Subprime lending was one of the chief instruments that brought down the U.S. economy a decade ago. Too many with low incomes, bad credit, and few assets borrowed more than they could afford to buy that dream house, which was then used as an ATM to fund lavish purchases and exotic vacations to Biloxi, MS. In the aftermath of the financial crisis, lawmakers sprang into action, placing on banks new rules and regulations that limited lending to subprime customers.
Ignoring the primary drivers of reckless lending – the Federal Reserve and public policy to make housing a right – these officials believed they reined in predatory practices. As politicians concentrated their efforts on plugging one leak in the sinking ship, new fissures formed that now threaten the foundation of the financial system and the roaring economy.
So, what’s this new threat looming on the horizon? Backdoor lending by shadow banks.
Subprime Backdoor Lending
Subprime has made it to the forefront of the financial services sector once again. Banks are providing zero-down mortgages, lending standards are dissipating, and lenders originated 3.4% more subprime loans compared to last year.
Because of legislation, big banks are not entrenched in subprime like they once were. That is not to say that they refrained from making subprime an integral component of the industry.
…60% of U.S. mortgage lenders are shadow banks
Rather than directly involve themselves, they extended subprime to non-banks by funding financial entities that provide unsecured mortgage products, business loans, and leveraged lending. The pillars of Wall Street – Wells Fargo, Citigroup, JP Morgan, and Bank of America – have shifted tens of billions of dollars to these companies that do not hold a banking license.
Between 2010 and 2017, the big banks loaned an all-time high of $345 billion to non-bank businesses. For example, Exeter Finance, which services customers with an average credit score of 570, received a $1.4 billion lifeline from Barclays, Deutsche Bank, and Wells Fargo.
Overall, this has resulted in two interesting developments: 60% of U.S. mortgage lenders are shadow banks, and backdoor subprime lending is in the trillions.
Bank executives say this move limits their exposure, but Marcus Stanley, policy director at Americans for Financial Reform, told The Wall Street Journal that “it’s very easy for people to deceive themselves.”
It is evident that the power players of finance have made risky loans an important element of their business model, failing to learn from the past. It is true that risk is an imperative aspect of business and entrepreneurship, but this would not be a fearful trend were it not for precedence in the financial system: taxpayer-funded bailouts.
Liberty Nation has documented just how enormous subprime has become again. Federal Reserve data show that direct mortgage lending to borrowers with credit scores of less than 620 totaled $20.4 billion, but subprime has seeped into other areas of the credit market – not just housing.
Subprime auto loans accounted for approximately one-third of the $1 trillion market. A sub-problem of this issue is the number of underwater trade-ins, known as the trade-in treadmill: cars that have zero value or negative equity. The effects of this unsound business practice are beginning to be seen: Delinquency rates – more than 60 days past due – are higher today than during the economic collapse, prompting experts to sound the alarm.
Some argue that the subprime bubble has already popped, primarily because the industry is wrought with fraud and underreporting of losses. The latest estimates suggest otherwise, likely fueled by improving consumer sentiment and tightening standards.
But we have heard this song and dance before.
Interest rates are gradually normalizing, making borrowing costs and debt-servicing payments much larger. It is going to be increasingly difficult to keep your head above water. Studies have already pointed out that rate hikes cost consumers billions more in interest payments, even if the Eccles Building hits the pause button on the three planned increases in 2019.
Running of the Bulls
The U.S. equities market is running out of steam, the consumer will soon be tapped out, and the nation’s bills are piling up. Money-supply growth has moderated, fiscal policy can only do so much, and rates are going up, leaving us one conclusion: The bull market of the last decade cannot be sustained. The bubbles are everywhere, and normalizing monetary policy will pop them one by one, creating carnage unlike 2007 and 2008. The flow of champagne has been corked. Let’s hope bailouts and stimulus are not orders of the day come the next crisis. Otherwise the U.S. will be too broke to spur the next boom of the cycle.