An engineer’s view of Islamic Finance

I spent two decades in construction and oil and gas services, and I can’t help looking at life through an engineer’s logical and scientific lens. Science never lies, is not diplomatic, and doesn’t care about feelings. It simply states facts.

As an engineer, Islamic Finance reminds me of a cofferdam – an enclosure built within a body of water to allow the enclosed area to be pumped out. This pumping creates a dry working environment so that the water can be carried out safely. Cofferdams are commonly used for the construction or repair of permanent dams, and – to me – the analogy seems appropriate.

What do I mean by all this? Well, look at the picture. The sea represents the world of interest-based finance that we live in, the cofferdam represents the relatively tiny yet growing Islamic finance industry, and the action of pumping water out of the cofferdam represents the efforts of well-wishing Islamic financial professional to purify, strengthen and grow Islamic finance by progressively removing the remaining conventional finance elements from within the Islamic finance industry. 

Just like a cofferdam, creating a space for Islamic finance to grow requires the ability to simultaneously keep principles of Shariah-compliance while working within state regulations of the country one is operating in and following the “laws of the land” as far as possible without breaking Islamic principles. It’s not the end state but a step on a journey towards a world without riba. 

The Holy Prophet, Muhammad (saww) said, “Religion is very easy and whoever overburdens himself in his religion will not be able to continue that way. So you should not be extremists, but try to be near to perfection and receive the good tidings that you will be rewarded with; gain strength by worshipping in the mornings, and the nights.” – Sahih Bukhari

I have spent, so far, three years on the journey towards launching scalable halal finance in Canada. As an engineer, I am satisfied with the cofferdam foundations we have built, as an entrepreneur, I am energized as I begin to see the results in front of me, and as a Muslim, I am humbled and grateful in front of Allah (swt) having seen the hundreds of miracles that He has brought about in the form of help from unlikely sources, the removal of insurmountable obstacles, and most of all, in giving me the strength to not give up despite hearing the initial “NO” from almost every party that I spoke to.

Just as a gym workout strengthens our muscles, reading strengthens our minds, actions based on strong morals, the right intentions, and faith in Allah empowers our nafs (souls). To me, bringing Islamic Finance to Canada has been exactly what I needed to become a better entrepreneur, a more self-aware person, and a more faithful Muslim. 

I pray that I am able to inspire my fellow Canadian Muslims and non-Muslims to join me in this amazing journey to one day be “near to perfection” inshAllah.

Ameen

Halal Home Financing in Canada – Traditional Product Challenges

NOTE: This is a technical article aimed primarily at individuals with a fair level of financial acumen. This article delves into the details as to why the three traditional Shariah-Compliant home financing products are not compatible in the Canadian economy. 

Three years ago, when I embarked on a mission to bring at-scale Shariah-compliant home financing to Canada, the first thing I did was to study why halal home financing has not become available at scale despite the enormous demand in Canada, with her 1.6 million strong Muslim population and its CAD 225 billion Shariah-compliant home financing market, expected to double within 10 years!

It took several months of discussions with financial industry experts, Shariah scholars, Islamic Finance industry professionals and Canadian lawyers, combined with detailed reading of the Income Tax Act, the Mortgage Brokers, Lenders, and Administrators Act (“MBLAA”), and other regulations to form a clear answer, which ultimately led to me, along with the help of many professionals from the Islamic and Canadian financial industries, to finally develop a product for Canada that works!

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Currently, across the world, there are three main Shariah-compliant home financing product structures in use. These are:

Simple Murabaha

Murabaha means “cost-plus financing”. In a Simple Murabaha product, the financier purchases the underlying property from the seller, then immediately on-sells it to its customer at a pre-agreed profit. Given that this is a sale and resale, riba is fully avoided, and replaced with shariah-compliant profit. The entire cost-plus amount becomes the principle that is now payable by the customer to the financier, and is paid off over the pre-agreed financing term e.g., 10, 15, 20 or 25 years etc. 

