Causes of Current Financial Crisis

Allah will destroy Riba….” (The Qur’an: 2:276)

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Allah will destroy Riba….” (The Qur’an: 2:276)

It appears that the month of October has a special place in the history of international finance. The bitter love affair between the month October and the financial crisis that erupted in 1929 in the form of “Great Depression” is again hitting the headlines albeit the wrong reasons. After eighty years the wheel has turned full circle. The “Great Depression” left many a heart wounded, millions of people jobless, hapless and senseless in America. Despite its best efforts the US could not pull itself out of recession until it went into the World War II.

It is again October – of 2008 – which has witnessed the most severe financial crisis ever faced by Americans. Billions of dollars have been pumped into the ailing institutions but nothing seems to be working. The contagion has spread to engulf the entire continent of Europe. Many countries which have strong trade and economic relations with US and Europe are also severely affected. People have lost their entire life savings in the course of a few weeks. News of mentally disturbed cases and even suicides has started pouring in from various parts of the world.

A deeper look into the causes of the problem will reveal that certain financial practices that are proscribed in Islam but prevalent in the contemporary global financial system are    accountable for the current mess. These injunctions are Riba, Gharar and Maysir. All of these are strictly prohibited in the system we call “Islamic finance”. Let us just very quickly try to understand how each of these Sharia’ forbidden elements have been pivotal in crushing the global financial structure. For the sake of argument, however, let us agree that mother of the current turmoil is the sub-prime mortgage crisis. Let’s see what happened in the sub-prime case.

Bankers flush with easy liquidity, caused by years of loose monetary policy of the Federal Reserve Board (Fed), coaxed gullible borrowers, whose credit ratings were not good and income flows unpredictable, to borrow. These loans were approved by appraisers whose business interest was linked with the amount of loans sanctioned. The borrowers were lured with only interest payment option or schemes like “2:28”, “3:27”, or “5:25” loans in which the initial number represents the short initial repayment period with a very low rate of interest, whereas the latter number represents the remaining (major) part of the life of the loan in which the interest rate was as high as 5% above the 12-month Libour.

Appraisers played a key role in heating up the market valuation for real estate, as their commission was linked with the amount of loan sanctioned. These loans were then securitised and mixed up with other loans and then sold out to financial institutions trading in them. After completion of the soft period, borrowers found the cost too high to bear. Defaults started happening. On the other hand the Fed in a bid to quell the heat in real estate increased the Fed rate, which further increased the cost to the borrowers.

Thus began the process of short selling Mortgage Backed Securities (MBS). Some Hedge Funds made billions through short selling. While borrowers kept losing their houses due to default in their loan payments, financiers too had to book losses due to fall in housing prices. On the other hand Fund managers continued becoming billionaires through short selling in these securities. Similarly, short sellers took huge positions in foreign banks and financial institutions having exposure to the US securities.

In a very short span the US financial crisis had spread to UK and other European countries, leading to acute distress of scores of reputed financial institutions. Regulators tried banning short selling in securities but it was too little and too late. The contagion had spread fast making people insane as the Qur’an says, “Those who swallow usury cannot rise up save as he ariseth whom the devil hath prostrated by his touch.” (2:275)

May Allah the Almighty save us all from the blight and plight of Riba (Ameen).

[The writer is CEO, Bearys Amanah India]