#22 - Shadow Banking: The Other Financial World

It sounds like something from a science fiction movie: a shadow world that exists alongside the one we know. But “shadow banking” – an unregulated, opaque world of financial dealings that functions alongside usual commercial banking practices – is very real. And the transactions these institutions conduct have the potential to affect the affairs of investors and bank users throughout the country.

Shadow banking hit the news recently because of concerns about the scope of unregulated financial dealings in China. But it turns out that the United States is the home of the most shadow institutions in the world. And although shadow banks are legal, their very nature makes them vulnerable to crashing – and their involvement with the home mortgage industry means that homebuyers of all kinds could be affected.

The Financial Stability Board, a supervisory board of financial experts that oversees banking practices, defines shadow banking as unregulated banking activity that falls outside the definition of a commercial bank. According to the FSB, if an institution performs the core functions of a bank – taking the deposits of savers and using them to make long term loans to others, but isn’t subject to banking regulations and oversight, it’s a shadow institution.

Shadow banking isn’t illegal, and because these institutions operate largely on the level of investing and the buying and selling of securities, it might appear that the average bank customer would be unaffected by any of their activities. But shadow institutors played a role in the great housing collapse of 2008 and the massive number of transactions involving mortgage loans hat followed – and the fact that home mortgage loans that have been bought and sold numerous times may pass through the hands of shadow bankers means that mortgage applicants around the country could be affected by this kind of transaction.

The Federal Reserve’s newsmaking stimulus plan put the term “mortgage backed security” into the news. And that “securitization chain’ is how home mortgage loans become trapped in the shadow banking system. Those home loans that have been sold and resold eventually end up as part of a loan package used to back the value of securities that are then purchased by investors or government entities.

But if those loans go bad or loan holders fall victim to unethical lending practices, there’s little recourse. Because shadow banking is unregulated, it falls outside the scope of financial legislation and banking oversight that followed the crash. Shadow banking is a world of secrecy too, as these institutions aren’t bound to release information about their practices. And, if one of these institutions falls into crisis, it won’t be able to turn to the Federal Reserve or other government mandated fail safes for help. And that means little recourse for those involved in the transaction.

The FSB and other bank regulators are attempting to collect data on the scope and practices of shadow banking in the US, but true to it nature, little is known. But income property investors may want to follow Jason Hartman’s advice to stay aware and informed – and keep their transactions out of the shadows.