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The “Shadow Banks” Are Back, and Still Too Big to Fail

The financial institutions behind the last economic crash haven’t gone anywhere, and they’re looking for a bailout yet again.

Mike Coppola/Getty Images

On April 14, Nancy Wallace, a real estate professor at Berkeley, gave an interview to the University of California’s business school, during which she warned of “a looming nightmare” in the economy. Her dire prediction, in this instance, was centered on nonbank mortgage servicers: lightly regulated financial intermediaries (Quicken Loans being one of the more familiar examples) that own the right to collect mortgage payments and repackage them into other financial products, such as the infamous mortgage-backed securities, which you might remember as the inglorious stars of the last financial crash. As Wallace explained, she wasn’t certain that some of the more prominent players in the nonbank mortgage game had the necessary funds on hand “to last even 30 days,” let alone those that wouldn’t “be able to do it for three months, much less a year.”

The proximate cause of these firms’ miseries is familiar to anyone who’s not been comatose for the past two months: the coronavirus pandemic and its concomitant impact on the economy. In this instance, the CARES Act, Congress’s somewhat widely panned attempt to stabilize the economy, allowed mortgage holders to defer payments for up to a year. Mortgage servicers were still, during this period of time, required to pay their investors, meaning that they could quickly run out of money. “We are going to see bankruptcies,” Wallace said.

It’s hardly surprising, then, that nonbank mortgage servicers and their powerful lobby, the Mortgage Bankers Association, have been begging the federal government for a bailout. The fact that these firms had been left out of the initial round of Federal Reserve actions to combat the economic impact of the pandemic was due to a history of malfeasance: During the decade they’d spent taking over the market for mortgage origination from the big banks, Wallace noted, they had “pushed every boundary” while refusing “every form of oversight.” Even a group of sympathetic senators, who beseeched the Treasury to lend a hand to mortgage servicers in early April, were forced to concede that while these businesses need help, “we understand that some nonbank lenders may have adopted practices that made them particularly susceptible” to a crisis.

And so, amid the storm of the Covid-19 pandemic, we have an additional dilemma. If nothing gets done to backstop these financial firms, the businesses that originate over 60 percent of all mortgages in the country would speed over a cliff, possibly dragging substantial portions of the financial system down with them. But if you bail them out, you risk affirming their oversight-free existence, or at the very least release them from the consequences of their bad behavior. They’ve revealed themselves to be a new vampiric subspecies of institution we learned to classify in the last crash as “too big to fail.”

Perhaps there is ironic comfort to be drawn from the fact that in the middle of a global health calamity comes a more recognizable crisis. This is the exact same situation the country faced in the lead-up to the last financial crisis in 2008: powerful and unregulated financial institutions that had scoffed at efforts to restrain their excesses, begging for a government (that is, “taxpayer”) rescue when their failures drew them to the brink of imperiling the society at large. They’re like the worst dinner guests: They never want to prepare the food, but they always demand to eat.

These financial institutions are best understood as “shadow banks,” to use the term of art that economist Paul McCulley introduced in a 2007 speech. The name refers to financial businesses that aren’t regulated in the same ways as conventional banks—including hedge funds, payday lenders, private equity firms, asset managers (like BlackRock and Vanguard), fintech companies (PayPal), mortgage servicers, insurance providers, and even Sotheby’s, which now makes loans to wealthy clients. These businesses make good money selling loans and other financial products, but they don’t carry the same regulatory burden as conventional banks, and unless they are publicly traded, they are functionally opaque to outsiders. The most important distinction, however, is that shadow banks are able to lend out more money while holding less in their reserves, which allows them to profit in ways conventional banks can’t.

The trade-off, McCulley noted, is that since “they fly below the radar of traditional bank regulation, these levered-up intermediaries operate in the shadows without backstopping from the Federal Reserve’s discount lending window or access to FDIC [Federal Deposit Insurance Corporation] deposit insurance.” That is to say: The one thing that defines their existence is that the government doesn’t guarantee their business. But, just like the bailout of the shadow bank American Insurance Group in 2008, recent events have made a mockery of this idea. Even before mortgage servicers came looking for a handout in April, the Federal Reserve agreed to protect exchange-traded funds, repurchase agreements, and money market accounts, which are the main financing avenues for many shadow bank entities, such as asset managers.

It would be delusional to think we’ve learned the dangers of shadow banking after 2008. Since the crash, shadow banking has grown into a massive $52 trillion industry, a 75 percent increase since 2010. With little information about the risks these firms have taken over the past decade, there’s no telling how deep the problems might go. This is going to be a hell of a time to find out.


It’s important to understand why conventional banks undergo the strict regulation that shadow banks profit from avoiding. Banks are subject to charters, licensing, and regulation in order to prevent what was a common occurrence in the nineteenth century: bank runs. Rumors and panics, both real and imagined, could spur customers to pull their deposits, which could ruin banks’ livelihoods and bring commercial activity to a standstill. Long recessions and depressions were common.

Banking, without a government guarantee, is a volatile business. The establishment of the Federal Reserve in 1913 stabilized it to some degree, but it was the creation of the FDIC in 1933 that put the full weight of the federal government behind the banking system. The FDIC allowed the government to guarantee depositors that their money wouldn’t vanish, which in turn helped to ensure that banks could count on their cheapest and most important source of funding. The agency effectively underwrites the entire existence of commercial banks. In return for the profits and stability, banks were subject to strict regulation, which in turn limits the cost of the FDIC’sand thus the taxpayers’big guarantee. This system worked well: Bank failures from 1933 to about 1980 were rare. People trusted the solvency of the government, and that trust allowed banks to make money.

