ISLAMIC FINANCE AND THE GLOBAL ECONOMIC STORM

IN NEARLY EVERY market worldwide, Islamic finance is now attracting the attention of investors who only a year ago would not have given it the time of day.

Islamic financial centers are flourishing in Dubai, Bahrain, Singapore, and Malaysia. Over the last several years, the demand for Islamic financial instruments has been growing at a rate of up to 15 percent – Standard and Poor’s now estimates the potential Islamic market to be over $4 trillion. Here in the US, Islamic mutual funds are outperforming their conventional counterparts in the wounded US market. Clearly, investors are paying attention to Islamic finance for good reason.

But with all the added attention, Muslim investors should remember the virtue of humility. What goes up must come down, or as those in the investment community are fond of chanting, “past performance is no guarantee of future results.” Instead of rubbing salt in the wounds of conventional markets and jubilantly reiterating their failures-as some of us have been doing-Islamic financial institutions should acknowledge that its own system is not impervious to such disaster. We should learn lessons from recent events, and take the necessary precautions to prevent a similar crisis in Islamic finance.

During the “dot.com” era, just before the new millennium, the Dow Jones Islamic Index (DJIM) surged ahead of the S&P 500. Muslims were excited as their funds, many of them over-weighted in the technology sector, outperformed the market. But in their enthusiasm, many forgot the bedrock principle of investing: elevated returns come at the price of elevated risk. When the tech bubble burst, the DJIM fell harder than the S&P 500.

The seeds of the current financial crisis were planted in the lush soil of easy monetary policy in the United States. (Remember the 1 percent Fed Funds rate? We expect rates to once again fall to that level.) In something of a feedback loop, consumers binged on the lowest mortgage rates in decades with cash-out refinancing, treating homes like two-story cash machines. That cash was used to boost consumption of all manner of goods, many of which were imported from China and Japan. Eager to keep their exports cheap and their currencies from rising against the dollar, China and Japan diverted the river of dollars into US Treasuries, buying up large portions of new debt issuance, holding down longer-term interest rates, and limiting the supply of noor low-risk bonds.

But consumers were not the only ones with access to the cheap and easy credit. Leveraged investors such as hedge funds, private equity firms, investment banks, and mortgage lenders – incurably addicted to complex derivative instruments and eager to make loans and investments with their easy-to-borrow money – were willing to accept relatively lower rates of return for relatively higher levels of risk.

Finally, in response to the lack of supply of low-risk bonds, investment banks dramatically stepped up their structured finance operations – packaging and then re-slicing pools of loans made to dubious borrowers, and/or against dubious collateral into pieces of varying quality. The “safest” pieces were made safer with credit insurance written by companies like AIG, and given AAA grades by credit rating agencies. After payment of hefty fees, they were sold to investors such as pension funds and insurance companies who were seeking “safe” investments with better rates than ultra-low yielding treasuries. As structured finance deals increased, lenders expanded their forays into higher risk loans, particularly sub-prime mortgages, with the knowledge they would be able to quickly sell the loans to investment banks for repackaging. The plan worked fantastically, until interest rates went up and new homeowners realized they were unable to afford their mortgage; housing prices plummeted so homes could not even be sold to bring owners out of debt. Throughout it all, no one asked the obvious: how are a thousand dodgy mortgages any better than one?

In the aftermath of this mess, it is easy to proudly claim that catastrophe was averted because Islamic finance, forbidden to dip its toe in the interest-laden pool of mortgages, was standing on morally higher ground. It is true that Islam forbids riba, deception, and over-speculation, but while the mortgage money was flowing, there was quite a clamor amongst Shari’a compliant-minded consumers for “no-doc” Islamic mortgages. If Mr and Mrs Jones could get a house with nothing down and a handshake, why not Muslims? Why not package an Kara portfolio of mortgages into a sukuk and sell it to Islamic banks? When housing prices declined and Muslim homeowners stopped paying their mortgages, Islamic banks would have been left holding the same toxic assets that are currently blighting conventional markets.

The rampant greed that fueled this crisis is not a behavior limited to conventional finance. Though there has not been an Islamic scandal of Enron proportions, in September of this year over 100 Muslim investors were forced to come to grips with the fact that they had been hoodwinked out of millions of dollars by a leader in Chicago’s Islamic financial community. Sunrise Equity was a real estate developer that won the confidence of many Muslims who trusted it with their life savings for investment with the promise of Shari’a compliance. With the market decline and investors clamoring for the same returns as when times were good, one man – the president and CEO of Sunrise Equities – disappeared along with an estimated $80 million. Much of the ramifications of this catastrophe are still to play out as many Muslims refinanced their homes with Islamic mortgages to invest in this company.
These are not merely lessons on the ubiquity of greed: when conventional financial stocks finally bottom out (and they will) and then begin to rebound, they will likely lift up global equity markets along with them. Investors, who know a bargain when they see one, will buy the securities at fire-sale prices in hopes of profiting from the upside potential. When the financial sector recovers, Islamic funds might be left behind as the markets regain strength.

In another sign of caution, recently Reuters reported that the central bank of the United Arab Emirates injected $13.62 billion into its financial system in order to ease liquidity restraints. Unlike the recent $700 billion American “Rescue Plan” to save an economy on the brink of seizing up, the UAE released funds so growth could continue at the same breakneck speed. The central bank is assuming that there will be buyers for all the new projects that it is funding. But what happens if there are no buyers? Consider that perhaps the global credit crunch could impede foreign investments, and plummeting oil prices will eliminate the spending money of Islamic markets’ purses. Instead of worthless sub-prime mortgage backed securities, the UAE might find itself with an attractive portfolio of vacant buildings and half-finished artificial islands. At least they can sell the scaffolding for scrap.

While the odds of such a scenario are slim, they are entirely possible. The point is that from its current position of success and prosperity, Islamic finance needs to examine how it got there, and use that knowledge to develop new strategies for the future.

“Now is a golden opportunity for Islamic finance to provide an alternative model which, by its very nature, binds both the real and financial economies: just what the world needs right now,” said Swati Taneja, Conference Director for the International Islamic Finance Forum in Istanbul. “There has never been a more interesting time for cautious investors burned in the conventional credit crunch to begin looking at what the Islamic markets have to offer.”

Rather than filling with a false sense of pride, the Islamic finance industry should analyze the failings of conventional finance in order to ensure that the same disasters do not happen to us as an industry. And as it attracts new investors, not all of them Muslim, how should Islamic financial institutions approach these new investors?

Do not boast. Do not be negative. Show your strength with value-added products .

Americans are not interested in hearing over and over again what went wrong and who made the mistakes. They want alternatives to the status quo. They want solutions. It is not just American investors who are looking for new investment opportunity. With national economies rocked and unsettled all over the world, the global market is primed for a new approach to investing and finance.

Will the Islamic approach lead the way? Or will it be no more than one of the many financial fads that briefly thrived, then faded? If Islamic finance cannot provide the value-added products and services that consumers are demanding, because we are too mired in arrogance and a “holier than thou” attitude, we will fail to take advantage of a golden opportunity.