The Shadow Banking System

Photo courtesy of FinancialAidPodcast (via flickr)

Photo courtesy of FinancialAidPodcast (via flickr)

A major player in the CMO market was  the so-called “Shadow Banking System,” a collection of financial institutions including investment banks, hedge funds, money-market funds, and finance companies, as well as newly invented entities called “asset-backed conduits” (ABCs) and “structured investment vehicles” (SIVs).  Since shadow banks were not part of the formal commercial banking system, they were not subject to the same strict regulations as banks, and thus could use high leverage to gain quick and large profits in good times but also huge losses in bad times.  On April 28, 2004, the US Securities and Exchange Commission waived the net capital rule for the largest investment banks: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley, allowing them to take on as much debt as their internal risk management analyses deemed prudent.  The 1997 net capital rule had limited firms to a debt/equity ratio of no more than 15 to1.1

As a result of the change, all five investment banks increased their leverage dramatically; Bear Sterns increased leverage to 30 to 1, double the net capital rule.  The shadow banking system is not a niche element in credit markets.  Indeed, shadow banks were estimated to provide as much as 60% of total lending; commercial banks only 40%.

The collateralized mortgage obligations sold by these shadow banks were similar to the mortgage-backed securities sold by Fannie Mae and Freddy Mac, but with an extra twist.  Instead of an investor purchasing a security representing an entire pool of mortgages, the CMOs were sold in tranches (or slices) to investors based on the investors’ risk preference.  Suppose the CMO was sliced into three tranches: top, middle and bottom.  Each month, the first mortgage payments from the pool would go to the top tranche.  When enough money comes in, the top tranche’s interest payments are paid.  The next mortgage payments are allocated to the middle tranche.  When its interest payments are paid, the remaining mortgage payments go to the bottom tranche.  If any mortgage holders failed to make their payments, the shortfall would apply to the bottom tranche, which would thus have less money to pay out as interest.  To compensate for this possibility, investors in the bottom tranche were paid a higher interest rate.  Only if there were enough payments difficulties to wipe out the interest payments to the bottom tranche, would the problem affect the middle tranche.  And only if there were enough difficulties to wipe out the interest payments to the bottom and middle tranches, would investors in the top tranche be affected.  By design, the top tranche is least risky; thus, it pays the lowest interest rate.  Similarly, the bottom tranche, since it’s the most risky, pays the highest interest rate.  The middle tranche pays an interest rate in between.  2  The upper tranches were rated AAA by the bond rating agencies; thus, they were perceived to be safe investments.

To sum up, easy credit and loose lending standards in the mortgage market created an escalation in subprime mortgage lending.  Even Freddie Mac and to a lesser extent, Fannie Mae joined the party.  As the two began to lose market share during the mid-2000s, they entered the subprime market aggressively, purchasing $175 billion (44% of the market) in 2004 and $169 billion (33% of the market) in 2005.

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  1. The net capital ratio was formally defined as debt / liquid net worth.
  2. For a graphic explanation of how CMOs work, see “How Mortgages Became Part of the Mess.” Washington Post, December 16, 2008.…