Sunday, March 28, 2010



(Author : Muhammad Zahid Abdul Aziz, Director, Muamalah Financial Consulting Sdn Bhd - February 11 2010.

(A term paper for Islamic Economics Msc Islamic Banking & Finance IIUM)


The paper will argue that the Western originated subprime crisis is a crisis that emanates from the fundamental flaws in the conventional system. Western analysts writing on it are still missing the point; they do not address the issue of the world view. They do not know what they do not know. Application of the Islamic world view and the resultant Islamic system will heal all the pains. However it’s a gigantic task to get the world to listen and appreciate the Islamic world view. A journey of a thousand miles begin with the first steps.

As far as Sukuk is concerned, the Islamic Financiers will inherit the Western ills for so long as they do not move away from debt Sukuk and focus on the more Shariah compliant equity Sukuk. Sukuk with equity names but decidedly debt features pleases the Sukuk players but contributes naught or little to the achievement of Maqasid AlShariah in Islamic Finance.


In 2008 for the first time since 1930s the world economic system was on the brink of collapse. The international financial system was a like a train screeching to a halt. Fortunately it did not happen this time, the train hobbled on, a wrong system saved by, in all likelihood, an equally erroneous solution that probably sowed the seeds for an even bigger disaster to come. Nobody knows the ultimate impact of the crisis of October ‘08 but the causes are now generally understood, within the context of conventional understanding without the benefit of an Islamic worldview.

A lot of literature has been written on the causes and solutions. This paper examines the issues from a pure Islamic point of view. Siddiqui summarised the crisis as follows: “It started as a credit crunch due to highly overstretched leverage, was aggravated by the complexity of the products and reached its zenith due to moral failure generating conflicts of interest and mismatch between incentives of the various groups and individuals involved in the saga.”

What happened?

According to C Stephanou of the World Bank the following were the landmark events.

Early 2007: US mortgage lenders go bankrupt

August 2007: BNP Paribas freezes funds due to exposure to subprime mortgage bonds; German authorities rescue two small banks

September 2007: deposit run on Northern Rock, forcing its (eventual) nationalization by UK authorities; Structured Investment Vehicles (SIVs) come under pressure

End‐2007: top‐tier banks announce record losses and are forced to bailout their SIVs

Late 2007/early 2008: financial guarantor monolines get downgraded, prompting big declines in the value of bonds they had insured; the US auction rate securities market freezes

March 2008: Bear Stearns sold to JPMorgan to stop it from failing, with Fed guarantees

Early September 2008: Fannie Mae and Freddie Mac put under ‘conservatorship’ by US government; Lehman Brothers files for bankruptcy; AIG rescued by Federal Reserve

Late September 2008: credit markets freeze; UK government arranges HBOS‐Halifax merger and nationalizes B&B; WaMu taken over by FDIC; Wachovia sold to Citi(later Wells Fargo); MS and GS convert to BHCs; Fortis recapitalized by BEL‐NL‐LUX; Hypo bailed out by consortium; Dexia is partially nationalized

October 2008: the main Icelandic banks are nationalized; several US and European banks are recapitalized by their governments


The trigger was a decline in US housing prices which unraveled highly leveraged and unsound lending which has been building up over time specifically in the market for subprime residential mortgage. The highly leveraged and unsound lending was in the form of securitisation of housing loans or mortgages as they are called in the US. Banks gives out residential mortgages which are then sold to a special purpose company which issue securities to investors to pay for the mortgages. The Arrangers of these securitisations are investment banks who get paid a fee and their employees gets paid huge bonuses as more fees are generated from this structuring, now generally referred to as the originate and distribute securitisation model. Everybody was making lots of money. The banks who gave out the housing loans were happy because they can continue to extend housing mortgages without keeping them too long on their books; they get debt sale profits and keep their capital within Basle Accord confines. The investment banks who arranged the securitisations are happy because they have found a new source of fee income; as long as house mortgages continue to be generated much demanded securities can be repackaged and sold to investors who like the nature of the securities in terms of yield as well as their risk instruments value that help bank investors meet capital adequacy dictates. The Investors in the securities are also happy, if they are pensioners in Sweden or Singapore they are holding clever US originated securities; if they are banks the securities as mentioned are a perfect fit for the new Basle capital accords they have to abide by. The US government are also happy and assisted the development of the saga further by deliberately keeping interest rates low in pursuit of Alan Greenspan’s idea of creating a home owners’ democracy. Soon the good credits dry up. Prudence would have stopped the securitisation machine however a system without values pays no credence to prudence if players involved find they can get way with it, and got away with it they did, and some. They started to get involved in predator lending. They seeked sub prime housing loan borrowers aptly described as NINJA borrowers, i.e. individuals with No Income No Job and Assets. Their objective is to keep the production line of housing mortgages churning so that the securitisation model can continue to securitise the mortgages and mortgaged backed securities sold to the ever waiting investors. In doing so the Arrangement companies are happy, the originator banks are happy and the personnel involved continue to get their fat bonuses. A clever idea at the time had the poor credits bundled with the better ones to create more saleable securities. To ensure investors continue to buy these securities they got another party into the picture to deliver credit enhancers. Thus enter AIG, US’s major insurance corporate with the now infamous credit default swaps or CDS. What this paper actually does is to take the credit risk away from the securitised papers or Credit Debt Obligations (CDO) which is the official name of the securitised or repackaged housing mortgages. AIG gets a fat fee for selling the CDS to the CDO structurers, assuming credit risks they have no way of measuring. The structurers do not have to keep the CDOs on their books and the investors are lulled into believing they have a truly secured paper, secured by the largest insurance company of America.

