11/21/2011 12:07:17 PM
Salman Ahmed Shaikh
Current Home Financing Structure in Islamic Finance
In home financing using declining equity ownership structure, the customer approaches the bank for joint purchase of an asset/property. The seller of the property is paid by the bank and the bank and the customer enter into a Joint Property Purchase Agreement.
In this arrangement, the ownership stake of the tenant increases and that of the bank decreases or diminishes with the passage of time. The rent decreases as the ownership stake of tenant increases.
The share of the bank in asset/property is divided into units. These units are purchased by the customer periodically until he/she has purchased all units and become the sole owner of the asset/property. Rent is not charged immediately and is charged at the end of the month for the use of asset/property. Rent for at least one period is fixed. Unit price fixed for a period is not changed during that period. The rent is calculated based on 1 year LIBOR. The floor rate (minimum rate) and the ceiling rate (maximum rate) are stated based on which the rentals rate can vary. In agreement, it is stated that if payment is made on time, the transfer of ownership will take place accordingly.
The risk of damage to the property is borne by the bank and the customer, according to the stake in the property at the time of loss due to accident. Just like in conventional mortgage, a penalty is charged if a customer withdraws from the contract that is paid to charity. The logical argument presented for such a penalty is that the contract involves a promise/undertaking to pay rent and purchase units of the asset/property and if a customer withdraws from the promise/undertaking, he/she can be asked to pay a penalty for maintaining financial discipline. The penalty can’t be taken as income by the bank because change in price after the execution of sale can’t be made as per Islamic scholars. That is why; the penalty collected from customers is paid to charity.
Critical Analysis of Current Islamic Home Financing
In home financing using equity ownership concept in Islamic finance, two contracts i.e. tenancy and sale are included as two separate components of a contract. Both these contracts are separated by way of a unilateral undertaking in place of the actual simultaneous sale/purchase of units of the asset/property. Upon close inquiry, one can notice that unilateral undertaking or promise makes the contract conditional. This argument is further substantiated by the fact that if the client refuses to undertake or promise to buy the asset (in units), the bank will not make contract with him/her. Furthermore, the promise gives the legal cover to the bank and is acceptable in a court of law.
Following table compares the conventional mortgage and ‘Diminishing Musharakah'.
OIC Fiqh Academy rendered ‘Organized Tawarruq’ impermissible, but the ‘unilateral undertaking’ in almost all prevalent Islamic finance contracts - including Murabaha, Ijarah, Diminishing Musharakah, Salam, Istisna, Musawamah etc - is an ‘organized’ way of avoiding price and market risk (the only relevant risks and the only dividing line between trade and lending for interest). Hence, with the same logic, OIC Fiqh Academy should have rendered ‘unilateral undertaking’ an ‘organized’ tool for avoiding price and market risk and the Fiqh ruling of ‘no return without taking risk’.
Options in Islamic finance are not allowed due to the ruling that transactions should be Gharar free i.e. free from ambiguity and uncertainty. In the opinion of this author, the concept of “Gharar” (uncertainty) should not be used as a shield to avoid price/market risk. 1400 years ago, the economy was agricultural and the agricultural yield was not predictable and homogenous. In Options contract, the obligation rests on one party and the other has an option. Therefore, it does not have any element of Gharar (uncertainty). Call premium is also charged to create financial discipline. If there is no call premium, then one will buy an unlimited number of options contract to hedge for each date for a same or similar price.
Hence, options could be used in fixed asset/property financing to separate sale and tenancy contracts.
In the practiced Islamic banking, taking an undertaking from the financee is just like buying a put option from the financee who is acting as a put option writer. If this is reversed, the financee would buy the call option and the bank will sell the call option i.e. acts as a call option writer.
The alternative is as follows:
a) The bank buys the asset/property paying the asset owner the full amount of the asset. The Bank is now the owner of the asset.
b) It gives the asset/property on rent to the financee and the bank also enters into an option contract as the call option writer. In a European option contract (exercisable only at expiration date), the financee buys that call option which gives him/her the right to buy the asset at call expiration. He/She has the right but not the obligation to buy. The option writer however, is obliged to sell the asset if the call buyer (financee) decides to exercise the contract. For short term options contracts, American style call options contracts (exercisable on or before expiration date) could also be used.
c) If the call buyer does not exercise, the option contract expires and the bank is in a position to give the asset/property on rent again.
d) If the call buyer exercises the contract, the bank gets the asset price plus the rental income for the period before the expiration of the contract.
The rent could be benchmarked using House Rent Index. The issue arises whether a fixed premium could be added or not. Due to the fixed premium, even if the property for any reason reaches a value equal or close to zero, there is some rent charged greater than or at least equal to the fixed premium. However, since the contract itself does not have any connection with interest or interest rate benchmark and the rent is charged as long as the asset is in usable condition, it does not contradict with any of the Islamic principles.
This is not a new proposed avenue for investment to the investors. Hence, it is neutral to the issue that whether it should have a secondary market or not. We have lived without securitization of mortgages and in a much better way than in Great Recession.
Second, the proposal meets following specific objectives:
a) To allow people to break free from conventional mortgage if they feel they are not able to keep paying installments. It is done by making them Call option buyers i.e. take a long position.
b) To achieve separation of tenancy and sale contract. It is a requirement in Islamic jurisprudence. This is achieved in Islamic finance currently through a unilateral undertaking which is legally enforceable. Hence, current mechanism to separate tenancy and sale are not ideal and are just legal solutions to the problem.
c) To propose a mechanism that still allows the bank to have reasonable returns even when future prices are low and when they are high. Future prices will influence the client’s decision to exercise or not exercise the call option contract.
d) To propose a mechanism that still allows the client to have a place for living and an option to purchase the house at a fixed price rather than paying fixed installments until maturity.
e) To propose a mechanism for setting rentals which reflects true market rent than linking it with an interest based benchmark. Hence, an alternative to LIBOR as a benchmark/pricing rule has also been provided by linking the rentals with House Rent Index.