Alternative financing: Issues and opportunities for lenders and interest-averse populations

What do you do if you want to buy a home or borrow money for your business but your religion prohibits you from paying interest?

Millions of Muslims in the United States face that question. A set of Islamic principles—based on the goal of providing economic justice for all—prohibits Muslims from paying or receiving interest during financial transactions. Some Jewish and Christian groups face a similar prohibition. Since the financial-services industry in the United States is interest-based, there is great demand among Muslims and certain other faith-based populations for alternative financial products that provide access to credit in a manner consistent with their religious beliefs.

In the Twin Cities and surrounding communities, demand for alternative-financing products is high due to the rapid growth of the area's Muslim population—growth that is driven primarily by a recent influx of Somali immigrants. The size of the Muslim population is difficult to determine accurately, but the market created by recent arrivals from Somalia and Muslims already living in the Twin Cities could be as large as 130,000 people. (For more information on the difficulty of determining the size of the area's Muslim population, see our feature article).

Storeowner Faduma Shurie tends the counter at International Clothing Bazaar in St. Paul. Shurie worked with the Neighborhood Development center (NDC), a local community development corporation, to obtain small business financing. The NDC's financial products, based on Islamic principles, are designed to help meet the growing demand for alternative financing in the Twin Cities.

A number of key factors intensify demand for alternative financing in the Twin Cities. First, the area has few rental properties that are large enough to comfortably accommodate families. Many Muslims must purchase single-family homes to meet their families' needs, and they face difficulty in obtaining mortgage financing that is consistent with their religious beliefs. Second, the many Somali and other East African immigrants in the Twin Cities are often low- to moderate-income, so it is difficult for them to make large cash purchases or down payments without relying on conventional debt-financing mechanisms. And finally, after they finance small business start ups through modest cash gifts and equity investments from family and friends, these individuals may need large amounts of working capital, but often have a difficult time finding credit products that are consistent with their religious beliefs.

These issues came to the attention of the Federal Reserve Bank of Minneapolis in the late 1990s, when local and state housing agencies noted a sharp increase in public requests for information about alternative mortgage products. In May 2000, the U.S. Department of Housing and Urban Development, in cooperation with the Federal Reserve Bank of Minneapolis and other organizations, including the Minneapolis Foundation, the Family Housing Fund, Islamic Relief and Social Services, Somali Community in Minnesota and Northside Residents Redevelopment Council, organized a seminar on mortgage financing for Muslim homebuyers. The event sparked interest in creating lending alternatives for Muslims and other interest-averse groups living in the Twin Cities area.

In 2001, the Minneapolis Fed convened a work group to explore Islamic finance, alternatives to interest-based lending and related issues. Partners in the initiative include local, state and federal government agencies; banks and credit unions; community development corporations; secondary market investors and Islamic and Somali community organizations.

Members of the work group have gained considerable experience with alternative-lending issues over the past year and now want to share their findings to help educate lenders and community development professionals in the Ninth District and across the nation. This article:

• Provides a brief explanation of Islamic-financing principles;
• Summarizes mortgage and small business lending issues explored by the work group;
• Presents various alternative-financing models identified through this initiative; and
• Recaps outcomes of the Twin Cities initiative.

Fundamentals of Islamic financing

Wafiq Fannoun, president of Reba Free, LLC, an Islamic financial- and investment-consulting service, explains the fundamental principles of Islamic finance as follows:

Islam's aim from any financial transaction is to maintain economic justice between those who have and those who have not. It is essential in Islam that all parties involved in a financial transaction share the actual profit or loss of a venture, and that no one gets predetermined compensation such as interest. In effect, the Islamic system functions much like western equity financing, while protecting borrowers from leveraging themselves into the poorhouse. 1/

According to the Holy Qu'ran, which Muslims consider to be the word of God through the Prophet Mohammed, trade and profit on business transactions are permitted as long as those involved share the risk and maintain economic justice for all participants. Islamic law, or shari'ah, set out in the Qu'ran prohibits riba or reba, translated from Arabic as "interest on a debt or loan, or any risk-free return on capital."

