financial crisis and islamic finance_2
TRANSCRIPT
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Financial Crisis and Islamic Finance
Graduate Thesis:
Jasmin Jusufovi
Mentor: Mehmet Can
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Outline
Introduction
Explanation of the instrument inconventional finance which are
blamed for the financial crisis. Inquiry into the crisis and its
timeline
Explanation of the comparablefinancial tools in Islamic Finance.
Conclusion
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Everyday panic over a financialcrisis seeks for someinvestigation.
The thesis has worked ontheoretical basis, to present, i.e.to understand the conventionalfinance and its alternative inIslamic finance
Theoretical approach is justifiedby the lack of data in Islamicfinance.
Introduction
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Our attention goes to...
Mortgage loans (mortgages)
How they work, and
Characteristics.
Prime and subprimemortgages
NINJA loans
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Mortgage loans - recollection
Mortgage means a backup forthe financier in real assetprovided by the borrower, in
case the latter defaults. Differed payment
Price - interest
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It is a contract involving twoparties financier andborrower.
Attention to clientscreditworthiness.
Good creditworthiness prime
Poor creditworthiness subprime.
Mortgages properties
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They are the result ofloosening the mortgagestandards.
Initially aimed at exploiting themarket demand for housingcredits.
Further geneaology gave birthto NINJA loans.
Subprime mortgages
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Stands for No Income No Jobor Asset.
It essentially means thatEVERYONE could be given loan.
Market demand exploited toits maximum
High risk involved backupneeded
NINJA loans
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Process of transfering illiquidor other assets into amarketable legal documents
securities. For banks the clients liability
(in form of a mortgage) is anasset and therefore thesecurity created from it isMortgage-based security.
Securitization the inventive backup
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Too much outstanding loans andloan-based securities mean tomuch exposition to risk.
Hedging is an inventive tool ofselling an excessive risk uponanother client, and thereforediluting the risk through the
market. Most common hedging is Credit
Default Swap
Hedging further insurance
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Rapackaging the risk in loansinto a hegde to be sold toanother entity in the market.
Lender faces credit risk anotherparty agrees to insure the risk inexchange for regular periodic
payments. If the loan defaults, insurer pays
the remaining debt to the lender.
Credit Default Swap (CDS)
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CDSs open door to speculation
It is an influence on prices inthe market with suspicious
actions, thus driving the pricesup and down drastically
Speculation
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The financial products andinstruments have become socomplex and twisted, that asthings start to unravel, trust inthe whole system started to fail.
Because derivatives are entirelyunregulated and trade on no
public exchanges, theiroriginators can deliberately hidetheir vulnerabilities.
So, what went wrong?!
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Soaring profits insecuritization market invitedeveryone to take part in it.
Banks loaned more and more,to have an excuse tosecuritize.
Running out of primes, thebanks turned to the risky, poorclients.
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Huge risks were taken, so otherparties were involved to insurethe risk.
People started realizing what ishappening; a cycle of defaultsoccured, and it all started tocrumble.
There was no money to sustain
the derivatives created, andmany market participants filedfor bankruptcy.
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1938: The Federal National MortgageAssociation, commonly known as FannieMae, is established to purchase andsecuritize mortgages in order to ensure thatfunds are consistently available to theinstitutions that lend money to home buyers.
1970: Federal Home Loan MortgageCorporation (Freddie Mac) is created by anact of Congress, as a government sponsoredenterprise, to buy mortgages on the
secondary market, pool them, and sell themas mortgage-backed securities to investorson the open market;
Major events in the crisis timeline
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1992: Federal Housing Enterprises FinancialSafety and Soundness Act of1992 required Fannie Mae and Freddie Mac todevote a percentage of their lending to supportaffordable housing increasing their pooling andselling of such loans as securities; Office of
Federal Housing Enterprise Oversight (OFHEO)created to oversee them.
1993: The Federal Reserve Bank of Bostonpublished "Closing the Gap: A Guide to EqualOpportunity Lending" which recommended a
series of measures to better serve low-incomeand minority households, including looseningincome thresholds for receiving a mortgage,influencing government policy and housingactivist demands on banks thereafter.
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19952001: Dot-com bubble andcollapse
1998-2008: With increase in sales ofmortgage-backed securities,companies buy more Credit defaultswaps, unregulated insurancecontracts used to protect debtholders; these increased 100-fold
from, with estimates of the debtcovered by such contracts, as ofNovember 2008, ranging from $33to $47 trillion.
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2000-2001: US Federal Reservelowers Federal funds rate 11 times, from6.5% (May 2000) to 1.75% (December 2001),creating an easy-credit environment thatfueled the growth of US subprimemortgages.
2002-2006: Fannie Mae and Freddie Maccombined purchases of incorrectly rated AAAsubprime mortgage-backed securities risefrom $38 billion to $90 billion per year.
Lenders began to offer loans to higher-riskborrowers, including illegal immigrants. Speculation in residential real estate rose.
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2004-2007: Many financialinstitutions issued large amountsof debt and investedin mortgage-backed
securities (MBS), believing thathouse prices would continue torise and that households wouldkeep up on mortgage payments.
Fall 2005: Booming housingmarket halts abruptly
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Throughout 2007 and 2008 home salescontinue to fall.
