Monday, August 22, 2005

mortgage discussion with David Loundy -- Part II

Let me reiterate that I appreciate your professional approach, and manifestly genuine desire to serve your clients' needs. That contrasts sharply with the vitriolic approach adopted by others, which I cannot dignify with a response. At any rate, their salient points are made much more coherently in your posting. Consequently, I hope that we can continue this dialogue.

I appreciate that you have superior knowledge of law and banking, and -- as you suggested in our earlier correspondence -- I am sure that I will learn from this dialogue, and hope that you may find it useful as well.

This is the second installment of my reply to your message regarding my mortgage challenge. For brevity, I am only quoting the sections on which I have comments, or which directly address my earlier assertions.

On Aug 20, 2005, at 12:40 PM, David Loundy wrote:

Next, you mention an institution that is facing penalty taxes due to use of an ijara transaction where the institution does not get the real estate tax exemption that applies to religious institutions. This is exactly the case that resulted in our creation of a murabaha product in the first place instead of using the ijara product that we had already developed. In this case, the legal mechanism employed does matter under U.S. law and produces a different result from a conventional mortgage. This argues in favor of a difference between conventional financing, not against. Yes, it is an increased "Cost of Being Muslim" (COBM), but it is a cost incurred BECAUSE there is a substantive difference-- the religious institution does not own its property. We run into this problem, and variations on it, frequently. Generally, the COBM for us on a transaction is very small, but tax issues can make a big difference to “special cases.”

I understand that some Muslims may feel that a "cost of being Muslim" or financial sacrifice is personal proof of piety. I do not feel that way. It is a general doctrine in Islamic legal theory (e.g. according to Al-Shatibi) that nothing purely useful is forbidden and nothing purely harmful is allowed, and in cases of mixed good and harm, the Law (Shari`a) aims to maximize net benefit. I recall in our private correspondence that you mentioned one of the younger scholars on your Shari`a board appealing to this COBM feature as a good thing. I disagree. Unless there is a proven benefit [worldly benefit] outweighing the harm, I cannot believe that the Almighty would require a financial sacrifice just for its own sake... Since there is no Canonical Text directly dealing with the case of mortgages, I find any jurist's analysis that relies on such claims to be unconvincing.

[Paragraph on IRS and 1098 forms: I sympathize, and hope that the IRS will issue an opinion.]
[Paragraph on Reg. Z "truth in lending": I am glad that US regulators are forcing providers to report the APR, and not to charge customers interest -- in the case of Murabaha -- despite pre-payment... At any rate, the OIC has allowed "Da` wa ta`ajjal", or discounting of debt for prepayment, which keeps you on the good side of traditional Shari`a scholars.]

Next, you have quoted Mohammed Fadel's distinction between equitable ownership and legal ownership as one with significance, but it is not. In part, this is an issue of timing and execution of the documents. If the documents are signed and recorded in the correct order, even where a mortgage, or "deed of trust" in some jurisdictions, conveys title, it is title that is conveyed only AFTER legal and equitable title has been transferred from the supplier to the bank and then on to the customer. All of the rights of the parties have properly attached, and in the correct order. Thus it IS true that you own the property, and in full—at least initially. First year law school property classes refer to property rights as analogous to a "bundle of sticks" which can be passed as a whole or divided up.

We teach the "bundle of rights" definition in undergraduate "Law and Economics" classes as well. This is a good point to recognize that classical Islamic jurisprudence evolved at a relatively early (primitive) stage of legal development, and thus resulted in a very limited bundle of rights recognition: You can split ownership of the property itself and ownership of its usufruct, and potentially divide those ownerships in unspecified co-ownership shares. Other than that, the only remaining rights are easement rights (Huquq al-'irtifaq), pre-emption rights (Haqq al-Shuf`ah) and possible entitlements ('istiHqaq). When property is used as security for debt (rahn), the mortgagee also has a right to extract the debt upon default.

Interestingly, even with this simple classification, jurists managed in the Albaraka London fatwa on real estate financing via Ijara to allow title to pass directly to lessee and eventual buyer: The mortgagee passes ownership of the property itself (milk al-raqabah) to the ultimate buyer, but retains ownership of the usufruct (milk al-manfa`ah), and collects rent accordingly through the lease period. This was derived from an old Shafi`i justification of sharecropping. This opinion, as I mentioned in an earlier posting, was signed in 1990 by Justice (retired) Taqi Usmani along with other prominent scholars. Why was this structure not used more recently to avoid the tax problems that we both agree should not be there?

