Finance & Investing

When the COVID Slump Hit Homeowners, Shadow Banks Were Slow to Lend a Hand

As borrowers sought debt relief, non-traditional lenders and loan servicers faced a financial shock.

September 16, 2022

| by Patrick J. Kiger
Black and white photo of a bank from below, in deep shadow and looking foreboding. iStock/RSeanGalloway

What they do in the shadows: Non-bank financial institutions are increasingly important players in the mortgage market. | iStock/RSeanGalloway

When the COVID-19 pandemic gut punched the U.S. economy in March 2020, Congress moved quickly to prevent struggling families from losing their homes. One of the key provisions in the Coronavirus Relief and Economic Security (CARES) Act was mortgage forbearance, which gave homeowners with federally backed mortgages the option of pausing or reducing their payments for up to a year without penalty. By May 2020, about 7% of all single-family mortgages had suspended payments, according to the Government Accountability Office.

While studying pandemic debt relief, Susan Cherry and a team of researchers made a surprising discovery. “Every borrower with a government-backed mortgage had the right to take out a forbearance,” explains Cherry, a doctoral student in finance at Stanford Graduate School of Business. “But we found that the type of loan servicer that a borrower had was correlated with whether or not the borrower ended up taking out a forbearance.”

In particular, Cherry and her colleagues found a striking contrast between traditional lenders and an increasingly important player in the home mortgage market: so-called shadow banks. Unlike conventional banks, these non-bank intermediaries don’t accept deposits and are lightly regulated. And unlike banks, which sometimes keep mortgages on their balance sheets, shadow banks’ business model is to sell their loans to government-sponsored enterprises such as Fannie Mae and Freddie Mac and then act as the servicer.

“Shadow banks are really important to the U.S. economy,” Cherry says. “They originate a lot of mortgages, and they also service approximately half of all mortgages.” As of early 2020, they were servicing more than 18 million loans worth $3.6 trillion.

“How these institutions behave differently than traditional lending institutions — particularly when it comes to debt relief and credit policies — could affect the futures of many American consumers,” says Stanford GSB finance professor Amit Seru.

During the financial crisis, loan servicers were often responsible for implementing debt relief for consumers. But here, too, shadow banks did things a little differently. “We found that shadow bank servicers were less likely to provide forbearance than traditional bank servicers,” Cherry says.

Shadow banks’ forbearance rates were lower at a moment “when this debt relief would have been the most important to borrowers,” Susan Cherry says.

Seeking Relief

That led Cherry, Seru, Erica Jiang of the University of Southern California, Gregor Matvos of Northwestern University, and Tomasz Piskorski of Columbia University to take a closer look at how shadow banks weathered the COVID-19–related financial shock and how they performed at providing debt relief to borrowers. In a recent article, they reveal that shadow banks’ forbearance rate from March 2020 to March 2021 was 27% lower than traditional banks’.

During the initial months of the crisis, shadow banks’ comparatively lower rate of providing forbearance was significant, because it was a time “when this debt relief would have been the most important to borrowers,” Cherry says. It wasn’t until August 2020 that shadow banks achieved forbearance rates similar to traditional banks.

The researchers didn’t study the mechanism through which shadow banks provided forbearance, though the evidence suggests that financing constraints may have played a significant role in accounting for their lower rates. Cherry notes that it is unclear whether shadow banks provided less information to consumers than conventional lenders or if they were less proactive in reaching out about debt relief options.

Debt relief did not reach all borrowers who might have taken advantage of it. A survey by Fannie Mae in August 2020 found that more than half of consumers were not aware of their debt relief options. In January 2021, the acting director of the Consumer Financial Protection Bureau noted that some loan servicers “gave consumers incomplete and inaccurate information about CARES Act forbearances” and failed to process requests for debt relief, though he did not mention shadow banks specifically.

Shocks in the Shadows

As a part of the researchers’ quest to study shadow banks’ performance during the pandemic, Jiang filed freedom of information requests for lending institutions’ call reports, which contain a wealth of financial data. Though only two states responded to the request, those reports contained information on shadow banks’ operations across the nation. “That gave us information on about 80% of the total shadow banks,” Cherry says. That data was combined with information from other sources such as Fannie Mae and Freddie Mac.

The data showed that shadow banks faced a serious financial threat during the pandemic shock. Even though servicers couldn’t collect monthly payments from borrowers who sought relief, they still were contractually obligated to pass along the same amount of money as usual to investors who owned the cash flow from the mortgages. For the median shadow bank, the payments it had to advance due to forbearance amounted to such a big chunk of its cash and net income that they threatened to cause “a severe liquidity and even solvency shock,” the researchers write.

To reduce the pressure, shadow banks altered their business practices, the researchers discovered. “Shadow banks seemed to be reducing their servicing activity in response to the COVID-19 pandemic, as well as forbearance,” Cherry says.

While the shadow banks continued to originate the same number of loans and sell them on the secondary market, they cut back on the number of loans they were servicing by transferring them to other intermediaries. That reduced their responsibility for carrying payments on behalf of borrowers in forbearance.

“We can’t actually see whom they’re selling their servicing rights to, but we think that they were reducing their need to advance payments for the loans they were servicing,” Cherry says. “So we see that the total value of their mortgage servicing rights is decreasing on their balance sheets.” The researchers note this was a solution used by shadow banks with the most exposure to loan servicing before the pandemic.

In addition, shadow banks also adjusted their capital structure by increasing their leverage to give themselves a bigger cushion. “If you’re less capitalized, you’re decreasing your ability to weather large shocks,” Cherry explains. The researchers also found that better-capitalized shadow banks had higher forbearance rates than less capitalized ones, a correlation not found in traditional banks.

The researchers’ findings suggest that more attention should be paid to shadow banks and their role in the U.S. financial system. “More broadly, regulators need to think of a new framework to monitor the functioning of these institutions since they are now intermediating large chunk of economic activity to households and firms in the U.S. and beyond,” Seru says. Cherry agrees, particularly in light of recent events. “Regulators and policymakers really need to understand shadow banks, their funding structure, and how they respond to economic downturns,” she says.

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