Finance is always alive with risk, but if you had to pinpoint exactly where the next big crash waiting to happen lies, it would be so-called “private credit.”
So if you can spare yourself for a moment from the gripping details of an election campaign that seems to have only one possible outcome, read on.
Alarm bells should start ringing when an area of finance grows too quickly, and it does so at a capsize.
Last week Goldman Sachs announced that its asset management arm had raised a further $13.1bn (£10.3bn) for private credit investment, bringing its current fund allocation to this asset class to $20bn.
Not alone. Blackstone, KKR, Apollo, Oaktree, Uncle Tom Cobley and others; almost all money managers of global importance accumulate.
Leveraged loans and private loans taken together have roughly doubled in the last decade, according to Bank of England estimates. Within this, private loans have grown even faster, quadrupling since 2015 to nearly $1.8 trillion globally. Given the limited nature of available data, the overall risk is likely to be much higher.
Private credit or private debt, sometimes referred to as the “shadow banking” sector, is just a generic term for non-bank loans and covers a highly diverse group of both providers and loan types.
Since the banking system collapsed in the 2008-10 financial crisis, non-bank forms of finance have increased rapidly and today account for around half of UK and global financial sector assets.
One way or another, finance always finds a way. When banks stopped lending, private credit stepped into the breach, partially compensating for the contraction in traditional types of credit and the multitude of restrictive regulations subsequently imposed on them.
Call it the “waterbed” principle of finance; As it is pushed down from one area, it rises up from another. Regulators always find themselves one step behind. While markets are busy shoring up the system against the latest setback, there will always be sowing the seeds of the next one in new pastures that are less transparent and unregulated.
Lee Foulger, director of financial stability, strategy and risk at the Bank of England, said in a recent speech that such forms of non-bank finance were responsible for almost all of the £425bn increase in net credit to UK businesses since the financial crisis. guessed. .
This can of course be considered a good thing, as private lenders are at least continuing to expand credit. Mainstream banks in general therefore welcomed competition, which kept many struggling companies alive, protecting them from further costly losses.
Private credit has also provided alternative sources of financing for many of today’s technology start-ups; The vast majority of banks are reluctant to lend, given that such businesses are a whim and a prayer with a lifespan of no more than a few years.
Prudent regulators are similarly fickle; they are acutely aware of the risks, but reluctant to block an important potential engine of growth and a ready source of financing for companies that would otherwise struggle to obtain it.
Private credit has therefore come to be widely viewed as an important alternative to banks, both as a useful shock absorber and – at a time when banking regulations are stifling – as a facilitator of economic growth.
But the dangers are clear. What’s really driving the growth in private credit is another enduring characteristic of finance: the search for returns.
Ultra-low interest rates have left investors seeking higher rates of return increasingly unaware of risk.
When something seems too good to be true, it usually is, and the returns on private loans can be as high as those in your teens.
As the banking industry regains its health once again, most creditworthy companies can borrow as much as they want, again at much lower interest rates; So you have to ask yourself what kind of business is desperate enough to accept such eye-watering debt servicing costs? .
Arrangement fees also tend to be punishingly high, giving financiers an added incentive to encourage this type of lending.
Providers insist that the high cost of the loan is a reflection of the high nature of the risk, but it still looks like something of a racket.
One increasingly common practice is “fix and extend” (A&E), in which lenders agree to postpone the maturity of the loan, often in exchange for a higher return. “Payment in kind” practices (Piks), where debtors with weak cash flows issue new debt to cover the interest payments on their old debt, are also becoming widespread.
This is Ponzi-style lending in which our old friends, the credit rating agencies, who were star players in the deteriorating risk assessment standards that led to the financial crisis, are again often complicit by giving them investment grade status.
As one experienced credit analyst told me: “Write what you want about private credit, but I strongly recommend not investing in it.”
The example below tells its own story. Blackstone’s latest loss from the sale of 1740 Broadway, a 26-story, nearly vacant office building near Manhattan’s Columbus Circle, was so large that it included some of the highest-rated AAA bonds, according to financial services firm Morningstar. It destroyed many layers of bonds, including slice.
The $40 million loss on the Triple-A-rated loan is the first failure of its kind this cycle. There will definitely be more.
So does it really matter if investors lose their shirts over credit risks like this? Or in other words, are such losses systematically important? Yes, they can.
It is entirely true that the banking system itself is largely insulated from losses on private loans. Banks often lend to private lenders, but they almost always have initial liability for assets, so they are unlikely to be badly affected by even a widespread private credit collapse.
But insurance companies and pension funds are up to their necks in such illiquid assets, and in some cases are already suffering significant unrealized losses. These are highly regulated institutions, but savers may be deluding themselves into thinking their money is safe.
Making things potentially even more dangerous is the fragmentation of the world economy. pressure created by increasing geopolitical tension It has already badly disrupted international efforts to secure better standards of global regulation.
The post-financial crisis reform agenda has run out of steam and is now almost dead.
Moreover, the global response to the financial crash that Gordon Brown managed to mobilize in 2009 is unlikely to succeed in today’s much more fragile world.
Even if it were politically possible, governments are financially strained to provide a second round of financing. It’s as if no lessons have been learned from what happened almost 16 years ago.