Examining US approvals of Islamic financing ...

International Journal of Islamic and Middle Eastern Finance and Management Examining U.S. approvals of Islamic financing products and the Islamic theory of lawful profit Adam Abdullah

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Examining U.S. approvals of Islamic financing products and the Islamic theory of lawful profit


1. Introduction Within Islamic banking and finance, there is still a lack of consensus (ijma’) on the validity of certain modern modes of finance adopted by Islamic banking and financial institutions. Notwithstanding the history or legal justification of these new modes of financing, every scholar or practitioner would agree that ultimately for something to be genuinely Islamic, the litmus test is that it must be beneficial and deliver justice (‘adl). It is clearly not the intention of the Shari’ah for Muslims be impoverished and experience injustice (zulm) as a result of engaging in commerce and financial transactions, for this is the hallmark of interest-based debt financing originating from the fractional reserve banking system. Accordingly, this paper analyzes whether three selected Islamic modes of finance approved by U.S. authorities, are indeed acting in the public interest (maslahah), or are in fact disguising harm (darar). We have deliberately selected U.S. legal interpretations, since U.S. authorities have not adopted Shari’ah law in business or financial transactions and we wondered just how Shari’ah compliant these products were, when they have been approved under the umbrella of usurious legislation. This paper primarily adopted qualitative document and content analysis, supported by quantitative numerical analysis, in reviewing legal interpretive letters from the U.S. Office of the Comptroller of Currency and National Administrator of Banks (OCC) and the U.S. Department of Revenue (DoR). Given that the Americans adopted economic substance over legal form, this study also applied the Islamic normative theory of profit to test their conclusions. The significance of this research for Islamic banking product design and development, is that by adopting the Islamic theory of lawful profit (ribh), it enhances the ability to block the legal means to an unlawful outcome (sadd al-dhara’i), thereby avoiding harm (al-darar) attributed to usury (riba), and upholding what is in the public interest (maslahah), in order to fulfill one of the objectives of the Shari’ah (maqasid al-Shari’ah), which is to protect wealth (hafiz al-mal). This paper is organized into five sections, including this introduction. The second section provides a review of literature, and the third section summarizes the methodology. The fourth section presents our findings and discussion on the (i) Net Lease home financing (ijarah wa iqtina) applied by the United Bank of Kuwait (UBK); (ii) Murabaha financing facility applied by UBK; (iii) Declining Balance Co-ownership Program (musharakah mutanaqisah) applied by Guidance Residential (GR); and (iv) the Islamic normative theory of lawful profit. The fourth section provides some concluding remarks. 2. Literature Review Murabaha and ijarah wa iqtina, as practiced by Islamic banks are new modes of financing and leasing, although the latter traces its roots to the classical ijarah contract, as defined for example in the Majallah. Ijarah wa iqtina is similar to ijarah muntahla bittamleek, which involves the transfer of title at the end of the lease period through a binding promise (AAOIFI, 2010). Murabaha, on the other hand, has been widely adopted by many Islamic banks and referred to as ‘cost-plus financing’. Although it has been approved by AAOIFI (2010), according to Al-Zuhayli goods can be sold at a price either at a loss (wadi’a), at break-even (tawliya), can be sold in full or in part (‘ishrak), at a disclosed profit (murabaha), or simply sold at a price without disclosure of the original cost (musawama) and are known as trust sales (Al-Zuhayli, 2003, 1:353-4). Thus, murabaha originally meant the disclosed profit of a price that was subject to market risk and certainly did not involve a pre-fixed or pre-determined risk-free ‘mark-up’ at the rate of interest. Musharakah mutanaqisah (MM) is a new mode of Islamic financing adopted by Islamic banks and financial institutions with a history that stretches back about 20 years, and the earlier discussions by IRTI (1995) and subsequent practices by Islamic banks in Sudan, Pakistan, the Middle East, the U.S. and U.K., and in Malaysia, has ensured that MM is now clearly defined and endorsed by AAOIFI (2010) as “a form of partnership in which one of the partners promises to buy the equity share of the other partner gradually until the title to the equity is completely transferred to him”. Bank Negara Malaysia (2010) 1


