Islamic Mortgage System as a Solution for Current Credit Crisis in Saudi Arabia

Introduction

After the financial crisis, the leaders have come up with Basel III, which aims at strengthening the banking sector. However, it should be noted most countries, which had implemented Islamic banking, had little effects of the crisis. This is because Islamic banking is founded on the sharia law called Fiqh al-Muamalat governing all transactions (Hassan, 2008). The major guiding principle is sharing of profit and loss. Since both the borrower and lender share the profits and losses resulting from the funding, both parties tend to have a close association with one another. The lender will be interested to know in what project the borrower wishes to invest or spend the money. This eliminates chances of such money being used to fund illegal activities or indulgence in immoral activities (Ayub, 2009).

Another principle states that there is no financing or involvement in activities prohibited in Islam. Islam banking mainly applies in transactions that are acceptable in Islam, with the sole objective of promoting ethical and moral transactions. Transactions involving goods and services outlawed in Islam such as alcohol, pork and gambling are not categorized under Islamic banking.

Additionally, no interest (usury/riba) is to be charged on capital funding. During mortgage transactions, a bank will buy an item from a seller and then sell it at small profit to a buyer. The bank does not loan out money to the buyer; it instead buys the item and gives him a chance to pay for the loan in installments. Like conventional banks, Islamic banks demand collateral from the borrower before selling out the mortgage. Once the collateral is approved, the property is registered under the borrower’s name and he then has to start paying in installments, an arrangement called Murabaha in Islam (Kettell, 2011). Another loaning arrangement involves the bank applying a floating rate- as rental. The bank and borrower partner in funding for the purchase of property. The property is then rent out to the borrower. The borrower the pays rent which is distributed between the bank and the borrower. This arrangement is called diminishing musharakah(Dusuki, 2010).

While paying the rent, the borrower buys the shares of the bank in the property at specified installments until the equity value of the property is transferred to him, effectively ending the bank-borrower partnership. In case the borrower defaults on rental payment, the bank and the borrower both share proceeds arising from sale of the property depending on the value of their equity in the property. An arrangement in which the bank provides the capital funding while the borrower (entrepreneur) provides labor and expertise is called mudaraba. This enables both parties to share profit and loss (Kettell, 2011).

The fourth principle states that some risks have to be shared by all partners in a venture, whether the funds are utilized on a commercial or a productive venture. Such risks are proportional to each partner’s efforts. The risk must be controllable. In such a partnership, the contract must have a clear purpose and this must be assessed at the end of the agreement so as to guard against a one-sided transaction, commonly termed as gharar (Kablan $ Yousfi, 2009).

Statement of the Problem

The global financial crisis originated from greed and irresponsibility by a few individuals in the real estate’s mortgage lending sector, and it eventually spread to the rest of the banking institutions, attributable to the Federal Reserve’s relaxed interest rates. From the United States, the crisis spread globally due to United States’ influence in global economic issues, ranging from fallen stock markets to reduced demands for products from abroad. The price of valuables such as oil decreased, which tremendously affected the economies of countries that depend on income generated from exporting such products. Islamic mortgage requires the lender take responsibility of ensuring certain sharia law are followed.

Due to the housing crisis, many people who had purchased homes and could not afford to repay the loans finally gave up such homes when mortgage firms came, calling. The displaced homeowners abandoned their pets as they were compelled to rent apartments. In many rental apartments, pets are not allowed hence cats and dogs had to be abandoned in the streets. Other people abandoned their pets because of priorities in a situation where there are limited funds and anything bought or consumed depends on the priority attached to it.

Purpose of the Study

The major objective of the study is to analyze whether Islamic mortgage can be a solution to solving the financial crisis. It is intended to examine the responses and strategies Islamic banks in terms of lending money for acquisition of property. It is also intended to analyze the ways in which real estate companies using Islamic mortgages are positively impacting consumer behavior in terms of motivating consumers to invest in real estate by making use of different marketing strategies.

Research Justification

Conventional mortgage lenders failed the world when they tried to adjust mortgages upwards. Most lenders who had borrowed mortgages from mortgage firms and those who had borrowed loans from banks for housing purposes without a sound financial base found themselves incapable of paying for such mortgage loans (Shiller, 2008). Majority of the mortgage firms were lending assuming that if a borrower failed to repay, their houses would be sold to recover the cash. How wrong they were! Most borrowers were unable to repay their debts after adjustable mortgages adjusted upwards, leading to losses for mortgage firms and other loaning institutions, banks included.