However a bubble by definition has to burst. By end 2006 real estate prices in the US reached unsustainable levels. As the Federal Reserve raise interest rates to address potential inflationary concerns weaker residential mortgage borrowers began to have difficulties meeting their obligations and defaults on housing loans began to increase. New purchasers stopped entering the housing market triggering a downward spiral in real estate prices. This process rapidly transmitted itself through the structures of securitisation. Lost in their own structuring in the initial stage they did not know who owned the securities that were becoming impaired; the housing loans being packaged and repackaged into CDOs repeatedly. Since the market did not know who owned the loans they stopped dealing in such securities. Soon their attention turn to the companies active in such instruments and who they believed are likely to hold large amounts of such impaired securities. Northern Rock of UK and Bear Sterns were the early casualties. Interbank lending and borrowing stopped and the credit crisis internationalised. The dominoes fell as outlined above.

Islamic perspective on the global financial crisis

Before we begin to address the Islamic solutions it is interesting to read the literature that mushroom to analysed and seeked solutions to the crisis. Amongst all the literature that came from Western writers not one touched the underlying world view; they either do not know the significance of world views or they did not know what they did not know. When world views are not addressed then existing systems and values or lack thereof are assumed correct so solutions are designed for a fundamentally defective system ; patches on balding tyres when what’s required is a full and complete replacement.

Lets first deal with the obvious culprit before we address the system that gave rise to such culprits, the process of securitisation. From the Islamic perspective there is nothing wrong in securitisation per se. Called tawriq it existed in the days of the Sahabah*. What is wrong is in the mechanics of securitisation, the subject matter, and derivative innovations on the concept of securitisation unfettered by Shariah parameters. Securitisation according to Shariah precepts has certain basic rules to comply with which limits its growth within the confines of the allowables. Such rules include rules of ownership where if sales are made then ownership must be transferred whole; Shariah does not allow sales where it is not clear whether and to whom ownership has been transferred. Apart from the issues of gharar or uncertainty such incomplete transfers approaches the definition of a batil transaction. Secondly is the asset which is being transferred itself; is it Shariah compliant and are parties trading the securities that represent ownership of the underlying assets fully versant with the assets? If the contracting parties do not know or understand the underlying assets being traded we are clearly in the realms of gharar, what more if the assets are of the nature of easily being ‘toxic’. This is what happened in the securitisation of subprime mortgages. Even before we deal with the subprime aspect there are already issues in the securitisation structure. A special purpose company or Structured Investment Vehicle (SIV) is set up to buy the housing mortgages from banks, and the SIV issue mortgage backed securities to investors in return for proceeds to purchase the mortgages. Housing mortgages are in the nature of receivables or dayn. Under strict Shariah precepts receivables or dayn are not tradeable. Strict Shariah interpretation under all mazhabs other than Shafie and to a certain extent Maliki, require the purchase of the houses with the attached mortgages in order to make securitisation worked. Seen in modern context this idea seems far fetched, however if an alternative Islamic financial system is able to make such purchases happen then clearly we have removed the gharar elements in respect of the underlying assets; owners of such asset backed securities actually owns the houses! Now compare this with the conventional version where the securities holders own receivables associated with the houses. Are all the receivables collectible, what is the value of the asset purchased; the value of the house purchased is obviously different from the value of the mortgage purchased? In some structures it got so complex structurers can buy pools of asset on sale to underlie their securities, distancing further the structurer and ultimately the security holders from the originators and the ultimately the individuals taking up the mortgages. The zenith of the structure are CDO’s of CDO’s where SIVs are formed to purchase mortgaged back securities and issuing mortgage backed securities to purchase the said underlying mortgage backed securities. If the sentence is confusing so is the structure the sentence is trying to described. This is what happens when structuring are limited only by the imagination of the structurer without benefit of guidance by revealed Shariah. The asset which the securities represent ownership thereof is gharar of the highest nature. Such instruments will not see the light of day under an Islamic system.