also defines MM as “a contract of partnership that allows one (or more) partner(s) to give a right to gradually own his share of the asset to the remaining partners based on agreed terms”. Meera argued that under MM, the “return to the financier is neither determined by the initial capital provided by the financier nor the duration of the contract which is usual under debt financing. The return is solely but determined by the rental alone as a percentage of the house price” (Meera, 2005:12). Meera subsequently considered adjusting the rental to reflect current market conditions according to a rental or house price index (Meera, 2009:5), although he noticed that “rental yields for all categories of houses are generally lower than BLR and average lending rate” (Meera, 2009:19). It is worth pointing out that historically in the U.S. with Savings and Loan Associations, and in the U.K. with building societies as mutual cooperatives, such institutions could provide financing for real estate on one hand, and could build and carry a housing inventory on the other, which banks are not permitted to do. By owning and operating a housing inventory, the ability to accept market risk can permit income and capital appreciation for its members, and one wonders if an Islamic equivalent (absent of any interest) could be developed, whether through cooperatives or through waqf institutions. Meanwhile, Hasan pointed out correctly that MM or indeed other Islamic home financing products (citing Lariba’s lease to purchase product based on ijarah wa iqtina in the U.S.) had interest embedded into their products (Hasan, 2011:3-5), but then only proceeded to conceptually propose the Zubair Diminishing Balance Model or ZDBM (Hasan, 2011:5-7), which adopts the methodology of a fixed principal declining interest loan. Over the life of such a loan, payments decrease (decreasing installments), the principal portion remains constant and the interest portion decreases. In this type of amortization the principal paid, not the total payment, remains constant. Meera did subsequently acknowledge that “once market interest rate replaces the rental rate, of course, the MM would no longer be Islamic in character” (Meera, 2012:12). Rammal’s MM payment schedule also mirrored a constant rate return amortization (Rammal, 2004). Khan’s view echoed that of Meera, by stating that with MM, “in theory, the ‘rent’ charged should be based on comparable homes in the area but, in practice, the ‘rental rate’ invariably varies according to the prevailing mortgage interest rate” (Khan, 2010:814), pointing out just such a practice adopted by the Islamic Bank of Britain, where “the ‘rental rates’ are ‘benchmarked’ to commercial rates ‘such as LIBOR plus a further profit margin’ and so the rental amount will vary” (Khan, 2010:815). El-Gamal also noticed in GR’s MM programme that, “examining the periodic payments, the customer will find that they look very much like a conventional mortgage schedule. Early on, a large portion of the payment is ‘rent’ (corresponding to ‘interest payment’ in conventional mortgage), and a small part is ‘buy-out’ (corresponding to the ‘principal payment’ in a conventional mortgage)” (ElGamal, 2000:16) and furthermore he stressed that there should be “a fundamental difference between a mortgage company, which holds a lien on a financed house, and the actual joint ownership of the house between the client and the Islamic financial institution” and yet GR’s MM programme does require a lien. Whilst this study seeks to primarily address the validity of Islamic home financing, other aspects of home financing, such as home insurance, involving liability (for loss), also deserves some discussion. Hatem AHaj provided the Assembly of Muslim Jurists of America (AMJA) with analysis on insurance, which adopted legal form over economic substance (AHaj, 2011). AHaj mentioned AlZarqa, who stipulated that commercial insurance must be specifically resorted out of necessity (dharurah) in order to meet the needs of the people. However, AHaj noted that Al-Zuhayli stipulated that, presently, there is no excuse to resort to conventional commercial insurance, if its goals can be met through permissible means such as Islamic insurance companies. In this regard, Risk Specialists Companies (RSC), a subsidiary of AIG Commercial Insurance, announced in December 2008 that, it was introducing a takaful homeowners policy in all 50 states (RSC, 2008). That being said, perhaps in a separate study, we would prefer to provide a more complete analysis of the nature of guarantee in Islam, the mechanics of takaful, commercial and mutual insurance including re-insurance and retakaful, and analysis of probability weighted cash flows, from the context of economic substance over legal form, to fully assess the underlying obligations and validity of takaful models and associated products currently on offer. Finally, AMJA also delivered a legal opinion (fatwa) in September 2014, which summarized the degree of validity of Islamic home financing products that are currently being offered in the United States. There are two reasons why we have not relied upon it. First of all, the AMJA fatwa provided 2


no detailed reasoning, except that it was an opinion clearly based on legal form and the legality of the contracts used, which we feel is exactly the problem with contemporary methodology. Secondly, AMJA proceeded to analyze four institutions and their products that they largely deemed acceptable, apart for “some legal components”, relating to invalid clauses, which were not elaborated upon in great depth, except to highlight issues relating to late payment and so on. We intend to demonstrate that the entire structure of these products is invalid by taking economic substance over legal form. The Islamic finance institutions (IFIs) and their products, which AMJA did discuss, are in any case, all based on the three products, which we intend to analyze. They are well known to the Federal Reserve, who had earlier summarized the same American IFIs and products (Chiu, 2006:10) and confirmed that, “the OCC specifies that the standards set forth in the [ijarah and murabaha] interpretive letters, must be strictly adhered to in order to receive approval. At this time, no other agency rulings have been made” (Chiu, 2005:3). Indeed, there have been no further agency rulings, on additional products, or changes in the original OCC (1997, 1999) rulings relating to rent-to-own (ijarah wa iqtina), cost-plus purchase (murabaha) and the DoR (2005) ruling relating to diminishing partnership (musharakah mutanaqisah). The implication is that, with no new product applications, IFIs must adhere to the current ones and all associated requirements. We have summarized them in table 1, excluding HSBC Amanah, which from 2015 is now only offering Islamic financial products in Malaysia and Saudi Arabia. Table 1 Summary of U.S. institutions offering Islamic finance products. Institution, Location

Type of Institution

Home Financing Product

United Bank of Kuwait (UBK), New York, NY.

