Islamic Mortgage System as a Solution for the Credit Crisis

Abstract

The purpose for this proposal is to lay out the study foundation and also give light on the Islamic Mortgage system as a solution in insulating against credit crisis. The study will use comparative approach, descriptive design and analytical method to examine the Islamic Mortgage System and Conventional Mortgage system with intention of explaining any underlying differences.

The study will contribute to the current literature of Islamic Mortgage system by confirming that Islamic Mortgage system is the only solution to the current credit crisis.

Introduction

This chapter explains the research background and statement of the problem. The statement of the problem describes the situation of the study. The chapter also identifies the research questions, the significance or the purpose of the study.

Background

The current global credit crisis has confirmed that the existing international financial structural design which is supported by the Conventional Banking system is a failure (Sesric.org, 2009). It has confirmed to be ineffective to cope with difficult financial structure of the conservative banking instrument which by extreme risk-taking resulted to the current sub-prime crisis in the United States mortgage industry and consecutively the credit crisis that advanced into the recent international financial crisis (Sesric.org, 2009). The recent international financial crunch has, consequently, produced crisis of “self-assurance” in the current worldwide financial system (Sesric.org, 2009).

Many concerns have been raised on the effectiveness of the Bretton Woods System along with its main institutions such as the World Bank and International Monetary Fund (IMF) (Sesric.org, 2009). Several views have concentrated on the necessity for modernization and restructuring of the international financial system in such a way that will enable prevention of the similar financial crisis. Concerns over organization of a new financial structural design require the engagement of chief developing and emerging nations in the international process of decision-making. This means that the industrialised or developed nations such as the G8 (Group of 8) are unable to deal efficiently with international financial and economic issues without close collaboration and coordination with the emerging or developing economies.

In reality, it sounds reasonable for every organization having the mandate to supervise the international economy to take in all major economies’ represented (Islamicity.com, 2008). In this perspective, it is of value stating that in his opinions on the limitations of the recent international financial system, Robert Zoellick (World Bank president), argued that the global organisations that did not include economies such as India, Saudi Arabia, Russia, China and South Africa, was out of date (Islamicity.com, 2008).

Previous cases of financial crises have charged the practices of convectional banking for being the foundation of the recent crisis. Great fear in the meltdown of the international financial system instantly lend to grand search for plans to bail out the banks. The crisis elevated several voices calling for second thoughts on another financial system; amongst these options, the Islamic Finance and Banking Systems were largely debated mainly in developing nations as well as members of the Organisation of Islamic Conference (OIC) (Freedomtale.com, 2009).

Statement of the problem

These days, most people argue that the recent international financial crunch might have been avoided if Islamic Finance and Banking System existed as an alternative to Conventional Banking system (Sesric.org, 2009). International financial crisis unfastened several opportunities for Islamic Finance, and the Islamic finance Model was the only solution to the continuing economic turmoil as it was unaffected by the sub-prime crisis in the mortgage industry (Sesric.org, 2009). Many non-Muslims resorted to Islamic banking, because clients who were influenced by the Western or Conventional banking system believed that Islamic banks were secure, as it was resilient to global crisis as a result of native business ethics in the Islamic banking (Economonitor.com, 2008).

Given this situation of the affairs, this proposal intends to confirm that Islamic Mortgage System is the only solution to the current credit crisis compared to Conventional Mortgage systems which triggered the recent credit crunch.

Research Questions

  • Q1. What is the difference between an Islamic Mortgage system and Conventional Mortgage system?
  • Q2. What are the most important structural reasons and costs of the recent credit crisis?
  • Q3. What opportunities did the Islamic Mortgage system encounter over and above the conventional mortgage system from the credit crisis?
  • Q4. What part does Islamic finance play in securing the mortgager against credit crisis?

Significance of the study

This study intends to compare the Islamic Mortgage system and the Conventional mortgage system and determine the best among them that is most effective in insulating against the credit crunch. Therefore, the study will help to throw light to the financial institutions and banks on how structural differences in their systems may lead to varying performance of the mortgages. Thus they will be able to choose the best system to use. It will also benefit the mortgagor in giving them the relevant information on the best type of mortgage system they can borrow money from.

Literature Review

Economic overview

The world’s economies were faced by the global credit crisis which speeded up the international economic recession; this financial crisis brought confusion and fear in 2007 within the international financial markets resulting to mortgage market of United States to burst (Hassan, 2010). The crisis took over $3,000 million of liquidity and bailout amount from some developed nations, to cave in a certain degree of the crisis intensity; however, the credit may have exposed the international economies to a long-term financial hold up (Wilson, 2009). Therefore, the need for a new financial structural design was necessary to reduce the rate and sternness of such an occurrence in future.