The reader should note that Islamic Financial Institutions also use alternative Murabaha products that are pure in their Shariah-compliance and in accordance with global AAOIFI standards and yet are NOT dependent on purchase and resale of the underlying property itself. EQRAZ’s Murabaha-based product is an example of such a product. https://eqraz.com/our-halal-mortgage/ 

Diminishing Musharakah (“Partnership”)

In a Diminishing-Musharakah product, the financier and the customer jointly purchase the property. Then, each month (or other agreed payment period) the customer pays to the financier two types of payments: (a) property purchase payments wherein the customer buys a slice of the property from the financier, and (b) rental payment through which the customer compensates the financier for using the latter’s portion of the property. In almost all cases, the regular payments follow the exact same amortization pattern as that of a conventional mortgage.

Ijara (“lease”)

In an Ijara product, the financier purchases the property and rents it out to the customer against equal monthly (or otherwise agreed) payments, then transfers ownership to the customer at the end against a nominal residual value. As with a Diminishing Musharaka product, the regular payments follow the exact same amortization pattern as that of a conventional mortgage

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The section below addresses the problems in detail that each of these three types of products face in Canada, due to which reason, it is currently very difficult to offer them at scale. 

Simple Murabaha

Of all the three traditional types of products, the Simple Murabaha is the easiest one to structure from a documentation perspective.

Complication #1: Unaffordable & Non-Renewable

The most common conventional mortgage in Canada is a fixed rate mortgage with a five-year term and a 25-year amortization period. Every five years, it is customary for clients to renew their conventional mortgage at a new profit rate based on economic conditions at the end of the five-year term. This is due to the Canadian legal requirement that clients must be given the opportunity to fully pay down their mortgage every five years, or transfer it to another mortgage provider[1].

The three ways that a simple Murabaha can be amortized in Canada are shown below: 

1. Five-Year Murabaha – Not Affordable for Client as Balloon Payments Cannot be Financed

If the amortization period and term under a Murabaha were five years, clients’ mortgage payments would be very high, severely limiting the number of people that could qualify for such a mortgage. A CAD 450,000 mortgage paid over five years to finance the purchase of a CAD 600,000 home could generate mortgage payments of almost CAD 9,000 a month, which, to be affordable and to meet Canadian underwriting standards for Gross Debt Service Ratios for obtaining mortgage insurance, would require the homeowner’s household annual income to be very high (over CAD 300,000)[2]. To put this figure in perspective, the average median annual household income in Canada as of the last census in 2011 was CAD 76,000.

Alternatively, if the amortization period was longer than the mortgage term, the client would be forced to close out the Murabaha by making a substantial balloon payment at the end of the term. However, a new Murabaha to finance the balloon payment cannot be established, since there is no further property to sell and it is not allowed to use the same asset that was the subject matter of previous Murabaha transaction with the same customer (AAOIFI Shariah Standard 8, Clause 2/2/8). Therefore, the alternative of having lower ongoing payments and a final large balloon payment is not possible with a Murabaha structure.

2. 10-Year Murabaha – Not Affordable for Client and Unduly Risky for Professional Investors

The same restricted affordability issue that would apply to a five-year Murabaha product would also apply to a 10-year Murabaha product. For example, a CAD 450,000 mortgage paid over 10 years could generate payments of just over CAD 5,000 a month, which would also require the homeowner’s annual household income to be very high (over CAD 185,000), severely restricting the number of mortgage applicants that would meet the underwriting requirements for a 10-year Murabaha mortgage product.

As legislation in Canada does not allow a borrower to be locked into a mortgage arrangement with a particular lender for more than five years, practically speaking, a borrower must have the right to renew the mortgage every five years. However, due to the significant risks associated with the Canadian legal requirement that clients must be given the opportunity to fully pay down their mortgage every five years, or transfer it to another mortgage provider, without other than a small financial penalty, a mortgage with a term longer than five years would generally not be desirable to professional financing sources practicing advanced asset-liability matching risk management techniques. This unavailability of capital from professional investment sources would render a 10-Year Murabaha product unavailable at scale, leaving the vast majority of Muslim clients in the same situation that they are currently in.

3. Murabaha with Term and Amortization Greater than 10 Years – Affordable for Client but Unduly Risky for Professional Investors

Amortization periods and terms longer than 10 years would be much more desirable to clients. For example, a CAD 450,000 mortgage paid over 25 years could generate payments of just under CAD 3,000 a month, requiring household income to be just over CAD 115,000 per year. However, as explained above, a Murabaha mortgage product with a term greater than 10 years would not be desirable to professional financing sources.

