of intersection, default prone 1 t T Figure 2: Asset/Lien Value Over Time Formal Mortgage

7 Cooperative Home Mortgage Asset/Lien Value Over Time Cooperative Home Mortgage Asset/Lien Value P1 Q1 Equity cushion faster, bigger gap, less likely to intersect, less default prone 1 t T Figure 3: Asset/Lien Value Over Time Cooperative Home Mortgage References/Bibliography: Ebrahim, M. S. (2009) Can an Islamic Model of Housing Finance Cooperative Elevate the Economic Status of the Underprivileged?. Journal of Economic Behaviour & Organization. 72(3), pp Ebrahim, M. S., Jaafar A., Molyneux, P. & Salleh, M. O. (2014) Agency Costs, Financial Contracting and the Muslim World. Durham Business School Working Paper Series. Engel, K. C. & McCoy, P. A. (2010) The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps. USA: Oxford University Press, USA. Garnaut, R. & Smith, D.L. (2009) The Great Crash of Victoria, Australia: Melbourne University Press.

8 Malpezzi, S. (1990) Urban Housing and Financial Markets: Some International Comparisons. Urban Studies. 27, pp Thomas, A. S. (1995) What is Permissible Now?!. Singapore: The Muslim Converts' Association of Singapore. The Financial Crisis Inquiry Commission (2011) The Financial Crisis Inquiry Report: Final Report of The National Commission On The Causes Of The Financial And Economic Crisis In The United States. Washington. U.S. Government Printing Office. Wikipedia (2015) Subprime Mortgage Crisis [online], Available from: ms Accessed on 8/1/2015. Wolf, M. (2014) We Are Trapped In A Cycle of Credit Booms. Financial Times, 8/10/2014, p 13.