Tuesday, July 7, 2009

Islamic-Compliant ETF

Below is an interesting article about how deeply religious Muslim investors avoided the full brunt of the stock market crash:


Hint: if you can't invest in companies that charge interest on loans, you avoid investing in banks.

Update: my friend, M. Izak, reminds us that Muslims aren't against banks per se. He says the current banking system is anti-Islamic because it charges interest rather than fees. Banks may rely on fees instead of interest payments but have chosen to rely on interest payments.


Adam Rogoyski said...

How would a bank which does not use interest be able to give out new business loans or do mortgages?

K_Yew said...

Adam, as I understand it, Islamic finance encourages limited partnerships rather than master-servant or creditor-debtor relationships. Rather than charge interest, an Islamic lender will take an ownership interest in a house or business and receive profits (or losses) from the investment. For example, if I own a law firm and want money to expand, an Islamic bank will charge me x% of my profits or rental income for the next five years in exchange for x amount. (As you can see, this forces the lender to actually verify the soundness of a business or rental property.) If all goes well, everything works out the same as a regular American business loan, except the bank doesn't profit if the "loanee" don't do well. In a nutshell, Islamic lenders do well when the "loanee" does well, and do poorly if the "loanee" doesn't do well. As a result, Islamic finance promotes only conservative lending or non-exploitative lending. The downside is that economic growth will be slower b/c fewer people will get loans, and businesses with untested but potentially good ideas won't be easily funded. On the other hand, Islamic finance would discourage an entry-level janitor from getting a 750K jumbo loan or businesses like pets.com or webvan.com

Adam Rogoyski said...

How do make an unsecured loan in this system? For a secured loan like a mortgage, what is in it for the bank? Do they get free use of my garage for 30 years? Unless these institutions make enough of a return on their assets to overcome the risk involved, they will not survive. I don't see how it can be anything other than a bank which makes money off of leveraging existing money.
As for the low-income person getting a 750K loan, this makes sense if the underlying asset is worth at least that much or more. I don't see why a bank shouldn't charge someone a few thousand in fees and collect a few months of interest before foreclosing if needed. Just as the bank takes risk that the secured asset may not be worth buying, the home buying takes the risk that he is not able to afford the house. The ways these loans are advertised and pushed on to consumers may be poor, but the general idea is sound for both parties.

K_Yew said...

Adam, check out this link (BBC News, Dominic Casciani, 11/29/02):


The lender buys the house upfront. The lender owns the property and receives a rent until the "loanees" pay the final installment.

"In Islamic terms, the rent is not another name for interest: It is seen as a fair payment for use of the property rather than a charge for borrowing money."

It sounds like semantics until you understand the lender would not be able to issue mortgage-backed securities ad infinitum. Without interest, you limit the number of investors/players and therefore the size of any financial bubble. Thus, when a bubble pops, fewer investors are affected. As a result, although you will have slower growth, you will also have a more stable financial system.

I agree that Islamic finance probably makes unsecured loans more difficult. Visa/Mastercard would not flourish under an Islamic financial system, but they would be able to collect fees per transactions, not interest. Debit cards, of course, would be perfectly fine.

The upside (or release valve) of the American system is the bankruptcy option. When an American runs into financial problems, filing bankruptcy allows him/her to avoid a master-slave relationship. The downside is that speculative bubbles are more easily formed b/c unsecured debt is readily available. Consequently, in the American system, unsecured debt may grow so large that it impacts the entire economy, including innocent non-investors.

K_Yew said...

BTW, I know there are some grammar mistakes in my comments above. I used to be an English tutor, so it really bothers me to see them, but I do not have the capability of editing the comments. In my defense, I was writing at 1:00AM and 3:30AM :-)