Tuesday, May 6, 2008

The Anatomy of an Islamic Finance Deal

Quote of the Week:

'Over the next two years, 1.8 million more subprime mortgages, those aimed at riskier borrowers, are expected to reset at higher interest rates, prompting many experts to say the worst is yet to come. It is expected that as many 1.2 million of the loans will go into foreclosure and even those who don't default will barely get by after making their payments.' - Paul Waldie in the Globe and Mail.

Simple Calc. - 1,200,000 (No. of homes) x 300,000 (avg. price of home) = $360,000,000,000 - or $360 Billion. These are the obvious, expected loan losses. As the loans are called in, other assets will be affected as they are sold to meet debt payments etc. This general contraction will thus have a negative multiplier effect. As people begin to price assets for pennies on the dollar, the big question will be whether consumers continue to buy assets thinking they are 'cheap', or whether consumers delay purchases because they think things will get 'cheaper'. The first choice leads to a recovery, the second to deflation and stagnation as in Japan. Sort of puts the $145 Billion aid package in perspective, which explains why the markets fell so drastically after this announcement.

Commentary for the Week:

The Anatomy of an Islamic Finance Deal:

Many people ask me simple sounding questions such as 'How is Islamic Finance different?', or 'What makes Islamic Finance 'Islamic'?. This usually happens at a dinner or event where I have about 20 seconds to summarize and answer questions that people spend years researching. What is worse is that sometimes people ask me these just as I am about to launch into a delectable main course, so there is a clear conflict of interest between me doing justice to the question, and me doing justice to the cook's labours. This usually results in a mumbled response about how 'interest' is almost as bad as mushrooms, which results in a confused audience that is unable to focus until dessert. I exaggerate of course, but only just. Recently however, someone asked me to give them not an overview but an example of how Islamic Finance is different. I thought that was a brilliant question and what follows is an example that makes the difference strikingly clear.

Instead of launching into theories on Finance again, lets imagine a simple scenario. Abu the Architect and Bill the Builder have an idea and concept for a Green building. They identify the property, land, the subcontractors and the buyer. The buyer puts down a deposit and agrees to buy the building after construction, which will take one year. Now all they need is to finance the project so they can commence with the digging and construction. The land and construction is slated to cost $1.1M and the building concept has been sold to the buyer for $1.5M. The deposit is $100k and Abu and Bill have the option to seek conventional, or Islamic financing, for the rest.

Scenario 1 - Conventional:
Abu and Bill seek conventional project financing. They are given a line of credit or mezzanine facility at a floating 12% interest. This means that they will have to pay 1% of whatever they have borrowed every month. As they will probably not borrow the full amount up front, their interest payments will be low in the beginning and balloon quickly as the cumulative amount they have spent increases and the project construction comes to a close. Let us assume that they will borrow $350k for the land and $350k for the first phase of construction up-front. In another 6 months, they will borrow the last $300k. For the first six months, they will be paying $7000/mth. After 6 months, they will be paying $9000 / mth. This means that the total they will have paid in interest will be $96,000 and the profit on the deal would be $304,000 ($1.5M - $1.1M - $96k). If Abu and Bill default on their monthly cash obligation, they will lose the entire project as the creditors will seize the property to retrieve their $1M. If the uncompleted property sells for less than $1M, they will be sued for the difference. From their perspective, this is a high stakes game. There is possibility for large gains, but the risk to them is not negligible either. As the property itself does not generate cash on a monthly basis, the interest costs must be part of the initial borrowing.

Scenario 2 - Islamic Finance:
Abu and Bill seek funding on a profit and loss sharing basis. They require $1.1M for the land and construction, out of which they have $100K already (the buyer's deposit). Abu and Bill are introduced to 10 investors by Islamic financiers such as yours truly. Each investor puts in $100k, sharing in a percentage of the profits / losses at the end. Let us say that the Builders and Islamic Finance co. are given 50% of the profits between them, and investors are to enjoy 50%. The building is completed on time (just as in scenario 1) and the buyer pays the rest of the balance in a year. The profit is in this scenario is $400k ($1.5M - $1.1M), of which 50%, or $200k goes to the 10 investors in addition to their capital. This translates into $20,000 profit on the deal per investor, representing a 20% Return on Investment over the year in question.