Now under Shafie as practiced in Malaysia purchase of debt is considered acceptable subject to certain conditions and if we scrutinise recent Sukuk structures coming out of the Middle East in particular Sukuk Istithmaar by the Islamic Development Bank (IDB) we are beginning to see some convergence on the acceptability of purchase of debt. Under the IDB Sukuk Istithmaar issuance, Murabahah and Istisna’ Financing of IDB are sold together with their Ijarah financing to a special purpose company which then issues Sukuk representing ownership of these receivables. The Sukuk are declared tradeable on condition that the Ijarah assets remains at least 51% of the portfolio at all times. The idea being Ijarah represent assets. However a close scrutiny revealed that what was purchased by the SPV was the Ijarah receivable not the Ijarah asset so the Sukuk being traded represented 100% ownership of debt. Some argue this is convergence on the validity of the purchase of debt. Having said that we note that the Shafies laid down some strict rules before debt trading is allowed. Firstly it must be dayn mustaqir, a valid and collectible debt. Secondly it is purchased with cash. The subprime mortgaged backed securities being discussed is certainly not dayn mustaqir and similar issuance cannot arise in an Islamic environment assuming a non-interest based version is designed. So we may conclude jumhur ulama will not allow structures of securitisation that gave rise to the mortgage backed securities through purchase of debts and even in jurisdictions where debt purchase is allowed subprime mortgages would have been disallowed on the premise that it does not represent dayn mustaqir, i.e. valid and collectible debt. If the initial purchase is forbidden the second step of bundling with good credits is also redundant.

Let’s now look at the second issue which is the credit enhancer in the form of Credit Default Swap or CDS. An Insurance company will sell a CDS to the SPV issuing the Mortgage backed Securities in return for a fee. By virtue of the CDS the insurance company says it will reimburse all credit defaults resulting from individual mortgage borrowers defaulting on their commitments. Siddiqui argue that the insurance or whichever companies that sells CDS for a fee have engaged in a maysir or gambling transaction. They certainly do not know whether or not the mortgage borrowers will default and they hope their calculation on the fees is correct should they have to pay upon such defaults. When the property bubble burst their calculations were off big time and their gamble also failed big time. A takaful company would have been prohibited from issuing CDS because as a product it would not have obtain Shariah approval because of gharar in the nature of asset purchased and the overall maysir features of the transaction. Giving a guarantee in return for a fee is still generally not permissible. We offer our opinion that even if it is permissible it should be backed by solid collateral to avoid the element of maysir or gambling in the transaction. In the case at hand it was easy money in the early days that clouded the judgement of insurance companies in the likes of AIG. In an Islamic system no Takaful company would be allowed to engage in instruments like CDS thereby precluding their obvious pitfalls. As an aside we worry however about new Islamic Finance jurisdictions like Singapore who has openly declared it will not have a Central Shariah Advisory board at the Regulator’s level. Lax Shariah oversights may breed innovations other more stringent jurisdictions have protected themselves against.

A discussion in this context cannot avoid the topic of moral hazard or the weakness of man to conduct muamalat in an honest and God fearing way. It is quite obvious in the western problem the only worry is getting caught and if one has to choose between individual interest and public interest, individual rights and interest are upheld almost all the time. So obviously the structural problems of subprime were made worse by the dishonesty of the players in pursuit of incentive payments and fat bonuses. Personnel of Arrangers in cohort with personnel of banks engaged in predator lending which cannot be acceptable under any scenario. Personnel of CDS providers blind themselves to the potential pitfalls of the products they are selling. A lack of world view in the personnel aggravated a defective structure to deliver a killer blow to the economy. An Islamic system with God fearing personnel should remove some if not all of the moral hazards for in an Islamic system it is not about being caught but about being watched over.

Do the recent problems in Sukuk issues indicate that Islamic finance is also crisis prone?

Recent problems in Sukuk issues may be divided into the following categories namely:
1) Lack of liquidity to take up Sukuk leading to deferment of Sukuk Issues
2) Sukuk defaults leading to lack of confidence in new Sukuk Issuance
3) Legal jurisdiction problems revealed by the Sukuk defaults
4) Non-Shariah compliancy as highlighted by the famous AAOIFI declarations on Sukuk
on 14th February 2008.

