New Markets Mortgage program broadens homeownership opportunities in Minnesota

When Nawawi Shiekh and Rukia Ali bought their three-bedroom, two-bathroom house in South Minneapolis last February, the transaction marked two important firsts. It was the first home purchase for the young husband and wife, who were thrilled to realize part of the American Dream for themselves and their two small children. It was also the first deal closed under a program that aims to make homebuying a possibility for a previously underserved market of Minnesotans.

The New Markets Mortgage (NMM) program is a home financing product that is profit-based, not interest-based. Although it is open to any qualified first-time homebuyer in Minnesota, the program is most likely to appeal to buyers like Shiekh and Ali, whose strict interpretation of their Muslim faith prohibits them from paying interest.

The NMM program was conceived as a three-year, $15 million pilot. It is offered and administered by the African Development Center (ADC), a community-based economic development organization in Minneapolis. Creation of the program was spurred by ADC, which worked in partnership with Fannie Mae, Minnesota Housing (the Minnesota Housing Finance Agency), and Devon Bank over a three-year development period. Program delivery involves ADC acting as mortgage broker; Devon Bank acting as originator, underwriter, and servicer; and Minnesota Housing acting as investor. While the NMM is not the only non-interest-based mortgage program available in the U.S., it is the first in which a community-based organization serves as the lead entity and a state housing finance agency provides investment funding. And while it has an unconventional financing structure that meets the requirements of Islamic law, the NMM product resembles a conventional mortgage in nearly every other respect.

"Cost-plus" financing

Technically, Islamic law does not directly prohibit interest. Instead, it prohibits reba, a concept that loosely translates as "renting" money, or making money off of money itself.^1/ Interest is a vehicle that carries reba, so Muslims are prohibited from participating in financial transactions that involve interest payments. Islam is not the only faith with such a prohibition in place. Orthodox Jews and members of some Christian denominations may observe similar prohibitions, depending on their interpretation of certain scriptural passages. However, Muslims make up the single largest interest-averse segment of the population in the U.S. This is especially true in Minnesota, which is home to thousands of Somali refugees, almost all of whom are Muslim.

The Islamic prohibition against reba was set down 14 centuries ago in the Koran as a means of preventing usury and promoting economic justice. In observance of the prohibition, the Muslim world developed a financing system that does not involve interest. Under this system, a murabaha, or "cost-plus," sale is a common type of financial transaction. In a murabaha sale, a financier must first own the item that is being sold. The financier then sells the item to the buyer at a marked-up price, and the buyer pays the financier the total price in installments over a period of time. In this way, the financier profits from the sale of the item instead of profiting from the sale of money.

Because individual Muslims have differing interpretations of the Koran, the degree of observance of the reba prohibition varies. In Western countries, where reba-free financing options may be limited or nonexistent, some Muslims participate in interest-based mortgage transactions willingly and comfortably. Some Muslims will not participate at all, even if they experience overcrowding or other housing hardships as a result. And some fall in the middle; they are ill at ease with the idea of interest-based financing, but will participate as a last resort, in order to acquire adequate housing for their families. In some cases, local Islamic scholars may need to issue special rulings to ease the families' worries about violating their faith. For Muslims who live in the West and follow a strict interpretation of the Koran, developments like the NMM program can be the key to achieving homeownership while living in harmony with deeply held religious beliefs.

Developing the program

The idea to create the NMM program took root nearly a decade ago. Demand for alternative mortgage products grew in Minnesota in the late 1990s as the state's population of Somali refugees and other Muslims from East Africa surged. In the spring of 2000, the Minneapolis Fed convened a daylong conference so lenders and community leaders could meet and discuss the issue. Hussein Samatar, the founder and executive director of ADC, was then a banker at Wells Fargo in Minneapolis. He participated in the Fed conference and on an alternative financing workgroup the event spawned. When the workgroup later disbanded, Samatar continued to pursue the idea of bringing reba-free mortgages to Minnesota. Shortly after he left Wells Fargo and founded ADC in 2003, Samatar launched a focused effort to create a murabaha-based mortgage financing product. He initially approached Fannie Mae, which started developing alternative mortgage documents in response to his requests.

