Thursday, March 12, 2009

Mortgage for profit: everyone does it 

Last weekend Ed Morrissey posted a story on the use of state money to create a mortgage loan program consistent with Islamic banking principles (wiki). The plan is to use the murabaha instrument, in which the bank buys the asset and embeds a return on its investment in a higher resale price to the person who wants to own it. It's a sort of "rent-to-own" principle. (You can see the contract here.) If you ever bought a house on a contract-for-deed, you've got a feel for what these contracts are like. (Unsurprisingly, in tight credit markets these kinds of mortgage-buying instruments are on the rise.)

Ed objects to the policy not because of Islamic principles at all but that the state is intruding into the private market. Sorry to say, Ed, that horse left the barn a very long time ago, with mortgage deductibility, Fan/Fred, CRA, etc.

The story has spread quite a bit. Yesterday James Taranto wondered if the users of these contracts had deprived themselves of a benefit:
Since mortgage interest is tax-deductible and principal is not, one assumes this means that borrowers with Islamic mortgages end up paying considerably more for the same house than those with regular mortgages. (The AP does not answer this obvious question.) If the law provided for an equivalent tax break for Islamic mortgages, however, presumably Shariah would permit Muslims to take advantage of it, since the ban is on interest, not tax advantages.
I think that misses Ed's point though. If you give a deduction for interest on home mortgages you've handed a tax benefit for those who negotiate contracts that use interest to compensate lenders. An Islamic bank is compensated for the use of funds via marked-up principal. If that profit is not tax-deductible to the homebuyer, a dollar paid in mark-up is more costly than a dollar paid in interest, and the Islamic bank will face a lower demand curve for mortgages. Since the state has already intervened through the mortgage interest deduction, there's not much ground to stand on to say the state should abjure from supporting an Islamic mortgage instrument.

But what supports the use of Islamic mortgage instruments is, to go back to my hobby horse of the week, is a set of institutions that make banks comfortable with such an instrument. Virginia Postrel a few years ago interviewed Timur Kuran, a USC professor who has written the best one book on Islamic economics that I have read, Islam and Mammon: The Economic Predicaments of Islamism. Banks were supposed to work principally as venture capitalists, sharing in profits and loss. But that didn't work out very well for Islamic banks, for much the same reason as actors who are supposed to get residuals from their artistic work get screwed: the borrower simply says there are no profits. So contracts like murabaha came about, and there needs to be enforcement of these contracts. Enter the government who normalizes the contract form (see links above) and establishes damages for default. Contract law has to adjust to deal with a different kind of contract, and just like the rent-to-own deal that goes bad in this story, the law still has some catching-up to do.

Kuran warns that sometimes the purposes of Islamic banks goes beyond the creation of these contracts, though.
Islamic economists not only want their own banks, Professor Kuran writes. They ''desire new regulations that would force all banks to limit themselves to variable earnings and commitments.''

''And they want interest-based banking outlawed.''

But that's simply rent-seeking behavior, and that's not unique to Islamic banks.

Labels: ,