Islamic law allows for alternative forms and techniques of financing with a moderate rate of return. It simply prohibits the receipt or payment of interest as a means of determining that return or profit. Therefore, while Muslims cannot pay or earn interest, they can pay and earn a profit.

In other words, financing for Muslims must be structured without interest, but can include a profit to the lender. This seeming paradox makes it difficult for some American lenders to understand the distinction between profit-based, non-interest financing and interest-free or no-interest financing. Islamic financing is not no-cost financing. The profit to the lender in Islamic financing is simply structured in alternative ways that do not rely on interest but do involve shared risk in the lending transaction.

Islamic financing and American banking: Key issues

The application of Islamic principles to American financial practices raises many complex issues. The receipt and payment of interest is just one of those issues. The sections below explore other issues that further complicate lending to interest-averse communities. They also highlight models that address the issues—or explain why a particular issue is difficult to overcome. In those cases, non-bank intermediaries can often fill gaps that regulated financial institutions cannot fill.

Asset ownership and risk sharing

Islamic financing is not based solely on the prohibition of riba. Islam outlines additional principles pertaining to the ownership of assets and the sharing of risk. Importantly, followers of Islam believe that in order to sell an asset, one must own it outright. This concept, referred to as murabahain Arabic, protects buyers from purchasing a good that is not actually available for sale by the true owner or seller. Islamic law also states that a fair business transaction requires all parties to share the risk involved. Thus, if a lender acts as a third party in financing a buyer's purchase of an asset from a seller, the action is deemed unacceptable under Islamic law unless the lender directly purchases the asset and owns it outright. These principles govern any financial transaction that Muslims engage in, and they have clear implications for lenders, especially government-regulated financial institutions.

In most cases, U.S. banking regulations prohibit financial institutions from purchasing and holding real estate for mortgage transactions. The National Bank Act includes restrictions on the ability of nationally chartered banks to hold real estate. The restrictions " . . . are intended to: (1) keep the capital of banks flowing into the daily channels of commerce; (2) deter banks from embarking on hazardous real estate speculations; and (3) prevent banks from accumulating and holding large masses of real estate in perpetuity." 2/ State laws impose similar restrictions on state-chartered banks.

Richly patterned carpets are featured items at Al Furqan, a home-accessories, clothing and jewelry store in St. Paul. In 2001, owner Omar Salah used Islamic-financing products from the NDC to purchase inventory and secure working capital.

In compliance with these rules, domestic banks typically finance customers' home purchases by using properties as collateral instead of actually holding title until the loan is paid in full. The transfer of property is a direct transaction between the homebuyer and the seller. Under this transaction, the lender never actually purchases the property for resale to a buyer, does not have an equity-ownership position in the home and does not share risk in equal amounts with the homebuyer.

A number of mortgage-financing models have emerged that not only include profit-based repayment terms, but also address the issues of asset ownership and risk sharing. Many of the entities offering these products are not subject to banking regulations, which allows them greater flexibility in developing models that are acceptable under Islamic law.

For example, Hennepin County, Minnesota, offers an alternative-financing program for the purchase of tax-forfeiture property. In certain cases, properties revert to the county's ownership through the State of Minnesota's tax-forfeiture process. The county can then sell these properties, through public auctions, directly to interest-averse homebuyers and other individuals. The county is able to do this because it is not restricted from owning and holding real estate for lengthy terms. (For more information on the county's program, see the box below.)