Bank (since closed)

• Rent-to-own (ijarah wa iqtina) • Cost-plus purchase (murabaha)

Lariba Finance House, Pasadena, CA.

Finance House

• Rent-to-own (ijarah wa iqtina)

Guidance Financial Group (Guidance Residential), Reston, VA.

Finance House

• Diminishing partnership (musharakah mutanaqisah)

Ameen Housing Cooperative, Palo Alto, CA.

Cooperative

• Diminishing partnership (musharakah mutanaqisah)

Devon Bank, Chicago, IL.

Bank


University Bank (University Islamic Financial Corp.), Ann Arbor, MI.

Bank


Shape Financial Corp.

For-profit wholesaler / consultant

• Rent-to-own (ijarah wa iqtina)

Sources: Adapted from Chiu (2006), AMJA (2014), Thomas (2007)

Our review of literature highlighted contrasting views, which serves to emphasize the significance of our study and could have formed part of our findings and discussion within documentary analysis, but we nonetheless focused on the primary material at hand as discussed in the introduction and our methodology. 3. Methodology Document analysis involves a systematic procedure for reviewing or evaluating documents including both printed and electronic material (Bowen, 2009). It requires that material and data be examined and interpreted to gain meaning and understanding, in order to develop empirical knowledge (Corbin

3


and Strauss, 2008). The U.S. interpretive letters (and patent) have been clearly identified and listed in the references, and contain text that has been recorded without our intervention. The documents are readily available online (hence cost-effective), providing stable, reliable and sufficient material and data for the purposes of this study, which was culled in a manner that was efficient, since the data was selected and not collected. The systematic evaluation adopted in this study also involved a review of prior literature, which served to support the overall research, although we have not relied on previous interpretation or description within our findings and discussion (Bowen, 2009). Moreover, this study yields excerpts, quotations and selected passages, that required discovery, selection, appraisal and clarification, which were organized through content analysis (Labuschagne, 2003) to detect the presence of usury and absence of market risk in selected modes of Islamic financial products. Quantitative numerical analysis of formulae and calculations, in additional to data presented in tables or figures, were also intended to clarify and make sense of the underlying existence of any usury in these transactions. These themes were then synthesized and tested involving a recognized Islamic Theory of Profit to confirm our findings. 4. Findings and Discussion In this section, this study will review each legal interpretation chronologically, commencing with (i) UBK’s Net Lease proposal, which was approved by the OCC in December 1997 (OCC, 1997), followed by (ii) UBK’s Murabaha financing proposal, which was approved in November 1999 (OCC, 1999), and then (iii) GR’s declining balance co-ownership program, which was reviewed by the Massachusetts’ Department of Revenue in assessing at what point the deeds excise tax (stamp duty) would be paid (DoR, 2005). We do not intend to discuss the legal form in terms of the Islamic law of transactions (fiqh muamalat), but in terms of Islamic jurisprudence (usul al-fiqh) and blocking the legal means to unlawful outcome (sadd al-dhara’i), by emphasizing the economic substance over legal form, in order to detect the presence of market risk (if any) in the context of (iv) the Islamic normative theory of lawful profit, and thereby ascertain the real nature and validity of these products. 4.1 Net Lease - Ijarah wa Iqtina (Al-Manzil) In terms of regulation, UBK operated under the U.S. National Bank Act as a U.S. federal branch of a foreign bank and was thus regulated by OCC. UBK was acquired by Ahli United Bank (AUB) in 1999 and although its U.S operations were subsequently closed, the Net Lease programme was implemented as Al-Manzil and was continued in the U.K. by AUB until today (Zyp, 2009:11). In 1997, UBK applied to the OCC to establish whether the Net Lease programme was part of the business of banking and could thus be offered by UBK under the auspices of the National Bank Act. In fact, UBK argued that the economic substance of the Net Lease will be functionally equivalent to secured real estate lending, and that its proposal satisfies accounting requirements so that the Net Lease would be characterized as financing rather then leasing. Essentially, the structure of the Net Lease is to provide a residential home financing arrangement, whereby the Lessee (the consumer), will contract with the Seller to purchase a private residence and tender a down-payment towards securing the property. Before funding the remainder of the purchase price, UBK and the Lessee will simultaneously enter into a Net Lease Agreement and a Purchase Agreement. UBK will then supply the remainder of the funds to purchase the property from the Seller under the sales contract. UBK will have ‘legal title’ to the property and record its interest in the property in the same manner as it would record a traditional mortgage (OCC, 1997:1-2). UBK did not hold any inventory of properties nor does it act as a real estate agent. The Net Lease Agreement requires the Lessee to maintain the property and pay all costs and expenses that an owner would ordinarily have to pay. Monthly lease payment will cover principal, interest, insurance and property taxes, and the Lessee will amortize the principal by the end of the lease period. In the Purchase Agreement, the Lessee will acquire title to the property the end of the lease term, or earlier by repaying the balance of the purchase price. In the case of default the Lessor will recover the property as if it had been acquired in foreclosure, by treating it as Other Real Estate Owned (OREO) and accordingly sell it (OCC, 1997:2,8). Even though UBK would separate Islamic Home Finance Lease Receivables and Loan Receivables in the general ledger, the OCC noted the significant presence of interest: “although the

