Islamic Mortgages: Lessons for the West? Uzair Azmat and Kenneth Kasa

Abstract

This paper compares default rates on Islamic and Western mortgages. Islamic mortgages feature a ‘partnership’ arrangement between the bank and the borrower, which allows the borrower to recover the current market value of his accumulated equity upon default. By itself, this makes default attractive relative to Western mortgages. However, we show that if agents care about realized gains and losses, as in models based on ‘Realization Utility’ (Barberis and Xiong (2012)), the equity recovery associated with Islamic mortgages creates a powerful disincentive to default. Using a standard real options framework, we use data from Indonesia, Malaysia, and Pakistan to show that our model can explain the relatively low default rates on Islamic mortgages.