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Torah Law, Usury, Debt Forgiveness … and Iceland

What can we learn from Jewish scholars about financial theory and practice?

Dinosaur Derivatives

By Jeremy Josse, author of “Dinosaur Derivatives and Other Trades

The curious philosophical connections between many concepts in finance and economics are typically hidden. They are also sometimes embedded deep in many Jewish teachings from the Talmud and the Torah itself. I want to touch on a set of connections between three economic concepts embedded in Jewish law: Ribbit (translated as “interest” or “usury”), Shmita (the Sabbatical year) and the Prozbul (a legal device of rabbinic origin). These are notions with unlikely connections, yet ones which inform our modern economies—their impact can be felt even in such remote locales as Iceland!

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Let’s start by looking at the very definition of a “financial instrument.” They are essentially types of contracts, but contracts constructed in such a way as to achieve very specific commercial objectives. And I believe one way of understanding many “financial instruments” is to understand them by reference to Judaism’s prohibition on usury (i.e. ribbit).

The law against usury appears in the Torah itself, but was of course outlined in much greater detail by Talmudic scholars. The rabbis recognized the bondage that debts could create and that vulnerable people, in need of cash, could be subjected to egregiously high interest rates. The policy would have been all well and good, but for one thing: it is not technically possible to lend money without there being some cost to that money. If I am due to get $100 from you in one year, the money you pay to me on that “due date” does not have the same value as $100 that you might give me right now. That’s because there is always a chance (a risk) that I will not actually get the $100 payment that you promised to make to me in one year. And interest rates reflect this critical point.

It is probable that the intrinsically time-based value of money was only fully understood in late medieval times. But in the meantime, Jews, Christians, and Muslims had all adopted, in one form or another, the prohibition on charging interest. As society developed and commerce grew in late medieval/early Renaissance times, the problems associated with this prohibition became increasingly apparent. In order to make any sort of commercial sense of lending, some form of lending on interest had to be created which at the same time could be effected… without lending on interest.

The solution was of course one of those great legal devices–the “legal fiction.” Said fictions allow for conformity with a certain law (at least in one sense), but also allow for the achievement of an objective that might otherwise appear to be prohibited by the relevant law. “Legal fictions” are in fact a fundamental part of our financial infrastructure and I believe financial instruments are really all “legal fictions” of one form or another.

The most straightforward use of a legal fiction to circumvent the prohibition on usury is the “repurchase agreement.” If Reuven sells something (say an ox) to Shimon for $100 on condition that Shimon sells it back to Reuven for say, $110 in one year’s time, you have effectively created a one-year, 10% loan collateralized against an ox. Yet it appears to be a sale and repurchase agreement. The interest is, as it were, hidden or disguised by the legal fiction of the repurchase agreement. In fact, these types of agreements are still very prevalent in financial markets—they are called “repos” (short for repurchase agreements) and are used for stock lending.

The most fascinating legal device to solve the usury problem emerged in late medieval/early Renaissance times among Jewish (and Islamic) scholars—the Heter Iska. It works like this: Say Shimon goes to Reuven in need of a loan. Rather than having Reuven (a capital provider) lending on interest to Shimon (the businessman), Shimon and Reuven will be deemed to have entered into a partnership agreement. Shimon will contribute his business/labor into the partnership, while Reuven will contribute his cash. Reuven will effectively be a 50% equity holder in this partnership, but his equity rights will be constituted so as to give him a fixed return on his investment (the fixed return, of course, being interest by another name).

This itself then looks just like another modern financial instrument, namely “preference stock” – which is equity, but equity commonly structured in such a way that it has all the features of debt.

But the use of “legal fictions” and Talmudic financial law takes us still further into some of the most curious bank restructuring issues in modern times – including understanding the fragile state of the Icelandic economy.

Here we must flip to Iceland’s recent mortgage debt forbearance scheme. Iceland’s bloated banking system was entirely bankrupted by the credit crisis. All its banks had to be nationalized and the country has faced very high levels of inflation since then. Icelandic mortgages are all Adjustable Rate Mortgages, hence as inflation set in, rates went up. In many cases this incremental interest was capitalized as more principal debt owing. So Icelandic mortgages effectively ballooned with rates and inflation. Many consumers have therefore been sitting on unsustainably large mortgages for the past several years.

