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Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance

Sources of Funds Used in RF Financing

One of the biggest challenges to our effort to popularize RF financing in the United States has been the availability of capital. When we started LARIBA in 1987, it was very difficult to raise the necessary capital. We were faced with many challenges. The first and most important challenge was the novelty of the effort. Many members of the community had talked about having a bank or a financial institution that serves our community, which is one of the most underserved by the banks and financial institutions because of the prohibition of riba. However, when many of these community members were contacted to invest, they politely declined, with many excuses. We understood their position and prayed more.

The other approach we thought of trying was to start a public drive to raise capital. That option was very expensive because it required the use of very expensive attorneys and U.S. Securities and Exchange Commission (SEC) registration, which required exorbitant expenses that can reach more than $1 million in legal, application, consulting, auditing, operating, and other fees. It was quickly concluded that we could not afford this approach. In addition, we did not have a proven track record of a working model with tangible results to include in our application for SEC registration to raise funds to capitalize this RF effort. It was simply a venture capital project that needed high-risk capital — and it is known that high-risk capital comes at a very high price.

We also thought of starting or acquiring a bank. This would have been a wonderful solution, because all depository institutions are allowed to take deposits that can be used to finance different projects. However, that was a formidable task because we did not have the capital or the qualified staff that could be certified and accepted by the regulators.

On another front, we went through the process of applying to start a credit union and we were very close to receiving a charter. However, after reading the details of how a credit union works, we found that every depositor is considered a shareholder. We found that regardless of the size of the deposit, each individual represents a vote. We became very concerned due to prior experiences in the field of political manipulations of elections and voting in many nonprofit organizations. We discussed the matter and decided to back off.

We finally decided to start a small finance company, organized as a small — Subchapter S (the S stands for Small) — corporation. This option had its advantages and disadvantages. The main advantage was the flexibility of raising the capital needed and the avoidance of double taxation. The avoidance of double taxation means that the company's profits are not taxed at the company's level as in the case of regular corporations, which are taxed at a high rate that can reach 42 percent for state and federal taxes. In a Subchapter S corporation the profit is not taxed at the company's level and is distributed to the shareholders, and the shareholders subsequently pay taxes according to their own income tax situation. The disadvantages were many, but we had to start from what was possible in order to eventually achieve what is impossible. The first disadvantage was that the number of shareholders was limited to a small number (it was 35 members when we started in 1987; as of 2013, it was set to 100 shareholders). In addition, a Subchapter S company cannot solicit funds from the public because that would not comply with the conditions of the Subchapter S articles.

We started American Finance House (FARIBA) in 1987 with a small capital of $200,000, which we had gathered from close, lifelong friends in the United States. We had humble means, but our dreams and aspirations were much greater. We started a website ( that became very popular throughout the world. We financed cars, homes, and small businesses. It is true that we only did one or two financing deals per month, but those deals helped us to start a balance sheet, an income-expense statement, a financial ledger, and a successful track record for the company. The biggest challenge was the huge demand for RF financing applications we at LARIBA received from the community. We were heartbroken to say to prospective customers, “We are sorry, but we do not have enough capital.” We asked our friends whom we knew could afford to participate in our efforts to increase our capital, but they refused. They indicated that they would be more comfortable if their funds were federally insured by the FDIC, something that was impossible at the time. We used to finance homes with a 40 percent down payment and a term of seven years. This financing term could be afforded by only a few, who were mostly the believing affluent puritans. Flowever, we reasoned that one has to start at any level possible.

It may prove useful to share with the reader the size of the problem of raising the necessary capital by focusing on one aspect of the business of mortgage financing. If we wanted to finance only 50 homes a month at $200,000 each, that would require that we come up with $10 million a month or $120 million per year. Knowing the community, we did not have this kind of money available. Some recommended that we contact the oil-rich countries. We tried, but the competition had gone ahead of us, promising investors in these countries the wonderful American dream and returns of 20 to 50 percent rather than the more realistic numbers we, as responsible bankers and businesspeople, projected with no guarantees. Of course, many of the rich Gulf countries' owners of capital put tens of millions of dollars into the companies that promised high returns but not into us at LARIBA. We decided to remain patient and never to compromise our standards and values.

