Residentential Mortgage Crisis

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Draft- Confidential

Khan, Iliasu, Chowdhry 1

Preventing Residential Mortgage Crises: An Islamic Finance Perspective By Waleed Khan a , Dr. Fatimah B. M. Iliasu b & Sajjad Chowdhry c Abstract The 2008 Financial Crisis has compelled the international financial industry, politicians and homeowners to search their souls for the root causes of the problem. Many point to insufficient regulatory supervision, others to a culture addicted to credit and sheer greed. While these issues certainly exist, we believe that the residential mortgage and capital markets harbor structural attributes that are fraught with uncertainty and create opportunities for unjust enrichment and exploitation. These malaises, among others can be prevented by applying some core principles from Islamic Finance, a system predicated on transparency and justice, and which seeks to benefit society as well as entrepreneurs. In this paper, we employ Islamic Finance principles to analyze the current predicament and to make recommendations that can prevent similar crises from recurring in the future. Introduction The current credit crisis has hemorrhaged hundreds of billions in losses worldwide, leaving in its path ruins ranging from venerable banks to individual homeowners. Despite the efforts of government to limit the fallout, limited liquidity, eroding homeowner equity, mounting loan defaults and inflationary pressures have hampered the U.S. economy, which is languishing now in a deep recession. Efforts underway to create stability have been short-term and mostly address the symptoms; however, the root causes persist and must be targeted to prevent another crisis. Even with the passing of the

a

waleed.khan@gmail.com iliasu@post.harvard.edu c sajjad.chowdhry@gmail.com b

waleed.khan@gmail.com
Electronic copy available at: http://ssrn.com/abstract=1481984

7/9/2009

Draft- Confidential

Khan, Iliasu, Chowdhry 2

“Wall Street Bailout” package uncertainty in the credit market looms and no clear end appears in sight. The question on everyone’s mind becomes, which model can be used to tackle the root causes by retooling the residential mortgage system and solving for longterm financial stability? Islamic Finance (IF) offers an attractive model because its core values are built on benefiting humanity, justice, accountability and calculated risk-taking. It promotes and facilitates responsible entrepreneurship and investing, pursued with high integrity in an endeavor that benefits society and profits investors equitably. IF bases its worldview in one of the great world religions. Therefore, it sees all humanity as being essentially noble and free 1 and as such discourages anything which would subjugate one human being to another unjustly. In the case of IF, excessive debt and usury (e.g., transactions involving interest) are viewed as forms of exploitation. 2 In addition, IF is based on the premise of risk sharing and not risk transfer which we believe is another cause of the current financial crisis. This dedication to faith, its ideals and ample liquidity have promoted a steady rise of Islamic Finance assets, which are growing 20% annually and may reach $2 trillion in 2010. 3 Several experts argue that IF-conforming transactions are intrinsically safer due to stronger accountability, conservative financials and transparency. In fact, Shariah Boards and other regulatory bodies (e.g., Accounting and Auditing Organization for Islamic Financial Institutions, Islamic Financial Services Board) have defined oversight measures that have reduced risk levels of IF products and transactions. For example, the Dow Jones

waleed.khan@gmail.com
Electronic copy available at: http://ssrn.com/abstract=1481984

7/9/2009

Draft- Confidential

Khan, Iliasu, Chowdhry 3

Islamic Market Index, which subscribes to IF principles filtered out Enron and WorldCom months prior to their demise.3 Similarly, the root causes that contributed to the current financial...
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