In summary of the above-mentioned Murabaha term options, as capital to fund Murabaha products with terms longer than five years would be extremely difficult to source from professional investors, and because a Murabaha mortgage product with a five-year term would be unaffordable for the vast majority of prospective home buyers, a Murabaha product is not viable in the Canadian marketplace.

Complication #2: No Renovation Financing 

Since the profit established at the origination of a Murabaha financing product cannot be changed, a Murabaha does not accommodate additional financing for the purpose of renovation since the underlying asset is already in the ownership of the client. It is common in Canada for clients to purchase homes requiring renovations, and then to renovate them after purchase, as this practice provides much better overall value for home buyers. We expect that many Muslim clients will follow this practice, and hence will require renovation financing.

Complication #3: Non-Portability of Existing Conventional Mortgages

Many Canadian Muslims have received permission from their imams to take out a conventional mortgage from a Bank, and continue to pay interest on these loans, due to the scarcity of Shariah-compliant financing products in Canada. EQRAZ’s product, however, would allow these Muslims to immediately refinance the principal portion of their existing loans, and immediately stop dealing with riba. Alternatively, they could refinance their loan principle at the end of the term to avoid interest penalties.

Complication #4: Non-Portability of Murabaha Mortgage

Since the profit established at the origination of the mortgage cannot be changed, a Murabaha does not permit a mortgage to be ported when the homeowner wishes to move for any number of very common reasons, including as examples:

· Moving to a larger home as family size grows

· Upgrading to a better home as income increases rapidly in the first 10-15 years of one’s career

· Moving to accommodate a career shift or job change

· Consolidating households on marriage

· Downsizing after children finish education or become married

· Downsizing on retirement

· Downsizing due to financial distress (e.g., divorce, lay-off, business bankruptcy)

· Moving to facilitate elder care

· Moving to a district with better schools

· Relocating to one’s country of origin

With a Murabaha product, a client would not find it affordable to change homes, since they would have to pay the full amount of the remaining Murabaha in the event of changing homes. Although AAOIFI Standards allow for the financier to reimburse the client the remaining profit on a discretionary basis, the AAOIFI standards do not allow this rebate to be contractually included in a Murabaha agreement. To Canadian clients, this would not be acceptable as they would require a 100% guarantee that they would be refunded the proportional Murabaha profit. Furthermore, the Murabaha contract, without this guaranteed refund of profit in the event of early settlement, could be challenged legally as Canadian authorities could interpret this to lead to a “usurious” profit / “criminal rate of interest”[3]interest rate in the event of very early settlement.

Complication #5: Prepayment Problems

Since the profit established at the origination of the mortgage cannot be changed, a Murabaha does not permit prepayments to be made on a contractual basis. Muslims have a strong savings tendency and many of them would wish to be able to make prepayments, as other Canadians taking out a conventional Canadian mortgage are able to do. As mentioned elsewhere in this document, under the Canadian legal and market environment, Canadian clients dealing at arm’s length with the financier would absolutely require rebates on early repayment to be a guaranteed contractual item in the offered product.

Complication #6: Variable Rate Mortgages Not Possible

Since the profit established at the origination of the mortgage cannot be changed, a Murabaha product cannot accommodate variable rate mortgages. Variable rate mortgages account for about 20% of the Canadian mortgage market.

Complication #7: Retail Investor Funding Risk(s)

Due to the above-mentioned complications, funding at scale for a Murabaha product would not be available from professional investors such as banks and pension funds. Funding would have to be obtained from less knowledgeable retail investors, such as through a Mortgage Investment Corporation (MIC).

To underwrite a mortgage, the financier would have to fund the same amount in the MIC. The terms of an MIC would establish a redemption period such as 12 months, meaning that an investor could demand a redemption of their investment within 12 months of making their original investment in the MIC[4]. While the MIC could theoretically demand a redemption period that is longer, under the Canadian financial markets environment and norms, the vast majority of potential investors would not be interested in such an investment opportunity, resulting in the same severe funding constraints faced by existing Shariah-compliant Murabaha financing products that have been offered in Canada for the past several years. A very significant term mismatch risk arises because the redemption period (e.g., 12 months) is significantly less than the mortgage term (e.g., 10 years).