Mortgage firms found it hard to resell houses that had initially belonged to mortgage borrowers since all financial institutions had already been affected tremendously and their liquidity positions had dropped. There were insufficient funds in all financial institutions hence the economy’s creditworthiness started dropping. During the 2007/2008 financial period, there were overestimations by investors in the house industry about future house prices. They expected prices of houses to shoot up which resulted in more investments in the sector. The housing industry eventually became flooded resulting in excessive supply with a limited demand.

Literature review

What is considered a valid contract under the Murabaha system is very clear-cut and involves a five-step process. First, an agreement is made between the client and financer, signed and stating the profit that will be received from the deal. Second, when the client requests that a specific commodity is needed, the financer and the client need to sign a contract that details the specifics of the commodity and the order. It is important is that the nature of the commodity and the intent to order the commodity is clearly outlined. Third, the commodity is actually purchased. Fourth, the client offers the financer that they would like to purchase the commodity. Lastly, the financer accepts the clients offer and the transaction is concluded and ownership of the commodity is officially handed over to the client (Timm, 2007).

In order for a transaction to be valid under the murabaha system and truly distinguish itself from the traditional banking system, steps three to five are essential since these are the stages that greatly differ from the steps needed to secure a traditional loan(Robbe and Ali, 2005; Murphy, 2003). When purchased, the commodity needs to be still considered a risk on the behalf of the financer, “The property must remain at risk of the institution for that period. The goods have to be purchased by the financer and they must have been in her ownership at the time of sale” (Timm, 2007). What is critical to a contract under this system is that the definite price of the commodity needs to be set forth before the actual purchase. However, depending on when the client would like to buy the commodity the financer could offer a pricing schedule based on the time frame and the client can choose what is best for them. However, it needs to be also noted that the later the client chooses to delay the payment, the higher the commodity mark up gets. After the rate is selected, the financer and the client cannot change it. What is most interesting about this system in contrast to the traditional loan system is that even if the client is unable to pay at the agreed upon time, the financer cannot charge the client any type of penalty for the incident since any type of penalty would be strictly against the principles set forth in Sharia law (Timm, 2007).

Although there are differences between this system and that of the traditional loan system, there are similarities as well. For instance, murabaha transactions like any other financial institution use current interest rates as a guide as to how much they should charge in interest for the commodity they are selling, “The use of interest rates as benchmarks for determining mark-ups, and more generally for pricing Islamic financial instruments, is widely accepted by fiqh scholars, be it with a lack of enthusiasm” (Visser, 2009; ITC, 2009). The main problem with this system is that there are many complications attached to the full disclosure rule. For instance, as previously mentioned the seller must tell the buyer the true price of a commodity as well as the exact mark-up price. This is not always feasible on the part of the seller since prices tend to fluctuate depending on the market (Siddiqi and Hrubi, 2008). The primary purpose of the murabaha system is to finance trade transactions such as the purchase of equipment. In order for any contract under murabaha to be acceptable, the financer must be relied upon to cover the risk that may be incurred in case any damage is done to the goods involved. Insurance may be taken out on the commodities and requires the financer to actually sign a contract with the supplier of the commodities as well as the buyer (Visser 2009).

In terms of securitization, many Sharia scholars argue that murabaha debt cannot be securitized hence any sukuk that is offered against murabaha debt is not allowed. The logic behind this train of thought is selling a document which is a representation of money is the same as trading money which is unacceptable under riba. However, in response to this belief, many Malaysian scholars argue that the transaction is permissible just as long as the receivable has a clear connection to a transaction that is based in legitimate trade that is non-monetary (Gurulkan 2010; Al-Suwaidi, 1994).

The manner in which the securitization process within the framework of murabaha takes place as follows:

1. An agreement is signed between the SPV as well as the borrowing party.
2. The SPV is responsible for issuing sukuks to investors as well as receiving any fees that may come from the sukuks.
3. The SPV then must buy commodities from the supplier.
4. The SPV sells the product to the borrower at a predetermined profit.
5. The borrower then sells the commodity to the commodity buyer.
6. The investors get the final sale price in addition to any profits that may have been incurred (Nisar, 2007).

