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Right Your Move-Islamic Ruling on Properties

Back to Right Your Move-Islamic Ruling on Properties
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Article Source In Islamic Banking And Finance Magazine, September 2004 Edition
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An Edited Version of This Article Was Published In Islamic Banking And Finance Magazine, September 2004 Edition.
Gordon Brown is a little less vocal these days in his claim of having brought an end to boom and bust in the UK. One might wonder what radical policy the chancellor has implemented to achieve this goal but, in truth, reform has been superficial and the key drivers of the boom-bust cycle remain firmly in place.

Nowhere is this clearer than in the domestic property market, where a familiar tale is beginning to unfold. An ever more indebted nation is buying property for the economically inefficient reason that "prices are going up", while older commentators worry that steep rises in interest rates will be required to calm things down. Conveniently for the government, headline inflation measures have been adopted that exclude asset prices, thereby allowing ministers to boast of achieving price stability in the middle of this roaring boom. Yet, the most expensive item most people ever buy is a house: so why aren't houses included in measures of the cost of living?

Attention is now focusing on the ratio of average house price to average income in the UK, which is at an historical high. Received wisdom says that it will soon fall back to its longer term average, but how this will happen is difficult to predict. It is entirely possible that the adjustment in the price to income ratio will occur by means of a rise in incomes, most likely accompanied by a rise in the general level of inflation.on the other hand, a fall in nominal house prices could achieve the same result

Meanwhile, lending institutions point to growing incomes, high employment, and a shortage of supply as factors that will spare us a sudden collapse. The motivation behind such arguments is probably a selfish one, given that lending against property has proved such a profitable endeavour over recent years. If an argument is needed to justify present prices, it would be more plausible to suggest that a low interest rate environment will become a feature of the British economy, similar to that which persisted in Germany for so many decades and allowed a much higher price to income ratio to become established there.

The more likely and worrying scenario is, however, that the Bank of England will in due course react by raising short-term interest rates. This is the same monetary orthodoxy that was unleashed on an unsuspecting population in the late 1980s. The results were disastrous. Typical was the case of a local taxi driver who, in 1988, put 40,000 of his own money together with a further 20,000 of mortgage finance towards the cost of his first home. Within two years, interest rates almost doubled and his bank repossessed the property. Not long after, the house was sold at auction for not much more than the 20,000 that was secured on it.

In the 1980s, buyers at auction expected to sell off their newly acquired stock at higher prices by hiring an estate agent and applying a little patience to the process of selling. Anecdotes abound that those auction buyers were often within the same corporate group as the selling institution, which may have been legal, but from every other perspective amounted to little more than co-ordinated theft. For the taxi-driver, the net result was that his life savings disappeared, the original lender got back its loan plus interest and costs, and a third party walked off with the remaining equity in the property.

Two factors will probably conspire to force the burden of adjustment in the present housing market largely upon borrowers. First, the money being pumped into the housing market is created by credit institutions at a marginal cost close to zero. In other words, the money home-buyers are borrowing is created by the banking system out of nothing. Banking business logic, therefore, dictates that the money produced should be maximized so long as it can be rented for more than zero. This is the reason Britons are waking up daily to letters on their doormats offering loans via credit cards, personal loans and mortgages.

Second, the Bank of England's monetary policy committee seems to regard interest rates as the only tool for meeting the government's inflation target. The reasoning is that, if people are spending too much, interest rates should be increased so that they borrow less and, therefore, spend less.

There is, however, another way of managing the problem. If monetary expansion is a major motor of house-price growth, then one obvious way to reduce the upward pressure on house prices is to reduce the ability of the banking system to create money. Interest rate increases do not necessarily achieve this goal because banks are more concerned about the the interest spread on their lending than the absolute rate at which they lend. Furthermore, borrowers don't always respond to interest rate increases until the level of interest rates becomes truly punitive. An alternative way of reducing lending is needed, and one way is to increase compulsory bank reserve ratios. The commercial banks hold reserves in the form of state-created money (M0) to meet requests for withdrawals of bank-created money (loosely speaking, M2), and also because of regulatory requirements on holdings of reserves at the central bank. If a reserve requirement is gradually increased such that the commercial banks must in due course hold more M0 per unit of M2 then, assuming that the state does not expand M0, the change in the reserve ratio can be achieved only by a corresponding reduction in M2. Growth in bank lending will thereby be restrained without blighting the rest of the economy with higher interest rates.
At a conference in 2001 organized by the Riyadh Development Authority, I gave a presentation on the modes of home financing. At that time, the Saudi government was providing interest-free loans to Saudi nationals to finance the purchase of their homes but had become concerned the scheme was draining financial resources. The conference, therefore, sought to identify alternative funding sources. Needless to say, the banking sector was a keen participant.

My argument was: if the banks were invited to provide finance for home purchase in Saudi Arabia, they would simply create that money out of nothing and lend it to prospective home owners at interest. Why, I asked, could the government not create the same amount of money out of nothing and lend it to the people interest-free? I also pointed out that an increased reliance on bank finance within the property market would bring the boom-bust cycle to Saudi Arabia.

