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).
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”.
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.
The concept of interest: conventional economic perspectiveClassical economists’, simply defined interest as the costof capital in investment process, modern theory tends toset up the interest rate as the center of policy andeconomic control.The classical economist argued that it is only bypostponing consumption that capital can be created. Toabstain from consumption is agreeably painful, but thelender is paid a reward in form of interest.
Islamic perspective of interest and its prohibitionQur’anic verses have revealed clearly and unambiguouslyabout 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)
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).
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.
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.
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.
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,
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.
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).
ConclusionInterest stands out as the major cause of the crisis. Thepassion for interest prompted greedy financial experts toinvent risky interest-yielding assets/derivative loanswith devastating consequences on investors andinvestment. With prohibition of interest, gharar and anyform of uncertainty; Islamic economic and financialsystems can serve as a reliable alternative.