A real life example of how a murabaha sukuk can be utilized occurred when Arcapita Bank in Bahrain presented a murabaha backed sukuk that had an expiration date of five years. The money generated from the sukuks will be used to sell and buy a variety of assets within the framework of murabaha transactions. The holders of the sukuks were offered a return of three-month LIBOR + 175 bps. The SPV will be transferred back to the bank making the sukuks transferable if approved by the banks advisory board. Hopefully, the SPV will successful in retaining a competitive amount of inventory as well as a decent amount of fixed assets so that it has more sukuk leveraging power (Gurulkan 2010).

Ijarah is essentially a form of what conventional banking refers to as a leasing contract. In this case, a certain financier purchases an item and then makes it available to lease to their client or clients. It can be formally defined as, “The sale of a definite infrastructure in exchange for a definite reward” (Timm 2007). Under ijarah, a financier first purchases something that is in demand and then leases that asset to the client. Similar to other transactions under the Islamic system, all details are ironed out prior to any actual contract or agreement is signed. Details such as the length of the lease, the price of the lease, the necessity of the item as well as the condition of the asset are discussed so that confusion is adverted and both parties understand what they should expect, “To avoid any ambiguity, it is agreed upon every detail in advance and by both parties. The rent must be determined at the time affecting the lease, and it cannot be increased unilaterally. The financier remains the owner of the asset” (Timm,2007). Not only is this system popular with small leases such as cars but it is also utilized in bigger situations such as financing buildings as well as factories.

The exact specifications for ijarah are not as detailed as they are for other Islamic structures but there are still a few rules to follow.

1. Any commodity that is consumed upon lease is not allowed within the confines of this transaction. For instance, it is against Islamic law to lease commodities such as money, food, as well as firearms. As well, the rent amount needs to be clearly communicated. Assets that are not yet built such as a building are allowed to be contracted under this structure as long as the client is informed as to when it will be made available and what the costs will be.
2. Rent under this structure needs to be clearly communicated as does any increases in future rentals. Mainly, rent needs to be consistent to a specific variable.
3. The liabilities attached to the asset need to be covered by the owner but any liabilities that are incurred when the asset is used are the responsibility of the client.
4. In relation to an ijarah sukuk, a SPV needs to be created in order to purchase the asset and transferred to the investor. The asset is then leased to a third party to use and rental money is distributed to the investors.
5. Any sukuks, which are distributed under this system, can be traded on the secondary market.
6. In leases, which are long-term, there is a certain level of flexibility allowed if it is agreed upon by both parties. For instance, if a house is leased for a very long period, an increase in rent should be discussed beforehand so that accurate market values are reflected in the lease (Nisar, 2007).

Another form of ijarah is referred to as ijarah waiktini in which it is implied that eventually the client will buy the asset and complete ownership will be transferred to him, “The contract is like an Ijarah contract with an additional agreement that the payments by the customer eventually lead to the transfer of ownership of the asset from the financier to the customer. The lease payments constitute a part of the actual purchase price” (Timm, 2007). Ijarah waiktini is composed of two main contracts, which are the leasing contract and the purchase contract. In order for this type of transaction to function, both parties must agree that after the lease period has expired, the client will buy the asset at a specific rate. Traditionally, Islamic banks offer this type of leasing option for a period of around three to seven years making it a first option for leasing machinery as well as transportation items while longer leases are acceptable for home financing (Timm,2007).

The main problem with this particular system is the difficulty in distinguishing between an operating lease and a financial lease. Since both ijarah and ijarah waiktini are very similar to traditional financial leases, there are is some doubt within the community as if they are actually permissible under Islamic law. In terms of long-term lease contracts, all risks associated with the asset are transferred to the client because ijarah contracts are binding and impossible to cancel (Visser, 2009).

The uncertainty of this type of contract can be clearly seen if it is combined with a sales contract and the value of the asset is predetermined since it is virtually impossible to guess the quality of the asset after the lease is up, “The quality of the asset at the end of the lease period is unknown. Agreeing a resale price beforehand is therefore, in the eyes of those fuqaha, a case of gharar” (Visser 2009). For instance, if a client agrees to a long-term lease even without agreeing to purchase the asset at the end, the cost may be much more than if the client had bought the asset with a loan while paying interest. If a client agrees to a five year lease contract and finds that he no longer needs the asset, he cannot do anything about that. However, if the asset is purchased through a loan with interest, the client can easily sell the asset if it is no longer needed and finish paying off the loan; in this case, his losses are cut. Under an ijarah contract, the client cannot legally sell the asset and if he can no longer make payments and may lose what investment he has already made in the asset (Visser 2009).