4


two products will have different documentation, the monthly lease payments will be calculated in the same manner. UBK will add its margin to its cost of funds at the beginning of the lease. The London Interbank Offering Rate will be used to determine UBK’s cost of funds. UBK will then allocate lease payments to mirror the principal and interest breakdown of a conventional mortgage” (OCC, 1997:2). Indeed, “UBK will use the same formula that it uses to set traditional mortgage payments to determine the amount of monthly lease payments. The amount of the monthly lease payments will cover principal and interest and will be sufficient to amortize the entire purchase price by the end of the lease term. The Lessee will acquire title to the property at the end of the lease term or earlier if the Lessee pays the remainder of the purchase price. And, as is the case in a conventional mortgage transaction, the Lessee will not have to take any additional action to acquire title after the lease expires. Thus, UBK’s Net Lease proposal, in substance, has the characteristics of a financing transaction” (OCC, 1997:8). In evaluating whether UBK’s Net Lease is within the scope of the ‘business of banking’, OCC adopted “economic substance of the transaction, rather than its form [to] guide our analysis of whether national banks can engage in a particular activity” (OCC, 1997:5). Moreover, the OCC analyzed case law, historical OCC precedents, the Generally Accepted Accounting Principles (GAAP) in relation to leases, commercial law and legal opinion from the Internal Revenue Service (IRS), all of whom recognized economic substance over legal form, and the OCC concluded that “it is apparent that UBK’s Net Lease proposal is functionally equivalent to a financing transaction in which the Branch occupies the position of a secured lender” (OCC, 1997:9). A valid rental contract in Islam (al-ijarah) requires the Lessor to accept liability of ownership and market risk (Majallah, Bk.2, also Art.85,87), which necessarily involves an operating lease, where the rate of return is dependent upon the asset value, performance, or costs associated with the asset, as opposed to a financial lease, where the asset is amortized absent of any market risk, but the OCC stated that an operating “lease of this nature would be more akin to conducting a rental business. To engage in this type of business would cause national banks to assume risks that they are not permitted to undertake…only those leases which are functionally interchangeable with loans were within the business of banking” (OCC, 1997:4-5). Islamic finance is supposed to be asset-backed and not assetbased. It should not rely on the creditworthiness of the customer, but instead accept the market risk, with recourse to income and capital appreciation associated with the investment. However, the nature of the lease (and the same attitude is adopted in the subsequent products that we have analyzed below) is only concerned with what is owed to the institution, not any residual market value during, or on completion of, the financing period. Indeed, the IRS recognizes “that a lease may be functionally equivalent to financing and UBK anticipates that the IRS will allow the Lessee to deduct the interest portion of the monthly lease payment from its taxes in the same manner as interest is deducted on a traditional mortgage” (OCC, 1997:9). Finally, the OCC summed up with a crucial observation concerning market risk, where UBK “will function like a ‘riskless principal’ because it will not purchase any real estate until the Lessee requests that it do so, and the Lessee enters into a Net Lease to occupy the property immediately and a Purchase Agreement to take title to the property at the end of the lease term. Once UBK purchases the real estate from the Seller, it will transfer all indicia of ownership to the Lessee. The Lessee will be the beneficial owner of the real estate. UBK will assume no greater risks than it already assumes when it underwrites a traditional mortgage. UBK will not purchase real estate for its own portfolio. UBK will not hold itself out as a real estate broker or agent. UBK will not maintain an inventory of real estate for sale to customers. If a Lessee defaults on the Agreements, UBK will consider the property to be OREO and dispose of it in a manner consistent with [legislation]” (OCC, 1997:15). On this basis the OCC approved UBK’s application, which in terms of economic substance over legal form, involved an interest-based financial lease and the bank operating as a riskless principal. 4.2 Murabaha Financing Facility In 1999, UBK applied to the OCC for approval to offer Murabaha financing products as part of the business of banking. OCC’s interpretive letter was much shorter (6 pages) as compared to the earlier Net Lease letter of 1997 (16 pages), as the OCC was by now accustomed to the requirements and often referred to the earlier ruling. It reaffirmed that “in the current financial marketplace, lending takes on many forms. UBK’s Murabaha financing proposals are functionally equivalent to or a