Hennepin County alternative financing Hennepin County is the largest metropolitan county government in Minnesota, encompassing Minneapolis and several other communities. When a property in one of those communities goes into tax forfeiture, its ownership reverts to the state, in trust for the local taxing districts. The county administers these tax-forfeited properties, and, following the statutory public-auction process, can sell them on an annual or semiannual basis. Financing the sale of these properties to interest-averse populations was an obstacle. To address the problem, the county developed an alternative-financing contract. The contract and its supporting documents are based on a model of monthly installment payments over a negotiated term, typically five or ten years on a contract for deed. A typical transaction works like this: the property is sold at auction to the highest bidder, but not for less than the appraised-value minimum-bid price. If the buyer decides to use the alternative-financing contract, he or she agrees to regular, fixed installments that are calculated by marking up the purchase price no more than 14 percent. The 14 percent markup is considered the county's profit on the property sale, not interest earned. According to state law, the interest rate on tax-forfeited property is adjusted annually, based on market rates, and must fall between 10 and 14 percent. To ensure that the county is not underpaid, the 14 percent rate is the implied interest rate. Buyers then pay fixed monthly installments to the county. The county converts the monthly payment amount to an interest-based-equivalent payment and then pays the county treasurer an amount equal to the principal and interest owed to the state. The state bases the interest rate on the fluctuating market rate, as established by state law. In the event that the state charges less than 14 percent interest during a given year for tax-forfeited properties, the county calculates the amount equivalent to the interest that buyers have overpaid throughout the year and refunds them the difference. The benefits of the county program are threefold. First, it closely adheres to the Islamic principles requiring direct asset ownership and non-interest financing. Second, the program enlarges the pool of prospective residential real estate purchasers and thus enables the county to return tax-forfeited properties to private ownership, which increases the property-tax base. Finally, the alternative-financing contract and documents establish a replicable model that can be used across the country.

American Finance House LARIBA (LARIBA), a private finance and mortgage company, offers another alternative mortgage product. LARIBA ensures that risk is shared equally among all parties by structuring home financing under a conceptual partnership model that involves a decreasing-equity position for the company. LARIBA and the buyer jointly purchase the property, with the buyer providing a down payment and LARIBA providing an equity investment in the home. As the buyer makes monthly payments to LARIBA at a markup, the buyer's equity in the home increases and LARIBA's equity decreases until, at the end of the financing term, the buyer owns 100 percent of the home. (For more information on LARIBA, see the box below.)

American Finance House LARIBA American Finance House LARIBA (LARIBA) is a Web-based finance and mortgage company in Pasadena, California, that is licensed to finance home purchases in 25 states, including Minnesota. LARIBA developed a financing model based on ijara-wa-iqtina (lease-purchase) transactions, in which the company and the homebuyer enter into a conceptual joint lease-purchase agreement, with LARIBA providing the capital for the portion of the purchase price that is not covered by the buyer's down payment. To pay off the balance, the buyer agrees to make monthly lease payments to LARIBA for its share of the property. Despite the fact that the property is purchased jointly by LARIBA and the homebuyer, title transfers directly to the homebuyer at the point of sale. Once a Muslim buyer selects a property, LARIBA and the buyer each consult with three different local real estate agents to determine what the property's fair-market rent would be. Using these six independent rent estimates as a base, LARIBA calculates a fixed monthly payment. The buyer's monthly payment covers repayment of capital, which decreases LARIBA's equity share in the property while increasing the buyer's share. It also includes a return on capital, which is calculated according to LARIBA's share in the rent, proportionate to its total share in the venture. LARIBA ultimately determines the imputed interest rate in order to comply with regulations such as the Truth in Lending Act. In the past, LARIBA lacked the necessary capital to finance a large volume of home purchases. In 2001, LARIBA began working with Freddie Mac, one of the largest secondary mortgage market investors in the country, to recapitalize its loan fund. Under the LARIBA-Freddie Mac partnership, customers sign traditional Freddie Mac mortgage documents and a patented LARIBA agreement—a rider—explaining that, despite references to interest in the standard loan documents, the loan is structured in a manner that does not include interest. For more information on LARIBA, visit www.lariba.com.

Despite the limitations of domestic banking laws, regulated financial institutions are beginning to develop alternative products that are acceptable to interest-averse populations. HSBC Mortgage Corporation (USA), or HSBC Mortgage, in New York now offers a murabaha product to address the issue of asset ownership. HSBC Mortgage is a wholly owned subsidiary of HSBC Bank USA, a New York bank that is regulated by the New York State Banking Department and the Federal Reserve System. In November 1999, the Office of the Comptroller of the Currency issued Interpretive Letter #867in response to a request from the United Bank of Kuwait. The letter states that it is permissible for national banks to offer murabaha financing products ". . . to help Islamic customers engage in real estate financing transactions and commercial inventory and equipment financing transactions."