1) Lack of liquidity to take up Sukuk leading to deferment of Sukuk Issues

Technically the subprime crisis should not permeate to Islamic Sukuk market and Islamic countries. Islamic Banks, Financial Institutions and Shariah compliant Islamic Investors do not hold US subprime papers as a matter of Shariah dictates. So unlike pension funds in Sweden, mutual funds in Singapore and asset management companies in Hong Kong, the Islamic world was spared the direct impact of holding subprime papers. However what they suffered from was the secondary disease of credit squeeze which resulted from the sub prime debacle. As we saw above interbank lending virtually froze at the heights of the crisis. As the major Sukuk players in the Middle East include international banks Sukuk issuance also halted due to the perceived lack of liquidity. One would have thought that a region wealthy in its own right, with its own set of capable Bank/Sukuk arrangers and its array of wealthy Sukuk investors would cushion this area from the impact of the subprime and the ensuing credit squeeze. However geopolitical factors and globalisation, globalised the subprime problem and this area was not excluded its excesses. Hence they too suffered albeit less severely from the US originated financial disease. If Europe can set up a Common market and so other major groupings in this world the idea of an Islamic Common market with the natural membership of OIC countries is long overdue. Since we have the strength to survive as a group why open ourselves to disease infected areas in the financial, or even ideological, sense?

2) Sukuk defaults leading to lack of confidence in new Sukuk issuance
If we examine the Sukuk defaults the great majority of them relates to property development and its accompanying excesses. Islam promotes moderation in all things and development is not excluded. In pursuit of material developments spiritual parameters are required so that we do not fall into the western habit of bubble and bust. If we do not exercise restraint even in economic development excesses will transpire, Islamic or conventional. Sukuk default was confined to a particular geographical area in the Middle East where excessive real estate building took place. One cannot blame Sukuk structures when it was the underlying projects which were the problem. The bubble burst and Dubai property came a tumbling and brought down with it not a few Sukuk. Shariah says exercise restraint and moderation in all we do; we can hardly blame Islamic Sukuk structures for our weakness in that area.

3) Legal jurisdiction problems revealed by the Sukuk defaults
One really cannot launch new Capital Market Instruments on borrowed conventional infrastructure. That’s the position when Sukuk are designed, packaged and launched but we then say it is subject to English Law. Someone not familiar with the nuances will assume that most of the Sukuk investors are Englishmen or at the very least Europeans. Why do Arab investors of Arab Sukuk need to rely on English law? The problem is Arab Investors rely on western fund managers to advise them on how to invest their funds. Hence the peculiar reliance on a foreign law to regulate what is essentially a local Sukuk. English Courts case laws have declared Sukuk contracts to be valid only when read in context of English contract law. Where does Shariah advice now stand? Judgements obtained in one jurisdiction cannot be implemented in another jurisdiction. This also a crisis in a manner of speaking but a crisis of our own making. Muslim funds supporting Muslim Sukuk in Muslim Projects supported by Muslim law should remove the jurisdiction crisis from our Sukuk, but will the people concern hear our plea?

4) Non-Shariah compliancy as highlighted by the famous AAOIFI declarations on Sukuk
on 14th February 2008.

Sukuk as popularly structured will almost certainly attract some if not all of the problem associated with western securities. The prevalent practice is how to deliver Sukuk with equity name like Sukuk Musharaka and Sukuk Mudharabah but with decidedly debt features. These debt features are usually in the form of Purchase Undertakings which equates to capital guarantee which incurred the wrath of AAOIFI as not compliant with Shariah dictates for Musharakah and Mudharabah. In fact AAOIFI’s declaration of such Purchase Undertaking not being Shariah Compliant in February ‘08 resulted in 85% of the prevailing Sukuk as not Shariah compliant. Amongst the problem with the subprime securities was it was a debt structure that allowed no lee way for failure in payments. Lack or non payments on the securities demand the securities to be devalued leading to its demise and the demise of institutions heavily involved with it. An equity instrument on the other hand are much more forgiving as in the nature of equity where what you lose today can be more than compensated by what you earn in the future since your earnings is based on a ratio and is not capped as in debt. Therefore if Sukuk take the nature of debt it will inherit whatever problem inherent in conventional debt instruments. So a crisis in a conventional debt instrument has a great possibility of being repeated in an Islamic debt instrument. Hence it’s not entirely wrong to say that Islamic debt sukuk will also be crisis prone. Some Shariah rules like avoidance of poor debts will mitigate the crisis somewhat but it will not be as crisis free as true blue Islamic equity instruments would be.

1. The Global Credit Crisis of 2008: Causes and Consequences. - Douglas W Arner. The International Lawyer. Chicago: Spring 2009. Vol 43, Is 1, p 91-136
2. The Financial Crisis. Financial Services Liberalisation Workshop –C Stephanou The World Bank 5 November 2008
3. Current Financial Crisis and Islamic Economics M.N. Siddiqui 31 October 2008
4. Resolutions of the Securities Commission Syariah Advisory Council. PPN Malaysia October 2003 *
5. Islamic Securitisation After the Subprime Crisis – Andreas A Jobst Journal of Structured Finance Winter 2009
6. Lest We Forget Paul Krugman The New York Times November 28 2008

* Sahabah = companions of the Prophet pbuh

1 comment:

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