Saturday, August 20, 2005

Another mortgage discussion (with Abdulkader Thomas)

Abdulkader posted his reply to my mortgage challenge on ibfnet. The following is my reply to his. As usual, my own comments are in black, and my interlocutor's are in red and indented:

wa `alaykumu s-Salamu wa raHmatu Allahi wa barakatuh

Thank you very much Br. Abdulkader for an interesting, if predictable, response to my question about whether a conventional mortgage is riba.

In what follows, I shall respond to your posting section by section. However, I would like to begin by summarizing the main points where I think that your assertions are incorrect:

1. You claim that I borrowed money from the bank, when in fact that never took place, from a juristic/legal viewpoint. In Islamic jurisprudence ownership is transferred through a qard (loan). This would mean that the bank would have given me cash, which I could have used any way I wanted... The concept of "secured lending" as it exists today in the west was alien to classical jurists, and hence using the documentation of debt via a "loan" contract as proof that I borrowed money is fallacious. The anachronistic analogy to a medieval transaction where I borrowed the money first, then used the property as a rahn (pawned object) to secure the debt is incorrect, since the bank would never give me any period of time within which I could have run with the money and done whatever I want with it, and the seller would never give me a clean title, knowing that the bulk of his price is collected from the mortgagee (see point 2).

2. It is not true that I "own a property" when the bank has a lein on it, if you would allow me to quote Mohammad Fadel's comment on the issue on my blog, he said:

From the perspective of a lawyer, the transaction you describe has two aspects: one contractual and one relating to property rights. Mortgages are interests in property, in this case, real property, and under the common law, title exists in two forms, legal and equitable. When a person purchases a home with borrowed funds, his obligation to repay that money is contractual, and is documented by convention in the common law as a loan. If he grants a mortgage to the lender as security for repayment, he is transferring legal title to that property to the lender, until such time as he "redeems" his title by paying off (typically) all amounts owed to his lender under the loan contract. The mortgagor retains what is called "equitable title", since he retains the right to use the property and the right to redeem the property on condition of repayment of the loan. As a purely formal matter, therefore, the payments are not in respect of the mortgage, but rather in respect of the loan. Once the loan is repaid or otherwise discharge, the mortgage is "redeemed" and legal and equitable title are united in the owner (resident) of the house.

To repeat, the bank never gave me money, but only paid the balance of my home price on my behalf, and in essence retained legal title through the lein/mortgage, while my debt -- documented as a loan -- was being repaid.

3. The claim that substance trumps form is the way economists think is definitely true. It is also the way good jurists think, as ibn Qayyim al-Jawziyyah devoted an entire section in a`lam al-muwaqqi`in which he labelled "al-`ibrah fi al-`uqud bi-l-ma`ani, wa laysat bi-l-'alfadh w al-mabani" (what matter in contracts is substance, not terms and forms).

4. The claim that forms marketed as "Islamic" are different and that differences in form can entail differences in substance is also true. However, it does not follow that those differences ensure absence of riba in the resulting contract... If it is not accepted that the contract being replaced constituted riba, then adding those differences -- at a cost -- becomes very questionable.

I just happen to know of the principal of an Islamic school in CA who is in dire straits because he financed his non-profit Islamic school through an ijara wa iqtina' of the form you discuss (from a provider that you know well). He was shocked to learn that he owes many thousands of dollars in taxes, because the property title is not in the name of his non-profit school, but rather the SPV created by the Islamic financial provider.

This is the outcome of requirement that title is not in the ultimate owner's name. Mind you that Albaraka London had a fatwa, signed by Taqi Usmani, Yusuf Al-Qaradawi and others in 1990, that allowed title to pass straight to the eventual buyer in a lease-to-purchase.

There are so many other things that are wrong with the "Islamic" models that I will restrict my point-by-point responses to the more important issue that I raised: Is my conventional mortgage riba? Obviously, if I am not convinced that it is, then there is no need to migrate to a more expensive and ill-conceived alternative. (I so wish that Islamic finance was about something Islamic!).

Date: Fri, 19 Aug 2005 13:37:21 +0000
From: "Abdulkader Thomas"
Subject: FW: Dr. Elgamal's challenge

As salamu alaykum, Dear Fellow IBF Members, Please find below a practical analysis of an American mortgage loan and some points that demonstrate it to be ribawi.