If an investor asks for their money back, the MIC would have to replace the redemption with the same exact amount from another investor. If this cannot be done, because the mortgages cannot legally be called, the MIC goes into receivership. If this happens, all remaining investors would have to hold their investment until the mortgages mature or receive a discounted value of their investment. This situation would create apprehension amongst the community and possibly make it more difficult for future entrants into the market to successfully provide Shariah mortgages to the community funded from professional investment sources.

Many factors could precipitate the unfortunate situation described above:

If market interest rates and expected returns increase, then investors may ask to redeem their investment so they can invest in higher returning asset classes

If market interest rates and expected returns are expected to decrease in the future because the economy is expected to underperform in a manner that could impair the performance of the mortgage portfolio, then investors may redeem their MIC investment in order to transfer their investment to options that they may deem to be safer going forward

Other reasons for the MIC underperforming could also cause a high level of investor redemptions from the MIC. Underperformance could be triggered because of sub-standard underwriting, higher than expected foreclosures, or competitors entering the market leading to fewer mortgage sales as some of many other possible examples

A credit crisis in Canada could cause a high level of investor redemptions from the MIC[5]

A housing crisis in Canada could cause a high level of investor redemptions from the MIC[6]

The above complications with a simple Murabaha product explain the scarcity of Shariah-compliant mortgages in Canada. While some products are being offered, the vast majority of Muslims remain unable to access a mortgage product to get riba-free financing that have sufficiently client-friendly product features. Due to these complications with a simple Murabaha product, a different solution is required.

Diminishing Musharakah (“DM”)

While a few Murabaha products do exist in Canada, Diminishing Musharakah products are practically non-existent, due to very challenging issues posed by current Canadian laws, as described in further detail below.

Complication #1: Title and Legal Ownership

As mentioned earlier, DM requires joint ownership of the property by the financier and the customer. This means that, by both Shariah standards and Canadian law, title and legal ownership must be jointly held by the two parties. This means both parties will jointly share the pricing risk as well as the maintenance, taxation, and other costs / responsibilities. 

In Canada, some firms try to get around these issues by offering a so-called DM product in which title and legal ownership is fully that of the customer’s, and then they charge “rent” to the customer. This is not only illegal and non-shariah compliant, but also a disservice to the Islamic Finance industry as it creates an impression of fraudulent, deceptive and unprofessional conduct by industry professionals.

Complication #2: Capital Gains Tax – Property Cost and Administration

As mentioned above, in a Diminishing Musharakah, title must be co-held by the homeowner and the financier. This exposes the financier to risks related to double taxation of capital gains, as the financier will not be able to take advantage of the capital gains exemption that is available for a homeowners’ principal residence, with respect to the financier’s proportionate ownership of the home. 

More specifically, due to the nature of Diminishing Musharakah products, multiple purchase and sale transactions are required instead of one. Therefore, CGT will be triggered twice for each home purchase transaction, where title transfers first from the property seller to the financier, and then from the financier to the client in tranches over the term of the financing.

Although double taxation of capital gains can possibly be avoided in the case of a Murabaha product by transferring ownership directly from the home seller to the home buyer in order to avoid the second application of CGT, this is not currently possible under a Diminishing Musharakah product, wherein CGT would be triggered each time a portion of the property ownership is transferred from the lender to the home buyer over the term of the financing.

Complication #3: Capital Gains Tax – Prohibitively Expensive Administration

Due to Canadian tax rules that CGT is applied on the Fair Market Value (“FMV”) of the transacted property, the FMV would have to be assessed each time a periodic purchase-of-property payment is being made by the client to the financier. It would be almost impossible and prohibitively expensive for the financier to manage the administration related to determining FMV individually for the thousands of properties in its mortgage portfolio, getting the FMV approved by the authorities, determining the CGT applicable, and incorporating the CGT into each individual client’s periodic payments. In order to make the business viable, all these expenses would have to be passed on to the client, making the financing transaction extremely expensive and rendering the Diminishing Musharakah mortgage product unviable for the client.

