Risk in the Shadows: Leverage and Liquidity in Nonbanks

Abstract

High levels of short-term leverage raise concerns about the fragility and systemic risk of nonbank mortgage companies (NMCs). We find that NMCs also face high business risk, with revenue growth fluctuating between-26% and +128% at the 10th-90th percentile. Surprisingly, bankruptcy rates remain extremely low. We resolve this apparent tension by examining NMCs' cost dynamics, revealing that they substantially deleverage and cut operating expenses following adverse shocks. Thus, a true assessment of NMCs' credit risk must account for these dynamics. Supporting recent capital structure theory, we emphasize the role of collateralized borrowing in allowing high debt while mitigating distress costs.

Keywords: shadow banks, mortgage market, dynamic capital structure, collateral, systemic risk