HSBC Mortgage is thus able to employ the murabahamodel in purchasing a home from the seller and then, subsequently, selling it to a Muslim buyer. This model does not fully address equal risk sharing, and HSBC Mortgage is finding that many customers actually prefer an ijara-wa-iqtina, or "lease-purchase," arrangement, to a murabaha, or "buy-sell," agreement, because the ijara-wa-iqtinamodel satisfies both risk-equity and asset-ownership principles of Islam. (For more information on HSBC Mortgage, see the box below.)

HSBC Mortgage Corporation (USA) HSBC Group serves customers around the world. Its global presence has led it to develop products for international markets, such as the Middle East, where some consumers lack previous exposure to U.S. banks. The company houses a group in Dubai, focused solely on Islamic finance issues, to serve its Middle Eastern customers. As these issues gain visibility in the United States, HSBC Mortgage Corporation (USA), or HSBC Mortgage, has tapped into this existing knowledge base to develop a domestic product that adheres to Islamic principles. After a lengthy product-development process, HSBC Mortgage rolled out a riba-free mortgage product in the state of New York in March 2002. The product is based on the murabaha (buy-sell) model, in which the customer identifies a property and negotiates the purchase price with the seller. During negotiations, the customer presents the seller with a document explaining that HSBC Mortgage will actually be buying the property from the seller. A closing takes place at the point of sale, with HSBC Mortgage buying the property from the seller and immediately reselling it to the homebuyer. Despite making the initial home purchase, HSBC Mortgage does not take title to the home at any point and is exempt from any state transfer taxes. To finance the sale of the home, customers are eligible for fixed-profit financing with terms of up to 30 years. The financing operates like a conventional bank loan and HSBC Mortgage offers flexible terms such as low down payments and the use of nontraditional credit for underwriting purposes. Buyers make installment payments that equal a portion of the purchase price, plus HSBC Mortgage's profit margin. HSBC Mortgage escrows a portion of the payment for taxes, and any interest earned on the escrow account is donated annually to a charity. The customer receives a Form 1098 from the Internal Revenue Service for the mortgage-interest deduction, but it is his or her personal decision whether or not to claim a tax deduction. The bank has closed four loans to date, and it hopes to introduce its Islamic-financing product to other parts of the United States in the future. For more information on HSBC Mortgage and its riba-free mortgage product, visit www.amanahfinance.hsbc.com.

These issues can be less complex for small business financing, due to the nature of small business transactions. The type of asset being financed by a small business owner—typically a commercial building or piece of equipment—lends itself to lease-purchase or markup-and-installment arrangements for shorter terms than those required in housing transactions. However, complexities arise when businesses require start-up or working capital.

The Neighborhood Development Center (NDC), a community development corporation serving the Twin Cities, offers several transaction models to address the issues of asset ownership and risk sharing in small business finance. The first model involves a murabaha (buy-sell) transaction, in which the NDC purchases an asset directly from a seller and then sells the asset to the buyer at a negotiated price. The NDC receives a 10 percent profit and signs an installment payment plan with the buyer for a negotiated term of up to five years.

A second model employed by the NDC is a lease agreement with an option to purchase, structured with monthly payments. This ijara (lease-purchase) model works well for equipment purchases by small business owners.

Another model used by the NDC, which illustrates the risk-sharing principle, follows a royalty-investment structure. The NDC makes an investment in the business, the business owner provides owner equity, and then both share in any profits or losses over a given period. The amount of capital provided by the business owner is negotiable, but typically falls within the range of 5-10 percent. Working capital loans are also available under this model but typically are in small dollar amounts due to the increased risk involved. (For more information on the NDC, see the box below.)

