For quite some years now, scholars and regulators have been telling practitioners about Musharaka Mutanaqisa (Diminishing Equity Partnership) and its answer to the many questions regarding other term financing structures available in the market. It is deemed as the solution for various issues such as:
- Ownership issues under BBA or Murabaha. Many times especially those regarding financing of properties under construction, the question of constructive ownership and physical ownership is being questioned for the sale validity. Issues where developers have not released the rights to a property during construction, and whether customers have the right to enter into a sale contract where there is no clear ownership of the asset is determined, are common arguments in the term-financing space. Or when the customer puts in a significant downpayment, questions are asked of who has the controlling rights on the property. With Musharaka Mutanaqisa, this was expected to be resolved.
- Issues surrounding interconditionality is also seen to be resolved with Musharaka Mutanaqisa. This is because the downpayment paid by customer is now deemed as equity purchase (instead of purchase for ownership). No longer will there be an issue of BBA being similar to Bai Inah, where the transactions will be a 2 party transaction i.e. Customer owning 10% of the property is selling this ownership to the Bank and re-purchasing it from the Bank = Bai Inah transaction.
Below is an outlook of how a Musharaka Mutanaqisa works as a concept.
But not all things are beautiful with this contract. A lot of groundwork were still missing when it was first introduced in Malaysia, ranging from:
- Issues of Housing developers understanding of the ownership structure, especially the partnership arrangement. For example S&P is usually done in the customer’s name and developer, no room for the Bank to come in as equity partner.
- Issues from the Land Offices. Land Offices in Malaysia carries different standards from state to state. Registrating a partnership that consist of a corporate entity (Bank) was the subject of many discussions and confusion.
- Issues from the legal practice. As when developing new structures without clear precedent, legal firms have many differing interpretations amongst the legal industry, not to mention clashes of understanding between the legal firms and the Bank’s Sharia Committee. Every Bank and legal firm scrambled to identify potential risks and comes up with clauses to mitigate these risks.
- Shariah requirements vs Operational requirements. I remember the excitement we felt by the SAC tapered down to the operations team, where they realised the amount of new documents that they have to go through. Then the panic button started when no one was really sure of what needs to be done whenever a new scenario was encountered.
While the groundwork was being developed (even now!!!), more and more issues were identified which needed a resolution one way or another. We really need to sit and look at how ideally a Musharaka structure needs to operate. For example:
As the contract is essentially a partnership where financier’s equity is redeemed by the customer, any capital appreciation will is rightfully owned by both parties according to the equity participation. In events of disposal or default of the financing and the property is disposed at market value, is the Bank entitled to the capital appreciation? Likewise, in events of capital losses, would the Bank bear the losses based on the equity participation? Terms and conditions can be built into the agreements but this is still the point of contention.
In determining the rental payable based on market value, the rental will rely on the both appreciation and depreciation of the property value. A periodic valuation is ideally done, but Bank may not want to practice this especially in times of depreciation where rental should be rightfully be revised downwards.
- As a Musharaka arrangement turns sour and goes into default, is it right to bankrupt your own partner while essentially a Musharaka arrangement also means sharing of losses based on equity. On-going arguments whether it is morally correct to end the partnership as a partnership can also turn around as long as the value of the property is stable. Is it logical that in times where profits are good, it is shared amongst the partners, but in bad times, only one party to bear all the losses?
- Nuances with regards to partnership, for example insurance coverage, costs related to the house (shouldn’t we share the costs based on equity holding?), rights to the house. If a customer goes into default, can they sell their equity back to the Bank to settle the default? Technically, an event of default can be minimised by this method.
- [And the list really goes on and on….]
Each of the above warrants an interesting theoretical discourse on its own and after the dust have settled, everyone agreed that Musharaka Mutanaqisa was in fact able to behave very similarly to a conventional method of financing a property, except for the areas where Sharia’ deemed necessary to intervene.
The end result was very much like a conventional mortgage facility, something the consumer themselves are familiar with, while the Banks adheres to the minimum tenets of Musharaka Mutanaqisa. The example provided below illustrates that the methodology of calculation is similar to a conventional loan, where there is no longer a Selling Price to cap the financing obligations of the customer, under the Ijara (rental) contract (see sample illustration below).
As a summary, a lot of hopes have been placed on Musharaka Mutanaqisa to be the next big thing in Islamic Banking. It has a lot of potential and can be further expanded to take even more calculated risks. With strong push from the regulators, this product can flourish even on the international market. But it has been quite a let down in our haste to introduce the product, a lot of infrastructure and support from various parties have been lacking; resulting in many issues remaining unresolved. In the end, what we see now is an alternative working structure to the conventional housing loan product as we incorporated a lot of their features into the Musharaka Mutanaqisa product.
Maybe one day someone will come and take the reins and realise the potential under Musharaka Mutanaqisa to be developed into a product that is differently innovative.