So what was to be done? Well, the Government ran a scheme where large chunks of the population simply had parts of their mortgages written off–a debt forbearance program. We’ll come back shortly to the scheme–to see how successful it really was.

But what was actually going on here? Well it harks right back to another Talmudic concept: the Shmita year. Under Shmita, all debts in the Land of Israel were to be released every seven years and, as it were, the economic playing field was leveled. This idea had some curious implications. First of all, when the seven-year debt forbearance was due to be implemented in Second Temple times, many bankers just refused to lend leading up to the Sabbatical year. The bankers, being a shrewd bunch, wouldn’t lend one or two years before the Shmita year precisely because they did not want their debts written off at the forbearance date. The result was an ancient credit crisis (they’ve been going on for millennia)–a shortage of credit supply.

This itself was solved (by Hillel) by yet another “legal fiction.” It was called the Prozbul. The concept was that debts would still be collected for creditors, but it would be done by the Government, not by the creditor in the Shmita year. So it was true that the creditor would forgo collecting on his debts in that year, but at the same time the creditor was protected by having the state do it for him.

It’s Interesting also to contemplate whether the Shmita year debt forbearance regime was a socialist or a capitalist-type idea. Well I think most of us would initially see it as fairly socialistic (think of the relief debt forbearance is trying to provide in Iceland). Effectively debt forbearance sounds like a way of relieving the poor and indebted and of equalizing the nation’s wealth distribution. But looked at from another perspective, however, it was perhaps a fairly pure form of libertarianism.

One of the elements clogging up our free market today (aside from Government) is that fact that our economic systems are filled with oligopolists and “rent seekers.” These are established firms that have dominant market positions who do not want to encourage competition at all. And here’s the thing: Debt forbearance breaks some of the stranglehold of the oligopolists. In leveling the financial playing field it effectively re-sets the whole economic game, back to a more pure form of capitalist free for all. No doubt over the next seven years the most powerful build-up again, but then at the next forbearance date they are (again) broken down and the race restarts, and so on.

Actually both the socialistic and the capitalistic interpretations of the Shmita are equally possible – only going to show that nothing in economics is black or white.

In any event, the still more extraordinary thing about the Icelandic forbearance is that it happened at all. In reality the concept of such a wide scale forbearance today in any major economy would simply not be viable. But it was possible in Iceland since, following the credit crisis, all the country’s banks had been nationalized (they had to be as they all went bust). So in releasing consumers from parts of their debts it was really just the Government taking the pain–i.e. the Government paying down part of people’s debts. The banks really had no say in the matter as they are currently just arms of the Icelandic Government.

The question this then raised was whether it was ultimately a good use of Icelandic Government money. Should the Government be paying off the debts of its citizens, rather than say using its resources for other items, such as roads, schools, healthcare, and so on? The rules as to whose debt was written down and by how much were also slightly arbitrary and that caused some consternation as well.

So there it is – a curious set of financial connections. We have seen financial instruments emerging in the form of “legal fictions” used to circumvent the Talmudic prohibition on usury. We have modern debt forbearance reflecting another ancient economic concept–the Shmita, a concept which itself triggered its own antique credit crises and required its own “legal fictions” (the Prozbul) to function in the real world. And all of these serve to illustrate a fascinating set of modern-day financial puzzles that it turns out aren’t so modern-day at all. The rabbinic sages seemed to have anticipated them and found innovative solutions for hundreds, and in some cases thousands, of years.

Interested in more of the curious economic/philosophic riddles, moral dilemmas and insights that are part of our modern financial system? Make sure to check out Jeremy Josse’s new book: “Dinosaur Derivatives and Other Trades, ” published by Wiley & Co.

About the author

Jeremy Josse has spent the last twenty-plus years of his career working as an executive in some of the world’s leading financial institutions, including Schroders, Citigroup, and N M Rothschild. He has published numerous articles on a wide range of financial subjects including the credit crisis, bank restructurings and financial engineering.



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