Introduction

The economic crisis resulted from fault in the mortgage industry in form of sub-prime loans and fraudulent activities carried out by the financial institutions. In addition, inadequate principles and regulations in the mortgage industry ignited the economic crisis (Ahmud, 2009). The financial crises led to international recession which eventually resulted to the lack of confidence by the investors in the financial system (Ahmud, 2009).

The supporters of Islamic Finance think that if principles of Islamic had been functional, the economic crisis would not have taken place; Islamic Finance is explained by 1% of the international financial market, with a 15% yearly growth and is expected to do so for no less than ten years. Many people in the Western nations are uninformed on the prosperity and intensity within which Islamic economies handle significant issues of trade, debt, land reform and poverty.

Indeed, the Islamic systems vary primarily with the recent neo-liberal international concept, since it is created through a wide monetary and practical method.

Cause of the crisis

Typically the most accepted cause of the recent financial crisis was the irresponsible and extreme lending by the financial institutions and banks for a long period of time, as well as the inadequate principles and regulations in the mortgage industry. This crisis made the investors timid in investing in the international financial system, leading to more financial meltdown (Sesric.org, 2009).

Effect of the crisis on the mortgage industry

The modern credit crunch of the United States also referred as Sub-prime Mortgage crunch or crisis that took place in 2007 caused disorder and excessive unrest in the international markets (MobeenAlam et al, 2011). Almost all banks or financial institutions failed, nationalised or were bailed out by the United Kingdom, Europe, United States and other countries governments, but its impact on the Islamic banking was insignificant (Ahmud, 2009

Closed vs. Open Mortgage

Closed and open mortgages are the two categories of mortgages; the major distinction between the two is the mode and terms of payment (MobeenAlam et al, 2011). A closed mortgage commits the mortgager for a particular length of time and it is frequently denoted as locked system (Differencebetween.net, 2011). In this system the mortgager is able to pay the mortgage when the property is sold; in contrast, open mortgage is not severe as the mortgager can pay the mortgage at any particular time with no penalty charges (Differencebetween.net, 2011).

Closed mortgages are for a longer period than open mortgages and the period of time may fluctuate from one year to six months, although the rates of interest for open mortgages are very high (Ahmud, 2009). In a closed system, the mortgager cannot negotiate or refinance the mortgage, before the end of specified term and mortgage renewal carries with it penalty charges (Hamwi and Aylward, 1999). This penalty payment is determined by the lender of the mortgage and may comprise of interest charges for a time period or differential amount of the interest rate; the mortgager may benefit from the closed mortgage just like the open mortgage if it has various pre-payment alternatives (MobeenAlam et al, 2011).

The benefit of opting for closed plan over an open mortgage plan is the period of time since either plan can have a scope of six months to twenty five years. For an open plan the time period can be up to two years while for a closed plan up to twenty five or thirty years (Calomiris, 2008). In a closed plan the principal amount can be paid in various instalment sets, depending on the mortgager convenience (Calomiris, 2008).

Closed mortgage system is also more secure; this is unlike open mortgage system which is influenced by the conditions of the market due to its short-term nature and high rate of interest, but they are not rigid like the closed system (Differencebetween.net, 2011). The mortgager can be freed off duty from the mortgage at any period of time with no penalty payments (Hamwi and Aylward, 1999). The rate of interest is high for an open plan but the terms are less than in closed plans where interest rate is paid for a longer time of period, which may counterbalance with an open system interest rates (Calomiris, 2008). In periods of financial uncertainty, an open system is the best option for a mortgage plans as the interest rate may be expected to drop (Differencebetween.net, 2011).

The Islamic Mortgage System

Introduction

Islamic banking came into being to suit the requirements of devoted Muslims who follow the ban of Riba (interest rate); many Muslims particularly the ones in non-Muslim nations, renounced the plan of possessing their own houses (Calomiris, 2008). Therefore, they opt to pay rent for a long period of time instead of applying for mortgage loans which entail paying the rate of interest; currently, the financial markets have accepted the Islamic (no Riba) mortgage loans which are accommodating the Islamic Law (Matthews and Tlemsani, 2010).

Islamic mortgage system exists in Muslim society in various forms based on time as the system has the capacity to fulfil the community needs in a reputable way (Kassim and Majid, 2009). The Islamic banking sector is growing with its assortment in various sections and scale which takes care of religious Muslims in the Islamic community and nations with minority population of Muslims (Hamwi and Aylward, 1999). Islamic banking is defined by the OIC (Organisation of Islamic Conference) as “a financial institution whose statutes, rules and procedures expressly state its commitment to the Principles of Islamic Shariah and to the banning of the receipt and payment of interest (Riba) on any of its operations” (Ahmad, 2008).