Genuine Islamic financing, and the monetary system that accompanies it, would produce an entirely different set of outcomes for the property sector and the wider economy. If a bank was to share the risk of a property price fall with its home-buying client, it would be more cautious before pumping money into the market. This alone would be a strong restraining factor upon property booms, whereas what we see today is a positive feedback circle in which newly injected bank loans send property prices higher, thereby making the sector an even more attractive target for lending.
To achieve this vision, certain fundamental changes need to be made in how we organize our banking and monetary affairs. That these changes will reduce the profitability of interest-based commercial banks is clear. If left to their own devices, the possibility also exists that Islamic banks and their regulators might in due course adopt the necessary reforms. Hence, the widespread encouragement from among the interest-based establishment for a form of Islamic commercial banking that does not challenge the conventional paradigm of lending newly created money at interest.
Looking at the crop of so-called Islamic home mortgages offered by UK banks today, this fact becomes quite clear. If Shariah scholars were to argue that the present Islamic mortgage is a temporary step on the road to a fully acceptable product, the position would boil down to one of accepting Islamic mortgages due to overriding circumstances - necessity, for example. This may be a perfectly acceptable Shariah position, one that I am certainly not qualified to oppose or support, but it is not the position many of the scholars are adopting. Many argue that interest is not being charged at all in these Islamic mortgage contracts. I say that a "money now for more money later" contract is being agreed at the outset, and to me that's the same as interest.

Take a numerical example in which a bank transfers 100,000 to Person B on condition of receiving 150,000 in return from Person B over the next 10 years. This is clearly an interest-bearing transaction, but what if an Islamic bank were to structure a transaction such that 100,000 is transferred to Person B on condition that Person C pays back 150,000 over the next 10 years? This, after all, is a murabahah mortgage in which Person B is the seller of a house and Person C, the Muslim client, who wants to buy it.

The promises and other contractual arrangements put in place to fix and secure the cash-flow in these cases serve only to confirm suspicions of the intent behind the structure and it is, therefore, important for the longer term credibility of the industry to meet such questions head-on. It is not good enough to say, as one lawyer did when I questioned him at a product review, that "the Shariah scholar has approved it".

Neither is it sufficient for the Islamic bank to argue that, if it shares capital risk, it will go out of business or be in breach of regulatory requirements. It may well be that compromises have to be made after Islamic banking principles are established, but the principles themselves must surely be established in a compromise-free environment.

One common example of the tendency to compromise is the variable rate ijarah mortgage, on offer in the UK, in which rents are reset yearly in line with market interest rates. Although scholars have argued that this in itself is not haram (AAOIFI Shariah standards allow it), the fact is that the client does not know what rent he has contracted to pay to the bank until the beginning of each new rental period.
If interest rates increase significantly, the ijarah rental rate will likewise increase and the client could well find himself locked into the payment of lease rentals that he cannot afford. If Shariah requires that the price in a contract of sale be known, doesn't linking the price (in this case, the price of a usufruct) to an uncertain future value (LIBOR) defeat that requirement? Are Islamic bankers just mimicking the instruments of interest-based banking, floating rate mortgages included?

Furthermore, if the client decides that he can no longer afford the rent, the bank's mortgage contract requires that he must guarantee to repay the finance initially provided by the bank. In those cases where the house has to be sold to achieve this, the possibility arises that property prices may have fallen in the meantime and that the sale proceeds are, therefore, insufficient to repay the financed amount. The client will be required to make up any shortfall to the bank, and the prospect of negative equity arises. If the bank is renting the property to a customer, this can be only because the bank owns the property. How can it follow that the customer must suffer the consequences of a fall in the price of the property upon sale? Conceptually, it should be obvious that, if the ijarah mortgage product really is a rental, the client should not have to bear the risk of a fall in property prices. On the other hand, if the client is bearing the capital risk because he owns the property, then why is he paying rent to the bank? Perhaps the client and the bank both own part of the property, in which case both parties should suffer the capital risk but, under the dominant form of ijarah home financing contract, the bank owns the house in its entirety until the final payment on account is made by the client and only at that point is title transferred to the client.

The truth of the matter is that the core Islamic contracts of sale and rental have been mixed so that neither bears integrity any longer. The danger of such mixing should be obvious from a consideration of what would happen if an Islamic moneylender was allowed to combine a gift with an interest-free loan and a promise, all three of which are acceptable contracts in Islam. The client could simply be asked to promise to give the money-lender a gift on repayment of an interest-free loan. We know what kind of cash-flow that combination produces, and the scholars no doubt prohibit it on the grounds of legal trickery. So why does the reasoning not apply when the trick is played with promises and houses?

At a seminar in London in October 2003 given by a Shariah scholar to one of the big UK banks, the nature of the monthly payment made by the bank's Islamic mortgage clients was discussed. According to the scholar, the payments represented a combination of a rental (for use of the property) and a further amount in respect of goodwill (to confirm that the client will have sufficient funds to fulfil his promise to buy the property at the end of the rental term). When it was pointed out by a member of the audience that the bank's marketing literature used the word "down payment" to describe what the scholar had referred to as "goodwill", the latter informed the audience that this language was invalid and had to be changed. Such a structure would constitute a combination of two sales in one - in this case a rental and a sale - something that is prohibited in Shariah. Apart from the point that this emphasis on labels makes no difference to the bank's cash-flow, there is another more telling fact that emerges from the story. Namely, that several months of product development may be of little use if the right questions aren't being asked.
Five hundred years ago the Church in Europe was faced with the dilemma of the contract-um trinius, the triple contract. This was an invention of the merchants and the financiers who had together devised a way around the Church's usury prohibition. The triple contract was a combination of three contracts in one: an investment, an insurance contract and a sale of profit.

From the Church's perspective, all three components were permitted, but the outcome was a payment of interest on a loan of money and this was undoubtedly prohibited. Yet the Church was powerless to defend itself, for the principle of combining permitted contracts to achieve prohibited ends seemed beyond its ability to legislate.

Now it seems that the Muslims have invented their own triple contracts and given them such grand titles as "murabahah to the purchase order-er" and "tawarruk". We should not be celebrating these innovations, nor clapping their apostles to the conference podium. By these contortions, the Islamic prohibition of usury is now threatened with the same fate it suffered in Christendom.

Tarek El Diwany, September 2004.