Around the turn of the century, in 1999, demand for our services was so large that we could not meet it because of the lack of capital. One of our executives suggested that we close the company down because we could not meet the demand. My reaction was simple. I told him, with tears in my eyes, that all God asks from us is to do the best we can with what we have. In a few months, we received an e-mail from Ahmad Elshal, who used to work with Freddie Mac. He told us that he had visited our website and that he liked it. He called me to inquire about the details of what we do at LARIBA. He asked one of the Freddie Mac executives at that time, Saber Salam, to contact us. The rest is history. As stated earlier, LARIBA received early approval from Freddie Mac, and we were elated. New problems erupted but they were much sweeter. Now, our problem was not capital but how to organize ourselves to serve the growing demand.

Freddie Mac and Fannie Mae were originally organized as government- sponsored public companies (GSEs) by the U.S. government to provide necessary liquidity to the housing market in the United States. To accomplish this goal, Fannie Mae and Freddie Mac provide the liquidity to the institutions that finance homes (called mortgage companies) and banks, by authorizing the companies to act on their behalf to finance homes according to universally set but strict guidelines, and proceed to exchange the note for cash. The GSEs assemble the notes in the form of asset-based fixed-income securities (bondlike) called mortgage-backed securities (MBSs). The GSEs offer these securities for investment to institutions looking for high-quality asset-based bond-like investments that yield a higher interest rate. This way, the GSE generates cash to turn around and reinvest that cash in mortgages. Buyers of these MBSs were U.S. institutions, banks, and retail savers, as well as international banks and investment banks.

In April 2001, LARIBA was the first ever RF finance operation in the West to be approved for investing Freddie Mac's money using the LARIBA Shari'aa-based RF home finance model. In 2002, LARIBA became the only U.S.-based Shari'aa-based RF finance company to be approved by the largest mortgage investor in the world, Fannie Mae. Later, LARIBA became the only RF finance company that issued — with Fannie Mae — RF MBSs. In 2003, the Bank of Whittier was approved by both Freddie Mac and Fannie Mae.

It is also important to state for the record that LARIBA — and, for that matter, any RF finance company or bank — is not allowed by the Judeo- Christian-Islamic Shari'aa law to borrow money with interest (riba) from Freddie Mac, Fannie Mae, and/or other investors. Freddie Mac and Fannie Mae are looked upon as investors in the RF LARIBA Shari'aa-based mortgages. In fact, we evaluate the financing of each home as an investment, and we offer it to Freddie or Fannie online as investors in the LARIBA-financed homes. If approved, they indicate to us the expected return they need to realize as investors. This is the rate we use to measure the economic prudence of the investment (using the rate of return on investment based on the actual market rent, as explained earlier). If approved, LARIBA forwards the money from its own funds to purchase the house and is paid back within a week or less by Freddie Mac or Fannie Mae. Freddie Mac and Fannie Mae were the real major source of capital for all “Islamic” finance companies and banks in the United States. We were fortunate at LARIBA to have acquired a national bank — the Bank of Whittier, NA — which accumulated the deposits needed for financing.

Another important aspect of dealing with Freddie and Fannie has been the documentation used in the RF financing process. Such documents must follow the same standards called for by the industry and regulations. Our LARIBA Shari'aa-based RF finance model paid us a wonderful dividend, because we did not have to receive a special exception from the GSEs or regulators to be approved. The risk of receiving an approval with an exception is that this exception can be taken away when times are not suitable, as it started to emerge in 2012 and 2013 with the GSEs trying to cut down on the mortgage companies they deal with and scrutinize RF banks and Islamic mortgage companies in particular. While others went through expensive legal maneuvers to make the documents look “Islamic,” then turned around and diluted the Islamic content to bring it back to the standard codes, we at LARIBA started on the right and straightforward track. It is important to note here that the LARIBA Agreement described earlier is a required part of the documentation called for by the GSEs. Many of the RF “Islamic” MBSs produced by RF finance companies, which are based on Shari'aa-compliant models, were designed for sale to the “Islamic” banks in the Gulf and Malaysia. In contrast, the LARIBA RF MBSs were designed to be offered for investors and all entities in all markets, and are of the highest quality. These RF MBSs are “produced” by us at LARIBA with Fannie Mae. That is why they, to us at LARIBA, are not a mere “black box,” like other MBSs, because we simply know the mortgage components of each of the LARIBA RF MBSs.