EQRAZ and its lawyers studied this extensively, and reviewed how DM products are treated in other countries. One example found was to have the client unofficially sell the property to the financier by signing an internal purchase and sale agreement which is not registered with the state government, but which may be acceptable to the Shariah Board. This allowed for the financier (as the Shariah-recognized purchaser of the property), to rent the property back to the client. However, EQRAZ’s lawyers confirmed that, under Canadian law, any “internal” arrangement between the financier and the client would have to be declared to the Canadian authorities, and all applicable Canadian rules would thus apply. Not declaring such internal agreements might be considered unlawful in Canada and certainly wouldn’t be acceptable to professional investors, whether located in Canada or abroad. As a result, this type of arrangement was found to be unworkable in Canada.

Complication #4: Land Transfer Tax – High Financing Costs

As mentioned earlier, LTT is triggered each time there is a transfer of property from one owner to another. Therefore, in a Diminishing Musharakah product, LTT would be triggered twice, the first time when the property is transferred from the seller to the financier, and then from the financier to the client with each periodic property-purchase payment. 

Paying LTT twice would be cost-prohibitive for most Muslim homebuyers and would put them at a significant disadvantage compared to homebuyers taking out a conventional interest-bearing mortgage. For instance, for a single-family residence sold for a total value of CAD 500,000, LTT in Toronto is approximately 2.6% (or $12,950), and 1.3% (or $6,475) in the rest of Ontario. Having to pay these amounts twice, on the purchase of the same single-family residence, would present serious and unfair barriers to home ownership for the ordinary Canadian Muslim, and strongly discourage prospective clients from subscribing to the Islamic mortgage product.

Complication #5: Legal Liability Issues

As mentioned earlier, in Canada, financiers are not typically assigned any legal liability/responsibility for the maintenance and proper use of the financed property or for environmental issues related to the property. As such, they are typically not made parties to lawsuits in case of injury on the property. Such liability/responsibility lies with the owner of the property, or (in some cases) with the occupant of such property (if the owner is not the occupant).

However, a financier offering a Diminishing Musharakah mortgage product would not enjoy such exemption from this type of liability/responsibility, because such financier would have to be a co-title-holder of the property, and thus have to share in the owner’s liabilities and responsibilities, from which conventional mortgage lenders in Canada are excepted. In many Diminishing Musharakah products in other countries (e.g., Al Rayan Bank’s product in the UK), the responsibility is passed on to the owner through maintenance agency and indemnity agreements. However, under current Canadian laws, this assignment of responsibility cannot be effectively done in Canada.

Even if the assignment of responsibility could be accomplished, the Canadian tax authorities would require that the client be deemed to be financially compensated for taking on such responsibility, and, as such, further require that a 13-15% Harmonized Sales Tax[7](“HST”) be applied on the Fair Market Value of the maintenance fees deemed to be paid to the client. The HST would be an added cost that would have to somehow be charged back to the client, adding to the expense of the DM financing.

The exposure of the financier to liability risk as a co-title-holder makes a Diminishing Musharakah product excessively risky for both the financier and the financier’s professional investors. In the event of large claims, the financier could end up facing financial and administrative difficulties, possibly even receivership, creating the risk that clients could lose their homes[8].

These above factors render a Diminishing Musharakah product currently unfeasible in Canada.

Ijara

The complications related to an Ijara product for Canadian Muslims are very similar to those faced in a Diminishing Musharakah Product.

Complication #1: Capital Gains Tax – Property Cost

As with a DM product, the client would incur CGT twice, once when property is transferred from the seller to the financier, and then – at the end of the financing term – when the property is “gifted” / transferred from the financier to the client. Under Canadian law, any property “gifted” or purchased-and-sold between two parties dealing at non-arm’s-length is considered to have been transferred at Fair Market Value, and corresponding taxes apply. Due to this rule, the CGT will be triggered for an Ijara product at the end of the term (at approximately 12.5% of the capital gain), at the current FMV of the property. While it would be the financier’s responsibility to pay this tax, the financier would want to be compensated for this tax, effectively meaning that the client would end up sacrificing 12.5% of any property value increase, which could render the transaction unaffordable for most clients, not to mention having to produce the funds to pay off this substantial amount in one lump-sum. 

