According to the Halifax Bank of Scotland House Price Index, the average house price in the United Kingdom as of January 2003 was £120,137. With average earnings in the United Kingdom standing at £27,379 (Office for National Statistics New Earnings Survey), average house prices are now almost 4.39 times average earnings. In some areas of the UK the multiple is much higher than this, in London for example, while in outlying areas of Scotland and Wales it is much lower. The following graph plots the ups and downs of the house price/earnings multiple through time and seems to indicate that the market is currently near a cyclical high.
Graph 1: Average UK House Price divided by UK Average Earnings
source: Halifax Bank of Scotland
The variability of the house price/earnings multiple does not of course reflect the performance of house prices themselves. Most people are well aware that average UK house prices have steadily increased for most of the last thirty years. Indeed, they have increased steadily over most of the last three hundred years. The following graph depicts recent growth in average UK house prices.
Graph 2: Average UK House Prices
source: Halifax Bank of Scotland
Those acquainted with the nature of the modern monetary system will be aware that the consistent increase in house prices is largely due to the way in which banks and building societies as a whole create new money when making loans. Borrowers spend the newly created money on houses (as well as cars, holidays, clothes and other consumption items) and in due course this spending leads to general increases in price. If bank and building society lending (read "money creation") for property purchase increases sharply, a property boom usually results. Real factors that would otherwise affect the value of a house (quality of construction or location, for example) can be completely overshadowed by monetary factors under these circumstances. On the other hand, if lending for property purchases decreases, property prices tend to stop increasing or even decrease where the slow down in lending is severe. The following graph depicts the relationship between changes in bank lending for property purchase and changes in property prices.
The same data can be plotted to show the relationship between price changes and lending changes, ignoring the element of time. The strength of the correlation between lending changes and house price changes is now clear (the r squared correlation coefficient is 0.5868):
Graph 3: Yearly House Price Changes versus Yearly Changes in Lending 1
source: Bank of England, Economist Publications, Halifax Bank of Scotland
Graph 4: Yearly House Price Changes plotted against corresponding Changes in Lending 1
source: derived from data in Graph 3
For individuals who buy houses using interest-bearing loans, the housing market can be a highly profitable place because, as lending institutions pump money into it, the price of houses increases but the debt that was borrowed in order to buy each house remains fixed in nominal terms. If house prices go up very fast the ratio of mortgage to house value can decrease very rapidly, thereby making the home owner richer in money terms should he or she wish to sell the house and repay the mortgage. Hence, many businessmen try to make profit by: a) borrowing money at interest; b) buying property; c) renting the property to a tenant for a while; d) selling the property; e) repaying the debt; and f) taking the surplus as profit. As long as the rental yield on a property plus the rate of price increase continues to exceed the rate of interest on the loan that was used to purchase the property, such businessmen continue to make profit.
For individuals who do not own property however, the situation is a rather grim one. Imagine that it takes ten years for an individual to save £50,000 towards a house that is today worth £50,000. With the constant increase in house prices, by the time that individual has saved the £50,000, the house might be worth £100,000 or more. In effect, the value of the individual's savings relative to house prices has been halved over time, which is another way of saying that house prices have doubled over the period. Ultimately, this devaluation has been caused largely by the manufacture of new amounts of money by the banks and building societies, for which reason their business has sometimes been regarded as a basic fraud upon society.
To summarise, the beneficiaries of the lending institutions' activity are firstly the lending institutions themselves (because they earn interest on their loans) and, secondly, property speculators (whose net assets increase during times of property price inflation). We should recognise too that many existing homeowners do not actually gain anything from increasing house prices. If I sell my house today and move to another house, price increases do not benefit me at all because although I sell my existing house more expensively than I bought it, I must also pay more for the next house that I purchase.
Against this background, Muslims in the United Kingdom need to make an important decision. Should they buy a house in order to get a foot on the property ladder, or should they rent? By buying a house the buyer protects the value of his or her hard earned savings in the long run as Graph 2 above shows. The alternative has, in the past, had distinct commercial disadvantages. In order to avoid the sin of borrowing at interest, some Muslim friends of mine in London have been renting since the 1960's when a four-bedroom house in Fulham cost £3000. Today, that same house can cost over £1,000,000. The Muslim tenant has paid far more in rent than he ever would have done had he bought the property on an interest-bearing mortgage, but the ironic thing is that the person from whom the Muslim is renting is often someone who actually did buy the house using an interest-bearing loan. That landlord not only collected all of the Muslim's rental payments, but also benefited from the house price increase from £3,000 up to £1,000,000. The landlord pays interest of course, but the total repayments on a £3,000 mortgage over the last 40 years would have been less than £15,000, which is not very much in the overall scheme of things. Under today's monetary system, the rental option seems to be commercially ill advised in the long run.