The structure and operations

Shariah prohibit receiving or making of interest from loans, as a result the Conventional loans offered by banks are not obtainable by Muslims who are committed to their faith (Reuters, 2009). Though, there are loans structures offered by the banks that make it easy for the Muslims to purchase property in accordance to their faith, there are two various forms of structure that a Muslim may obtain;

Murabaha Contract

Islamic mortgages were originally supported by Murabaha contract; in a contemporary situa (Hamwi and Aylward, 1999). The client then buys the property from the bank under a payment agreement intended to cover property cost as well as mark-up; the mark-up is the profit made by the bank and it’s used to represent the interest payment (Hamwi and Aylward, 1999).

Ijara contract

This type of structure is becoming largely accepted approach of acquiring property; it is a flexible method compared to Murabaha since it allows the client to settle up the mortgage before time with only one payment, or pay extra for the period of the loan, therefore reducing the loan time span (Wilson, 1997). Ijara, hire purchase and lease financing shares has several traits as it entails a lessor (bank) buying a property and renting the property to lessee (mortgager) for a particular period of time (Wilson, 1997). The lessee in return pays rent and the lessor receives the profit share from the property (Khan, 2000) two types of model exist; a long-term lease that conclude with property’s ownership transfer to lessee related to the finance lease and short-term lease that finishes with the lessor maintaining rights to the property just like operating lease (Mirza and Halabi, 2003). The bank and the client mutually own the asset and the client acquires the financial institution shares over a period of time (Yasaa.org, 2004).

The challenges

Since its foundation, Islamic financing has encountered several challenges; for the last 20 years Islamic financing has changed and advanced in various nations (Mirza and Halabi, 2003). The views of the Islamic scholars have made the Islamic financial institutions to suffer as a result of differing opinions (Shanmugam, Perumal and Ridzwa, 2004).

Islamic financial institutions lack qualified managers and scholars as they are not skilled to manage Islamic banking services (MobeenAlam et al, 2011). Islamic financial institutions in Western developed countries are coming across legal issues, since they are not properly governed, owing to this, tension between the regulators and Islamic financial institutions can be created (Salleh and Hassan, 2004).

Presently Islamic banking system is encountering threats from the new advancement, of Conventional banking opportunities opening to the Islamic financial institutions (Salleh and Hassan, 2004). The Islamic banks have to develop their services but their scholars have to work hard in upholding the Islamic Shariah (Garas, 2010).

The conventional Mortgage System

Introduction

This type of mortgage consists of several institutions driven by profit, they distribute credit risk as they seek profit and are uninsured by the government (MobeenAlam et al, 2011). A few of these institutions are funded by the government and the rests are funded privately; some institutions have the capability of holding loans in their asset collection and others insure the loans (Cushnie, 2006). There are three forms of these institutions; government-funded enterprises, mortgage insurers and asset collection (portfolio) lenders (Calomiris, 2008).

Portfolio lender institutions are funded privately and they have the facility needed to hold mortgages in their asset collection (Calomiris, 2008). These institutions include savings association, mortgage banks and commercial banks; the lenders establish their underwriting principles for loans they have, thus controlling the portfolio credit risk (Cushnie, 2006).

The structure and operations

The major factors that determine the payment of mortgage are terms and size of the credit; mortgage size and terms are the amount borrowed and time period in which amount owed must be paid, respectively (Hassan, 1999). Term and size of the periodical loan payment have a negative relationship, for example the longer the time period the smaller the periodical payments (Calomiris, 2008). There are four items that determine periodical loan payments, these are; insurance, taxes, interest and principal (Ahmad, 1999).

The property owner uses conventional mortgage manuscript as collateral for the loan illustrated in the notes payable which should be signed by the owner before a solicitor (Calomiris, 2008). If the mortgagers default on the notes payable, the bank may foreclose and compel the sale of the property and get income or property. Before the sale the mortgager is given a notice and offered a chance to pay foreclosure charges and penalties to secure the property; when the loan is fully paid, the banks carry out the “mortgage satisfaction” (Thomas, Cox and Kraty, 2005).

Conclusion

The Islamic and conventional mortgages systems have different structures that enable them to lend money to the mortgagers. The Islamic system does not use interest instead it uses mark-up on the property sold while the conventional system uses interest rate as profit. The Islamic financial institutions have encountered great challenges in the past due to inadequate information of the borrowing public and problems related to regulation.

Methodology

Introduction

The chapter focuses on how research will be designed and structured. It outlines the approach of the research design and also gives details on how the data will be collected, analyzed and presented.