Meanwhile, Minnesota Housing, together with the Federal Reserve Bank of Minneapolis and the Minnesota office of Fannie Mae, launched the Emerging Markets Homeownership Initiative (EMHI), a strategic plan to close the substantial gap in homeownership rates between white Minnesotans and the state's minority and immigrant communities. During the plan's design phase, Samatar helped EMHI's conveners identify the lack of alternative financing products as the major barrier to homeownership for many of Minnesota's newer residents.

Creation of the NMM program began in earnest in 2006. The process started with Minnesota Housing and Fannie Mae working to sort out legal complexities related to Fannie Mae's alternative mortgage documentation. Once the documentation was ready, Samatar arranged for local Islamic scholars to review it from a religious standpoint, and Minnesota Housing began conducting research to identify a lender with experience in profit-based financing. The agency ultimately selected Devon Bank, a 63-year-old, full-service community bank headquartered in an ethnically diverse Chicago neighborhood. Devon Bank began offering murabaha-based financing in 2003, in response to demand from Muslim customers in its service area, and is now one of the top murabaha mortgage providers in the country.

As Minnesota Housing was negotiating a servicing agreement with Devon Bank, Samatar was obtaining a broker's license and training his staff to administer the new program. By the final months of 2008, all the pieces were in place, and the first NMM homebuyers—Sheikh and Ali—were preapproved in December.

How the process works

While ADC's obvious goal in offering the NMM program is to get clients into homes, an equally important goal is to prepare those clients to be informed, successful homeowners for the long run. All prospective NMM participants are required to attend first-time homebuyer training workshops. Workshop graduates who are interested in applying for an NMM mortgage must then meet with one of ADC's trained counselors, who analyze the clients' financial profiles and, if needed, put them on a plan to resolve any outstanding credit issues. In addition, ADC synthesizes and shares information about any existing down payment assistance programs. If clients meet the program's income requirements and are in good financial shape to purchase a home, ADC forwards their applications to Devon Bank for preapproval.

Next, the preapproved clients go house hunting. They are free to purchase any single-family home in the state, so long as it is in mortgageable condition and meets price limits set by Minnesota Housing. Once the clients find a house and agree on a purchase price with the seller, ADC forwards the completed file to Devon Bank. Devon Bank then underwrites the mortgage, using standards that are based on Fannie Mae guidelines, and also draws up the mortgage documents, orders the appraisal, arranges for the title insurance, and coordinates the closing.

The process is identical to a conventional loan underwriting and closing process, except for the way the deal is structured. In a conventional mortgage transaction, the homebuyer borrows money from the lender, uses the borrowed money to buy the house directly from the seller, and then repays the lender the loan principal plus interest. In an NMM transaction, Devon Bank buys the house directly from the seller and then immediately sells the house to the homebuyer at a marked-up price. The profit markup, which is calculated according to market interest rates, is equivalent to the total interest payments that would be paid over the life of a 30-year conventional loan. The buyer then pays Devon Bank the total, marked-up price for the house, in the form of an initial down payment plus fixed, monthly installments that are paid out over a 30-year period.^2/ Since there is no interest involved, the transaction is acceptable under Islam and other faiths.

"Technically speaking, this isn't a loan, because we never gave them any money in the first place," explains David Loundy, corporate counsel and vice president of Devon Bank. "Rather, we stepped in and bought the house on their behalf, then turned around and sold it to them at a higher price, paid over time, but at no interest. So when they pay us, they're not paying us back principal and interest that was lent to them. They're simply paying us an installment sales price."

According to Devon Pohlman and Chuck Callender, who serve on the Business and Policy Development Team at Minnesota Housing, the deal involves three key documents created by Fannie Mae and Devon Bank: the mortgage, the note, and the agreement. The agreement is distinct from any of the documents used in a conventional home purchase, in that it spells out the terms of the murabaha-based NMM transaction. The mortgage and note documents are nearly identical to those used with conventional loans.