The financier may also suffer a risk under this type of contract if the client decides to default and decides not to continue making the agreed upon payments. If this happens, the financier most likely would need to find another client or lease the asset again at the current market value, which could be lower than the previously agreed upon rate (Ahmed and Tiby, 2011).

In terms of securitization, the ijarah contract is simpler than most and is easy to securitize, “The arrangement of ijarah has a good potential of securitization which may help create a secondary market for the financiers on the basis of Ijarah. Since the lesser in Ijarah owns the leased assets, he can sell the asset, in whole in part to a third party” (Usmani 2002). The structure is as follows:

1. A financier sells assets to a SPV at agreed upon price.
2. The SPV generates capital by the issuing sukuk certificates, which are equivalent to the amount of the assets.
3. These are transferred back to the financier.
4. A lease agreement between the SPV and the financier is agreed upon and the financier leases these assets.
5. The SPV receives rental money from the financier
6. The rentals are distributed between the sukuk holders.
7. At maturity, the SPV then sells the assets back to the seller at a previously set amount (Nisar, 2007).

Table

Perhaps one of the largest examples of securitization that took place under this system was in Saxony Anhalt Germany in 2004 by the ministry of finance in regards to a variety of buildings. Sukuk certificates worth €100 million were issued by a SPV located in the Netherlands. The reason for this was to avoid hefty municipality taxes in Germany. The sukuk was competitive with the municipality tax being applied in Germany. Saxony leased properties to the SPV and received a fee which is equivalent to the sukuk, this fee is a considered an advance on the lease rental. The SPV then agreed to a sub-lease agreement with the German Ministry of Finance, the period was set for a five year term. The sukuk certificates were representative of the pro-rates interest in the operating rights, which were held by the SPV. The sub-lease agreement required the state to make lease payments at specified intervals which were then passed on to the sukuk holders. Upon the last payment, the principle amount is extended under the sub-lease, “This five year certificate with a coupon payment of EURIBOR (flat) was co-managed by both Citigroup and the Kuwait Finance House. The Sukuk was fully subscribed with 60 % of the issue going to investors in Bahrain and the United Arab Emirates, while the other 40 % to investors in Europe, particularly Germany and France Like other German state debt instruments the Sukuk was listed in Luxembourg, with an additional listing in Bahrain to attract Gulf investors” (Gurulkan 2010).

It is clear that many Western countries are beginning to understand the potential of ijarah in terms of attracting investors from overseas and using it creatively to leverage assets. Perhaps the reason why this particular Islamic structure is so popular is because unlike other sukuks, ijarah sukuks are easily traded and can be bargained with on the market as well as converted to cash more readily than other sukuks. However, this clearly depends on the assets involved behind the sukuks and the risk factor that comes attached to them.

Methodology

Research Aim

The primary objective of this section is to discuss the research objectives, research questions, and research design. This study will use a combination of the qualitative approach and literature review to better understand how Islamic banking is working. In doing this, a questionnaire will be developed and delivered to the Islamic mortgage lenders.

Research Purpose

The purpose of research can include the following goals:

1. To further investigate an existing problem.
2. To find a solution to a problem
3. To analyze and explore issues
4. To create a new procedure
5. To explain a new phenomenon
6. To acquire new knowledge (Gratton and Jones, 2010).

Conventionally, research can be classified into four different categories which include: exploratory, descriptive, explanatory, and predictive.

Exploratory research

Exploratory research arises when there is little prior knowledge of the question. This type of research looks at the existing literature and tries to recognize similar patterns and ideas that emerge from it (Gratton and Jones, 2010).

Descriptive Research

Descriptive research defines a particular issue and examines what happened within a particular field rather than looking at why it happened (Gratton and Jones, 2010).

Explanatory Research

Explanatory research focuses on why something occurs and the relationship between different variables (Gratton and Jones, 2010).