Research method

The study will use descriptive design, analytical method and comparative (normative) approach; these are preferred because researcher will be able to analyse a wide range of content on the Islamic mortgage system and differentiate it with conventional mortgage system.

Data description and collection methods

The data for this study will primarily be collected through a survey in form of reading the existing material concerning Islamic Mortgage System and Conventional Mortgage System during and after the current credit crisis.

Data Assessment

The study will analyse the data collected using normative comparison. This is because the aim of this research is to identify, explain and improve on the current situation of affairs or to develop the same items in future and also to show the best amongst the options available. Data will then be presented inform of pie chart, bar graphs and line graphs where possible.

Expected Results

The study intends to generate qualitative information; the data will be collected from the already available literature materials such as books, journals, articles and magazines as well from internet sources.

The data will then be analysed using a comparative approach that is Islamic and conventional mortgage systems will be compared. The test of differences will also be appropriate, since it is a comparison between two systems which have varying structures.

Schedule

Table 1: Timetable

Activity Time
Introduction 1 week
Literature review 2 Weeks
Methodology 2 weeks
Data collection 3 weeks
Data analyses, discussion and presentation 1 week

Conclusion

To carry out this study the researcher will need some resources, such as physical resources (finances, library facilities), personal resources (knowledge in this area under study), time, and human resources to assist in providing relevant information.

References

Ahmad, S. 1999. Towards Interest-Free Banking. New Delhi: International Islamic Publishers.

Ahmad, W. 2008. Islamic Banking in the United Kingdom: Opportunities and Challenges, Web.

Ahmud, N. 2009. Islamic Finance: A possible Solution to a Crumbling Economy, Web.

Calomiris, R. 2008. The Subprime Turmoil: What’s Old, What’s New, What’s Next? Web.

Cushnie, L. 2006. Islamic finance presents firms with new opportunity to make their mark. Lawyer, 20(27), pp. 17-17.

Difference Between.net. 2011. Difference between open and closed mortgage, Web.

Economonitor.com. 2008. The Financial Sector Crisis and Islamic banking, Web.

Freedomtale.com. 2009. Islamic Finance and global economic crisis, Web.

Garas, S. (2010). Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution, Web.

Hamwi, B. and Aylward, A. 1999. Islamic International Finance: A Growing International Market. Thundebird International Business Review, Vol. 41(4/5), 407-420.

Hassan, A. 2010. The Global Financial Crisis and Islamic Banking. Web.

Hassan, K. 1999. Islamic Banking in theory and practice, the experience of Bangladesh. Managerial Finance, 25.5: pp 323-345

Islamicity.com. 2008. Islamic finance can solve global crisis. Web.

Kassim, S. and Majid, M. 2009. Islamic Finance: A growing Industry: the proliferation of Interest-free Finance, Web.

Khan, M. 2000. The challenges for Islamic banking. In M. Khan (Eds.), Anthology of Islamic banking. London: Institute of Islamic Banking and Insurance.

Matthews, R. and Tlemsani, I. 2010. Ethical Banking the Islamic Mortgage in the United Kingdom, Web.

Mirza, A. and Halabi, A. 2003. Islamic banking in Australia: Challenges and opportunities. Journal of Muslim Minority Affairs, 23.2: 347‐359

MobeenAlam, H., Norren, H., Karamat, M., and IIyas, M. 2011. Islamic Banking: Insulation against US Credit Crisis, Web.

Reuters. 2009. UBS sees growth in Islamic Finance, Web.

Salleh, H. and Hassan, F. 2004. Islamic banking system in Malaysia performance and challenges. Paper presented at the International Conference on Banking and Finance. Greece.

Sesric.org. 2009. Islamic Finance & Banking System; A potential Alternative in the Aftermath of the Current Global Financial Crisis, Web.

Shanmugam, B., Perumal, V. and Ridzwa, H.A. 2004. Islamic Banking: An International, Perspective, Serdang: University Putra Malaysia Press

Thomas, A., Cox, S. & Kraty, B. 2005. Structuring Islamic finance transactions. London: Euromoney Books

Wilson, R. 1997. Islamic Finance and Ethical Investment.” International Journal of Social Economics, 24.11: 1325-1342.

Wilson, R. 2009. Why Islamic Banking is Successful? Islamic Banks are Unscathed Despite of Financial Crisis, Web.

Yasaa.org, 2004. Shariah Compliant Mortgages, Web.

Appendices

Table 1: Timetable

Activity Time
Introduction 1 week
Literature review 2 Weeks
Methodology 2 weeks
Data collection 3 weeks
Data analyses, discussion and presentation 1 week