financial crisis and islamic finance_2

7/29/2019 Financial Crisis and Islamic Finance_2

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Financial Crisis and Islamic Finance

Graduate Thesis:

Jasmin Jusufovi

Mentor: Mehmet Can


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Outline

Introduction

Explanation of the instrument inconventional finance which are

blamed for the financial crisis. Inquiry into the crisis and its

timeline

Explanation of the comparablefinancial tools in Islamic Finance.

Conclusion


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Everyday panic over a financialcrisis seeks for someinvestigation.

The thesis has worked ontheoretical basis, to present, i.e.to understand the conventionalfinance and its alternative inIslamic finance

Theoretical approach is justifiedby the lack of data in Islamicfinance.

Introduction


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Our attention goes to...

Mortgage loans (mortgages)

How they work, and

Characteristics.

Prime and subprimemortgages

NINJA loans


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Mortgage loans - recollection

Mortgage means a backup forthe financier in real assetprovided by the borrower, in

case the latter defaults. Differed payment

Price - interest


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It is a contract involving twoparties financier andborrower.

Attention to clientscreditworthiness.

Good creditworthiness prime

Poor creditworthiness subprime.

Mortgages properties


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They are the result ofloosening the mortgagestandards.

Initially aimed at exploiting themarket demand for housingcredits.

Further geneaology gave birthto NINJA loans.

Subprime mortgages


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Stands for No Income No Jobor Asset.

It essentially means thatEVERYONE could be given loan.

Market demand exploited toits maximum

High risk involved backupneeded

NINJA loans


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Process of transfering illiquidor other assets into amarketable legal documents

securities. For banks the clients liability

(in form of a mortgage) is anasset and therefore thesecurity created from it isMortgage-based security.

Securitization the inventive backup


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Too much outstanding loans andloan-based securities mean tomuch exposition to risk.

Hedging is an inventive tool ofselling an excessive risk uponanother client, and thereforediluting the risk through the

market. Most common hedging is Credit

Default Swap

Hedging further insurance


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Rapackaging the risk in loansinto a hegde to be sold toanother entity in the market.

Lender faces credit risk anotherparty agrees to insure the risk inexchange for regular periodic

payments. If the loan defaults, insurer pays

the remaining debt to the lender.

Credit Default Swap (CDS)


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CDSs open door to speculation

It is an influence on prices inthe market with suspicious

actions, thus driving the pricesup and down drastically

Speculation


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The financial products andinstruments have become socomplex and twisted, that asthings start to unravel, trust inthe whole system started to fail.

Because derivatives are entirelyunregulated and trade on no

public exchanges, theiroriginators can deliberately hidetheir vulnerabilities.

So, what went wrong?!


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Soaring profits insecuritization market invitedeveryone to take part in it.

Banks loaned more and more,to have an excuse tosecuritize.

Running out of primes, thebanks turned to the risky, poorclients.


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Huge risks were taken, so otherparties were involved to insurethe risk.

People started realizing what ishappening; a cycle of defaultsoccured, and it all started tocrumble.

There was no money to sustain

the derivatives created, andmany market participants filedfor bankruptcy.


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1938: The Federal National MortgageAssociation, commonly known as FannieMae, is established to purchase andsecuritize mortgages in order to ensure thatfunds are consistently available to theinstitutions that lend money to home buyers.

1970: Federal Home Loan MortgageCorporation (Freddie Mac) is created by anact of Congress, as a government sponsoredenterprise, to buy mortgages on the

secondary market, pool them, and sell themas mortgage-backed securities to investorson the open market;

Major events in the crisis timeline


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1992: Federal Housing Enterprises FinancialSafety and Soundness Act of1992 required Fannie Mae and Freddie Mac todevote a percentage of their lending to supportaffordable housing increasing their pooling andselling of such loans as securities; Office of

Federal Housing Enterprise Oversight (OFHEO)created to oversee them.

1993: The Federal Reserve Bank of Bostonpublished "Closing the Gap: A Guide to EqualOpportunity Lending" which recommended a

series of measures to better serve low-incomeand minority households, including looseningincome thresholds for receiving a mortgage,influencing government policy and housingactivist demands on banks thereafter.


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19952001: Dot-com bubble andcollapse

1998-2008: With increase in sales ofmortgage-backed securities,companies buy more Credit defaultswaps, unregulated insurancecontracts used to protect debtholders; these increased 100-fold

from, with estimates of the debtcovered by such contracts, as ofNovember 2008, ranging from $33to $47 trillion.


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2000-2001: US Federal Reservelowers Federal funds rate 11 times, from6.5% (May 2000) to 1.75% (December 2001),creating an easy-credit environment thatfueled the growth of US subprimemortgages.

2002-2006: Fannie Mae and Freddie Maccombined purchases of incorrectly rated AAAsubprime mortgage-backed securities risefrom $38 billion to $90 billion per year.

Lenders began to offer loans to higher-riskborrowers, including illegal immigrants. Speculation in residential real estate rose.


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2004-2007: Many financialinstitutions issued large amountsof debt and investedin mortgage-backed

securities (MBS), believing thathouse prices would continue torise and that households wouldkeep up on mortgage payments.

Fall 2005: Booming housingmarket halts abruptly


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Throughout 2007 and 2008 home salescontinue to fall.

