2. Background to the study and statement of the problem
The subprime mortgage crisis was far more serious than
any experienced since the Great Depression.
Subprime loans or mortgages are risky for both lenders
and borrowers, due to the combination of high interest
rates, bad credit history, and murky financial situations
often associated with subprime applicants (karmila et.al
2010).
In general, interest rates on subprime mortgages are higher
than on prime mortgages to compensate the lender for the
(additional) default risk associated with subprime loans (
Demyanyk and Van Hemert 2008).
3. Cont……
Many factors were identified, some of the majorly
identified-factors have been (1) poor regulatory
oversight, (2) excessive risk taking, (3) under pricing of
risk, (4) corporate governance problems, (5) moral
hazard among others.
However, one of the cardinal features of conventional
economics that is interest has been given less attention.
“Interest is the cost of credit and played and served as
the major determinant of credits and loans in
conventional financial system”.
4. Review of related literature
Saddiqi (2008) attributed the crisis to the ribawi (interest) in
the global financial system, he outlined the broad features of
the crisis, trying to establish the thesis that most of them are
rooted in a moral failure that leads to exploitation and
corruption.
Classical economists’ simply defined interest as the cost of
capital in investment process, modern theory tends to set up the
interest rate as the center of policy and economic control. The
classical economist argued that it is only by postponing
consuming that capital can be created. To abstain from
consumption is agreeably painful, but the lender is paid a
reward in form of interest.
5. The concept of interest:
conventional economic perspective
Classical economists’, simply defined interest as the cost
of capital in investment process, modern theory tends to
set up the interest rate as the center of policy and
economic control.
The classical economist argued that it is only by
postponing consumption that capital can be created. To
abstain from consumption is agreeably painful, but the
lender is paid a reward in form of interest.
6. Islamic perspective of interest and its prohibition
Qur’anic verses have revealed clearly and unambiguously
about interest prohibition.
"O Ye who believe. Fear Allah and give op what
remains of your demand for usury, if Ye are indeed
believers". If Ye do it not, take notice of war from Allah
and his Apostle: But if Ye turn back. Ye shall have your
capital sums: Deal not unjustly and Ye shall not be dealt
with on unjustly". (Al Baqarah: 278-279)
"O Ye who believe! Devour not Usury, doubled and
multiplied; but fear Allah that Ye may (really) prosper.
Fear the Fire, which Is prepared for those who reject
Faith". (Al Imran: 130-131)
7. The subprime mortgage crisis
The decade-preceding the crisis: (1) high volumes of loans,
(2) high loan arrangement fees, (3) flexible short-term
lending to increase chances of new mortgage and
arrangement fees, and (4) punitive exit fees when
borrowers wanted to change their mortgage providers
before the lapse of maturity period.
Good and poor quality mortgages were bundled together in
securitized packages that were deemed able to endure an
economic downturn.
Further, complicated when these securitized mortgages
were sold through special purpose vehicles (SPVs) to
interested-investors, such as investment banks (i.e.
Lehman Brothers and Merrill Lynch).
8. Cont…….
The flaws in the system were hidden, because real-estate prices
were rising, partly in response to the inflow of funds generated
by this very system.
However, after real-estate prices began to fall in the summer of
2006, the credit risk in the underlying mortgages became
apparent (Hellwig, 2008).
CDOs increases, less cash flow is available to pay to the
bondholders especially to the lower bond tranches. Hence,
MBSs and CDOs bonds-backed by these subprime mortgages
were downgraded.
As a result, many investors in those securities such as
insurance companies, pension funds, mutual funds, and hedge
funds have suffered substantial losses from this credit crisis
situation.
9. Interest as a cause of the subprime mortgage crisis
The nature and the means of delivery of the interest and
debt-based conventional banking have caused the
financial system to be completely “split-off from the real
economy”.
Deals and transactions have been concluded and executed
on papers, and what have been sold and bought was of no
real or economic value. Low interest rates create demand
for loans that cannot be repaid when interest rates
subsequently rise as was the case of the subprime
financial crisis in the US (Hassan, and Kayed, n.d.).
The adjustable-interest-rate schedule allowed for very low
and, in some cases, zero-interest payments for the first 2-3
years of the mortgage.
10. Cont.……
After this period, the interest rate would be reset every six
months based on a benchmark interest rate such as the
London Inter-bank Offer Rate (LIBOR) or the prevailing
market rate.
In the initial years of the mortgage resets there is the
likelihood that the cash commitments can only be met by
increased-borrowing or refinancing at some future date to
meet the shortfall between the higher interest costs and
the borrower’s income (Kregel, 2008).
Another dimension to the subprime mortgage crisis is
predatory lending; it is associated with subprime markets
where the so called subprime borrowers were charged
higher interest rate.
11. Cont.…..
In this regard Kamil, et, al., (2010) opined that the high
numbers of defaulters, i.e. home owners in making their
mortgage payments was the outcome of the predatory,
excessive and imprudent lending practices of mortgage
brokers and lenders in subprime lending.
In like manner the passion for interest prompted greedy
financial experts to invent risky interest-yielding
assets/derivative loans with devastating consequences on
investors and investment.
Sub-prime mortgage loans attracted patronage on account of
guaranteed stream of interest to private investors and
financial institutions. This argument summed up all the
causes of the subprime mortgage crisis and the subsequent
financial crisis to interest charging,
12. Islamic finance as an Alternative
The US subprime mortgage crisis and the subsequent global
financial crisis have invalidated the argument promoted by
free market advocates that “markets are efficient on their
own” and market forces are capable of managing and
correcting market inefficiencies should they arise.
Reforms by the so called capitalists’ economies and the two basic
components at the heart of the reform were adjusting the rate of
interest to 0% and revising the tax rate to about 2%.
Incidentally, these are the core elements of Islamic
economics; Islam prohibits interest (riba) and requires all
Muslims who possess minimum net worth above their basic
needs (Nisab) to pay Zakah (2.5% of the assets that have been
owned over a year) Thus Islamic economics can serve as good
alternative.
13. Cont.….
Although sukuk are structured in a similar way to
conventional asset-backed securities, they have
significantly different underlying structures, provisions and
are shariah-compliant.
In particular, it prohibits the receipt and payment of
interest and stipulates that income must be derived from
an underlying real business risk rather than as a
guaranteed return from interest. With regards to sukuk
securitization, an asset is one of the vital elements that
should exist as an evidence to support the process and
make it permissible in Islam (Kamil, et, al., 2010).
Finanlly, Hassan, and Kayed, (n.d.) reported that the extent
of the financial meltdown has incited some Muslim
scholars to construe such losses of virtual wealth as being
God‟s fulfilled promise that “Allah will deprive usury of all
blessing and will nourish deeds of charity”(The Holy
Qura‟an [Al Baqarah] 2:276).
14. Conclusion
Interest stands out as the major cause of the crisis. The
passion for interest prompted greedy financial experts to
invent risky interest-yielding assets/derivative loans
with devastating consequences on investors and
investment. With prohibition of interest, gharar and any
form of uncertainty; Islamic economic and financial
systems can serve as a reliable alternative.