Predictive Research

Predictive research forecasts future issues within a particular field depending on how the issues are interpreted through explanatory research (Gratton and Jones, 2010).

Research Approach

The manner in which research is approached is either deductive or inductive. Choosing between the two methods is critical for three primary reasons. First, selecting an approach allows the researcher to make knowledgeable decisions about the design of the research. Second, it allows the researcher to study which choices and research strategies are best for them personally. Third, a better knowledge of various research methods allows the researcher to realize particular constraints in terms of knowledge regarding the subject matter (Collins, 2010)

Deductive Approach

A deductive approach is scientific and requires that the research is independent from the issue that is being observed hence the research needs to remain objective. It needs the researcher to use a theory in order to develop a thesis and then test it (Collins, 2010).

Inductive Approach

An inductive approach needs the researcher to comprehend the context of where the research takes place thus takes a more flexible approach towards the research. A less structured methodology allows the researcher to use qualitative data as well as employ different methods to study the presented questions (Collins, 2010).

Primaries and Secondary Research

Primary research can be described as research that requires collecting original data. This type of data comes from various research methods such as surveys, questionnaires, and interviews. Secondary research can be described as research that uses unoriginal data collected from existing literature. Stereotypically, a research project will contain elements of both primary and secondary research. Primary research is necessary in order to find new information regarding a particular topic while secondary research is important in order to support new findings as well as give readers background information on the topic (Gratton and Jones, 2010).

Quantitative Research and Qualitative Research

Quantitative research

Quantitative research involves establishing the connection between variables in order to test a theory. Variables are typically measured and analyzed using statistical procedures. Data for this type of research is normally gathered through surveys, questionnaires, interviews as well as specific tests (Creswell, 2009).

Qualitative Research

Qualitative research is used mostly when the problem in question relates to the social sciences. The type of data analyzed in this type of research is non-numerical and can be collected from sources such as interviews, observation and existing literature, “The process of research involves emerging questions and procedures, data typically collected in the participant’s setting, data analysis inductively building from particulars to general themes, and the researcher making interpretations of the meaning of the data” (Creswell, 2009, p. 4).

Choosing the appropriate method

In order for a research project to be valuable, the researcher needs to select the most beneficial method depending on the subject matter involved. In this particular case, an exploratory approach was used to answer the research questions as well as to gain further information on the purposed questions.

The researcher established that in order to collect as much relevant information on the subject matter as well as to adequately answer the questions, both primary and secondary research was necessary. The reason why secondary research was necessary is because there is currently a very significant amount of literature on the Islamic banking and mortgages. This literature provides a great amount of reference material in which the researcher can observe and note specific trends that may be helpful in answering the questions related to the direct impact of Islamic mortgages of acquisition of property. Primary research was necessary in order to gain a fresh perspective on the presented questions in a real life environment. In addition, a mixed method approach was utilized to address the questions using both quantitative and qualitative data collection techniques as it was determined that the qualitative method alone would have been insufficient in terms of being adequately analyzed.

Research Design

The research design section presents readers with an overall idea of how the research questions and objective of the study will be approached.

Research Aim

The primary objective of the study was to understand the impact of Islamic banking in acquisition of property.

As discussed previously, the study was conducted under an exploratory view in an attempt to address the research questions. This study also took a mixed method approach to addressing the problems relying on both primary and secondary research methods as well as quantitative and qualitative data.

Data Collection Method

The research questions were answered through both primary and secondary data collection methods relying primarily on the use of surveys that were conducted. This data collection method was selected because it allowed the researcher to collect a sufficient amount of data within a reasonable time frame.

Data Analysis

The manner in which both the quantitative and qualitative data will be analyzed is by placing it in narrative format and then proceeding to summarize re-occurring themes as well as statistically analyzing results. According to Jankowicz (2005), it is acceptable to analyze existing data through interpretation as well as use supporting quotes to demonstrate reoccurring themes and conflicts.

Limitations

The primary limitation the researcher faced throughout the research phase was having a sufficient amount of time to gather all relevant literature. As well, it was challenge to construct survey questions that were efficient in terms of answering the research questions while being simple enough for respondents to understand. Another limitation was the amount of literature available in contrast to the timeframe needed to conduct research. Since there is an immense amount of literature, it was difficult to consider every important piece ever written on Islamic banking.

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