Blain’s Morning Porridge – December 7^th 2023: Betraying Ukraine and the Myth of Systemic Crisis in Private Credit

“Financial literacy around private credit has actually gotten quite sloppy.”

The Bank of England is worried about Private Credit Markets – good to know they’ve heard of it! Their concerns are valid, but it’s a market very different to banking and doesn’t share the same systemic risk triggers. Its full of opportunity!

First Up – Ukraine

Vladmir Putin will be a happy chap this morning. He spent yesterday with his new-found besties in Saudi Arabia and the UAE. (He will be meeting Iran’s President Raisi today.) Last night the US Republican Party did what the Russian Army could not – handed him Ukraine. Today is 7^th December, and their vote makes this another “day that will live in infamy.”

US funding for Ukraine will run out early next year – potentially putting an entirely different spin on the conflict’s outcome. Europe is also split on the aid it has promised. Sensitivity to energy prices and access to non-Russian supplies remains the economy’s key vulnerability for Europe. If the Middle East and the rest of the “non-aligned” Global South see the outcome of the war moving in Russia’s favour, then the current weak oil market could swing, deepening economic crisis in Europe, encouraging Russia to go “outward bound” on other parts of its lost empire, while China pulls the strings.

Loosing Ukraine will cost the credibility of the West. Spare a thought for Ukraine this morning. I bet they are more than a little peeved.

Private Credit Markets

Back in London, it would be easy to start this morning with a classic Bank of England joke: “Private credit markets must already be busted if The Bank and Andrew Bailey have woken up the risk of a systemic collapse in the £1.8 trillion private credit market.”

I will resist the temptation – I don’t have a problem with Governor Bailey. It must be tough being the Tory’s whipping boy for every monetary failure, yet when the plan comes good and inflation falls, nary a thank-you from Rishi Sunak who is busy claiming all the credit. It’s in the Torygraph: Bank of England warns Private Credit poses threat to financial stability.

Private Credit – a large part of my day job in Alternative Markets – has been difficult this year. Deals are getting done, but a slew of headlines about unconstrained lending losses, investment portfolios run by careless investment managers crashing, and a number of high-profile deal horror-stories, have put off many wealth managers from investing in the sector. It’s easy to say no to investing in “story” credits at the beginning of what may be a recessionary 2024 market if corporate credit default fears are set to multiply.

The crux of The Bank’s concern is the likely impact of higher interest rates on private credit. Borrowers, and the projects financed, tend to fall into the more speculative buckets of the debt market. As rates rises their default rate will rise fastest. The Bank cites private credit as an example of a market fuelled by the ultra-low interest rates of the QE/ZIRP era, but this only partly true.

The private credit market is a consequence of the Global Financial Crisis, spawned by the response of banking regulators and the evolution of markets and risk. Yet, there is a massive systemic difference between how banks handled risk, and how direct-lending/private credit funds now manage that credit risk.

The biggest fear in Credit Markets is liquidity – in a crisis bankers panic because it will prove impossible to sell credit investments. Who would want to buy corporate credit if the market turns “offered-only”? (That’s exactly what happened across the credit markets in 2008 – there were no bids for bank or structured product at all.) That’s a liquidity crisis.

Liquidity is a killer than slaughters Banks quickly. Start a rumour a bank has lost a lot of money and investors start to pull their deposits – worried about its’ survivability. Liquidity events are usually terminal for banks – every bank failure I can think of has been a liquidity driven failure. It illustrates how the problem for banks is the deposits they lend is “impatient money”. Deposits can walk any time. They are sensitive to any market noise. Lending long with short-term money is where banking becomes performance art rather than financial science. It was a massive conjuring trick – some banks did it well.. others were Credit Suisse, Lehman, RBS, or Silicon Valley Bank.

