"Consumer Choice in Residential Mortgage Market: An Islamic Mortgage Contract,” Journal of Real Estate Research, pp. 1-37, 2021, with Azmat, S., Hassan, M.K., and Ali, S.Z
https://www.tandfonline.com/doi/full/10.1080/08965803.2021.2003509
Abstract: This paper examines the Islamic mortgage contract of Diminishing Musharakah and its impact on consumer welfare, house purchase, and mortgage payments. We build both static and dynamic models to study a homeowner’s decision-making. We pay special attention to expectation formations and simulate the model to analyze both Islamic and Conventional mortgage holders’ responses to changes in income growth, house prices, and interest rates. Estimates of the model, using housing data set of U.S. economy (1990–2018), indicate that Diminishing Musharakah contract holders achieve 2.5 to 4% higher discounted utility under constant and declining learning expectations. The reducing balance feature of the Diminishing Musharakah contract provides relative protection to a consumer from adverse income shocks and high-interest rate environments. Simulation results suggest that under dynamic conditions, the Diminishing Mushrakah provides 3.4% lower mortgage cost per housing unit. It prevents consumers of average and low-risk appetite from relatively riskier housing decisions. We learn that consumer chooses a 2.5% smaller house size under Diminishing Musharakah. The model also examines consumers with vector autoregressive (VAR) based expectations. We find that homeowners with optimistic forecasts may achieve a higher utility in a conventional mortgage.
"Islamic Mortgages: Lessons for the West?” with K. Kasa, 2023. (Working Paper)
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.
“Measuring Faith-Based Debt Aversion” with K. Kasa and S. Azmat, 2024 (Working Paper)
Abstract: This paper provides a novel strategy to measure debt aversion. It exploits the fact that banks in Pakistan simultaneously sell both Islamic and Western mortgages. Our key assumption is that Islamic mortgage holders are more devout than Western mortgage holders. (More than 95% of Pakistanis identify as Muslim). A real options model, calibrated to match observed prepayment rates on Western mortgages, suggests that nearly all the observed prepayments on Islamic mortgages are driven by debt aversion. Robustness checks using micro-data on over 3,700 individual mortgages confirm our findings.
"Religious Screening in Mortgage Markets:Evidence from Pakistan" (Working Paper)
Abstract: This paper studies how borrowers with varying degrees of debt aversion self-select between Islamic (Diminishing Musharakah-DM) and Western (Fixed Rate) mortgages. Debt aversion is defined as a preference-based distaste to holding debt. I show that when a borrower’s debt aversion is private information, the equilibrium is separating, with debt-averse borrowers opting for DM mortgages. This study extends the Rothshild and Stiglitz (1976) framework to a dynamic behavioral finance setting, incorporating heterogenous debt aversion, screening, and endogenous selection. Using micro-data from Pakistan, the model shows quantitatively how banks can sort religiously motivated debt-averse individuals by offering both DM and Western mortgages. The findings of the model align with observed market share data and mortgage curtailment patterns in Pakistan’s housing sector.