Sharia-compliant mortgages are common in Islamic finance core countries and increasingly common in other countries. There is also potential scope for Sharia-compliant securitizations, backed by these arrangements.

Here, S&P Global Ratings presents responses to frequently asked questions from market participants. In the appendix, we set out the main features of Sharia-compliant mortgages in the U.K. and Saudi Arabia.

This article exclusively covers high-level risks that are common among Sharia-compliant mortgages and Sharia-compliant residential mortgage-backed securities (RMBS) structures. Other risks may exist and may differ by jurisdiction.

Frequently Asked Questions

What are Islamic or Sharia-compliant mortgages and how do they differ from conventional mortgages?

To answer this, we must take a step back to explain how conventional mortgages--in this case, mortgages that are not Sharia-compliant--work. A conventional mortgage provider typically charges interest. A property purchase through a conventional mortgage usually means that the borrower--who uses their own funds and the mortgage from the mortgage provider to buy the property--owns the property in its entirety and that the lender has a security interest over the property that they will enforce if default amounts are owed.

The principles of Islamic finance and Sharia law prohibit "riba"--the practice of earning interest and making money solely from money. Therefore, Sharia-compliant mortgages are not technically mortgages in the conventional sense. In certain structures, they are better classified as joint participation in a property between two parties with ongoing lease payments, which is also referred to as rent. This arrangement replaces the concept of mortgage interest.

In practice, one of these parties will resemble the borrower in a conventional mortgage and the other will resemble the lender. To reflect the distinction between providing finance and joint participation, some countries legally differentiate between a conventional mortgage and joint participation. For example, joint participation arrangements in the U.K. would typically be categorized as home purchase plans rather than mortgages.

Throughout this article, we use the term "intended ultimate owner" (IUO) to describe the party that would generally be the borrower in a conventional mortgage. We use the term "bank" to describe the entity that would typically lend money to the borrower to purchase the dwelling in a conventional mortgage, although we acknowledge that non-banks can offer Sharia-compliant mortgages too. Likewise, we use the term "Sharia-compliant mortgage," even though we acknowledge that the arrangement differs from a conventional mortgage in several ways.

Who determines whether a product is Sharia-compliant?

This is typically done by a bank's Sharia supervisory board, which usually comprises suitably qualified Islamic scholars. The board opines on the compliance of products on a case-by-case basis. Thus, different Sharia supervisory boards can have different opinions on a product's compliance with the Sharia.

How many types of Sharia-compliant mortgage are there and how do they differ?

We observe three types:

• Musharaka (partnership): At the outset of the transaction, both parties contribute to the purchase price, and ownership is shared in proportion to their respective contributions on day one. The IUO agrees to pay regular, usually monthly, payments to the bank. These regular payments have two components that are very similar to conventional repayment mortgages: One part of the payment contributes to the repayment of the bank's initial capital outlay that helped purchase the house. The other part is the bank's profit. As the IUO makes regular payments, they acquire an increasing share of the property over time, until they eventually buy out the bank's share and gain full ownership of the property. This form of arrangement, where ownership interest changes over time, is referred to as a "diminishing musharaka."
• Murabaha: Under this arrangement, the bank purchases the property on behalf of the IUO and "sells" it to them immediately, generally with an appropriate security structure, for a higher price. The payment made by the IUO over the course of the financing arrangement will repay the initial purchase price of the property, plus the bank's profit. The murabaha structure is similar to fixed-rate financing arrangements.
• Ijara: This is best categorized as a form of leasing arrangement, where the IUO pays an agreed amount (the rent) to the bank to use an asset for an agreed period. An ijara contract can be structured in such a way that ownership of the asset moves to the individual from the finance provider at the end of the pre-agreed term. Since the rent changes over time, the ijara contract is similar to a conventional mortgage with variable interest rates. One key difference is that the bank in an ijara contract is typically the legal owner of the asset financed. The IUO's monthly payment is intended to mean that the mortgage capital is paid off at the end of the term.

If interest is not charged, does rate risk exist in Sharia-compliant mortgages?