Neighborhood Development Center small business financing The Neighborhood Development Center (NDC) is a nonprofit community development corporation located in St. Paul, Minnesota. It offers business training, loans and technical assistance to help inner-city residents revitalize their neighborhoods. In partnership with 18 community groups, the NDC has helped nearly 400 entrepreneurs open businesses since 1993. The NDC provides Islamic financing to Muslims and non-Muslims alike in target neighborhoods throughout the cities of Minneapolis and St. Paul. Target neighborhoods include low-to-moderate income areas, where residents earn 80 percent or less of the 1999 area median income. The NDC also considers applications for business assistance if the applicant demonstrates a high degree of community impact. Alternative forms of financing available through the NDC in accordance with Islamic law include: Buy-sell agreements with deferred payment terms whereby the NDC will purchase the asset and then sell it at a profit to the business owner. Lease-purchase agreements, in which the NDC will purchase the asset, then sign a lease agreement with the business owner that includes an option to purchase the asset. Royalty investments, where the NDC will contribute capital to a specific project or deal, sharing the profit or loss from the transaction with the business owner. Interest-free loans, which are only available in conjunction with one of the other financing options listed above and can be used to finance small amounts of working capital. Loan availability depends on the size of NDC's Islamic-financing fund. The NDC offers alternative-financing deals ranging from $500 to $30,000, depending on the nature and size of the business enterprise and the availability of funds. NDC assistance may be used to finance items such as office and production equipment, office furniture and computers, short- and long-term assets, inventory, leasehold improvements and working capital. Terms are typically from six months to five years, depending on the amount of financing and the needs of the business. The NDC's finance committee reviews all applications. For more information about the NDC, visit www.windndc.org or www.rebafree.com, or call (651) 291-2480 or (612) 501-5122.

Documentation and accounting

As previously discussed, Western financial institutions must comply with banking regulations and follow standard accounting practices. These conventions can make even slight deviations from interest-based products very difficult to accommodate. Most financial institutions in the United States use standard mortgage documents that adhere closely to banking and consumer compliance laws. These forms and documents were designed for interest-based loan products. As such, they contain terms and conditions specific to interest. Standardized loan documentation is used not only to streamline loan processing and help lenders maintain compliance with laws and regulations, but also to make the process of packaging and selling loans to secondary market investors straightforward.

Clockwise from above left: A neon sign greets visitors to Casablanca Hair Design, a barbershop in Minneapolis. Owner Abdel Wahad Batal purchased the shop's chairs through a murabaha, or "buy-sell," transaction arranged by the NDC. During a brief pause between haircuts, one of the chairs sits vacant while the tools of Batal's trade await the next customer.

Lenders and financial institutions face significant challenges when altering standard loan documents to reflect terms and conditions that are not based on interest. Complex loan-processing and information-technology systems make it challenging for financial institutions, especially large ones, to manage loan products and documents that deviate from the norm.

A partnership between LARIBA and Freddie Mac, a major investor in the secondary mortgage market, attempts to address the documentation issue. The partners developed a program that allows Muslim homebuyers to use standard Freddie Mac loan documents. When buyers sign those standard documents, they also sign a patented LARIBA agreement consisting of a rider that replaces interest-related terminology with language related to markups and installments.

Accounting issues may seem minor in comparison to the other issues discussed here, but they can be just as challenging. The primary accounting issue pertains to the value of an asset before, during and after a transaction. If a lender purchases an asset at a certain price, marks up the price to make a profit and then sells the asset to a Muslim buyer, which price—the original selling price or the higher, profit-based price—should be recorded on the lender's books? This matter is complicated further if the lender wishes to sell these loans on the secondary market.

Business owner Faduma Ali takes a quick break from assisting customers at Marqaan Store, her gift, clothing and furniture boutique in St. Paul. Ali opened the store in 2001 with the help of an inventory-purchase loan from the NDC.

Religious Interpretation

For many Muslims, Islam is a way of life, defined by the Qu'ran and the Hadeeth, or the examples and sayings of Mohammed. When a new matter or question arises in Islam, Muslims consult these two sources. If the sources provide a specific answer, Muslims must abide by it, except in special or extreme situations. If the Qu'ran and Hadeeth do not directly address the matter in question, local boards of Islamic scholars provide guidance by consulting and interpreting the two sources and issuing a decree, or fatwa.Scholars sometimes disagree, depending on the question. In the case of Islamic financing, scholars review and evaluate financial products based on their consistency with principles contained in the Qu'ran and the Hadeeth. They advise Muslims to avoid any financial products that violate those principles. However, scholars may disagree about the acceptability of products and services that are not specifically prohibited under Islam.