Stock market experiences downturns September 2008

September 7: Federal takeover of Fannie Maeand Freddie Mac. This causes panic becausealmost every home mortgage lender and WallStreet bank relied on them to facilitate themortgage market and investors worldwide.

September 17: The US Federal Reserve lends$85 billion to American International Group

(AIG) to avoid bankruptcy. The crisis spreads to Europe in the ending of

2008.


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Our attention will be on:

Musharakah (Partnership)

Regular and deminishing

Mudarabah (Commerce withagents)

Murabahah (cost-plus sale)

The Islamic alternative


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Constracts / Instruments inIslamic Finance

Contracts / Instruments

TransactionalContracts

Bay'

(Sale)

Sarf

(Exchange)

Sale of Rights toUse

(Ijarah, Istisna)

FinancingContracts

Trade financing

(Murabahah)

Asset-backed

(Ijara / Istisna)

Equitypartnership

(Musharakah)

Intermediation contracts

Parthership

Mudarabah

Musharakah

Fee-Based

Services

Guarantee

(Kifala)

Fee-basedservice

(Jo'ala)

Custody

(Amanah)

Representation

(Wikala)

Insurance

(Takaful)

Social welfarecontracts

Gratuitous Loans

(Qard-e-Hasna)

Trust

(Waqf)

Sh i h f i


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It stems from Quran, Sunnahand the interpretations andoppinions of learned jurists(Ijtihad).

It manifests the faith into day-to-day actions.

Divided into two components: Ibadat (defining rituals and rites) Muamalat (defining social,

economic framework andpracticality of day-to-day life.

Shariah as a source of economicphilosophy...

N ti i I l i i


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Justice Property rights Property obligations

Contracts Trust Personal obligations, rights and

self-interest.

Work Wealth Risk sharing

Notions in Islamic economicsystem


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Islam prohibits the followingnotions know to conventionaleconomists:

Interest (Riba)

Gambling (Qimar)

Ambiguity, uncertainty (Gharar)

Islamic prohibitions


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Wide scholar debate exists on whatArabic Ribameans in conventionalterms.

General agreement is that Ribais

interest per se, and any add-ups,swelling in value, over certain initialvalue.

There are: Riba al-Nasiah (excess in money-to-

money exhange) Riba al-Fadl (deals with hand-to-hand

goods exchange)

Interest in Islamic philosophy


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Comes from Arabih Shirakahwhich means sharing andparticipating together in

certain activity, project, etc. Branches into

Shirakatu l-milk

Shirakatu l-aqd Shirakatu l-emval

Shirakatu l-amal

Shirakatu l-wujuh.

Musharakah (partnership)


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Two parties combine theircapital to share the generatedprofit.

Proportions for profit sharingare predetermined beforeentering the contract.

Losses are borneproportionally to the portion inpartnership.


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Designed to meet the housingfinancing demand.

The bank (the owner of the

major part) rents its portion tothe client.

Clients installments include rentand amount to buy portion of

owners equity. Rent is adjusted according to the

deminishing equity.

Diminishing Musharakah


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Musharakah loans aremarketable.

The important prerequisite to

be met is that the certificates(or securities) must representthe real asset, i.e. house,

factory, etc.

Musharakah in financial market

Mudarabah (Commerce with


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Contract that includesfinancier and the agent(mudarib) who invests the

financiers capital on hisbehalf.

The profits generated by theproject into which the capital

was invested is shared amongfinancier and mudarib.

Mudarabah (Commerce withagents)


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Control

Profit and loss sharing

Profit distribution

Multiple tiers

Credit risks and defaults

It cannot be traded in thefinancial market.

Features of Mudarabah


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The basis for this model is thetrade.

The financier is the seller of

the good, who can sell thegood on deffered payement.

Since it is a trade, the seller

can charge a profit margin.

Murabahah (cost-plus sale)

Prospects of the trade in Islamic


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The item in subject must be tangible in themoment of sale.

The item must be owned by the seller. It must be in a physical or construtctive

ownership.

Purchase must be on the spot andimmediate. Item must be a real value. It cannot be used for haram. The item must be known to either party.

Delivery must be evident and unconditioned. The price, and markup, must be evident,

clear and well understood.

Prospects of the trade in Islamicteaching...


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Includes three parties: Borrower - client

Bank (financier - seller)

The innitial seller.

Ordinarily today, the model iscombined with mudarabah, wherebythe client is hired by the bank toaccept the delivery once the item is

purchased, namely, creating no needfor banks inventory.

It is not marketable.

Murabahah, further notions


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Islamic economic philosophyrecognizes the importance offinancial markets, but raises

many issues to be resolved.The debate is ongoing. Notion of limited liability

Tradability and negotiability

Speculative trading Short selling.

As we approach the ending...


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Are the unbound innovationsbeneficial?

Could an event such as the

current financial crisis with itsproperties, happen in theenvironment of Islamic Finance?

How can Islamic Finance be analternative or a remedy for thecrisis?

So... What?! (or conclusion)


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Now, YOU!!!

Questions?

Remarks?

Comments?


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YOUR ATTENTION WAS

APPRECIATED...

Have a nice day!

financial crisis and islamic finance_2

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