These New Deal–era restrictions on the financial sector, however, insured and constrained lending, and by the late 1960s, this was seen as a problem. It seemed to lawmakers that the best way to deliver the promise of equal rights, without massive government expenditure, would be to expand credit. As Sarah L. Quinn explains in American Bonds, lawmakers wanted to expand equality by encouraging homeownership, but instead of direct spending, they embraced loosened credit as a “politically light” way to do so. In 1968, the government privatized the Federal Nation Mortgage Association, better known by its nickname, Fannie Mae.

Fannie Mae was, in some ways, a proto–shadow bank, and it issued some of the first mortgage-backed securities. These financial products were an innovative way to privately fund home loans without deposits, and they inspired the emergence of similar tools. One such product was the money market account, introduced in 1971, which was similar to a bank account but classified as an investment. These allowed financial businesses an alternative way to raise money for lending, without the traditional regulation associated with banking. To many customers, money market accounts seemed to function a lot like normal bank accounts. But whether they knew it or not, their money-market deposits, unlike their standard bank deposits, weren’t insured by the government.

As alternative schemes of funding proliferated, so did shadow banking in general. Hedge funds and other types of investment banks started to dominate the landscape. One of the first warnings that the shadow banking industry might one day become the epicenter of economic calamity came in 1998, when Long Term Capital Management—a hedge fund—went belly up. LTCM had rapidly raised vast sums to make enormous bets on the debt of foreign governments, but when Russia unexpectedly defaulted on its sovereign debt, they imploded. By this time, however, the hedge fund had grown so big that Federal Reserve Chairman Alan Greenspan fretted that the firm could bring down the entire economy. Greenspan’s solution at the time was to organize a private bailout, thus sparing taxpayers from bearing the Too Big to Fail costs. But Greenspan failed (or refused) to scrutinize the possible wider societal impacts of the ever-growing numbers of private and unregulated banks.

A decade later, those full impacts became clear. AIG, which had grown to become a gigantic shadow bank, had—unbeknownst to many—recklessly agreed to be the counterparty to a bevy of credit default swaps, against which it held little capital. When things went south, the government had to stabilize the financial world by accepting the responsibility for all of AIG’s reckless lending—essentially assuming the role of the FDIC for a financial entity that taxpayers were never meant to backstop. In the aftermath of the financial crash, it was revealed that there were a number of grotesquely large shadow banks just like AIG, such as Metlife, Prudential, and GE Capital. These were so large that they could be considered, under the terms of the Dodd-Frank bank reform bill, to be “systemically important financial institutions,” or SIFIs. Yes, that’s another euphemism for “Too Big to Fail.”

Dodd-Frank created new regulators, like the Financial Stability Oversight Council, to prevent these sorts of world-shattering financial disruptions. One of the FSOC’s powers was the ability to attach the “SIFI” designation to any kind of business it wanted, which would in turn require that firm to provide more reporting and carry more capital in its reserves. These efforts, however, largely foundered when it came to shadow banks. For example, in 2013, the FSOC attempted to classify colossal asset managers like BlackRock (which has almost $7 trillion in assets under management and whose operations are funded by products similar to money market funds and arcane financial products such as repurchase agreements) as SIFIs. The asset managers pushed back and won.

Furthermore, says Graham Steele, a finance expert at Stanford University, the Federal Reserve also “never really got around to making the substantive rules to make [the shadow banks] safer,” before the Trump administration came in, de-designating and lifting regulatory requirements on a number of shadow banks, including the insurers Metlife and Prudential. GE Capital and AIG have reduced in size to rid themselves of their post-crash scarlet letters, but Metlife and Prudential are still large, undesignated, and less regulated than they should be.

Finance, especially post-2008, works because the state guarantees that the worst of what we’ve previously endured will not be allowed to come to pass. Not paying for these assurances is tantamount to fraud. Because shadow banks are funded by loans and lines of credit from big banks, the failure of one is inextricable from the other’s. When you consider the size of most financial institutions, shadow banks included, there isn’t really a portion of the financial sector that isn’t systemically important. Moreover, as Steele noted, size was not the only factor that, according to the Dodd-Frank bill, could make a firm systemically important. Another such condition was whether the institution in question was engaged in an important financial activity, as home financing could easily be considered. Bailouts and backstops, Steele says, need to be paired with—at a minimum—requirements to break up these larger entities into smaller, less risky companies, with more reporting and higher capital requirements. It’s even possible that some of these companies need to be turned into public utilities. “When push comes to shove,” he says, “we find out we are ensuring the survival of all of these shadow banks.”

Last week, the government announced it would, in fact, bail out nonbank mortgage servicers, by purchasing loans in forbearance. If it hadn’t, the banks that lend mortgage servicers the money to operate would have been hit, and that earthquake would surely be large enough to cause a tidal wave of problems that would crash on even the most far-flung shores. Mortgage servicers hinted that their failure would cause massive disruption for the housing industry, which could be interpreted as a form of mild extortion. The opacity of their inner workings means that we have no idea what sort of toxic sludge is floundering on their balance sheets, for which taxpayers might be liable.

The nonbank mortgage servicers recently caught groveling for governmental aid after lobbying for years against oversight are actually comparative Johnny-come-latelies to the federal government’s coronavirus bailout drive-through. The Federal Reserve has already bailed out huge asset managers and other shadow banks by backstopping money market funds, repurchase agreements, and other corporate financing tools. Hedge funds—which, by the way, are supposed to make money in a downturn—are turning to government loans. Venture capital and private equity firms are asking for help, too. It’s likely that more shadow banks will pile on, each with a story of need—and a warning of the consequences to the larger economy if aid isn’t duly rendered.