In response to the financial crisis of 2008–2009 regulators came down hard on big banks. The Dodd-Frank Wall Street Reform and Consumer Protection Act outlined numerous provisions designed to tightly monitor lending and reduce risks inherent in the U.S. financial system, including new oversight councils, credit agency reforms, and increased capital requirements.
Needless to say, traditional banks beat a path away from consumers and businesses that were deemed a higher risk. Mortgages became harder to get, credit seemed to evaporate, and a loan approval became a rare event reserved for the very lucky and the very few.
Ah, but where there’s a will, there’s a way. Nontraditional lenders lurking in the shadows were ready to make a deal. Enter “shadow banking.”
Shadow banking is an intermediary form of borrowing that provides both credit and capital outside the constraints of the conventional banking system. It is unsupervised lending by hedge funds, money market funds, trading houses, and structured investment vehicles that side-steps regulatory oversight. Shadow banking arose both from the need for credit and the desire for convenience. It is at once a reaction and a response to the arduous post-crisis loan application processes and the sting of credit denial.
Shadow banking has played a critical role in funding businesses and individuals in the wake of the subprime meltdown and is a vital source of capital for the private sector. It has grown an astounding 25% since the Great Recession, with mortgage funding leading the way.
The mortgage market share of shadow banks now accounts for 38% of all home loans. In the FHA market, shadow lending currently originates 75% of loans to less creditworthy borrowers. In the online realm, the nontraditional loan models, digitized interfaces, and automated underwriting of “fintech lending” has increased by 10%.
“Push button. Get mortgage!” Quicken Loans is a titan in the shadow banking sector. It is America’s largest online retail lender and has become the second largest mortgage company in the United States, having grown eight-fold since 2008. Rocket Mortgage, their online loan interface, enables consumers to get a loan decision in minutes.
While there’s little doubt that Dodd-Frank and other reforms dramatically increased the regulatory authority of the federal government, critics maintain that the onerous oversight reduced traditional lending, weakened the economy, and even slowed the recovery. Entities like Quicken Loans filled the lending void left by the post-crisis deluge of rules and regulations impacting everything from mortgages to credit cards, securities to retirement accounts.
But despite providing fast and easy access to heretofore unavailable capital, shadow banking is fraught with risk.
Unregulated lenders have recently increased mortgage offerings to lower-income applicants and penetrated areas of high unemployment and high-risk borrowers. Without clear guidelines, oversight, or controls, the potential for reckless lending looms large.
Since shadow banking accounts for 30% of the worldwide financial system, mass mortgage defaults would impact global investment, international credit, and borrowers around the world. Since shadow banks resell most of the loans they originate to federal agencies like Fannie Mae and Freddie Mac, it would also impact every one of us.
It is perhaps, the ultimate irony. The very regulations and reforms that were supposed to protect consumers and safeguard our banking system have actually driven lending into the shadowy corners of speculative credit. We’ve all seen this movie before—a subprime meltdown, a credit crisis, a real estate crash, foreclosures, stock shock, recession.
If 2008 is about to have a repeat showing, are you prepared?