Future is Islamic Finance

Turns out Atif Mian and Amir Sufi are closet Islamic bankers.

“Both student debt and mortgages illustrate a broader principle. If we’re going to fix the financial system—if we are to avoid the painful boom-and-bust episodes that are becoming all too frequent—we must address the key problem: the inflexibility of debt contracts. When someone finances the purchase of a home or a college education, the contract they sign must allow for some sharing of the downside risk. The contract must be made contingent on economic outcomes so that the financial system helps us. It must resemble equity more than debt.8
This principle can be seen easily in the context of education. Student loans should be made contingent on measures of the job market at the time the student graduates. For example, in both Australia and the United Kingdom, students pay only a fixed percentage of their income to pay down student loans. If the student cannot find a job, she pays nothing on her student loan.

For reasons we will discuss, we believe a better system would make the loan payment contingent on a broader measure of the labor market rather than the individual’s income. But the principle is clear: recent graduates should be protected“if they face a dismal job market upon completing their degrees.9 In return, they should compensate the lender more if they do well.

The disadvantage of debt in the context of student loans is not a radical leftist idea. Even Milton Friedman recognized problems with student debt. As he put it, “A further complication is introduced by the inappropriateness of fixed money loans to finance investment in training. Such investment necessarily involves much risk. The average expected return may be high, but there is wide variation about the average. Death and physical incapacity is one obvious source of variation but probably much less important than differences in ability, energy, and good fortune.”10 Friedman’s proposal was similar to ours: he believed that student-loan financing should be more “equity-like,” where payments were automatically reduced if the student graduates into a weak job environment.

Making financial contracts in general more equity-like means better risk sharing for the entire economy. When house prices rise, both the lender and borrower would benefit. Likewise, when house prices crash, both would share the burden. This is not about forcing lenders to unfairly bear only downside risk. This is about promoting contracts in which the financial system gets both the benefit of the upside and bears some cost on the downside.

Financial contracts that share more of the risk would help avoid bubbles and make their crashes less severe. Recall from chapter 8 how debt facilitates bubbles by convincing lenders that their money is safe, and how this leads them to lend to optimists who bid prices higher and higher. If lenders were forced to take losses when the bubble pops, they would be less likely to lend into the bubble in the first place. They would be less likely to be lulled into the false sense of security that debt dangerously offers. Charles Kindleberger saw time and time again that bubbles were driven by investors’ believing that the securities they held were as safe as money. We must break this cycle.”

“We have also shown that when borrowers are forced to bear the entire brunt of the crash in asset prices, the levered-losses cycle kicks in and a very severe recession ensues. If financial contracts more equally imposed losses on both borrowers and lenders, then the economy would avoid the levered-losses trap in the first place. This would force wealthy lenders with deep pockets to bear more of the pain if a crash materializes. But their spending would be less affected, and the initial demand shock to the economy would be much smaller. In the context of housing, a more equal sharing of losses would also help avoid the painful cycle of foreclosures. If financial contracts were structured appropriately, we could avoid foreclosure crises entirely.”

“In chapter 10, we advocated policies that would help restructure household debt when a crash materializes. But intervening after the fact requires political will and popular support, both of which are absent during a severe recession. The contingent contracts we propose here would automatically accomplish many of these goals. And they would preserve incentives because all parties would understand what they were signing up for. In the next section, we propose a specific mortgage contract that includes these features, which we call the shared-responsibility mortgage. As we will demonstrate, had such mortgages been in place when house prices collapsed, the Great Recession in the United States would not have been “Great” at all. It would have been a garden-variety downturn with many fewer jobs lost.”

Excerpt From: Sufi, Amir. “House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again.”

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