NEWHORIZON

NEWHORIZON April to June 2013
ANALYSIS
The Subprime Crisis and the Lessons
for the Islamic Finance Industry
By: Suleman Muhammad Ali, Manager- Product Structuring & Research;
Product Development and Shar’iah Compliance, Meezan Bank Limited
Background
The subprime mortgage crisis is
ongoing. It started in the United
States and was characterised among
other things by evaporating liquidity
in the world’s credit markets,
declining asset prices especially in
the housing sector, high rates of
foreclosures on mortgage assets
and the failure of mortgage-backed
securities. Although the crisis
started in the United States its
effects have been contagious and
have extended to other financial
markets around the globe.
Factors Leading to the Financial
Crisis
The crisis started when the US
housing asset price bubble started
to burst. US housing asset prices
had risen sharply during the five
years up to 2006. During the
period of the bubble more and
more people were encouraged to
borrow money at low interest rates
by various financial institutions.
Adjustable Rate Mortgages (ARM)
were offered by numerous banks
under which mortgage loans were
available at very low initial interest
rates, with a pre-agreed increase
after a certain period, for instance
after two to three years. Similarly
mortgage loans were offered on
very easy terms or with minimal
credit appraisal requirements often
flouting the process of adequately
checking the assets or the existing/
future income streams of the
borrowers. All of these efforts were
geared towards encouraging more
and more borrowing to acquire
residential property.
The High Consumption
Mindset
Similarly the long-term trend of
rising prices encouraged more
and more home owners to use the
increased value of their homes
as security for getting a second
mortgage or credit for financing
their consumption expenditures
or for financing investments in the
stock market. In 2008 the average
US household debt was around
134% of disposable income and
the total nationwide household
debt was $14.5 trillion according
to US government statistics. All
these figures show that the average
American was consuming more
than he or she was earning. How
is it possible for anyone to spend
more than they are earning? The
answer lies in incurring debt to
finance consumption expenditure.
All this was due to low credit rates,
easy or zero-credit application
terms and the increasing value of
the underlying mortgaged assets.
Bad Credit Practices and
Subprime Lending
In the years leading up to the
crisis the US economy had seen
unprecedented growth, which in
turn resulted in high capital inflows
from the growing economies of
Asia and from elsewhere around
the world as the US was seen
as a safe haven for investment.
The money that was coming
in resulted in a high supply of
liquidity. This coupled with lower
interest rates and the high rate of
origination of mortgage-backed
securities produced a mindset in
which banks were more eager to
service large volumes of credit
applications in shorter time spans
rather than focusing on ensuring
the quality of the credit. The
result was the emergence of
various schemes allowing credit
to individuals with an impaired
or no credit history. Automated
credit application schemes based
on concepts such as NINA (No
Income No Assets) basically
allowed borrowers to apply for
and get credit without showing
any proof of employment or
assets. Credit was, therefore, given
without taking into consideration
the ability of the borrower to
make repayments. This was also
partly prompted by the greed and
short sightedness of those bank
managers, who were keen to inflate
their performance by showing high
credit disbursements in the hope
of getting short-term benefits and
high-performance bonuses.
The Case of Mortgage-Backed
Securities (MBS)
Mortgage-backed securities are
underpinned by the earnings or the
cash flows from various mortgage
loans. The payment, return and
the security are all tied up in these
mortgage loans. It is a product
created through modern financial
engineering, which allows various
banks to pass on their credit
exposures to other banks and
financial institutions or individuals
by repackaging the original
mortgage loans into securities or
bonds representing an ownership
or security interest in these
mortgage loans. The previous
mortgage or lending model
envisaged that the banks originating
the loans would hold on to them
until maturity; however, with the
engineering of securitisation, banks
were able to originate and distribute
the loans to other entities by
repackaging them into securities.
This had two detrimental effects on
the US financial market. Firstly it
resulted in the availability of excess
liquidity to the credit markets.
Banks were able to originate the
loans through their deposits and
then sell these loans throughout
the world by repackaging them
into securities thereby releasing
the liquidity tied up in the original
loans to finance yet further
mortgages and loans.
Secondly the policy of originate
and distribute led to the moral
hazard problem and encouraged
the banks and investment banks
to originate high volumes of
mortgage loans with little emphasis
on the credit quality of such loans
since their focus was short term
in nature, i.e. to earn large profits
through origination fees; fees for
structuring complex mortgagebacked
securities and profits from
the sale of such securities. These
banks and investment banks were
not concerned about the longterm
quality and results of such
securities or the defaults that would
arise if housing prices started to
fall. The structuring managers
were appraised and were paid
substantial bonuses on the basis of
the various complex securitisation
structures of MBS that they were
able to sell successfully and the
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