Before getting into an analysis of how the shadow banking system played a role in the 2008 economic downturn, we must first understand what this system is in the most basic sense. Although the term "shadow" may conjure up all sorts of nefarious and unpleasant images in one's mind, it would simply be unfair to characterize this aspect of our financial system in such an emotional or negative context. (Four major players slice and dice your mortgage in the secondary market. To learn more, check out Behind The Scenes Of Your Mortgage.)
Tutorial: Banking

We all know the traditional banking system provides checking and savings accounts, auto and home loans, and various other financial services. But most people fail to understand that these institutions do not possess infinite capital, and are therefore limited in the amount of loans they can provide to consumers or small businesses. This limitation is where the shadow banking system came into play.

The Rise of Shadow Banking
Prior to the Great Recession, banks realized their ability to profit from lending was limited by access to capital and the size of their balance sheet. So instead of lending and holding loans like banks did in the "good old days" (limiting profit potential), they began specializing in originating loans, packaging them and selling them to other investors through securitization processes via investment banks; hence the inception of the unregulated "shadow banking system" which provided a conduit capital seeking to purchase these securities.

How this worked is rather simple. A financial institution would lend as much money as possible for home, general consumer and auto loans, and would then work with investment bankers to securitize these pools of assets. These securities would then be sold to a variety of investors such as pension funds, endowments, mutual funds, hedge funds and other financial institutions; these were the funders of the shadow system. These instruments could take a great many forms such as asset-backed securities (ABS), collateralized debt obligations (CDO), mortgage-backed securities (MBS) and collateralized loan obligations (CLO). (Learn more in CDOs And The Mortgage Market.)

It was through these instruments that more and more people were easily able to access credit as financial institutions could profit from making ever increasing amounts of risky loans. This led to the lending institutions selling these loans to other investors in the form of innovative fixed-income securities. So it seemed a win-win situation for everyone involved. Consumers got the cheap credit they desired and investors found a way to earn higher returns over Treasuries with minimal perceived risk in the face of robust and stable economic growth.

The Problem
So if this was such a good thing, how did it turn so ugly? Well the answer to this question centers on one very persistent aspect of investor behavior in that people tend to extrapolate current events too far into the future. In this particular instance, investors implicitly believed through their pricing of risks (or required credit spread over Treasuries) that the economic stability we enjoyed during the mid 2000s would persist. Premiums investors required for bearing the credit risks associated with MBSs, CDOs, ABSs etc., were not priced accordingly for the level of underlying risk. This relationship can be dimensioned by using the proxy of falling credit spreads between the U.S. 10-Year Treasury and Moody's AAA rated corporate bonds as demonstrated in Figure 1. (Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point. For further, see Bond Rating Agencies: Can You Trust Them?)

Figure 1: Spread Between Moody\'s AAA and U.S. 10-Year Treasury
Source: Federal Reserve

What Went Wrong?
The question then turns to what went wrong and why did investors sour so precipitously on what had become an apparently successful means to provide easy access to credit for the average American and bolster investor returns? The answer to this question is rather simple in that it involves the relationship between leverage and the cost thereof.

Although Americans were more than happy to have easy access to credit cards, cars and home loans, it is unlikely they were aware this practice was placing the U.S.'s societal balance sheet in the most precarious position in its entire history. As you can see from Figure 2, total leverage in American society had not only reached its highest levels in history, but had done so at an accelerating pace in recent years. The result was our economy had become extremely addicted to leverage and overburdening unrealistic budget practices.

Chart 2: Total Societal Leverage (Household, Farm, Corp. Government and Financial) - June 2007
Source: Federal Reserve

One of the many problems in hindsight is that the Federal Reserve failed to take into consideration not only the incredible leverage inherent in our economy, but the reliance on low interest rates. Corporations were not the only parties dependent on low interest rates, home owners could only pay off their mortgage if rates remained low. Thus, they could not pay interest payments on their mortgages that exceeded the initial teaser rate. The shadow banking system enabled such a system to flourish because many of these economic anomalies remained hidden in the unregulated market.

So with the dual effect of high 2008 energy costs (recall gasoline at around $4 per gallon) alongside the higher interest rates that followed the mortgage teaser rates, the economy began to sputter. But more importantly, investors began to discount a recession into their pricing of securities and willingness to bear risk. This in turn created a positive feedback loop that hit the economy with higher credit costs as investors now required greater compensation for bearing risk given the fragility of the U.S. economy and peoples' ability to service their interest payments. See Figure 3.

Figure 3: Spread Between Moody\'s AAA and U.S. 10-Year Treasury
Source Federal Reserve

So the end of result of this confluence of events was exactly what the economy did not need. Investors were far less likely to lend money over fears over economic weakness and the shadow banking system essentially collapsed. So any lending that did take place was done at far higher interest rates than people were accustomed to. On top of this, the highly levered U.S. economy was not only unable to bear these precipitous increases in interest rates, but the lack of availability of credit in general. This is what led to the precipitous decline in U.S. economic activity, or the "Great Recession." See Figure 4.

Figure 4: Total Borrowing/Lending in U.S. Economy And Annualized Real GDP Growth
Source: Federal Reserve, BEA

The Bottom Line
point of this article is two-fold. The first is to serve a big picture history lesson for what the shadow banking system was, what caused its failure, how that failure contributed to the 2008 economic woes, and also to provide a demonstration of how important this system is to our economy given societal leverage. Albeit people always seek to demonize someone or something when things go wrong, it's important to remember that the shadow banking system could never have existed if there had been no demand for its services - the demand created the supply.

Like it or not, this aspect of our economy is essential given our country's penchant for borrowing to support consumer spending. Can we regulate it for the betterment of society and preclude such future meltdowns? Well, that remains to be seen. (Find out how this economic cycle affects both small and big business. Read The Impact Of Recession On Businesses.)

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