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logical outgrowth of secured real estate lending and inventory and equipment financing, activities that are part of the business of banking. The economic substance of the transactions, rather than its form, guides our analysis of whether national banks can engage in a particular activity” (OCC, 1999:6). In terms of the Murabaha financing arrangement, UBK will acquire the property on behalf of the customer and then re-sell the property to the customer at a mark up on an installment basis. The Murabaha financing facility would be used to acquire real estate properties, real estate construction transactions, commercial inventory operations and the acquisition of commercial equipment. The customer will identify the property, inventory or equipment, negotiate the price with the seller and apply to UBK for financing. If the customer satisfies underwriting criteria, being identical to its current underwriting standards for conventional and Net Lease financings, UBK will require the customer to pay a 25% down-payment (OCC, 1999:3), and will agree to simultaneously enter into a purchase agreement with the seller and a Murabaha Agreement with the customer, involving the original purchase price plus UBK’s cost and profit amount, being the cost of financing. In this regard, UBK “will add its margin to its cost of funds to calculate the Murabaha profit (the mark-up on the sale)…Libor will be used to determine UBK’s cost of funds. In all cases, the amount of the Murabaha profit will be calculated to comply with applicable usury laws” (OCC, 1999:2). Additionally, the Murabaha products will be financing products and “considered as loans for both tax and accounting purposes” (OCC, 1999:4). The customer agrees to insure the goods with UBK as the insured party to the extent of its security interest and to indemnify UBK against all actions, claims and costs relating to the purchase of the equipment or goods, and in the case of real estate, the customer will operate and control the property, paying taxes, insurance and maintenance, and also assume third party liability for accidents or injury. The OCC concluded that UBK’s “Murabaha financing proposals are functionally equivalent to conventional financing transactions…[and] UBK will function like a riskless principal” (OCC, 1999:6-7). Given the simultaneous transactions and risk-free mark-up, “UBK will assume no greater risks that it already assumes in a conventional mortgage or loan transaction” (OCC, 1999:7) and since “under the Murabaha financing facility, UBK will essentially be functioning in a riskless principal capacity” (OCC, 1999:1), its proposal was approved and deemed permissible under the National Bank Act. 4.3 Declining Balance Co-Ownership Programme - Musharakah Mutanaqisah (MM) GR was established in 2002 and is the Shari’ah-compliant home financing subsidiary of Guidance Financial Group (GFG). GR operates as a U.S. finance company and being an independent non-bank mortgage provider is not regulated by the OCC, but rather falls under the purview of the Bureau of Consumer Financial Protection. Therefore, absent of any Shari’ah standards or institutional review by U.S. regulators, it is the consumer whom is responsible to determine whether an Islamic finance product is Shari’ah compliant. GR’s MM programme has already originated over USD1.0Bn in financing (Thomas, 2007:5). Essentially, the MM programme involves a declining balance coownership financing arrangement, in which GR as the financier is the co-owner and the consumer is the borrower of funds to purchase a residence from a seller, such that GR and the consumer co-own the residence through common tenancy. The consumer makes monthly payments to the co-owner (GR) to repay the amount funded, by increasing the co-ownership interest until full ownership is eventually acquired. The monthly payment includes a profit payment and an acquisition payment, and the latter is used to gradually decrease the co-owner’s interest in the property. Meanwhile, the coowner’s interest in the property is transferable to a secondary market investor (Hammour et al, 2003:1). As such, before we examine the DoR interpretation (DoR, 2005), as a non-deposit-taking bank, it is useful to understand GR’s source and cost of funds. In the U.S., independent mortgage companies rely heavily on the secondary market for securitization of origination and short term liquidity, before permanent investors are found. GR typically sells its Islamic mortgages to Freddie Mac on the secondary market, whom securitizes them and sells them as mortgage-backed securities (MBS) to investors on the open market. Freddie Mac, or the Federal Home Loan Mortgage Corporation (FHLMC), and along with Fannie Mae, or the Federal National Mortgage Association (FNMA), are government sponsored entities, whose purpose is to expand the secondary mortgage market by securitizing mortgages in the form of MBS, to permit lenders to reinvest their capital into more lending, thereby increasing the number of lenders in the mortgage market. Indeed, Fannie and