The mortgage loan process in America works something like this:
1. The consumer goes to a bank or mortgage broker and applies for a loan.

In fact, I never applied for a loan separate from the property. I was referred to my mortgagee by the builder of my home. Then, I was "qualified" for secured mortgage-loans (not the same as qard, as argued above) up to some level of debt secured by a primary family residence, having already known the property builder, etc.

a. The loan, at this point, is unspecific and unconnected to a property.

Not true. There was no loan at this point, and never any "loan" in the sense
of qarD, whereby I would have owned the money and possibly used it to buy
a Bentley instead of my house.

b. The consumer qualifies for a loan amount based on how much he or she earns and what is his or her credit score; some ratios may be taken into account.

This is the same qualification process used by Islamic banks or any others. The question is simply whether or not the consumer can afford this property,and whether or not the financier/mortgagee would be taking too large a risk by investing in this credit.

c. The loan is "pre-approved" subject to certain conditions including an
appraisal of a property that will secure the loan.

Again, characterizing it as a "loan" is equivocal. The financier approves becoming a creditor to the home-buyer for an amount not to exceed a certain dollar value, and subject to the buyer holding sufficient home equity (determined by the appraisal and down-payment) to ensure that the mortgagee/creditor is not taking too much risk. That that debt is documented by a "mortgage loan" document does not make it a loan in the classical juristic sense of qarD.

2. The consumer contracts to buy a property.

This contract was never drawn independently from the mortgagee providing the funds with which the property is bought. We agreed on the property specifications, then they referred me to the bank to see if I can get funding, the bank agreed that
I qualify for the balance, based on my salary, etc., I made a first payment to begin the building, and that's how it started.

3. Any loan conditions are met and the property appraised.

The appraisal was done before closing, but approval was made based on thebulider's pricing formula for given specifications.

4. At the closing the lender funds the money on the consumer's behalf to an independent party (this is a legal requirement due to fraud in the 1960's) and the independent party manages the closing; delivering the consumer's down payment, the loan proceeds and any other requirements to the seller in exchange for title to the property

This is an accurate description of the Title Company's role as a mutual agent for me, the mortgagee and the seller (in my case a building company that had built my house to certain agreed-upon specifications, and only after they received
part of my downpayment, proof that I have the rest of the downpayment, and proof that the mortgagee will pay the balance).

5. At the closing, there may be 50 documents, depending upon the state in which the loan is made, three of them are contracts under American law:
a. Contract 1: The Purchase Contract: This is the contract conveying the property from a buyer to a seller subject to specific conditions and for financial consideration, i.e. give me money and I will give you title.
b. Contract 2: The Promissory Note: This is the evidence of a loan or debt and the maker, Dr. Elgamal in this case, promises to pay a set rate of interest for a specific period. He also promises to pay penalty interest at a specific rate if he is late in making his monthly payments. If he does not pay for three months, the lender will take the note to court in order to seize the property under the terms of the next item.
c. Contract 3: The Mortgage: this is a specific lien on the house mandating specific behavior by the grantor of the security, again Dr. Elgamal. When the note is presented to a court, the mortgage allows for the note holder to seize the property and take title.

The bare-bone structure of those three contracts are what I characterized as:
1. Some money from me and some money from mortgagee to seller/builder,
2. Property title from builder to me, simultaneously lein to mortgagee
3. Note promising that I will make payments to bank
No money-for-money transactions between any two parties!

As I mentioned in my previous response to Hood, the late payment interest provisions are definitely a defective condition, but I nullify it personally by planning never to make such payments -- giving up the property, declaring bankruptcy, etc. to avoid it. The same applies to credit cards, which I use for travel, my rental agreements when I rented apartments, and my past and
present utility companies, all of which would require me to pay interest if I am late.

The fact that the creditor can seize the property is the very nature of mortgage. Indeed, form a pure banking viewpoint, if you do not have the luxury of charging interest on late payments, you as mortgagor (Islamic or otherwise) would be much
more likely to foreclose earlier, to cut your financial losses. As one provider of Islamic mortgages told me in private correspondence "yes, of course, that's how a banker or economist would think about it, but we keep this out of our
sales pitch".

