There are always risks involved in the financial sector, but if you had to put your finger on where exactly the next big disaster will happen, it would be in the area of so-called ‘private credit’.
So if you can tear yourself away from the harrowing details of an election campaign that seems to have only one possible outcome, read on.
Whenever a financial sector is growing very quickly, alarm bells should start ringing, and this sector is growing like it is upside down.
Last week, Goldman Sachs announced that its asset management arm had raised a further $13.1 billion (£10.3 billion) for private credit investments, bringing the amount it now spends on this specific asset class to $20 billion.
It’s not the only one. Blackstone, KKR, Apollo, Oaktree, Uncle Tom Cobley and the like – virtually every money manager of global importance has signed on.
According to estimates from the Bank of England, the size of leveraged lending and private credit has roughly doubled over the past decade. Within that, private credit has grown even faster, quadrupling since 2015 to around $1.8 trillion globally. Given the limited nature of the available data, the total exposure is likely to be much higher.
Private credit, or private debt – sometimes also called the ‘shadow banking sector’ – is just a collective term for non-bank lending and includes a very diverse group of both providers and forms of credit.
Since the banking system failed during the 2008-2010 financial crisis, non-bank forms of finance have grown explosively, and today represent around half of all assets in the UK and global financial sector.
One way or another, finance always finds a way. When banks stopped lending, private credit ran into problems, partially compensating for the shrinkage of traditional forms of credit and the mountain of restrictive regulations that were subsequently imposed on them.
Call it the ‘waterbed’ principle of finance; is pushed down in one area and only rises up in another. Supervisors are always one step behind. While they are busy protecting the system from the latest misfortune, the markets will invariably sow the seeds of the next one in new, less transparent and unguarded pastures.
In a recent speech, Lee Foulger, director of financial stability, strategy and risk at the Bank of England, estimated that such forms of non-bank financing have been responsible for almost all of the £425 billion net increase in lending to UK businesses since the financial crisis. crisis. .
This can obviously be seen as a good thing, as private lenders have at least been able to sustain credit growth. On the whole, mainstream banks have therefore welcomed the competition, which has protected them from further costly write-downs by keeping many struggling companies alive.
Private credit has also provided alternative sources of funding to the current glut of technology startups, where banks are reluctant to lend as the vast majority of such businesses are made on a whim and a prayer with a lifespan of no more than a few years.
Prudential regulators are also ambivalent; they are well aware of the risks, but are loath to crack down on an important potential growth generator and an easy source of financing for companies that might otherwise struggle to obtain it.
Private credit is thus quite widely seen as both a useful shock absorber and – in an era of stifling banking regulation – an important alternative to banks as a catalyst for economic growth.
Yet the dangers are all too clear. What has really driven the growth of private lending is one of the enduring hallmarks of the financial world: the search for returns.
Ultra-low interest rates have made investors less aware of risk as they seek higher returns.
If something seems too good to be true, it usually is, and returns on private credit can be as high as the mid-teens.
Now that the banking sector has returned to health, most creditworthy companies can once again borrow as much as they want at much lower interest rates. So you have to wonder what kind of company is desperate enough to accept such eye-watering debt loads. .
The transaction costs are also often punishingly high, which provides an additional incentive for financiers to promote this form of lending.
Providers insist that the high cost of credit reflects the high nature of the risk, yet it appears to be some kind of racket.
An increasingly common practice is ‘amend and extend’ (A&E), where lenders agree to postpone the term of a loan, usually in exchange for an even higher return. “Payment-in-kind” (PIKS) practices, where borrowers with poor cash flow issue new debt to meet interest payments on old debt, are also becoming widespread.
This is a kind of Ponzi loan in which our old friends the credit rating agencies – key players in the deteriorating standards of risk assessment that led to the financial crisis – are once again often complicit by awarding investment grade status.
As one seasoned credit analyst put it to me, “Write down what you like about private credit, but I would strongly advise you not to invest in it.”
The following example tells its own story. According to financial services firm Morningstar, Blackstone’s recent loss on the sale of 1740 Broadway, a virtually vacant 26-story office building near Manhattan’s Columbus Circle, was so large that several layers of bonds were wiped out, including some of the highest-priced bonds AAA rating. tranche.
The $40 million loss on triple A-rated credits is the first failure of its kind this cycle. There will certainly be more.
But does it really matter if investors lose their shirt on credit exposures like this? Or in other words: are such losses systemically important? Well, maybe.
It is quite true that the banking system itself is largely insulated from losses on private credit. Banks often lend to private lenders, but they will almost always charge fees on the assets first, so they are unlikely to be badly hit even by a widespread private credit crunch.
Yet insurers and pension funds are up to their necks in these types of illiquid assets, with in some cases already significant unrealized losses. These are highly regulated institutions, but savers can fool themselves into thinking their money is safe.
What makes things potentially even more dangerous is the fragmentation of the global economy pressure from increasing geopolitical tensions has already seriously damaged international efforts to achieve better standards of global regulation.
The post-financial crisis reform agenda has been exhausted and is now virtually dead.
Moreover, the kind of global response to the financial collapse that Gordon Brown engineered in 2009 is highly unlikely in today’s much more troubled world.
Even if it were politically possible, governments are already in far too much of a budgetary bind to save their finances a second time. It is as if no lessons have been learned from the events of almost sixteen years ago.