Nevertheless, there are advantages to renting which must not be overlooked. These include the ability to quickly leave a property and move somewhere else, freedom from maintenance worries, and the freedom from mortgage debt. For a sincere Muslim, the freedom from the sin of paying interest is of greater importance than all of these.
If a Muslim does wish to buy a residential property, and if he or she has decided that it is better to buy now than wait for a fall in house prices, the question now arises as to how to arrange finance. In this respect, and given that few are fortunate enough to have sufficient savings at their disposal, much of the Muslim community has been glad to hear of the recent appearance of Islamic mortgages in the UK market. It is widely believed that these financing schemes will finally allow Muslims to become part of the "property owning democracy", and escape the economic trap of long term rental. On account of this development UK lending institutions are of course very happy too, because the existence of an "Islamic" mortgage allows them to lend to a hitherto unexploited market, the Muslim market, and thereby make extra profits.
Having noted that Islamic home finance does not necessarily imply an Islamic mortgage (family and friends may not seek a mortgage on your property if they are the ones providing the loan), the following is a brief description of the three models of Islamic house financing currently in existence in the Western world generally, and in the United Kingdom specifically.
The murabahah model was first applied widely in the United Kingdom at the retail level by United Bank of Kuwait (now known as the Al-Ahli United Bank). Here, Person A (the bank) buys the house for £100,000 from Person B (the house seller) and immediately sells it on to Person C (the client and prospective homeowner) at a price of say £150,000 to be paid in equal installments over say 15 years. Person C must begin the process by promising Person A in writing that if Person A buys the house from Person B, then Person C will immediately buy the house from Person A. The shariah scholars who approve this transaction say that it is trading (buying and selling of houses), not lending at interest, and that it is therefore halal. Others point out that if banks are traders of houses then their stock in trade should be a portfolio of houses, just like every other property dealer, whereas in fact the stock in trade of a bank is money. No doubt the cynicism among some sections of the Muslim community is only increased when they see that the cash flows paid by the client to the bank are usually fixed from the outset of the transaction, just like the interest based alternatives. Viewed from the bank's perspective, as soon as the bank transfers £100,000 to Person B, the agreement with Person C automatically comes into effect requiring Person C to repay £150,000 to the bank at a later date. The transaction is therefore one of transferring money to Person B on condition that Person C repays a larger amount at a later date. Money now for more money later with the house in between, so to speak. Many bankers admit in private that this is an interest-bearing transaction, and indeed standard banking practice does not normally encompass anything other than an interest-bearing loan on the asset side of the bank's balance sheet. There have been exceptions to this rule, for example with the Shared Appreciation Mortgage issued by the Royal Bank of Scotland some years ago. Here, the bank's return was a share of the increase in the price of the property being financed. However, even in this case, the bank refused to share falls in the price of the property over time, and therefore fixed its minimum return on funds loaned at 0%.
Under the Ijara model, Person A (the bank) buys the property from Person B (the house seller) and rents it to Person C (the client). C pays A for the "use value" of living in the property, which most modern scholars see as an acceptable form of trade. The bank may agree at the outset of the Ijara to sell the house to the client at the end of the rental period, perhaps for a nominal sum of £1. Alternatively, the bank may require the client to pay regular amounts on account to the bank, and after an agreed amount of payments has been made the bank will transfer ownership of the house to the client. The Al Ahli Ijara model in the UK operates on the latter basis.
A number of Shari`ah problems relating to the above transactions have been discussed in recent years. In the Al Ahli Ijara model for example, rental levels are reset yearly in line with market interest rates. Although scholars have argued that this in itself is not haram (why shouldn't I make the same percentage of profit selling my lemonade as the chap next door makes selling his beer?) the fact is that the client does not know what rental he has contracted to pay to the bank until the beginning of each new year. If interest rates increase dramatically, then the Ijara rental rates will likewise increase, and the client could well find himself locked into the payment of lease rentals that he cannot afford. This is one basic reason that traditional scholars in Islam have made the specification of price a basic requirement of any sale contract. (How can I agree to buy something if I don't know the price?) Furthermore, if the client decides that he can no longer afford the rental, the Al Ahli contract requires that he must guarantee to repay the amount of finance initially provided by the bank. In those cases where the house has to be sold to achieve this, the possibility arises that, if property prices have fallen in the meantime, the sale proceeds may not be sufficient to repay the financed amount. In this case, the client is required to make up any shortfall to the bank, and the awful prospect of "negative equity" arises for the client ... a position in which the client owes more in debt than his house is worth.
