When Margot Robbie made a surprise cameo in the 2015 film adaptation of Michael Lewis’s book The Big Short, she did more to educate the general population about the risks of securitisation than most financial experts.
The Australian actor’s brief monologue, notoriously delivered from a champagne bubble bath, explained how banks were bundling up their growing cache of risky sub-prime mortgages into investable bonds, before slicing them up and selling them off for profit.
But the proliferation of these mortgage-backed securities in the early 2000s meant there was a catastrophic ripple effect across the global financial system when borrowers started to default on their home loans.
The resulting crisis in 2008 triggered a crackdown by regulators. They introduced new rules that could help ensure that asset-backed securities – once allegedly referred to as “crack cocaine of the financial services industry” by the billionaire Guy Hands – would never again spark such a massive meltdown.
But, 16 years later, some experts believe new risks are emerging. And this time, they are linked to highly indebted companies backed by private equity firms, which are part of the growing but opaque portion of the financial system known as the shadow banking sector. Shadow banking refers to financial firms that face little to no regulation compared with traditional lenders, and includes businesses such as hedge funds, private credit and private equity funds.
While the use of securitisation dipped in the wake of the 2008 financial crisis, as a result of a tarnished reputation and regulatory backlash, its popularity has subsequently risen. Today, the global securitisation market covers about £4.7tn of assets, according to estimates by analysts at RBC Capital.
The UK accounts for about £300bn of that total, but more than half – about £180bn – is part of the so-called public securitisation market.
In this public market, bundled loans are rated by credit rating agencies and sold on to a broad range of investors, and their terms, structure and sales are openly disclosed. These are the routes typically taken by traditional banks, which face far more stringent regulation. The remaining £120bn is made up of securitised loans bundled up by the shadow banking sector. Private securities are sold directly to a limited pool of sophisticated investors. They are less regulated, need not be reviewed by ratings agencies, and are far more opaque.
Some believe that the growth of the private market, and its lack of transparency, could pose a problem. “It probably is an under-appreciated risk, given the lack of regulation in that space and the complexities of the instruments that are being held there,” Benjamin Toms, an analyst at RBC Capital, said.
But even the public securities market warrants close review, according to Natacha Postel-Vinay, an assistant professor at the London School of Economics and expert in regulation and financial history. That includes risks related to collateralised loan obligations (CLOs). These are types of securities that are backed by a pool of debt, including loans to companies with low credit ratings, or struggling businesses that have been snapped up by private equity firms with the help of big loans, in what are known as leveraged buyouts.
“The private equity firms invest in companies that are almost failing, and in order to make these companies survive, they load them up with debt,” said Postel-Vinay. “These loans end up being repackaged as well, a little bit like the junk mortgages before the 2008 crisis.”
And although CLOs are usually made up of different kinds of loans to businesses in a variety of sectors, this does not entirely eradicate risk.
“It’s a game of whack-a-mole. You regulate stuff, but then the financial system finds ways around the regulation very quickly,” Postel-Vinay said.
The Bank of England is in the midst of compiling the results of its first stress test involving the shadow banking sector, the results of which are expected to be released at the end of next week. Although it will not focus directly on securitisation, the Bank has not been shy in flagging its concerns. It warned last December that, while UK banks were partly shielded from losses on CLOs by generally holding the highest-quality slices of the securities, the UK financial system was indirectly at risk through its connection to foreign banks and insurers that have a high and growing exposure to the loans held by already highly indebted companies.
And in June, the financial policy committee highlighted risks related to the private equity industry more broadly: “Vulnerabilities from high leverage, opacity around valuations, variable risk management practices and strong interconnections with riskier credit markets mean the sector has the potential to generate losses for banks and institutional investors.”
Postel-Vinay said it was important to determine who should be held responsible before things go wrong. “We want to make sure that we don’t repeat the mistakes [of the 2000s] and that it’s super, super clear who is responsible for the underlying credit risk in these loans.
“There are underlying loans that need to be repaid, and they need to be screened, and they need to be monitored … And in these cases, I have to say, there is a lack of transparency. I think a lot of people don’t know exactly what’s going on.”