In 2008 – following the collapse of Lehman Brothers – regulators realised the systemic risk in banking is liquidity. They determined the best way to address this was to stop banks taking and holding risk – introducing hasty new regulations increasing bank capital requirements, while effectively stopping risk taking activities in trading. Banks were already in the risk-transfer game – large capital market divisions selling bonds and structured investments (usually packaged securitisations of financial assets like mortgages, or buckets of debt in the form of collateralised loan obligations) to end investors.

These end investors – real money institutions including pension and insurance providers are very staid, careful and cautious investors. They have long-term liabilities to meet. Which means they are “patient money” investors. Investments are long-term. They don’t have to panic about mismatches or margin calls, or selling a bond today to repay desperate investors, creating a loss – investors have to wait. They worry about making sure they have enough money coming back in 20-30 years time to pay their liabilities.

Smart hedge fund types – usually former bankers like myself – immediately spotted the opportunity. They had seen how prices which collapsed in 2008 did so on fear – before there were any real losses. In fact, most financial assets, like corporate bonds, residential mortgage backed bonds, senior tranches of CLOS, and even bank debt, repaid on time at 100%. As banks stopped lending to property and corporate sectors, the private credit sector rapidly emerged to replace it – seeing the opportunity to make money by lending at higher “private” rates to markets starved of capital by the contraction in bank lending.

(This morning, I have to laugh at senior US bankers bleating to regulators about the high costs the latest Basle III capital requirements will place on them… how it will constrain their lending etc.. Have they missed their new evolutionary niche – they are no longer risk takers, they are risk processors!)

There is a large swathe of the market commentariat which fears all we have done is transfer risk from banks into the asset management sector. Regulators have warned about unfair access: many large-levered lending transactions have become club deals among the biggest non-bank lenders. Moody’s has warned that competition for deals has eroded “pricing, terms and credit quality” of deals. Others warn about conflicts of interest and the lack of oversight by regulators. However, the systemic risk is spread over hundreds of funds, not 10s of banks.

Where once banks had massive lending departments who could analyse risk by sector and economy, today that risk management expertise is spread around thousands of investment funds. In many cases the guys running risk on for credit hedge funds are more aware, better informed and more empowered to deal with risk than essentially bureaucratic bank risk fuctionaires who are managing for their compliance teams and to keep the regulator happy. Private credit funds – and the rest of the Alternative Capital Market Sector – manage for returns.

Of course, that does not mean the Private Credit sector is riskless. If you want to know how badly it can wrong, ask Lord David Cameron to explain what happened when he was on the board (but not a director) of Greensill and how its only real client, the Gupta’s, spun a web of deceit around their assets. (Don’t believe me – check out this week’s Private Eye City Pages… as always the best source for news of political skullduggery.)

But could Private Credit create a global financial crisis similar to the GFC of 2008? Perhaps. It would require the multiple private credit investors to all sell their assets simultaneously to mimic a liquidity crash, which may happen if a tsunami of corporate defaults occurred. (Even if that happens most private credit, direct lending, and structured credit investors have security over the assets and cash of their borrowers, meaning they could expect decent recoveries.)

What is slightly worrying is how the Private Credit Sector is becoming a de-facto less regulated shadow banking sector. At present most of these funds leverage themselves up by pledging assets vs bank borrowing (another potential trigger of systemic risk to banking). Now they are selling their own CLOs to other investors – effectively leveraging themselves. They effectively now create debt across the economy – every time a bank or fund extends a loan using leverage it creates money.  Every time you add complexity to a transaction you create potential consequences – like the LDI crisis that nearly sunk the UK gilt market.

Keep an eye on Private Credit… but not just because it might be a future crisis, but because of its opportunities.

Five Things to Read This Morning

FT                    Commercial Property confronts the “comedown” from easy money

FT                    Google’s Gemini makes mobile breakthrough for generative AI

CoinDesk         Crypto Exchange Bitzlato co-founder pleads guilty to US money laundering charges

WSJ                 Republicans Block Ukraine Aid Bill, Putting New Pressure on Border Talks

BBerg              China’s Weak Trade Data Signals More Economic Paint to Come

Out of time

Bill Blain

Market Strategist and author of the Morning Porridge