There are no new hammers on Wall Street, only new nails.
Investors borrow against stocks. People borrow against their houses. Private-equity firms borrow against the cash flows of the companies they own. The universe of asset classes — buckets of sufficiently valuable things that can be borrowed against, bet against, securitized, collateralized, indexed, and generally tinkered with for profit by enterprising minds — has expanded to include art collections, lottery winnings, and litigation awards.
Private credit is a logical addition to that list. From essentially a dead start before 2008, it has grown into a $1.6 trillion market, and BlackRock estimates it could more than double over the next five years. “That’s an entire asset class that has to be financed,” one banker told me last week.
Since 2008 it’s become hard for banks to lend to risky companies. But it’s easy for banks to lend to the credit funds that do lend to those companies. They’ve traded one client set that regulators don’t like for another set that, for the moment, regulators are fine with. In the Rube Goldberg machine that is financial regulation, it makes perfect sense.
The question is where the risk is hiding. So far, these loans look fairly safe. Banks lend 40 cents or so on the dollar, leaving ample room for things to go badly before they take losses. Loans are secured by dozens of individual borrowers, which should make it less risky.
But that’s what boosters of subprime mortgage bonds said in 2007. Housing prices wouldn’t fall everywhere at the same time, they argued, so a pool of mortgages from Phoenix and Orlando and Chicago was safer than any single loan. We know how that went.
The companies that private credit funds lend to are facing soaring borrowing costs, and more and more are having trouble paying. Most of them are smaller companies that are less able to weather downturns, and most of them make their money the same way, by selling software and services to corporate customers. The loans usually aren’t rated by firms like Moody’s, whose track record is far from flawless but which are at least a check on Wall Street’s worst instincts.
It’s not hard to see how assumptions about private credit could be faulty. “Correlations do sometimes go to one,” Fellows told me. Adding debt on top would only exacerbate a bust.