Stock market experiences downturns September 2008
September 7: Federal takeover of Fannie Maeand Freddie Mac. This causes panic becausealmost every home mortgage lender and WallStreet bank relied on them to facilitate themortgage market and investors worldwide.
September 17: The US Federal Reserve lends$85 billion to American International Group
(AIG) to avoid bankruptcy. The crisis spreads to Europe in the ending of
2008.
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Our attention will be on:
Musharakah (Partnership)
Regular and deminishing
Mudarabah (Commerce withagents)
Murabahah (cost-plus sale)
The Islamic alternative
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Constracts / Instruments inIslamic Finance
Contracts / Instruments
TransactionalContracts
Bay'
(Sale)
Sarf
(Exchange)
Sale of Rights toUse
(Ijarah, Istisna)
FinancingContracts
Trade financing
(Murabahah)
Asset-backed
(Ijara / Istisna)
Equitypartnership
(Musharakah)
Intermediation contracts
Parthership
Mudarabah
Musharakah
Fee-Based
Services
Guarantee
(Kifala)
Fee-basedservice
(Jo'ala)
Custody
(Amanah)
Representation
(Wikala)
Insurance
(Takaful)
Social welfarecontracts
Gratuitous Loans
(Qard-e-Hasna)
Trust
(Waqf)
Sh i h f i
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It stems from Quran, Sunnahand the interpretations andoppinions of learned jurists(Ijtihad).
It manifests the faith into day-to-day actions.
Divided into two components: Ibadat (defining rituals and rites) Muamalat (defining social,
economic framework andpracticality of day-to-day life.
Shariah as a source of economicphilosophy...
N ti i I l i i
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Justice Property rights Property obligations
Contracts Trust Personal obligations, rights and
self-interest.
Work Wealth Risk sharing
Notions in Islamic economicsystem
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Islam prohibits the followingnotions know to conventionaleconomists:
Interest (Riba)
Gambling (Qimar)
Ambiguity, uncertainty (Gharar)
Islamic prohibitions
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Wide scholar debate exists on whatArabic Ribameans in conventionalterms.
General agreement is that Ribais
interest per se, and any add-ups,swelling in value, over certain initialvalue.
There are: Riba al-Nasiah (excess in money-to-
money exhange) Riba al-Fadl (deals with hand-to-hand
goods exchange)
Interest in Islamic philosophy
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Comes from Arabih Shirakahwhich means sharing andparticipating together in
certain activity, project, etc. Branches into
Shirakatu l-milk
Shirakatu l-aqd Shirakatu l-emval
Shirakatu l-amal
Shirakatu l-wujuh.
Musharakah (partnership)
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Two parties combine theircapital to share the generatedprofit.
Proportions for profit sharingare predetermined beforeentering the contract.
Losses are borneproportionally to the portion inpartnership.
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Designed to meet the housingfinancing demand.
The bank (the owner of the
major part) rents its portion tothe client.
Clients installments include rentand amount to buy portion of
owners equity. Rent is adjusted according to the
deminishing equity.
Diminishing Musharakah
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Musharakah loans aremarketable.
The important prerequisite to
be met is that the certificates(or securities) must representthe real asset, i.e. house,
factory, etc.
Musharakah in financial market
Mudarabah (Commerce with
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Contract that includesfinancier and the agent(mudarib) who invests the
financiers capital on hisbehalf.
The profits generated by theproject into which the capital
was invested is shared amongfinancier and mudarib.
Mudarabah (Commerce withagents)
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Control
Profit and loss sharing
Profit distribution
Multiple tiers
Credit risks and defaults
It cannot be traded in thefinancial market.
Features of Mudarabah
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The basis for this model is thetrade.
The financier is the seller of
the good, who can sell thegood on deffered payement.
Since it is a trade, the seller
can charge a profit margin.
Murabahah (cost-plus sale)
Prospects of the trade in Islamic
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The item in subject must be tangible in themoment of sale.
The item must be owned by the seller. It must be in a physical or construtctive
ownership.
Purchase must be on the spot andimmediate. Item must be a real value. It cannot be used for haram. The item must be known to either party.
Delivery must be evident and unconditioned. The price, and markup, must be evident,
clear and well understood.
Prospects of the trade in Islamicteaching...
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Includes three parties: Borrower - client
Bank (financier - seller)
The innitial seller.
Ordinarily today, the model iscombined with mudarabah, wherebythe client is hired by the bank toaccept the delivery once the item is
purchased, namely, creating no needfor banks inventory.
It is not marketable.
Murabahah, further notions
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Islamic economic philosophyrecognizes the importance offinancial markets, but raises
many issues to be resolved.The debate is ongoing. Notion of limited liability
Tradability and negotiability
Speculative trading Short selling.
As we approach the ending...
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Are the unbound innovationsbeneficial?
Could an event such as the
current financial crisis with itsproperties, happen in theenvironment of Islamic Finance?
How can Islamic Finance be analternative or a remedy for thecrisis?
So... What?! (or conclusion)
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Now, YOU!!!
Questions?
Remarks?
Comments?
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YOUR ATTENTION WAS
APPRECIATED...
Have a nice day!