The financial crisis – Western banking versus Islamic banking
| Pages | 1-16 |
| Published date | 01 April 2011 |
| Date | 01 April 2011 |
| DOI | https://doi.org/10.1108/20425961201000026 |
| Author | Michael Busler |
| Subject Matter | Public policy & environmental management |
Copyright © 2011 WASD 1
†The Richard Stockton College, USA; e-mail: Michael.busler@stockton.edu
The Financial crisis -
WesTern Banking versus
islamic Banking
World Journal of Enterprenuership, Management and Sustainable Development, Vol. 7, No. 1, 2011
Michael Busler†
The Richard Stockton College, USA
Abstract: The financial crisis has had a devastating impact on financial markets in the
US and other western countries. Particularly hard hit were investors who purchased
mortgaged backed securities, since as the value of the asset declined below the amount
of debt, investors took large losses. Countries that follow Islamic Banking and Finance
(IBF) have largely been spared this loss due to the types of bonds that are allowed. This
research summarises the problem in the Western World and then compares it to a simi-
lar problem faced by Dubai World who had a ‘standstill’ when they were unable to make
a required payment. It appears that holders of Dubai World sukuk will be spared losses
because of Islamic banking laws. We examine both the short term and long term effects.
Keywords: financial crisis; Islamic banking; sukuk; Dubai World.
inTrODucTiOn
In the US, government policy has al-
ways encouraged home ownership. As
early as 1932 when then president Her-
bert Hoover said, “As a people we need,
at all times, the encouragement of home
ownership” government policy has fol-
lowed this view. Through government
sponsored home mortgages and special
tax treatment for homeowners who could
deduct home mortgage interest expense
from their tax liability, government policy
attempted to get as many households as
possible to own, rather than rent, homes.
In 1994, the US government made a con-
cen-trated effort to increase the percent-
age of households that own homes from
the existing 62% to 70%. This was ac-
complished when the Clinton Adminis-
tration set a ‘National Homeownership
Strategy’ which had the goal to put forth
“financing strategies fueled by creativity
to help homeowners who lacked the cash
to buy a home or the income to make the
down payments.”
M. Busler
2
mortgages in the belief they would be
able to quickly refinance at more favour-
able terms sometime in the future. In the
financial markets, investment bankers
cre-ated Asset-and Mortgage-Backed Secu-
rities (ABS and MBS) and Collateralised
Debt Obligations (CDO), which derived
their value from variable rate auto loans,
credit cards, mortgage payments and
housing prices. These securities were as-
signed safe ratings by the credit rating
agencies who assumed historic default
rates. This enabled financial institutions
to obtain investor funds to finance sub-
prime lending, extending the housing
bubble while generating extremely large
fees. Sub-prime, adjustable rate mort-
gages remained below 10% of all mort-
gage originations until 2004, when they
spiked to nearly 20% and remained there
through 2006 (Bernanke, 2007).
By September 2008, the upward ad-
justments to the mortgage rates resulted
in increases in defaults forcing the aver-
age US housing price to decline over 20%
from the 2006 peak (Standard and Poor’s,
2008). High default rates on sub-prime
and adjustable rate mortgages began to
increase quickly thereafter. As housing
prices declined, major global financial in-
stitutions that had borrowed and invested
heavily in sub-prime MBS reported signif-
icant losses. Falling prices also resulted
in homes worth less than the mortgage
loan, providing a financial incentive for
the homeowner to enter foreclosure. As
prices continued to decline, borrowers
with adjustable-rate mortgages could not
refinance to avoid higher payments asso-
ciated with rising interest rates so defaults
increased further. In 2008, lenders began
Government policy influenced mar-
ket conditions through stimulation of
demand. This was accomplished by low-
ering the credit standards necessary to
qualify for mortgages. While this may
appear to create more risk for banks and
mortgage companies that issued mortgag-
es, Fannie Mae and Freddie Mac, quasi
public agencies, were willing and eager
to purchase these ‘sub-prime’ mortgages
from the originators. Thus the default
risk was transferred from the mortgage
originator to the quasi public agencies
who eventually would package and sell
the mortgages to the investment commu-
nity (Makin, 2009).
After 2000, this effort intensified in
three areas. Firstly, the Federal Reserve’s
interest rate policy drove down the cost
of borrowing to historic lows. Secondly,
the government created special loan pro-
grams so that even those who could not
afford home ownership became quali-
fied. And thirdly, the private agencies
that determine security risk and value
were overly generous in their assessment
of financial derivatives which were collat-
eralised by mortgages.
Between 1997 and 2006, the price
of a typical American house increased
by over 120% (The Economist, 2008).
This surge in housing prices resulted
in many homeowners refinancing their
homes, but more specifically, increasing
spending by taking out second mortgag-
es secured by the price appreciation. An
increase in loan packaging, marketing in-
centives, such as easy initial terms and a
long-term trend of rising housing prices,
encouraged borrowers to assume difficult
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