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Aside from the wars that US President Donald Trump has started, there is one major question weighing heavily on the minds of financial-market observers. Are we heading for another meltdown? More specifically, does the rapid growth in private credit pose a threat to the stability of the financial system? The short answer, with apologies to the band Oasis, is “definitely maybe.”
On the “definitely” side of the argument are all the recent warnings from senior (and often prescient) financiers and regulators. For example, the International Monetary Fund has warned that 40% of private credit borrowers now have negative free cash flow. And UBS analysts project that default rates will likely double to 9-10% this year, causing significant stress in the system.
Likewise, Warren Buffett thinks that private credit poses a systemic risk through the links between private credit funds and banks. He has put his money where his mouth is, building a cash pile of close to $400 billion. Similarly, Andrew Bailey, the chair of the Financial Stability Board (FSB), warns of a “double or triple whammy” if tighter funding conditions accentuate already visible stresses. He calls our attention to “liquidity mismatches, opacity, and growing complexity in certain markets, notably private credit.”
Those on the “maybe” side of the argument include Paul Atkins, the chair of the US Securities and Exchange Commission, who recently told attendees at the IMF Spring Meetings that we should be grateful to have such a flourishing private credit market. “I think as we have been looking at this area, at least as of now, it is not a systemic risk,” he insists. Moreover, plenty of family offices and high-net-worth investors continue to pile into private credit, which has so far provided them with higher returns over time.
So, who has the better side of the argument?
For its part, the FSB has been worrying about the growth of non-bank financial intermediation for years. Overall, NBFI is now slightly larger than the global banking system, and within this broad category, private credit (definitions of which vary) has grown from around $300 billion in 2010 to close to $3 trillion today.
That is not such a great sum, considering that the global fixed-income markets mobilize about $140 trillion. But aggregate size is not everything, because there may be pockets (whether geographical or sectoral) where private credit plays a particularly important role, or where linkages with other finance providers could generate contagion risks across key markets.
A major issue that preoccupies regulators is whether the increase in banks’ capital requirements under Basel III has created a new kind of regulatory arbitrage, encouraging banks to lend to funds that pass the lending on to highly leveraged corporates. If so, regulators have simply made risky lending less transparent, causing overall risk to be underestimated. Far from being higher than in the past, the capital backing risky lending is lower—the opposite of what was intended.
Of course, those defending private credit would argue that the capital backing can be lower because a bank lending through other funds is not in the first layer of exposure and is more diversified across a portfolio of other loans. But that does not change the fact that the interposition of funds can result in hidden leverage, or that such funds may face redemptions or refinancing pressures that make the whole structure more brittle. These tensions burst into the open earlier this year when a Blue Owl fund was forced to halt redemptions. Efforts are now underway to construct a secondary market in private credit, but trading there has been negligible, leaving the sector’s basic liquidity problem unresolved.
Atkins dismisses such concerns. Investors who need liquidity should not have been in the market at all, he argues: “you have to be willing to take a loss… if you cannot take the heat, get out of the kitchen.” Fair enough, but if you hold a policy with a major life insurer, many of which have become big investors in private credit, you probably were not aware that you had ever entered the kitchen in the first place. You thought you were sitting at a table with a fixed-price menu.
A second area of concern for regulators are the so-called business development companies that raise money from retail investors to fund private loans. BDCs’ assets under management have grown to more than $500 billion, and they are typically leveraged at about 100%, mainly with lending from banks. Some are quoted; some are not.
Recent equity-market moves suggest that there could be trouble in the offing here, though the signals are not yet unambiguous. While bank shares have held up well in recent weeks (all the recent volatility has been a boon to trading desks), publicly traded BDCs are trading at a 10-25% discount. Declines in their stock prices signal growing caution about the private-credit cycle.
A final cautionary sign is that the big investment banks have started to make a market in credit default swaps against funds marketed by Apollo and others. This could be a positive development, since it allows investors to take out insurance against defaults; but until recently, such insurance was not thought to be necessary.
Should we see these developments as the proverbial canaries in the coal mine? Or is it just evidence that some funds have been exposed to a few “cockroaches,” as JPMorgan Chase’s CEO, Jamie Dimon, characterized the First Brands and Tricolor Holdings bankruptcies? While we cannot be sure, there definitely seems to be something burning in Atkins’s SEC kitchen. Any retail investors still in the vicinity would do well to don their oven mitts and keep a fire blanket close at hand.