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Freddie are the main investors of Islamic mortgages, and as Shari’ah compliant products, Islamic mortgages that are sold to Freddie Mac or Fannie Mae, cannot be further disaggregated or securitized, into any other collateralized debt obligation (CDO) (Zyp, 2009:32,44). However, the pricing of the secondary market is entirely conducted on the basis of Libor. Furthermore, in order to provide liquidity, initially GR would rely upon the resources of its parent company, GFG to allow GR to originate loans and hold them on its books until Freddie Mac securitized the mortgage contracts. However, as GR expanded, it established an Islamic funding facility with a warehouse provider in order to increase its liquidity (Zyp, 2009:42). Herein lies another problem concerning the economic substance of GR’s pricing. Warehouse lenders provide mortgage origination capital through revolving warehouse lines of credit, where a warehouse lender arranges a loan facility to an independent mortgage company or depository. The mortgage originator uses the revolving lines to fund the mortgages that it originates and the warehouse lender then simultaneously purchases an interest in the mortgage, which is subject to a commitment to repurchase the loan from the originator within thirty days. The originator pays a haircut for each dollar of loan balance originated, as well as an interest payment, typically priced at Libor plus a spread (Stanton, 2014:12). In fact, we do find evidence of this pricing in the MM programme, not just in terms of the legal interpretation provided by the DoR (2005), but also in the patented information technology arrangement that GR registered with the U.S. patent office to facilitate and process the MM financing programme ‘on-line’ (Hammour et al, 2003). In 2005, GR sought to clarify with the U.S Department of Revenue regarding the payment of the deeds excise tax (stamp duty) concerning GR’s declining balance ownership programme. In the DoR’s letter ruling 05-3, GR successfully persuaded the DoR that the deeds excise tax (stamp duty) was only payable once on the initial full purchase price of the property agreed by the seller and the consumer and not during, or at the end of the programme, when rental payments would alter (increase) the share of ownership by the consumer in relation to the co-owner (GR) as financier; neither would any tax be applicable under any re-financing of a property into the MM programme. The DoR understood that the MM programme consisted of six (6) key documents (DoR, 2005:1), as detailed in table 2. Table 2 GR’s Legal Documentation under the Declining Balance Co-Ownership Programme No.

Document

(1)

Definition of Key Terms

Includes defining the ‘Profit Payment’ and the ‘Acquisition Payment’

Remarks

(2)

Co-Ownership Commitment Agreement

The consumer enters into a the Commitment Agreement, which with list conditions and estimated closing costs that “are the same as those typically found in a loan commitment agreement” (DoR, 2005:1)

(3)

Co-Ownership Agreement

Under the Co-Ownership Agreement the consumer had the “exclusive write to occupy and possess the property…including the obligation to pay 100% of taxes related to the property and the right to claim tax credits (if any)…to pay all assessments levied…utility bills…maintain and repair the property and…obtain property insurance” (DoR, 2005:2). The consumer could also by-out the Co-Owner (GR) by paying the ‘Buyout Amounts’ being the “equivalent of the remaining principle balance in a standard mortgage loan” (DoR, 2005:2).

(4)

Obligation to Pay

Under the Obligation to Pay, the consumer is required to pay monthly amounts to GR being “similar to the payments made under a typical mortgage agreement…the Profit Payment is the monetary equivalent of the interest portion of a conventional mortgage loan. The Acquisition Payment is that portion of the consumer’s monthly payments that is applied to increase the consumer’s ownership interest in the property, which varies month by month according to the schedule. Acquisition payments are calculated in the same manner as, and will simulate, principle amortization under a traditional mortgage loan” (DoR, 2005:2).

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(5)

Security Instrument

The Security Instrument encumbers the consumer’s interest in the property for payment due under the Obligation to Pay and Co-Ownership Agreement, detailing the protection afforded to GR as the co-owner and financier, “which are similar in all material respects to the rights of a mortgagee in a traditional home mortgage financing” (DoR, 2005:2). It “creates a lien against the financed property and pledges the property as collateral for the declining balance contract provided by the financer” (Hammour et al, 2003:9).

(6)

Assignment Agreement and Amendment of Security

GR as co-owners, will then enter into an Assignment Agreement and Amendment of Security to assign its rights and interest under the CoOwnership Agreement, Obligation to Pay and the Security Instrument to either a warehouser or directly to a secondary market investor (Hammour et al, 2003:9,11), such as an investment bank, Fannie Mae or “Freddie Mac, which treats the transaction in a manner similar to other mortgage transactions in its system” (DoR, 2005:2).

Upon full payment of the ‘Buyout Amount’, the consumer is deemed to have acquired 100% ownership of the ownership interest of the co-owner (GR) as financier, and a Deed would then be delivered by GR to the consumer in consideration of a nominal amount, hence completing the rental and transfer arrangement under ijarah wa iqtina. The DoR concluded that the transaction was entered into “solely for the purpose of securing a debt…[by looking]…to the economic substance of the transaction, rather than its form” (DoR, 2005:3), and from an Islamic perspective the most damning observation was the constant rate loan calculation present in a conventional loan amortization contained in the Obligation to Pay document. GR admitted as such under its U.S. patent, “the monthly payment…is based upon a price set by the secondary market…and comparable to monthly payments paid by consumers with conventional mortgage…[and] a formula that can be used to calculate the monthly payment is as follows” (Hammour et al, 2003:3); Acquisition amount =

payment ⋅ (1−1 / (1+ r)ny ) / r

(1)

Where, n = the number of periods per year; y = the total number of years over which the acquisition payment will be made; r = the profit payment rate per period, thus r = annual profit payment / n. By adding the monthly acquisition payment amounts to the original down payment provides the dollar amount of ownership of the consumer and dividing the dollar amount of ownership of the consumer into the contract amount provides the percentage of ownership of the consumer in the residence (Hammour et al, 2003:3). Of course, the formula, which GR detail in their patent, is a balance financing calculation derived from a constant rate amortization. At closing, “the consumer will make the ‘initial acquisition payment’, which is the equivalent of the down-payment” (DoR, 2005:1), say 20%, and the remaining 80% will be paid by the co-owner (GR) as the financier, with a detailed ownership schedule included in the Co-Ownership Agreement (Hammour et al, 2003:8-9) as detailed in table 3. Table 3 Ownership Schedule under the Declining Balance Co-Ownership Programme Monthly Payment