To some degree, this depends on which of the three types of Sharia-compliant mortgages--musharaka, murabaha, and ijara--is being considered. Murabaha can be used to create a fixed payment plan that is predetermined at the outset and therefore is similar to a conventional fixed-rate mortgage. Ijara and musharaka payments are typically not fixed, and the overall rate payable is often based on a margin above a "rent rate." The rent rate can be reset at a frequency that is defined in the underlying contract.

Given that Sharia-compliant mortgages are not loans, how do you assess the loan-to-value (LTV) ratio to estimate default probability in your analysis?

For all three Sharia-compliant products, we can generally proxy the numerator of the original LTV ratio as the purchase price of the property minus the amount contributed by the IUO at the purchase date. This is equal to the amount the bank contributed at the outset. To calculate the current unindexed LTV (based on the initial value of the property at inception), we factor in subsequent payments made by the IUO. This means the equivalent of the current LTV is the current ownership interest of the IUO, multiplied by the initial purchase price and divided by the original purchase price. To be able to follow this approach, for all three products, we would require visibility of how regular payments are split between capital and profit/rent payments.

Since Sharia-compliant mortgages are not loans, how do you assess LTV to estimate loss severity in your analysis?

The calculation of loss severity follows the same logic as that for default probability. We ascertain what the IUO's ownership interest in the property is, relative to the current value of the property. For example, if the property is worth 100 and the borrowers' ownership interest is 40%, the bank's share is 60 and the LTV is (60/100), that is 60%. To be able to follow this approach, for all three products, we would require information on how regular payments are split between capital and profit/rent payments.

In musharaka, if the property is owned jointly with dynamic ownership interest, are recovery proceeds allocated according to this share in the event of default in your analysis?

This would depend on what has been agreed in the underlying mortgage contract between the IUO and the bank. In contracts in the U.K., we have observed the following: If the IUO defaults, the IUO's beneficial interest in the property converts automatically upon sale of the property at an amount equal to the amount of the sale proceeds of the property that remains after settling amounts payable to the bank. Accordingly, this beneficial interest is equal to the amount that is left after paying any amount that is due to the finance provider.

We note that, for all three products described above, it would depend on the details of the mortgage contract and the jurisdiction to determine if rent/profit amounts were included in the amounts owed to the bank in the event of repossession.

Depending on jurisdiction and contract specifics, the bank may therefore be able to achieve an economic outcome in the event of default that is similar to that of a conventional mortgage, where the loan is secured by a charge on the property. In practical terms, joint ownership is equivalent to a first-lien loan. However, we note that market practice may differ across jurisdictions and lenders, meaning every RMBS transaction would need to be analyzed by considering the underlying mortgage contracts.

Does the IUO have to contribute to the initial purchase of the property?

Although theoretically nothing explicitly prevents the bank from funding 100% of the initial purchase price, the borrower typically contributes part of it. The relative amount is similar to that seen in conventional mortgages. In some countries, this amount is set by the banking regulation to control the risks taken by the banks.

In the event of repossession, if the property value increases, can the bank receive an amount that exceeds its share of the property?

This would be governed by the mortgage contract. Where this has been contracted between the bank and the IUO, proceeds would clear any balance due to the bank first. We note that, for ijara, the amount would generally not cover accrued but unpaid rental amounts. Any additional surplus would typically be distributed to the IUO.

If the lender is also the full or partial owner of the property, are they responsible for property maintenance and repair?

This would depend on the nature of the product and the mortgage contract between the bank and the IUO. We understand that, for murabaha, it is common for the IUO to be contractually responsible for all maintenance and repair. For musharaka and ijara, by convention in certain countries, it is common for the maintenance costs to be borne pro-rata and by the bank, respectively.

Do operational risks differ from conventional mortgages?

The main operational consideration for securitizations backed by mortgages is usually the role of the entity responsible for cash collection, allocation, and dealing with borrowers in arrears, often referred to as the servicer. When we consider servicing risk, in our RMBS analysis we generally consider three separate risks:

• Is the servicer competent with the skills to undertake the role?
• Is the risk of fraud or misappropriation mitigated?
• Can the role of the servicer be transferred to another entity if necessary, without material disruption to the rated securitization?

For RMBS transactions backed by Sharia-compliant mortgages, our assessment of a servicer's competency and potential fraud risk does not differ from the assessment we use for conventional mortgage pools, although local market protocols might differ slightly. The ability to transfer servicing, however, is likely to be specific to the country, due to the difference in the depth of the replacement servicer market and product characteristics: If the product is inherently non-standard or complex transfer may be difficult and time-consuming.