Given that amortization periods are long and house price appreciation in Canada has been rapid, the amount of this tax could be very substantial and be unfair to Muslim Canadians as they would not be benefiting from the full capital gains exemption on principal residences available to Canadians taking out a conventional mortgage.

Complication #2: Land Transfer Tax – High Financing Costs

As with a DM product, the client would pay LTT twice with an Ijara product as well. Since the property title will be transferred to the client at the end of the financing term in one shot, the client would end up paying the entire second LTT immediately on transfer in one lump-sum. Combining this tax with the CGT above, this would make the transaction unaffordable to most clients. Another worry is that, many clients may enter into DM or Ijara property financing with financiers that do not educate the client in sufficient detail about these huge lump-sum payments that the client would incur at the end of the financing term, creating significant financial distress for the client at a future point in time. Clients having availed such products, once becoming aware of these complications post-purchase, might even turn to a conventional interest-bearing loan (to cover these unexpected expenses) in the absence of another Shariah-compliant product becoming available that does not have these complications.

Complication #3: Bankruptcy Risk

In an Ijara financing, the financier would be 100% on title. Under Canadian law, this would render the financier 100% responsible for all maintenance and liability-related issues and costs of the financed property. While in a DM product, the client would still maintain some share in the above costs, in an Ijara arrangement, the financier would be solely responsible for all costs. Given that injury on property, environmental damage, or other maintenance-related issues could result in lawsuits and payouts worth millions of dollars, the bankruptcy risk created for a financing business holding thousands of properties being used by and under the operational control of third parties (the clients) would be well beyond any acceptable risk levels for any professional investors wishing to establish a DM or Ijara mortgage business at scale.

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Conclusion

When I speak to fellow Canadian Muslims searching for halal home financing, almost without exception, while they express extreme concern regarding Shariah-compliance and Islamic permissibility of the halal home financing product, very few even think of the fact that an entire set of regulations and laws of the land in which they live, i.e., Canada have to be followed. The lack of financial acumen of the majority of such individuals makes it all the more difficult to discuss / explain the pertinent details related to Shariah-compliant products and the interaction, compatibilities and incompatibilities of Shariah laws with Canadian laws.

It is easy to create an Shariah-Compliant product. It is also easy to create a conventional Canada-compliant product. The real challenge for the past three decades has been to create a product that works for BOTH of these regulatory and legal systems. 

Alhamdulillah, EQRAZ has, with Allah’s unending blessings, and the support of some of the top Canadian and Islamic Finance industry professionals from the Middle East and Sub-Continent, completed it’s product and business infrastructure required to spread halal home financing across Canada at the scale Canadian Muslims require and deserve!

“Our Lord, let not our hearts deviate after you have guided us and grant us from Yourself mercy. Indeed, You are the Bestower.” 

                                                              Al-Quran [3:8]

[1] Under Section 18 of the Mortgages Act (Ontario) and largely similar statutes in most other provinces, a borrower cannot be locked into a mortgage arrangement with a particular lender for more than five years. After five years, any borrower may offer to pay out (redeem) the mortgage (even if the mortgage contract was for longer than a five-year term), provided that in such case the borrower delivers a three months’ notice of his/her intention to redeem, or pays three months further interest in lieu of such notice. Any Shariah-compliant financing product in Canada would be subject to the above rule.

[2] In reality, this simplified numerical example probably understates the severity of the complication, since a household with such a high level of income would likely purchase a more expensive home and thus require a mortgage greater than CAD 450,000 to fund the home purchase.

[3] As defined under Canadian law.

[4] While the MIC could theoretically demand a redemption period that is longer, under the Canadian financial markets environment and norms, the vast majority of potential investors would not be interested in such an investment opportunity, resulting in the same severe funding constraints faced by existing Shariah-compliant Murabaha financing products that have been offered in Canada for the past several years

[5] An example of the economy underperforming

[6] Another example of the economy underperforming

[7] Sales tax varies by province in Canada

[8] Since the financier is a co-title-holder with the homeowner

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