I apologize for the digression... next you said:

At this point, the whole bundle is yours. Only then do you convey away part of your interest (one of the sticks in the bundle)-- only then is the legal and equitable title bifurcated by the customer/property owner as a means of securing its agreement to repay the incurred debt. If you gain ownership of the property and then run out of the closing without executing the mortgage, there is no mortgage, and thus no security for the debt. (However, you have a breach of your obligation and will 1. be sued, immediately; and 2. may not have your deed recorded by the title company which may result in the "defeasance" of any ownership.)

While your timeline explanation (and solution in the sequencing of an Islamic closing described in later paragraphs) seems compelling, I do not feel that it makes the difference between riba and non-riba: Allow me to paraphrase your description in terms of the existence of a short period of time when I theoretically have full ownership of the property (the full bundle of rights associated with ownership), before passing some of those rights to my mortgagee. Then, you say that the only way to make use of that full ownership is to try to run and register the title illegally (which may have been possible in the wild wild west, but seems logistically very difficult), which -- of course -- I would not do as a Muslim, and would have to face legal
consequences if I do.

In addition to the illegality of taking advantage of this short period of time during which all ownership rights are united in my possession, the formalistic difference between this and the "Islamic" alternative is very reminiscent of the assertion that bank ownership of the property of a very short time in Murabaha justifies "profit" in the ensuing credit sale (when in fact the return is clearly compensation for time and credit risk). In both cases, there may be a formalistic point, but one that is neither practical nor economically meaningful. It is impossible for such formalism devoid of economic content to justify the difference between permissible trade and forbidden riba.

You state that the bank never gave you the money, but I have confirmed with a real estate lawyer my earlier comments to you about agency. Essentially, yes, the bank did give you the money, via your agent.

Even if it theoretically "gave me the money" in the sense of paying it in my name, that is not the same as "lending me the money" in the juristic sense of qarD. (I just saw that someone has sent a vitriolic message as I am typing this asking "what jurisprudence I am reading"... for now, I assure you that very respectable classical jurists determined that lending of money would imply change of its ownership to the borrower-- which suggests that to borrow the money, I should be able to take it from the agent to do something else with it... I need to write a separate message citing the various opinions about ownership of lent property). In fact, having money "given to me" or "paid on my behalf" and tied to a particular transaction is a new form
of secured lending that cannot simply fit into the classical mold of "qarD".

[Lengthy discussion of role of Title Company, which I may have to address in a third installment. I had promised earlier in private to take a closer look at the argument, and hope to do that shortly. However, you can already see that I am leaning towards dismissing those temporally brief formalistic distinctions that carry little, if any, economic value]

You also state that if this were a real loan under Islamic jurisprudence then you could take the bank's money and use it for any purpose. Here, you are perhaps caught in an inter-legal system difference. In a conventional loan, under U.S. law, it is conditional. It is a loan of money being given to you for the specific purpose of acquiring a specific piece of property-- it is a mortgage loan, not a personal loan. Theoretically, you could take the money and buy something else-- money is money. However, this money comes with strings attached, and you'd also be buying at least one lawsuit (probably two). Practically, it will not happen because of the dual agency of the title company, and because the bank does not bring a suitcase of negotiable cash to the closing. Your agent, that receives the loan proceeds that your agent then conveys to the house seller, is also the bank's agent to make sure that the bank's collateral is in place, and if you try to divert the funds a check can be stopped.

This is precisely my point. I will make a separate posting on the nature of qarD in classical jurisprudence,
and the legitimacy of a "conditional loan with tied strings" in the classical sense of "qarD".

So, I invite either your convincing replies, or your new murabaha application…

As you can see, I am still not convinced. I think that the Shari`a arbitrage opportunity that has led to this brand of Islamic finance comes precisely from anachronistic translations of words like "loan" and "qarD". When jurists trained in that classical tradition see a document that says "loan" and "interest", they immediately feel compelled to say "Oh, that is riba" [although, as an aside, you can see from my weblog postings of the Rachid Rida manuscript, the idea that any increase stipulated at the inception of loans is riba is itself doubtful, as there is no acceptable Canonical Text justifying it, and the report is that Abu Hanifa considered it reprehensible, which means that he did not consider it riba]. Be that as it may, my argument is that this
is not necessarily a "loan" in the traditional sense anyway, but a relatively new transaction for which serious ijtihad may reach divergent conclusions. So, while the majority of contemporary jurists would deem it ribawi, that is not the nature of my challenge, and I appreciate your effort to address my concerns as an observant Muslim who nonetheless needs to be convinced... Of course, there is the suspicion of riba, as I cannot definitively prove that my mortgage is not riba. That leads to the issue of looking at "Islamic" alternatives and determining if there is sufficient substantive difference to reduce that suspicion of riba (which is difficult when the resulting "note" will be sold to Fannie Mae or Freddie Mac at any rate).

