When you suddenly hear about a boom in a financial instrument in the mainstream media you can be pretty sure trouble is on its way. At the very least you can speculate that a peak market level, whether in volume or price has been or is about to be reached.
There are a number of reasons for this. It can be because so much money has been made that the ‘nouveau riche’ of this endevour are boasting about it, settling of a wave of FOMO that hits the media, or it simply can mean at the top of the market, holders of that asset want and start to need ‘exit liquidity’ and are out promoting what they want to sell, to pull in the final bag holders.
Either way it’s a signal to me that something wicked this way comes.
So the phrase ‘private credit’ markets, is popping up more and more and the narrative is that they have been booming. To me this says they HAVE boomed. ‘Private credit’ sounds like a long established thing but its relatively new, a term dating back to just after the aftermath of the GFC. The ‘Private credit market’ is barely a market at all because the financial instruments it generates are not publicly traded. Private credit is lending to companies at high interest rates by non-banks. A cynic could typify it as loan sharking to shaky companies by shady outfits, but that would be very harsh even for such a lucrative business.
So lets go digging. Where can I get some of this ‘private credit?’ It doesn’t seem to be exactly front and central in rustling up business and yet there is $2tr of ‘private credit’ loans out there. That is a systemically important amount of money.
So lets keep it simple.
Q: Who raises this ‘private credit’
A: Private Equity outfits
Q: So who do they lend it to?
A: Private equity backed companies
Q: Why do they lend it to Private Equity backed companies
A: To keep Private equity backed companies afloat and/or pay out dividends to Private Equity participants.
Q: Who do the Private equity companies sell the ‘private credit’ debit on to.
A: Institutions like your pension scheme, sovereign wealth funds, university endowments and the sort of operations that go stuffed with mortgage derivatives that blew up the world.
Q: Who invests in Private Equity outfits?
A: Institutions like your pension scheme, sovereign wealth funds, university endowments and the sort of operations that go stuffed with mortgage derivatives that blew up the world.
Q: Why do Institutions like your pension scheme, sovereign wealth funds, university endowments, invest in PE and ‘Private credit?’
Official A: Because the returns are great.
Cynical A: Because the value of the illiquid investments are made up in private not by public markets that trade daily, so the results are ‘smooth.’ Bad news can be left to the bitter end and that end is far away, as likely will be the initial buyers or sellers.
In summary PE buys companies with investors money, levers up the companies or keeps them afloat with high interest loans with more from the same kind of investor groups, making lots of money along the way.
Q: Isn’t this the kind of circular, opaque, conflicted dynamic that caused the ‘Global financial crisis.’
A: Yes, but thankfully the numbers are not as big. (If you don’t consider $2tr as scary)
Lets wave some red flags. The acronym of the day WCGR!
The market has grown 400% in 10 years.
Reall high-interest rate loans up to 15%
Returns to repay these high-rate loans have to come from successfully running complex businesses which were bought because they were either distressed or because the owners were happy to be shot of them.
Circular transactions of opaque, illiquid and not ‘mark to market’ are classic causes of financial meltdowns.
The customers for these instruments are classic Wall Street victims, see the S&L Loan crisis, the Credit Crunch/GFC and a never ending stream of scandals.
…but it might never happen but what might the impact be of trouble in this never blossoming financial juggernaut?
Just like the Mortgage market in the GFC, it depends on the quality of the assets generated by this financial process. The lower the quality on average of the edebt the more likely things could go belly up and send hundreds of billions to money heaven. The seeds of a vicious circle are all there. If the private credit market freezes, then companies who cant roll their barely sustainable debt fail, this devalue the value of the existing good paper, which will tend to create forced/panic sellers, which knocks on to a deeper freeze and further failures, contagion spreads.
The interconnectivity of this market through the financial system is not fully known but hundreds of billions of credit assets going up in smoke would certainly have ramifications.
However, here is the thing. This is all built out of cheap, near free money created by the history of recent bailouts and QE’s. This is turn is ultimately created by US fiscal deficits which drive the need for constant liquidity boosts, to drive money around the system to end up back in government coffers via tax or debt. It’s a highwire act and the circus has never been bigger.
This might actually be good news in the short term because a crisis in ‘private credit’ will simply be bailed out and that means money printing. This would probably mean QE or some version of it which is on its way anyway, is nearer than far.
A ratcheting of instability has no end in sight so this potential crisis is yet another indicator that the direction of travel for the dollar is weakness, inflation above the legacy 2-3% target and chronic heightening volatility.
Meanwhile the ‘Zombie treadmill’ will grind on as ‘Private credit’ industry heads from back rooms to the front pages. Another financial crisis in the making? Ultimately there is always another on its way, but this could certainly be the next one.