The market depth of mortgage servicers who are specifically set up to service Sharia-compliant home financing will depend on the country. As highlighted above, Sharia-compliant home financing is structured differently from conventional mortgage lending, but the overall behavior of the product mirrors that of a conventional mortgage. We would therefore expect, subject to details of the underlying mortgage contract, that conventional mortgage servicers should be able to fulfill the role if required.

Are Sharia-compliant mortgages available for buy-to-let properties?

Yes, Sharia-compliant financing is available for investment purposes. In the case of musharaka, it is possible to use a non-diminishing musharaka to achieve an arrangement that mimics an interest-only loan.

If interest is not charged, how are the changes in underlying interest rate dynamics reflected?

Since musharaka is a partnership based on shared profit, the bank passes on cost changes to the IUO. This is similar to a finance provider who adapts the interest rate on a conventional mortgage when interest rates change. Ijara products would also see the rent rate fluctuate as the costs of the bank fluctuate. For example, in a Sharia-compliant mortgage, the bank would pass on any savings that result from a cost decrease to the IUO.

Are there any other credit highlights associated with Sharia-compliant mortgages?

In certain jurisdictions, the costs of Sharia-compliant mortgages may be higher than those of conventional mortgages. Due to competitive dynamics, Sharia-compliant mortgages in some countries are complex, while the entities that provide Sharia-compliant mortgages may be smaller than those that provide conventional mortgages. This increases the cost of funding. Mortgage loans are underwritten relative to the relevant regulation in a jurisdiction and the rigor of affordability testing differs.

Are risks of negative carry the same for a conventional RMBS transaction and one complying with Sharia principals?

It is possible that a Sharia-compliant RMBS structure may have more risk of negative carry. We highlight two potential risks in this regard. Firstly, Sharia-compliant savings work broadly in the same way as mortgages. Since earning interest is forbidden, savers typically place their funds in profit sharing investment accounts (PSIAs) and earn money in the form of an expected profit rate (EPR). The EPR is expressed as a percentage and similar to an interest rate. Depending on the underlying Sharia contract of the PSIAs, savers may be exposed to the risk of negative returns.

Secondly, depending on the country the securitization is being executed in and depending on the rating sought, a bank with a sufficiently high issuer counterparty rating and Sharia-compliant cash accounts might not exist. This means that cash held on deposit by the issuer might not earn any return. In such a scenario, negative carry would be more pronounced than be in an RMBS transaction backed by conventional mortgages.

Can fixed-payment, Sharia-compliant mortgages be hedged?

Sharia-compliant derivatives are a complex topic. As with all products that are intended to be Sharia-compliant, the bank's Sharia supervisory board would need to opine on them on a case-by-case basis. This means each contract that is designed to hedge the fixed payment of the underlying Sharia-compliant mortgage and the potential variable rate payable by the issuer must be assessed individually. Even though profit rate swaps are available, we have not yet seen them utilized in a securitization.

Does the fact that Sharia-compliant mortgages are not mortgages in the conventional sense create complexity at the RMBS issuer level?

When conventional mortgages are being securitized, beneficial interest of the underlying loans and the security over the underlying properties is generally transferred to the issuer. For Sharia-compliant mortgages, what is being sold and by what mechanism may differ by product type (murabaha, musharaka, ijara) and jurisdiction, meaning that any legal considerations would have to be assessed on a case-by-case basis. For example, a musharaka mortgage--given it is not a loan but rather a direct participation in property ownership--will require a different transfer mechanism and have different risks than a conventional mortgage in the U.K.

Do Sharia-compliant RMBS structures differ notably from standard RMBS structures?

Examples of public Sharia-compliant RMBS transactions are limited. Since the concept of profit sharing applies to the liability side for Sharia-compliant RMBS transactions, the concept of tranching--which is common in most structured finance, including RMBS--might not be Sharia-compliant. This potential non-compliance centers on the fact that junior tranches in structured finance carry a higher risk than senior tranches, meaning the profits shared could be disproportionate to the risks they relate to.

Appendix

Table 1

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