We aren’t seeing any of the indicators that would normally signal the onset of a broader default cycle. That gives us more confidence in treating these recent events as idiosyncratic.
Has the growing interconnectedness of credit markets made them more vulnerable?
Since the end of the global financial crisis, we’ve seen a slow retrenchment by banks away from lending directly to consumers and businesses. Instead, there’s been an increase in banks lending to so-called “non-depository financial institutions.”
Let’s say a private credit company raises a $1 billion fund. Typically, the entities that are investing in these private credit funds are life insurers, pension funds, endowments, wealthy individuals—all of which are long-term committed capital. In that sense, the rise of private credit should be very non-systemic, because the sources of capital are all long-term, committed, locked up capital—not runnable capital like bank deposits.
But that fund might then go to a bank and take out a $500 million line of credit that they can use to add a little financial leverage to the portfolio and juice returns. That’s the linkage that people get concerned about. But the banks are the most senior creditor in this situation, and so in this example, the fund portfolio would have to experience 50% losses before the banks would ever experience any loss in this scenario, which is excessively high for a portfolio of secured loans.
People point to the fact that banks do have a lot of loans outstanding to these non-depository financial institutions as a sign of the interconnectedness of credit markets. I still think that the structure of these loans has kept systemic risk low.
How have markets reacted to these events?
This is playing out most clearly in the share prices of business development companies (BDCs)—funds which make direct loans to small- and medium-sized companies. BDCs are one of the few public-facing windows that we have into the private credit world, and their stocks trade on the market in real time.
One of the larger BDCs announced on their earnings call in August that they were marking down a large position in their portfolio. That piqued everyone’s interest, and it was followed by a sell-off in BDC equities. The bankruptcies and fraud allegations in September and October accelerated the rout.
And by now, a large gap has opened up between the market value of the BDCs and their net asset value (NAV). That means one of two things is going to happen: Either BDC equities are going to rally to bring the market value and the NAV back in line or the market is expecting that, over the coming months, these companies are going to have to mark down some of their positions.