Once the closing is completed, Minnesota Housing steps in as the investor and purchases the note, using part of the $15 million set aside for the NMM pilot program. The fund, which is drawn from the same pool of investment earnings that the agency uses to fund its other first-time homebuyer programs, will be in place for three years or until the money runs out, whichever comes first.

As conventional as it gets

The players involved in delivering and funding the program all emphasize the conventional look and feel of the NMM product. Aside from the way the payments are structured, an NMM mortgage transaction is virtually indistinguishable from any other first-time homebuyer purchase financed by Minnesota Housing. Buyers must meet all of Minnesota Housing's standard first-time homebuyer requirements, for example. Property taxes and homeowner's insurance are escrowed. Buyers whose down payment equals less than 20 percent of the home's price pay an additional markup that is used to purchase private mortgage insurance. And in the end, the monthly payment is identical to what a homebuyer would pay on a conventional loan.

"It really looks like PITI, except that the first 'I' is actually profit, not interest," says Samatar. "The structure of the financing may not be the same, but everything else is as conventional as it gets."

Callender characterizes the product as "different, but not 'special,'" and adds, "This product is built on standard Fannie Mae underwriting. With the New Markets Mortgage program, Minnesota Housing is doing what it always does in the first-time homebuyer market, and that's buy industry-standard mortgage products." In addition, Callender points out that in a worst-case scenario, an NMM mortgage would be treated just like any other mortgage Minnesota Housing finances. If the buyer defaults on the payment agreement, Devon Bank must foreclose on the mortgage on Minnesota Housing's behalf.

Uncertainty and optimism

So far, there is an ample supply of prospective NMM clients. ADC trains 30 to 35 families a month at its first-time homebuyer workshops, and there are currently several preapproved families in the pipeline. Given the finite amount of funding behind it, the NMM pilot will not be able to accommodate every potential homebuyer who expresses interest in the program. But the NMM's creators are hopeful that the market demand demonstrated during the pilot phase will pave the way for expanding the program's funding and capacity.

According to its proponents, the NMM program has worthy goals and, in light of the downturn in the real estate market, excellent timing.

"The ADC program is particularly rewarding," says Loundy of Devon Bank. "It's getting people into homes who otherwise wouldn't have the option. And it's bringing a new populace of buyers online at a time when we need to burn off the inventory of foreclosed homes and turn around the whole housing market." He notes that the house purchased by Shiekh and Ali was a foreclosed property.

Since the launch of the program, ADC, Devon Bank, and Minnesota Housing have fielded inquiries from lenders, developers, Realtors, and other industry players from around the country who are interested in bringing similar financing options to their communities.

"The homeownership industry understands the market benefits of this program. Real estate agents, developers, appraisers, lenders, home inspectors—they all see business opportunities here," says Pohlman of Minnesota Housing. However, she tempers her comments with a dose of caution.

Pohlman points out that due to the turmoil in the economy, "Our agency's financial position looks radically different than it did a year or two ago, and there are a lot of converging macroeconomic factors that could affect the program's viability." Examples include housing price fluctuations, employment rates, and tightened underwriting standards.

Samatar of ADC acknowledges the uncertainty, but remains optimistic about what the future holds for the NMM program.

"Nobody knows what will happen with the housing market and the financial crisis we're in, but given the conditions we have now, this product is a positive spot of growth. It could enable people to access homes right when we need people to access them. We're increasingly hopeful about this program, and I think the future is bright."

For information about applying for the NMM program, contact the African Development Center at 877-232-4775 or visit www.adcminnesota.org.

1/ American Finance House LARIBA Knowledge Center, www.lariba.com.

2/ Minnesota Housing, New Markets Mortgage Pilot Program Frequently Asked Questions, March 2009. Available at www.mnhousing.gov.