I suspect that there are hundreds of millions of Muslims like me, who are not convinced that what they are doing is indeed riba, or that there is sufficient substantive difference between what they have and what "Islamic finance" offers to conclude that one is riba and the other is not. An argument that convinces me can probably convince a large segment of that Muslim middle class, and thus would give a great boost to the industry. Otherwise, even if current arguments are not convincing to a sophisticated Muslim middle class, perhaps the dialogue can lead to other possibilities that will be more attractive to that group of Muslims whose views I hope to be representing honestly.


Blogger heraish said...


The question is whether to go conventional or go with the currently available "Islamic" option.

David has made the argument (in another forum) that Islam requires that you do your utmost to avoid riba. With the conventional if there is an accident and you can't pay the mortgage. There are late fees and compunded interest.

If you had chosen the Islamic option you would not have fallen into this situation.

So you could be held responsible for having not taken the Islamic option where you would not have fallen into this predicament. (His argument has been summarized by me)

God knows Best

4:17 PM  
Blogger Mahmoud El-Gamal said...


Would you then also recommend not deducting "mortgage interest" on Islamic mortgages, since the IRS may rule that this is not allowed, and demand past taxes + interest and penalty?

7:13 PM  
Blogger heraish said...

Does anyone know how does the IRS make its decisions with regards to these matters?

5:07 PM  
Blogger heraish said...

"(which is difficult when the resulting "note" will be sold to Fannie Mae or Freddie Mac at any rate)."

Is this necessarily un-Islamic?

In the Musharakah model of Islamic finance this is considered to be selling one's ownership to a third party, on the one hand. And then guaranting payment to the third party till the contract ends.

9:05 AM  
Blogger heraish said...


Hurricanes and Islamic Mortgages

In the Declining Balance Co-Ownership agreement that is based on the Musharaka model of Islamic Finance there is a provision that differentiates this agreement from a regular mortgage.

That provision says that in case of damage to property due to a Natural Disaster, and where the insurance does not compensate(e.g. due to bankropty of the insuring company) then the company practically takes the loss and does cannot hold the individual reponsible for the rest of the "loaned" amount that may be owed.

This is basically an increased level of consumer protection vs a conventional mortgage. This provision may be a justification for the higher price of a Islamic Mortgage due to the added value.

page 6:The Declining Balance Co-ownership Program

God Knows Best

7:07 PM  
Blogger heraish said...

Issues Related to relationship with Freddie/Fannie.


To my knowledge when the Islamic Financier sells its contract to Freddie/Fannie etc. the contract is indemnified.

This means that whatever happens between the Islamic Financier and the customer the Islamic Financier has to pay the balance to Freddie to close out the mortgage.

This may be problematic from a Shari point of view and may cause the the Islamic Financier to enter into giving riba to Freddie/Fannie under certain scenarios.

This is can happen for example in the case when there is a destruction of property within the "lease to own" and "Declining Balance Co-ownership" context.

God Knows Best

11:15 AM  
Blogger heraish said...

More on Freddie:

There is a comment on this in a publication by the Guidnace Financial Group named "Guidance Financial Group",

It says on page 21.
"Creating Islamic agency paper presented many new and daunting challenges. Only securities based on asset ownership, as opposed to pure debt, may be traded under Shariah. The difficulty is that the process of securitizing ownership-based fixed-income assets creates serious liability exposure in the U.S. legal context. We designed and patented a proprietary legal structure to address this challenge. In order to tap the deep liquidity of the conventional mortgage-backed securities market, we devised a security design strategy that allowed us to "borrow" liquidity and other investment charecteristics from the conventional market as opposed to creating them "intrinsically". Finally, in order to create this product, it was essential to develop our capability to originate Shariah-compliant real estate financing assets in the United States, to forge a close strategic alliance with Fressie Mac, and to integrate our Shariah Board's requirements with those of Freddie Mac as an issuer."

This basically indicates that some legal gymnastics has been done in this case. Whether these legal gymnastics are significant enough to kosherize (halalize) the deal I do not know.

God Knows Best

6:57 AM  
Blogger heraish said...


It has been confirmed that in the case of the Declining Balance Co-ownership agreement, freddie did formally agree to the clause that was imposed on them by the Shariah Board to share the loss if the insurance proceeds do not completely cover the damage on the house. However the contract clearly stipulates that the customer is required to get complete insurance of the house structure.

There are however cases where the Islamic mortgage may be a million dollars and the insurance of the structure would cover a maximum of $300000 for example. This may happen in the case where like California the partucular land in combination of the house has a high value.

The Islamic financier in question is not required to cover the balance in case of loss as it was implied by myself in a previous posting under the title,"Issues Related to relationship with Freddie/Fannie."

God Knows Best

4:43 PM  

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