Profit

Acquisition Payment

Increase in Consumer Ownership

Resulting Consumer Ownership

Resulting CoOwner Ownership

2,000

1,970

30

0.05%

20.05%

79.95%

2,000

1,969

31

0.06%

21.01%

79.89%

Source: Hammour et al, 2003:9

Therefore, we can conclude that by adopting GR’s formula, a 20 year partnership between GR and the consumer, involving a 20% down-payment, the financing is not as aggressive as the banker’s rule of 78, but as we may observe in figures 1 and 2, GR’s declining balance is exactly equivalent of the declining balance principal in a constant rate loan amortization schedule.

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Fig. 1: GR’s Declining Balance Co-Ownership Programme

Fig. 2: Constant Rate and Rule of 78 Loan Amortization Schedule

4.4 Islamic Normative Theory of Lawful Profit Given our analysis above, we must establish the validity of these modes of financing in Islam. In terms of Islamic jurisprudence (usul al-fiqh), essentially there are two alternatives. Either, one can adopt a legalistic approach in terms of legal form, to determine whether income is unlawful in the law of Islamic financial transactions (fiqh mu’amalat); or, one can analyze the economic substance of a transaction in order to assess whether income is lawful. The importance associated with determining the legitimacy of income in Islam, is that the consumption of unlawful income (quite apart from the injustice that it causes in society), in terms of Shari’ah compliance risk, can not only collapse an IFI, but in some jurisdictions, such as Malaysia ex post the Islamic Financial Services Act of 2013, it can involve imprisonment and fines. It can also invalidate all other aspects of the Islamic religion. This would not only include prayer (solat), charity (zakat), fasting (saum) and pilgrimage (hajj), but by declaring what is unlawful (haram) to be lawful (halal) in the form of a legal opinion (fatwa), it challenges the Oneness of God (tawheed), by attributing the opinion of a scholar in lieu of our Creator. Allah (s.w.t.) states, “They took their rabbis and their monks to be their lords besides Allah (by obeying them in things which they made lawful or unlawful according to their own desires

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without being ordered by Allah)” (Qur’an: 9:31). If this accusation applies to a rabbi, or a monk and their followers, it must also apply to a Shari’ah scholar and to those that blindly follow (taqlid) a legal opinion (fatwa) issued under the banner of Islam, without being fully evaluated. We do not insist that the American banking regulators were inaccurate in their assessment of these three core IFI products. On the contrary, we entirely agree with their methodology of adopting economic substance over legal form. Coincidentally, the methodology of the U.S. authorities involves a very Islamic approach. An important Islamic legal maxim (al-qawaid al-fiqhiyyah) states that, “In contracts, attention is given to the objects and meaning, and not to the words and form” (Majallah, Art.3). This Islamic legal maxim allows us to evaluate financial transactions in terms of economic substance over legal form. As mentioned in the introduction, this enhances the ability to block the legal means to an unlawful outcome (sadd al-dhara’i), thereby avoiding harm (al-darar) attributed to usury (riba), and upholding what is in the public interest (maslahah), in order to fulfill one of the objectives of the Shari’ah (maqasid al-Shari’ah), which is to protect wealth (hafiz al-mal). In Islam, usury (riba) is not just a sin: it is, in fact, a serious crime, which attracts a “declaration of war from Allah and His Messenger” (Al-Qur’an, 2:279). Regarding the Islamic theory of lawful profit, Ibn al-`Arabi (d.1148) said, “Every increase which is without an equal counter-value (‘iwad) is riba”, and as we may observe in figure 3, the components of ‘iwad are; (1) risk (ghunm), (2) liability (daman), and (3) earnings (kasb) (Ibn al-’Arabi, 1957, 1:242 cited by Ziaul Haque, 1995:10, also cited by Rosly, 1999:1249; Rosly, 2005:30; Rosly, 2001). The necessary components of profit (ribh) must be present for it to be lawful (halal), and if any of the components of ‘iwad are not present in a transaction then the income is unlawful (haram). In terms of risk (ghunm) it refers to market risk; earnings (kasb) implies to strive to earn or gain wealth, thus implying work and effort (amal); whereas, liability (daman) includes ownership (milkiyyah).