Other sources of capital are the share capital of the company and investments from accredited and qualified high net worth and sophisticated investors. It is important to note here that, by the grace and blessings of God, not a single investor or shareholder has lost a penny since we started our operations at LARIBA in 1987. In addition, we consistently distributed dividends and profits that were at least 1 to 2 percent higher than what any riba-based institution would offer on CDs.

Advantages of the LARIBA RF Shari'aa-Based Finance Model and Procedures

1. It applies the fundamentals of the RF law (Shari'aa) of the Judeo-Christian- Islamic system.

2. It does not use ruses (heyal) nor financial engineering and structuring techniques that are usually used in the Shari'aa-compliant models.

3. The LARIBA Agreement clearly spells out the bases from Shari'aa upon which the relationship, the process of financing, and the process of calculating the monthly payments are built.

4. It is universal and designed to benefit all people of all faiths.

5. It is not based on renting money at a price called interest rate. It is based on the Marking-to-Market Discipline, which requires the use of the actual market-measured rent of the items to be acquired as measured — live — in the marketplace by the customer and the RF finance company/bank finance officer in charge. It helps the customer make the decision to buy a property — or not to buy it, and instead rent until it becomes more economically sound to buy it.

6. It normalizes the monetary problem of paper (fiat) money by using the Commodity Indexation Discipline, by marking the property to the market, as called for by the Marking-to-Market Discipline. Using this approach helps us to identify economic and price bubbles before they fester and become speculative bubbles. In this way, we at LARIBA help the customer avoid participating in such a bubble. It is important to note that we at LARIBA detected the real estate bubble in many states in the United States as early as 2005 and 2006. This raised a red flag that stressed to our underwriters the necessity of exercising strict diligent and being cautious when evaluating the merits of the “investment” based on the Marking-to-Market Discipline and the Commodity Indexation Discipline.

7. It benefits the customer and the financing entity, because its method is based on investing in a property or a business and not on renting money when using an interest rate. It reveals the economic value of the purchased property, which ensures prudence in investing and protects against participation in an economic bubble.

8. It relies on arbitration using experts who are well versed in the Judeo- Christian-Islamic Shari'aa law that are chosen by each side.

9. It uses the standard financing documents and notes. This makes it fulfill the U.S. banking regulations, meet the requirements of bank examiners, and make it seamless in case other government requirements are implemented. This also helps the consumer and the RF financing entity settle any dispute before U.S. courts without confusion or misinterpretation that may cost a lot of time, money, and frustration. Using the standard finance document and notes allows the customer to declare its finances in an understandable and U.S. government-compliant way that benefits the customer in preparing and reporting their taxes and in reporting and complying with government agencies like the Labor Department's regulations pertaining to pensions and/or retirement plans.

10. It records the title of the property in the name of the customer direcdy. The model does not call for the title to be recorded in both the customer and the company's name, as is required in some Shari'aa-compliant schemes. Doing it this way may expose the customer to the unknown liabilities and unknown corporate future of the riba-based financing entity or riba-based bank, and it limits the freedom of choice of the customer.

11. It services the financing facility (servicing means among other things billing, collection of monthly payments, escrowing of insurance and tax payments, and resolving any problems) and it does not sell servicing to an outside servicing company. The LARIBA RF Shari'aa-based model requires that the RF finance entity or RF bank keep the servicing in house, with the work done by local community members. This practice helps the customers if a problem occurs, especially in cases when the customer loses his/her job or is temporarily disabled. The concept of mercifulness (tarahum) is applied. The customer who has developed loss of income, health and/or other family problems is turned over by the experienced and merciful attitude of the servicing department to a specially formed nonprofit assistance organization (the Miskeen Fund — meaning the Needy Fund — which is known as the Μ-Fund) to help meet the temporary needs of the family until the problem is resolved and saves them the devastation of losing their home and the pain and damage of being foreclosed on.

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