As you can see, the payout scenarios, risk profile and economic consequences of the two scenarios are quite different. Both scenarios are profitable for the parties concerned, but distribute profits in different ways. The first concentrates both wealth and risk such that the decision as to whether capital should be allocated to this endeavour rests with primarily the builders and a creditor. The second allows a broader section of the public to decide whether this project will be beneficial and for them to participate as partners. Also, the second scenario spreads wealth around the community while minimizing the risk inherent in monthly debt obligations. Both solutions work, but for different kinds of people.

The first scenario appeals to people who enjoy quick success. The second appeals to people who enjoy a shared success even more. The first appeals to people willing to take risks for quick success, the second to those that want to grow sustainably. One builds individuals and then a sense of community through them. The other builds community first and foremost, which is kind of the whole point of society, isn't it?

Scenario two is actually a close approximation of a deal that we are currently involved with, so it is not an ideal type that exists in books only. For those who want to judge whether Islamic Finance can really be different, I invite you to investigate further. Islamic Finance frequently comes under a lot of vituperation based on the folly of large, multinational institutions and their quest for new customers and our small company always gets lumped in with them for undeserved abuse as well. Although we are a small company, our intent and endeavour is to enhance the quality of choices available to all Canadians, not to display a thin veneer of piety over questionable ethics. I hope you will keep that mind and judge for yourself as you read the 3rd article in section 3 below.

Finance News:

1. Trader causes $7Billion loss at France's SG. Still think banks make money just buy the spread between what they pay to depositors and what they charge to lenders? ... read more here

2. How time engineers the best comebacks ... Mittal is doing to Europe what Europe and the East India Company did to India ... sending dividends back home ... read more here

Economic News:

1. Is the US housing mess headed our way? ... read more here

2. Talk about throwing money at a problem ... the US President unveils a $145B plan to 'spur' the US economy ... read more here

Islamic & Middle Eastern Finance:

1. Some changes on the horizon for OPEC members? ... Abu Dhabi investing $15B into clean energy ... read more here

2. Excellent article on what effect the concentration of Oil Wealth has on the world economy. The research on where this money has been invested recently is both timely and interesting. I don't think this is even close to the full picture because there is money cycled through the World Bank and IMF also. Plus there are official aid flows and investments into offshore funds that were not addressed in the 'Fueling Liquidity' section of the report. Nevertheless, a must read article because it summarizes things quite well ... read more here

3. A well-known commentator argues against Islamic Finance. While parts of the argument hold for many multinational banks getting into this space in a hurry, there are several problems with his view. First, he again misses the point that if we look at almost 5000 yrs of recorded history, all Abrahamic faiths and others as well were not confused on how Interest=Usury. It is only the last couple of centuries that fractional reserve banking has taken over and confused the issue. Second, he oversimplifies and mischaracterizes the argument made by the two authors he mentions. Dr. Saleem is not against Islamic Finance, he is against the fact that standards in the industry are so loose and what passes for Islamic Finance is frequently just marketing. Dr. Kuran's critique is a deeper questioning of whether finance and faith can mix and what happens when they do. Neither of them reduces Islamic Finance to a Mullah inspired industry, which is a gross oversimplification. Finally, Hassan Al-Banna and Maududi had about as much to do with Islamic Finance as a kangaroo does with Global warming - (which is minimal, as I understand it). Perhaps one of you will tell our newly-minted, self-appointed, 'financial expert' that Islamic Finance cannot be summed up in a shoddily researched newspaper column. Well, not intelligently anyway ... read more here

Miscellaneous / Personal Finance:

1. How to make a million! - even though the headline is cheapish and sensational, the article is refreshingly free of easy gimmicks and is quite good for the younger generation ... people over 40 have to work a bit harder though ... read more here

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