Fig. 3: The Islamic Theory of Lawful Profit

The Majallah reaffirms this with two important maxims: “reward begets risk” (al-ghurm bi alghunm) (Art.87), and “benefit begets liability” (al-kharaj bi al-daman) (Art.85). With this in mind, there is no market risk detectable in any of the three financing products that we have analysed above, especially given the presence in all cases of Libor-based constant rate amortization calculations and also simultaneous risk-free transactions. The OCC actually described UBK as a “riskless principal”, and without ghunm there is no ‘iwad and therefore the increase generated by these financers is not lawful profit (ribh), but in fact, unlawful usury (riba’). Indeed, we must agree with the conclusions of the American regulators, in that these products were risk free and involved interest. This may be contrasted with the Shari’ah advisory committees of the American IFIs and the AMJA legal opinion (fatwa), which relied on legal form and promptly declared them as Islamic. The value proposition of adopting the Islamic theory of profit is that Muslim consumers can evaluate themselves whether market risk is apparent. Therein also lies the solution for American IFIs, where they must design and develop financial products that accept market

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risk, rather than adopt a risk-free TVM amortization schedule. The end does not justify the means. Indeed, the means is the most important part. If a transaction is unlawful, all that follows from it is also unlawful: “when a thing has become void (batil), all that follows from it is also void (batil)” (Majallah, Art.52).


5. Conclusion and Recommendations In the above sections, we have analysed OCC and DoR documents involving three Islamic modes of finance in the U.S., that revealed inconsistencies in relation to what was being claimed (Shari’ah compliant financing) and what was being practiced, such that when tested by adopting the Islamic normative theory of profit, it revealed that the income generated is without any equivalent countervalue (‘iwad), due to the absence of market risk. As mentioned above, Islamic finance is supposed to be asset-backed and not asset-based. It should not rely on the creditworthiness of the customer, but instead accept the market risk, with recourse to income and capital appreciation associated with the asset, which therefore implies investment and asset management rather than credit management. However, the nature of all three products evaluated above, which are now currently being offered in the same format by all of the American IFIs, is only concerned with what is owed to the institution. The financing is not concerned with any residual market value during, or on completion of, the financing period, which is for the homeowners risk. Accordingly, despite the noble intentions of scholars in their design and development, the actual practice is a different affair and calls into question MM in the UK and Malaysia, as well as murabaha and ijarah wa iqtina financing in other jurisdictions. Indeed, our recommendation is that the concept of ribh and ‘iwad should be applied as a pre-requisite mechanism with regard to blocking the lawful means to an unlawful end (sadd al-dhara’i) when evaluating modern Islamic modes of finance in terms of economic substance over legal form. As part of product development and approval, a national or institutional Shari’ah advisory committee should publish its assessment of the validity of Islamic financial products, both in terms of legal form and economic substance, in order to obtain the widest possible feedback and consensus. In this regard, we can also detect a lack of market risk in the simultaneous bai al-‘inah sales contained within the bai bithaman ajil (BBA) mode of finance, which is typically used in jurisdictions in South-East Asia, such as Malaysia. Bai al-‘inah involves the customer selling an asset for a higher (marked-up) credit price on a deferred basis, and then simultaneously purchasing it back at a discount (at cost) for spot cash. A debt is greater than cash received, such that a bank produced (from an enquiry on BBA by the author in 2004) a constant rate amortization schedule that included payments of interest and principal derived from its own in-house loan software, as per figure 4. This exactly reconfirms the assessment of Ibn Qayyim when he invalidated bai’ al-‘inah, and referenced Rasulullah (s.a.w.s.) who said, “A time is certainly coming to mankind when they legalize (yastahillun) riba’ under the name of bai” (Ibn Qayyim, 1991, 1:352, cited by Rosly, 1999:9). Ibn Taymiyya condemned both tawarruq and specifically ‘inah, such that a merchant whom, (1) purchases goods in order to consume them, which is halal, (2) purchases goods in order to trade with them, which is halal, (3) if the reason is not (1) or (2), then the reason must be that he does not have dirhams (money) so he purchases goods on credit (with increased dirhams) in order to subsequently sell them and take that price [i.e. the goods are bought with a higher credit price], then this is ‘inah which is haram. This practice was prevalent in Medieval Europe under the name of mohatra, and also included a third party to disguise the circumvention of interest under the name of tawarruq, meaning to obtain silver (money) by trickery (Islahi, 1996:134-136). Perhaps, certain practitioners, scholars and accountants have therefore under-estimated the underlying problem associated with unfunded book-keeping entries for loans generated by fractional reserve banking (FRB), given the time mismatch between an FRB’s assets (being IOUs, which are long) and its liabilities (being deposits, which are short), which ensures that notwithstanding assetliability gap management, FRBs are inherently unstable and technically bankrupt financial institutions (Meera, 2006, 2007; Abdullah, 2014). This behaviour dictates that they must engage in risk-free debtbased non-participatory modes of finance, as opposed to risk-accepting equity-based profit-and-loss sharing participatory modes of finance (Khan, 2010). In comparison to debt financing at interest, Islamic mudharabah and musharakah equity-based profit-and-loss sharing investment contracts are

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more efficient at allocating investible resources, thereby increasing economic growth, production and employment (Sadeq, 1990:21-22).

Fig. 4: Maybank Islamic Banking - BBA Amortization Schedule

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