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.
MUSHARAKA MUTANAQISA AS A CONCEPT
Conceptually, Musharaka Mutanaqisa is geared to introduce the Islamic Banking market into the concept of “equity financing”. For many years, the market has been criticised of developing “debt-based financing products”, but have largely ignore “equity-based products” such as Musharaka Financing and Mudharaba Financing. Musharaka Mutanaqisa is hopefully the right step in that direction.
Below is an outlook of how a Musharaka Mutanaqisa works as a concept.
An alternative diagram on Diminishing Partnership (Musyarakah Mutanaqisah) is as follows:
LOTS OF GROUND TO COVER
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).
IS IT REALLY A MUSHARAKA STRUCTURE, THEN?
In my view, the structure of the product under Musharaka Mutanaqisa is not a equity-based structure; it is essentially still a debt-based structure. I say this based on the following:
- Musharakah Mutanaqisah, in the Malaysian context, is not an equity partnership arrangement, although some Banks would like to think so. A Musharaka structure where the equity is concerned, carries valuation risks where the equity is not principally guaranteed. In a Musharaka, if there is a valuation loss, the Bank and the customers share the losses. In Musharakah Mutanaqisah, this does not happen.
- Why does the above do not happen? It is because the main contract of Musharaka Mutanaqisah is not Musharaka, but Ijarah (Leasing) instead. This is the main operating contract, where the customer pays installment which consist of 2 elements i.e the rental for the right to use the usufruct (benefit) of the property, and purchase of “equity” from the Bank over a period of time (akin to principal payment in a Murabaha).
- Musharaka Mutanaqisah comes into the picture not as a transactional contract, but as an “arrangement” contract (for lack of better word). The “partnership” is to bind the main contract (Ijarah), with the various sub-contract necessary to make the whole arrangement viable. To support the Ijarah contract with the intention of transferring equity to the customer over a period of time, the necessary sub-contracts may include the following (the sub-contracts used varies from Bank to Bank, structure to structure):
- Ijarah Mausufah Fi Dhimmah (Forward Lease) or Istisna’a (Construction Sale) to support properties under construction or multiple disbursements
- Musharakah (Partnership) with undertaking to purchase equity over of period of time
- Wa’d (Promise) for the acceleration of equity purchase in the event of default, usually via Letter of Undertaking.
- Service Wakalah (Agency) where the client undertakes to maintain and keep in good working order the asset under lease to protect its usufruct.
- The use of “Letter of Undertaking” removes the valuation risks from the Bank and therefore converts the arrangement into a debt-financing arrangement. As such, the capital charge (and classification under the risk-weighted assets) revert to the familiar home debt financing weightage of 50%-100%, instead of the capital charge of 200% to 400% for a “pure-risk” Musharaka structure.
Letter of Undertaking : Going back to square One and do not pass Go
After all the years looking at the various structures in the market, I do notice some excellent development of Islamic contracts but when it comes to operationalising it, market forces tend to have a strong influence on the final product. Introducing a Musharaka-based structure in a banking environment is always going to be tricky. Most importantly, the element of credit risk, and market risk, do not allow a bank to take excessive risks. The way a bank is set-up is never one that allows for unmitigated risks. In a Musharaka, the notion of the structure imposing all parties jointly share risks is something shareholders of the bank, and the bank itself, was not set up to do in the first place. It is simply the wrong fit of product to be offered by a Bank.
Thus the use of Letter of Undertaking. Now what is “Letter of Undertaking”? Why is it important or even relevant?
In order to protect the Bank’s interest against adverse market condition or performance, the Letter of Undertaking is deployed. What is in a Letter of Undertaking? It general contains language where it gets the customer to agree that in the event that the customer default or breach the terms of the Musharaka, the Bank has the right to “accelerate” the payment of the remaining amounts due (principal outstanding, due profits and other incurred charges) immediately, effectively terminating the partnership. It means, the Bank wants to exit the partnership and all parties must settle the outstanding amounts immediately.
Shariah-wise, it borders on marginal non-acceptance but since all terms have been agreed upfront by all parties at the start of the financing, it remains acceptable.
But this document, effectively removes of all adverse risks faced by the Bank. While the Letter of Undertaking is irrelevant in good times where returns are premium, in bad times, the Bank have the way-out of transferring the “interest rate risks, valuation risks, and credit risks” to the customer. Loss-sharing? With the Letter of Undertaking, we have gone back to square number one where it reverts to “debt-financing”. As the risks are removed from the bank and transferred to the customer, the only outstanding consideration is the debt that remains to be payable, at no further “market, valuation and ownership risks” to the Bank.
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.
The end result, in its current form, is hardly an “equity-based” product, but instead a “debt-based financing” product, where the risks associated with a Musharaka is greatly mitigated, where the loss of equity has been prevented with the use of legal documents and deliberate structuring to reflect what you see in a conventional housing loan 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.