Regulatory Aftermath & Safeguards: Shadow Banking Risks in the Mortgage Origination Market

In response to the subprime mortgage crisis and increased regulatory protectionism, shadow banks have significantly increased market share in the mortgage origination market, originating over 50 percent of conforming loans. This paper explores the effect of an inevitable interest rate increase on a potential deterioration in loan quality. Using 14.8 million loans from the Fannie Mae Single-Family Loan Acquisition dataset, this study generates a scenario analysis of mortgage origination based on parallel yield curve shifts to better understand the strength of traditional and shadow banks and their ability to withstand the pressure of rising interest rate. A secondary analysis examines the loan performance under stress conditions similar to the recent financial crisis. The results demonstrate higher shadow bank sensitivity to interest rate changes and a higher risk premium for subprime mortgages among banks. The findings substantiate the strength of the conforming loan standards as safeguards to ensure minimum loan quality.