13There has been a lot of financial bad news lately, but one story which has slipped under the radar has the potential to be the bigger than most.
Over the summer, the Financial Conduct Authority (FCA) revealed that unsecured consumer credit had hit £200bn for the first time since the global financial crisis, and this sparked a Guardian investigation into revealed the scale of the UK’s consumer debt problems.
Then just a few weeks ago, the Bank of England issued a sobering warning about the state of the country’s debt, saying that banks could face bills of £30bn as a result of loan defaults, if interest rates and unemployment were to rise.
The default risk is so high that the central bank has asked the entire banking system to hold an extra £10bn in capital ahead of an impending debt crisis to avoid further bail-outs.
But this looming debt crisis isn’t just a problem for the banks – it is potentially a problem for any individual investor who has exposure to the UK’s rapidly growing unsecured debt market.
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What is unsecured debt?
Sometimes referred to as simply ‘consumer debt’, unsecured debts are loans which have been granted without collateral.
So for instance, a mortgage would be considered a secured debt, as the property itself acts as an underlying asset which could be sold off if mortgage payments were to stop.
However, credit cards and car finance plans are usually offered to consumers without any request for collateral. This means that if these payments aren’t honoured, it is extremely difficult for the lender to recoup their costs.
Unsecured debt has become more popular in recent years for a number of reasons.
The rise of quick and easy online credit checks has given lenders a sense of security that they didn’t have before – after all, if a borrower has passed a credit check, then they must be able to pay back their loans!
Furthermore, the current low-interest rate environment has send many investors searching for alternative investment opportunities that can offer inflation-beating returns.
Unsecured debt offers some of the highest returns on the market, as the borrowers are usually unable to get financing from elsewhere. This can prove all-too tempting for ambitious investors who are comfortable with the higher level of risk.
However, unlike most other forms of lending and investing, with unsecured debt, if the borrower (or group of borrowers) defaults, the lender is left with nothing.
Are you exposed to unsecured debt?
Many investors may not even realise that they are exposed to unsecured debt until it is too late. These debts are easily wrapped up inside larger investment portfolios and sometimes disguised as a securitisation or a derivative.
Even debt-savvy investors may be unknowingly investing in unsecured debts via their investments in the UK’s financial sector.
The vast majority of the UK’s consumer debt is managed by the banks and underwritten by the insurance industry, so these institutions stand to make huge losses if there is a string of defaults on credit cards, overdrafts, and car financing.
Financial firms make up a large proportion of the FTSE 100, so any FTSE-tracking funds will be investing heavily in this sector.
In essence, every active investor in the UK has been bankrolling the UK’s latest debt crisis, whether they wanted to or not.
How do you manage your exposure to unsecured debt?
If you are worried about your exposure to unsecured debt, it may be worth going through your portfolio with an accountant or financial adviser, and moving your debt investments into secured bonds, gilts, or asset-backed loans.
Last updated: October 20th, 2017