For instance, the purchase of insurance products can be a source of disagreement for Islamic scholars. Collective insurance is acceptable under Islamic law, but selling insurance to make a profit is not. There are exceptions; for example, many Muslims in the United States purchase auto insurance because it is required by law. However, it is not clear if mortgage insurance is acceptable. There are no legal statutes that require mortgage insurance; it is a requirement imposed by the financial industry, and different scholars have arrived at opposing conclusions about its permissibility. There is also considerable debate as to whether it is acceptable for a Muslim to knowingly obtain a mortgage that will then be sold on the secondary market, since that market conducts interest-based transactions. Some scholars do not feel that the secondary market poses a problem, as long as the transaction between the lender and the homebuyer is profit-based.

Scalability of models

Models such as the Hennepin County or NDC programs discussed above work well for a small number of transactions at the local level. However, these programs run into difficulty when the size or number of loans demanded exceeds the capital available. One alternative for regulated financial institutions that want to help meet the credit needs of the Muslim community would be to help intermediaries recapitalize and expand existing programs. In the Twin Cities market, low- to moderate-income Somalis make up a large portion of the Muslim community. Regulated financial institutions may be able to meet their obligations under the Community Reinvestment Act by lending to or investing in nonprofit organizations that provide Islamic financing.

Outcomes in the Twin Cities

The issues explored above are central to the work group that formed in 2001. Initially, the work group's goal was to bring Muslim community representatives, lenders, and housing and small business assistance providers together for the purpose of cross-education; that is, to help lenders understand the Islamic principles underlying the prohibition of interest, and to assist the Muslim community with an improved understanding of American banking practices. The Minneapolis Fed convened work group meetings and provided ongoing support by facilitating discussion, researching specific issues and potential alternatives and sharing information on models from other parts of the country.

Early meetings focused on gauging the demand for Islamic financing and exploring how it differs from traditional Western financing. Over time, the work group's mission evolved into identifying barriers to lender participation in Islamic finance, discussing how to eliminate those barriers locally and researching replicable models from other parts of the country. As a result of this process, several other objectives were accomplished:

• The group developed a shared understanding of the primary issues regulated financial institutions face in providing Islamic-financing products. Key partnerships formed between bankers and community organizations represented on the work group.
• Twin Cities lenders and Muslim community representatives gained an improved understanding of the constraints that they each face in providing or obtaining financing.
• The work group's efforts resulted in heightened awareness and visibility of this issue in the larger Twin Cities community.
• Work group members and Muslim community representatives connected with the local Homeownership Center to assist in the development of an Islamic-focused homeownership-counseling program.
• And, most importantly, the knowledge exchange resulting from this initiative is contributing to the development and introduction of new products in the Twin Cities market.

Looking ahead

Through their efforts, work group members discovered that developing financing alternatives for Muslims and other interest-averse borrowers is a complex and challenging process. This article explores key issues involved, such as asset ownership, risk sharing and accounting discrepancies, but the list presented here is certainly not exhaustive.

No single organization in the Twin Cities has the resources to explore these issues alone. Together, lenders, community representatives and other work group members have developed the expertise and momentum necessary to advance alternative financing in the Twin Cities. They demonstrated that partnerships are crucial for the development of alternative-financing products, and they continue to work toward a solution.

Meanwhile, the demand for those products continues to grow, and several key lending institutions are responding to the call. They are studying existing models and working to develop products that can effectively serve regional or national markets. Within the next year, at least two additional Islamic-financing products should be available in the Twin Cities. For area Muslims who wonder how to buy homes or finance small businesses without violating their religious beliefs, an answer may be coming soon.

Portions of our cover story are based on the article "Islamic Finance and the U.S. Banking System" by Margaret Tyndall, which appeared in the December 2001 issue of Community Investments, a publication of the Federal Reserve Bank of San Francisco. To access the issue, visit the "Publications" section of the San Francisco Fed's Web site at www.frbsf.org.

1/ Neighborhood Development Center materials, 2001.

2/ Office of the Comptroller of the Currency, Interpretive Letter #806, December 1997.