Furthermore, conceptually, it should be obvious that the client can only be renting the property if he doesn't own it. Yet if the Al Ahli product really is a rental, why does the client have to bear the risk of a fall in the price of the property? On the other hand, if the client is bearing this risk because he owns the property, then why is he paying rental to the bank? Perhaps the case is that the client and the bank both own part of the property, but the Al Ahli contract makes it clear that the bank owns the house in its entirety until the final payment on account is made by the client, and only at that time will title be transferred to the client. The truth of the matter here is that the core Islamic contracts of sale and rental have been mixed together so that neither bears integrity any longer. The danger of such mixing should be obvious from a consideration of what would happen if an Islamic money lender was allowed to combine hiba (a gift) with qard (an interest-free loan) and a promise, all three of which are acceptable contracts in Islam. The money lenders' clients could then be asked to promise to give the money lender a gift upon repayment of any interest-free loan that he made to them. That would clearly be a case of interest, but the contract documents would never need to mention the word "interest".
The third model of home financing to be made available in the United Kingdom is the diminishing partnership model. This model has been tried and tested over many years in Canada by the Islamic Co-operative Housing Corporation Limited, and has been recently introduced into the UK by Ansar Finance in Manchester through Ansar Housing Ltd. Here, a prequalification period is required in which each client purchases shares in the house financing organisation in order to gain the right to apply for house financing at a later time. Funds raised by the organisation in this manner are used to finance other clients who have completed their prequalification periods. When the client has qualified for house financing, Person A (the house financing organisation) buys the house in its name from Person B (the house seller). Person C (the client) then becomes a partner of Person A in a nominal partnership vehicle which is deemed to own the property ("nominal" because the name of this partnership vehicle does not appear on the property's title deeds). For this purpose, Person C transfers the value of his prequalification shares in the organisation to the partnership vehicle, and the relative size of Person A's and Person C's contributions determine the ratio of their shares in the partnership. Person C now lives in the house and pays rent to the vehicle. The rent is then distributed among the shareholders of the vehicle, which of course include Person C himself. Over time, Person C buys Person A's shares in the vehicle and eventually comes to own all of them. At this stage he is the full nominal owner of the house and therefore pays all of the rental on the property to himself. The final formal step is then taken of transferring title in the property to the client, following the making of a special final payment (see next paragraph) between Person A and Person C.
The most common implementation of the diminishing partnership scheme is one in which the rental levels and the purchase price of each share is fixed at the outset of the contract (rather than being related to market values at each point in the future). Models in which the purchase price of the shares has to be made at a price reflecting the property's market value at the time of purchase have not been well received by potential clients. This is presumably because clients know that house prices tend to rise over time and, therefore, that it is not in their interest to pay a price that reflects the market value of the property each time they want to increase their holding of shares. The disadvantage of such fixing is that the people who invest in the organisation's shares are often those who are doing so in order to save the deposit for their own house. If the organisation's property assets are sold off piece by piece at prices that were agreed several years previously then, given that property prices tend to rise, those assets will tend to be sold at below market value. This of course is a rather poor commercial deal from the point of view of the scheme, and in turn for the savers whose money has financed it. The fairest deal is for each sale of shares to take place as close to market value as can be achieved with cost efficiency. To this end, the Ansar Finance product attempts to some degree to share gains or losses in the capital value of the house among the partners (in a pre-agreed ratio) when the nominal partnership comes to an end. This is the special final payment referred to above.
Three main commercial issues are currently the subject of attention in the UK Islamic mortgage market. Clients are concerned about the level of deposit that they need to muster before being accepted by the bank. HSBC's new Islamic mortgage product to be launched at earliest in July 2003 in the UK may require as little as 10% (of the property price) in down payment by the client, but the Al Ahli murabahah and ijara schemes currently require a minimum 20% deposit from the client (reduced to 17% or less for larger property values), and the Ansar Finance diminishing partnership scheme requires a 20% deposit following the prequalification period. This level of minimum deposit does not compete with those interest based lenders who offer 100% mortgages, although Muslims who remember the experiences of the late 1980's property boom would probably not see this as a bad thing. On the other hand, following the announcement by Chancellor Gordon Brown in his recent Budget, the problem of double stamp duty (paid by the bank as purchaser from the original seller, and then again by the client as purchaser from the bank) is set to be neutralised. To achieve this, the two house sale transactions that occur in murabahah, for example, will probably come to be seen as part of one financing agreement operated in accordance with Islamic principles and not as two unrelated sales. Thirdly, bankers are concerned about the Basle capital adequacy standards in which a higher capital asset weighting is given to property assets than to property loans secured by mortgages. This requires a bank to devote more of its risk capital to Islamic mortgages than to interest based mortgage loans, and this in turn tends to increase the costs of Islamic mortgages when compared to their conventional counterparts.
