The economic crisis 2008

Even compared to the Great stock market crash of 1929 (Great Depression), the economic crisis of 2008 was the greatest crisis the modern global economy has faced in almost a century.

Lehman Brothers filed for bankruptcy on September 15th, 2008 and this day is considered to be the date on which economic crisis began. The tremor was felt much earlier but filing of bankruptcy made it clear, in black and white, the crisis is for real.

Complex derivative modelling in financial market, based on property transactions, the unrelenting belief the property market can go only one way & that’s upward and also availability of cheap credit had all the ingredients namely speculation, false belief and free money to fuel the crisis.

The property boom was bound to fail as large scale cheap finance on ever rising property value could not sustain forever.

The subprime crisis as it’s called originated in US due to the situation where banks were offering housing loans to people in large scale with low credit scores. Most of these people had very poor financial track records and had a history of defaulting payments to the banks. Even interest only loans were offered to subprime borrowers.

In the mean time some of the banks in order to remove these toxic loans from their books started issuing these ‘subprime loans’ as bundled derivative products promising higher than market returns with jacked up credit ratings. To makes things worse some of the other major banks, pension funds and even sovereign funds subscribed to these derivatives in large scale.

By 2004 – 2005, certain events were bound to trigger the crisis, namely;

  • The debt bubble has grown to an enormous level based on sky rocketing property prices.
  • Energy prices, especially crude oil prices made significant advances, causing inflation rates to go up.
  • The increasing cost of living caused by high debt servicing, high rental values, and rising fuel cost.
  • Increase in fed funds rate increased interest rates including housing loans rates.
  • Slowly as the liquidity started drying in the market, bank rates started moving up.
  • The supply of housing property started to outpace demand, resulting in fall in property prices.

These events squeezed the borrowers, who were struggling to repay the mortgages. The rising defaults triggered huge fall in property prices, eroding the value of collaterals held by the banks.

Having discussed the economic crisis, let us evaluate the Islamic perspective;

  • Islam is strictly against derivatives.

The very basis of derivative is uncertainty. It’s purely based on an unforeseen future event and its impact on the underlying asset. The parties to the contract have no control on the unfolding of this future event which might favorably or unfavorably impact the price of the underlying asset. The major reason for 2008 crisis was a species of credit derivative valued at $ 458 trillion.

But the world did not learn its lesson, today the world stares at the value of outstanding derivatives at $542 trillion+.

  • Interest (Riba) based mortgages are a complete no.

As Islam has forbid any dealing in any form of interest (Riba), there are mainly two forms of Islamic home loans commonly practiced;

1.Murabaha home loan: Where the bank buys the property on behalf of the buyer and sells it to the buyer at a profit. The buyer has complete title to the property and he makes payment to the bank without interest.

2.Ijara Scheme: Commonly known as ‘Decreasing Rent Scheme’. Bank buys the property and retain the title to the property until the loan is fully paid off. The buyer can take up residence immediately. Along with the bank payment towards the purchase, the buyer pays a fair market rental to the bank.

  • Fractional reserve based lending is not encouraged.

In fractional reserve banking the banks are required to keep only a fraction of the customers deposit as reserves. This allows banks to lend money to a borrower after maintaining only a small reserve from the customer deposit. This concept is based on the assumption that all depositor will not approach the bank at a single time for their money.

Conclusion;

Given the situations which lead to the crisis where basically due to greed, ethical down fall and collapsed risk management principles. Apart from these if the ground principles of Islamic banking based on Interest prohibition, ban on speculative products, discouraging high risk practices like fractional banking could definitely avert the occurrence of factors that might lead to yet another economic crisis.

 

 

 

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