Amna Nawaz:
Lately, investors and economists are warning about a piece of the financial system that could pose a risk, potentially similar in ways to the housing crash that preceded the financial crisis in 2008.
It’s part of what’s been called the shadow banking system, the private credit market, an alternative type of lending to companies that doesn’t involve traditional banks.
We asked economics correspondent Paul Solman to explain how it works, what’s at stake, and why alarm bells are sounding in some quarters.
Paul Solman:
Bought an aftermarket car part in recent years? Good chance it came from First Brands.
John Basquill, Senior Reporter, Global Trade Review:
First Brands was a large supplier of auto parts, things like wiper blades, spark plugs.
Paul Solman:
Over a decade the company borrowed heavily to grow, gobbling up 20 companies employing 25,000 people, until this fall, that is.
John Basquill:
The lenders had become a bit concerned about some of the financial goings-on at the company and requested some extra information which First Brands couldn’t provide.
Paul Solman:
What happened? Went bust. And who were its lenders? Many came from the world of private credit, a part of the global financial system that’s exploded in recent years and has some key players in finance rattled.
Jamie Dimon, Chairman, J.P. Morgan Chase:
I should probably shouldn’t say this, but when you see one cockroach, there’s probably more. And so we should — everyone should be forewarned on this one.
Paul Solman:
One such roach, First Brands.
Jeffrey Gundlach, CEO, DoubleLine Capital:
I have been saying this for probably two years now, that the next big crisis in the financial markets is going to be private credit.
Paul Solman:
OK, but what exactly is private credit?
Mark Zandi, Chief Economist, Moody’s Analytics:
Private credit is just lending by nonbanks, financial institutions like pension funds, insurance companies, sovereign wealth funds, but not going through the banking system, thus the word private.
It’s grown very rapidly. It’s now a sizable player in the financial system.
Paul Solman:
Growing from a $40 billion market in the year 2000 to nearly $2 trillion today.
Natasha Sarin, President, Budget Lab at Yale University: The reason for that growth is that, after the Great Recession, regulators realized that large financial institutions had been really exposed to making relatively risky bets without having enough of a backstop internally in the form of capital that they held that was available for the bank to draw down on in case some of those bets went sour.
And so the result of the aftermath of the crisis and the post-crisis regulation in Dodd-Frank was to say that, in order to take those types of risks, it would be more expensive for banks going forward.
Paul Solman:
As a result, most banks pulled back from riskier lending.
Natasha Sarin:
And private credit stood ready, in some sense, to take advantage and meet the need of the market to be able to make those types of loans.
Paul Solman:
For investors, returns on those loans were, well, mouthwatering, nearly double the rate of government bonds or other loans. So what’s the problem?
Mark Zandi:
One of the issues with private credit is, the lack of transparency is very opaque. It’s not like the banking system, where it’s highly regulated and exactly what’s going on. Here, we don’t know very much because it is private. And so that makes it a little bit more disconcerting.
Paul Solman:
For example, private credit firms can report the value of their loans according to their own internal models, rather than the market price, marking to model instead of marking to market. Problem is, it’s nearly impossible to verify that the loans are worth what they’re claimed to be.
Mark Zandi:
Most times, no big deal. That’s probably just fine. But when you get into kind of a risk-off environment, when things are moving quickly, prices are falling rapidly, that’s when mark to model becomes more of an issue.
Paul Solman:
A loan mark to model could even become a loan marked to zilch.
So how serious is the risk posed by private credit to the American economy as a whole?
Mark Zandi:
It’s consequential, but it’s still on the small side. And I don’t think it’s at a place yet where it could do us in.
Natasha Sarin:
In some sense, it’s a yarn that you start to pull and you’re worried that it’s both potentially unraveling, but also that it’s potentially connected to all the other parts of the financial system. And the system is still very much reliant on all of these different pieces in a way that regulators don’t yet fully appreciate. And I worry none of us fully appreciate the possibility of cascading downturn risk as well.
Marc Rowan, CEO, Apollo Global Management:
Most of the market is investment grade. Credit stats are actually improving, rather than declining.
Paul Solman:
Look, says Marc Rowan, CEO of private credit giant Apollo Global Management:
Marc Rowan:
There are good banks and bad banks and good insurance companies and bad insurance companies and good asset managers and bad asset managers. But there’s nothing that I see that is systemic.
Paul Solman:
Systemic risk, that’s the danger, which starts with risk to, well, viewers like you.
Tom Gober, Insurance Fraud Examiner:
A very large percent of the population is affected by this higher risk without knowing.
Paul Solman:
Insurance fraud examiner Tom Gober.
Tom Gober:
I look after policyholders and annuitants. If you have a life insurance policy or an annuity, I’m trying to help that you know you’re going to be safe. But now there’s a lot of pensioners who are also counting on the same insurance companies that are taking all these risks.
Paul Solman:
And suppose insurance policy and annuity holders get skittish and start withdrawing their, or, I should say, our money, the money that backs up the private credit loans, putting them in jeopardy?
In fact, recent headlines have featured bankruptcies of firms financed largely by private credit, Renovo, Tricolor and, where the story began, First Brands. A cockroach operating in the dark accused of engaging in blatant sleight of hand accounting.
John Basquill:
The company or group companies would make a sale, generate an invoice, and then sell that invoice or the sort of debt that generates to a third-party investor. And there were huge, multibillion-dollar investments in invoices that First Brands was generating.
Paul Solman:
Those billions came in large part from private credit, that is, private loans backed by invoices. Unfortunately, the head of First Brands was allegedly faking those invoices and selling them more than once.
And, worse still:
John Basquill:
We’re talking about a company that’s now being accused of siphoning off billions of dollars to fund its founder and CEO’s personal extravagant lifestyle.
Paul Solman:
That’s why the new CEO of the company is suing his predecessor for malfeasance, while a spokesman for the old CEO says he — quote — “categorically denies the baseless and speculative allegations contained in the First Brands complaint.”
But the point is, First Brands, financed in the so-called shadow banking industry, was operating in the shadows, which leads to the question of the day regarding the private credit industry. Were First Brands and its fellow private credit failures anomalies or an early harbinger of risks not unlike those that triggered the financial crisis of 2008?
For the “PBS News Hour,” Paul Solman.