From a wider economic perspective, the promotion of Islamic mortgages brings with it a series of dangers that have hitherto been confined to the interest based domain. Not least among these is that if Muslims start borrowing in earnest from the banks and building societies, then the price inflation disease may hit their communities with the same force that it has hit other communities across the UK. For example, in Leicester's Highfields area, whereas £60,000 bought a standard three bed terraced house in early 2000, local Muslims have found that the purchase of a similar property can now cost £120,000 or more. Most Muslims now have little choice but to borrow from the bank in order to buy a house in Highfields, but the situation would never have arisen if house buyers had not started going to the bank to get loan finance in the first place. Those who sell up to move somewhere cheaper do benefit from the property price inflation in Highfields, but those Muslims moving in to the community must carry higher debt in order to live in the very same houses.
Although banks and building societies as a whole are creators of money, at the individual level each bank and building society funds itself by borrowing at one rate of interest and subsequently lending to borrowers at a higher rate. Likewise, most Islamic mortgages fix the lender's financial return on money invested from the outset. The fixing is either achieved by quoting an absolute rate (for example, the client pays 70% "profit" to the bank in a murabahah) or as a spread above the interest rate at which the bank is borrowing (for example, the client pays a rental rate equal to the London interbank offered rate, LIBOR, plus 1% per year to the bank). Generally speaking, a bank will only put £x into the transaction if it knows that it has simultaneously contracted to receive £x plus something in addition from its customer at a later date. My guess is that Al Ahli borrows one year money at LIBOR from the London interbank money market in order to fund its Ijara scheme. Every year Al Ahli renews its borrowing on the money market for a further year, which is why it insists that every year the rental rate under its ijara contract is reset to an amount equalling LIBOR plus a quoted margin. That margin is Al Ahli's profit, and the Al Ahli Ijara contract seeks to guarantee that margin from the outset. If interest rates in the UK rise sharply in future, perhaps due to the weakness of Sterling on the currency markets, many Ijara customers may find themselves in great difficulty. If repossession orders were then to become common, Islamic mortgages might come to be seen as no less threatening to the financial health of a household than the interest-based alternatives.
The market for Islamic mortgages is substantial enough to provide a lucrative niche for those organisations that establish themselves early, but the retarded pace of development may have more to do with the attitudes of the Muslim community than lethargy on the part of mainstream lending institutions. I remember promoting a market-value based diminishing partnership model in 1995 to a Muslim Housing Association in London, only for the director to announce rather proudly at the end of my presentation that "We don't need Islamic finance. We have just agreed a five year fixed rate loan from Barclays Bank, thanks be to Allah". It was the "thanks be to Allah" bit that really depressed me.
For some, asking the Bank of England to organise a working committee on Islamic mortgages is like asking the local thief to install a security alarm. For others, an interest based mortgage is a price that has to be paid for living in a non-Muslim country. What seems clear at the moment is that many Islamic mortgage products have cash-flows and default conditions that are dangerously similar to their conventional counterparts. The Muslim community ignores this fact at its peril. Interest-bearing debt is the antithesis of true freedom and, like a heavily indebted country, a heavily indebted man is at the mercy of his lender and paymaster. People with big mortgages tend not to upset the boss on a point of principle. Likewise, the growth of an Islamic mortgage culture may be a powerful force for assimilating Muslims into the wider UK society. Is this the strategy being played out now?
The overriding political fact is that Islam provides the last serious institutional challenge to modern usury. Issues decided in the world of Islamic finance today may determine whether that challenge succeeds in years to come. At its worst, failure could mean that Islamic finance becomes just another way for conventional institutions to practice usury.
Tarek El Diwany
1 Changes in lending (figures quoted are for lending secured on dwellings) are reduced by the estimated average interest rate applying to all such lending during the period. This provides an approximate measure of the net funds flow to or from secured property in the UK.