An eye-popping new study by researchers at Stanford, Columbia, and the University of Chicago finds that nonbank “shadow” lenders write 38% of all home loans — almost triple their share in 2007 — and that they originate a staggering 75% of all loans to low-income borrowers insured by the Federal Housing Administration.
“Shadow banks” lend money like regular banks but don’t use bank deposits to finance that lending. They also aren’t subject to most traditional bank regulation. In part because of lighter regulation, as well as technological advantages, shadow lenders have enjoyed spectacular growth at the expense of their brick-and-mortar rivals.
Quicken Loans, which owns the online lender Rocket Mortgage, has grown eight-fold since 2008 and is now among the three biggest mortgage originators in the nation.
Could shadow banks, free of traditional regulation, plunge into the kind of reckless mortgage lending that nearly wrecked the economy a few years ago?
The new study — coauthored by Amit Seru at Stanford Graduate School of Business, Greg Buchak and Gregor Matvos at the University of Chicago, and Tomasz Piskorski at Columbia University — is agnostic on that question.
The study does find, however, that the shadow lenders have dramatically stepped up their loans to riskier borrowers with lower incomes and credit scores. The study also finds that shadow banks are at least as dependent on federal backstops and guarantees as traditional banks are.
“Knowing that it was government-subsidized institutions ‘funding’ the shadow banks was an important finding,” Seru says.
Shadow lenders immediately resell almost all the loans they originate, and they sell about 85% of those mortgages to government-controlled entities, such as Fannie Mae and Freddie Mac.
If borrowers default on those loans, taxpayers are stuck with the bill. In 2015, the U.S. Justice Department sued Quicken for millions of dollars in FHA-insured loans that went bad, accusing the company of misrepresenting borrowers’ income and credit scores in order to qualify their mortgages for FHA insurance. The company has denied any wrongdoing and is fighting the charges.
Traditional banks also can leave taxpayers on the hook, the researchers note. Although banks keep about 25% of the mortgages they originate, they finance much of that lending from federally insured customer deposits. If a bank fails, the government pays to keep the depositors whole.
Why are the shadow lenders grabbing so much business from traditional banks?
Perhaps surprisingly, it’s not because they offer lower fees or interest rates. In fact, the study found that online lenders charge slightly more to higher-income borrowers, apparently because those customers are willing to pay a premium for the convenience of “push-button” loan processing. For less affluent customers, who are more cost-conscious, shadow banks charge about the same as traditional banks.
The shadow banks’ primary advantage is analogous to one of Uber’s initial advantages over traditional taxi services: less regulation.
After the financial crisis, Congress and regulatory agencies cracked down on traditional banks. They increased capital requirements, tightened enforcement, and paved the way for huge lawsuits against many of the biggest banks. The shadow lenders escaped most of that.
Regulators cracked down especially hard on banks that were active in the cities and communities that were hardest hit by defaults. Many of those communities were dominated by lower-income families and minorities.
Sure enough, traditional banks retreated from those markets and shadow lenders moved in, the study shows. Shadow lenders increased their presence in counties with lower median incomes, higher unemployment, and higher percentages of African-Americans and other minorities. The researchers calculated that counties with higher unemployment generally had a higher penetration by shadow banks.
The most startling shift was in FHA loans, which are generally made to people with lower incomes and weaker credit ratings. There, shadow banks increased their share of loan originations from 20% in 2007 to 75% in 2015.
To be sure, shadow banks also made inroads among affluent borrowers. That was especially true for the tech-driven online lenders, such as Quicken’s Rocket Mortgage. Online lenders, which account for about one-third of shadow lending, increased their share of “conforming” mortgages (those that Fannie Mae or Freddie Mac will insure) from 5% in 2007 to 15% in 2015. The online shadow lenders had a noticeably higher presence in counties with higher incomes and education levels.
Overall, the researchers estimate that regulatory advantages account for about 55% of the growth in shadow banking, while technology advantages account for 35%.
Seru says it’s still unclear whether shadow banks are a force of entrepreneurial innovation or another example of unregulated players plunging headlong into a wave of recklessness.
But he says one thing is certain: For all of their entrepreneurial prowess, shadow banks depend on government backstops every bit as much as their old-fashioned rivals do.
“If you remove the government guarantees, the bailouts, and the subsidies, it’s not at all clear the shadow banks would step in to fill the breach,” Seru says. “Bailouts and subsidies impact the entire chain of intermediation — they not only affect ordinary banks but also shadow banks.”