6. Curiously, if Dr. Elgamal wishes and can find the lender, then he can sign more notes and grant second or third mortgages that represent loans far greater in value than his house. These are home equity loans or second (third.) mortgage loans.

First of all, it is highly unlikely that any bank would give me a second mortgage exceeding my equity in the property. Second, if I were devious, what is to stop me from getting an unsecured loan? The point again is not whether there are options to pay illegitimate interest, but whether I am forced to engage in riba.

In summary, Dr. Elgamal contracted to borrow money.

False! I never owned the money, and hence I never borrowed it. I engaged in a debt contract, yes. The bank paid for my house, and in some legal sense co-owns the property. I owe the bank for what it paid on my behalf, and that debt is documented as a "loan" for my protection. That does not make it a loan in the classical sense of qarD, and I certainly never borrowed money (see 1. above).

The terms of the loan were interest for a specific period; a grant of sufficient security (the house);

I have not read the word "interest" in the Qur'an and Hadith, only "riba". From where I stand, and where regulators stand under Reg. Z "truth in lending", what you call profit in murabaha or rent in ijara *is* interest. There is no finance (Islamic or otherwise) without interest (in the modern sense)!

Moreover, all providers of "Islamic mortgages" in the U.S. of whom I am aware send appropriate form 1098 to their debtors to deduct the "mortgage interest" on their personal income tax forms -- despite the tragic fact that the IRS has never ruled that they allow this!!


and an agreement by Dr. Elgamal to pay more interest if he is ever late. The bank did not insert itself into the sales process or title and takes its primary risk on Dr. Elgamal being able to pay with a secondary risk that the value of the house as collateral will be less than the value of the house.

Where does it say in the Qur'an and Sunnah that the bank had to do any of this? The mortgage transaction is a modern one, on which the Canonical Texts of Islam are silent. Contemporary jurists (who happen to be on the payrolls of "Islamic financial providers") have reasoned that way, thus creating an arbitrage opportunity. I am questioning whether I should pay the rents that come along with the costs of arbitraging it.

Let's compare this process to an ijara wa iqtina transaction, currently not available in Texas where Dr. Elgamal has borrowed money, but with which I am very familiar.

Not to advertise for anyone, but at least one provider that I know does
operate in Texas, and they describe their model as one based on lease.

...

The rest, deals with ijara wa iqtina' as offered in the U.S., which can be
the topic of a separate discussion, if you wish.

6 Comments:

Blogger heraish said...

Peace

(I so wish that Islamic finance was about something Islamic!)


The Musharakah (declining balance co-ownership) model of Islamic Finance that is currently being practiced in the US mimics the conventional mortgage functionally with the exception of three factors.

1) Fixed late payment fee of $50 for every payment missed.

2) No compounding of Interest in the case of successive missed payments.

3) In the case of default where the amount received after the house is sold is not enough to cover the “loan” furnished by the financing company due to a depreciation in the value of the property – there is a non-recourse clause. This means that the Islamic Financing Company does not pursue the customer through the courts to recover the loss by pursuing the other assets of the customer or through the garnishment of wages. This allows the customer to gain time so that he will be able to pay what he owes at his own comfort level.

My earlier proposal to further make this contract to further fall within the spirit of Islam was to practically share in the loss. That means the customer should not be responsible for covering the whole amount of loss due to the depreciation of the value of the property. The financing company should practically give the customer a break for at least some of that value.

Most mortgage customers nowadays sign 30 year mortgages to get the lowest payment and then sell the house after 5 or 6 years, pay the financing company the remainder of the unpaid “loan” amount and pocket the extra money gained from the sale due to the appreciation in value of the home. They do this to make money and/or because they have to move due to getting a job somewhere else for example.

In light of this, my second proposal is for the financing company to charge a fixed pre-payment penalty (in the spirit of Tantawi’s fatwa) or a percentage of the appreciated value. This way there is a sharing of profits between the two parties.

The immediate goal for the practitioners of Islamic Finance should be to develop products that move us up on the Islamic Permissability frontier towards the Islamic Economics Ideal as protrayed by El-gamal at:

"Reviving the Roots of Islamic Economics and Finance." 9th Annual Lariba Symposium, Pasadena, CA. (June 16, 2001)

God Knows Best

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