I guess I have to write about private credit...

And I guess you have to read about it.

[Just to be clear, I’m very tuned in to the economic costs of the war and busy prepping for a talk on that in a few days. So maybe tomorrow, I’ll get back to it. For now: the national average gas price just breached $4 (it’s $4.02 today), the SoH remains largely shutdown, and spillover costs, including food, appear to be rising. Read this, about which I’m very concerned—people were already stressed by grocery prices. The information from the admin about alleged negotiations is non-credible—Trump goes from de-escalation to escalation in the same sentence—so we’re flying blind here (here’s today’s latest on that).

I’ve said before and I’ll keep saying it: Americans will pay the costs of war if there’s a clear and compelling rationale for doing so. There is not.]

You know my methods, Watson. When enough people ask me about something, I write about it. That’s now the case with “private credit,” which I’ll define in a moment. For those who pay even passing attention to financial markets, there’s been a nervousness building around this asset class, and as a student of and firm believer in the “Minsky Cycle” (also defined below), the time has arrived for me to weigh in. Fortunately for me and you, others have done so with great clarity, so I’ll lean on some links here too.

BLUF: In terms of whether lending by private-credit funds, which has looked a bit shaky lately, is poised to hurt the broader economy, most experts, including the Fed, say “probably not,” for reasons I’ll give below. I’m less confident for two reasons. One, it’s a quite opaque market so it’s hard to assess its risk level, e.g., how systemically connected it is to the rest of the credit system, and two, I’ve seen this movie before and it usually doesn’t end well.

I’m reminded of the movie I started watching on Netflix last night called “Honey Don’t” about a detective. A client comes into her office to hire her because he suspects his partner is cheating on him. “I’m sure he is,” she responds. “How do you know!?” responds her surprised client. “Because by the time people come to see me about this, they know it’s true” (paraphrasing). I kinda feel that way about financial market implosions.

Unlike a lot of financial market nomenclature—“collateralized debt obligations” anyone?—”private credit” is a good definition. It’s credit, meaning somebody’s getting a loan, and it’s private, meaning it’s outside the traditional banking system.

On a recent version of Let’s Do Lunch, Mark Zandi, as is his wont, did an excellent job of explaining what private credit is and what it isn’t (go to minute 19:12). It’s another form of lending, he explained. Traditional banks take our deposits, and lend them out (actually, lend more than them out due to our “fractional-reserves” system) to businesses and individuals. “But private credit is outside the banking system. These are funds that are funded by, not deposits, but by insurance companies, pension funds, and other institutional investors. Increasingly, retail investors have gotten involved too.”

They lend those funds to businesses, some of whom might have had trouble getting banks loans, so the borrower pays a premium. But in other cases, the private-credit funds compete with banks, which has led some big banks, including Goldman Sachs and JP Morgan, to set up their own private funds.

The key point about private credit from my perspective—which, to be clear, is to worry about the risks they pose to the economy and therefore to regular people just minding their own business—is that they exist largely outside the regulatory perimeter. As Zandi put it, “they’re not regulated in any meaningful way.” What could go wrong with that?!

So, why is private credit in the news? Two reasons, they’ve been growing quickly, and there’s this interesting interaction going on between private credit, AI, and lenders to the private credit funds seeking redemptions.

On this first point, Greg Ip also has an excellent piece out on private credit, from which I borrow this figure.

On the second point, you may recall from a couple of weeks back, investors in smaller software companies got quite spooked by the prospect that AI-enabled “vibe-coding” would obviate the need for the companies in which they’d invested. Some of these investments were made through private-credit funds, and the investors, many of whom are institutional, as noted above, wanted to de-risk by withdrawing from the private credit funds.

But here again, private-credit funds do not operate like banks where you can walk in and demand to withdraw your deposits. The lending contracts include years-long commitments and impose caps on withdrawals, typically 5% of the funds. So, what was making the news was unmet redemptions, creating what felt to a lot of us like “run risk.” Some investors want to get their money back, some fund says “sorry, can’t do it,” and all the other investors freak out and want their money back too. Havoc ensues. Also, credit-market crash, recession, and your basic finance-driven cluster-mess.

This all sounds pretty worrisome, so why are most folks I hear talking about it not overly concerned? Are they just trying to talk themselves out of the angst that I suspect many readers are experiencing as we speak?

Not necessarily.

—Mark stressed that, even with their growth rates shown above, the funds in play are not that large, with around $1.7 trillion in credit outstanding vs. $2.8 trillion in subprime mortgages. And the latter figure is from almost 20 years ago, so it represents a much larger share of the economy. Still, $1.7t is over 5% of GDP, so there’s real risk herein.

—Both Greg and Mark note that private credit is less risky than subprime credit back in the housing bubble because its tendrils don’t reach as deeply into the broader system. As Greg puts it:

Subprime was more leveraged, and more complex. The loans were typically bundled into mortgage-backed securities, also known as MBS, which were then sliced up into tranches of differing risk. The MBS were in turn bundled into collateralized debt obligations, or CDOs, and sliced up again. Then, “synthetic” CDOs were created by writing derivatives linked to CDOs or MBS. These levels of leverage magnified losses.

Some private credit is packaged into collateralized loan obligations, or CLOs, but they are far smaller and less complex than their subprime forerunners.

Okay, but part of that is a matter of time—it’s spreading as we speak—and its opacity makes it hard to be certain of the magnitude of its dissemination and therefore its systemic risk.

—Because of its rules about holding periods and redemption caps, it doesn’t have the same run risk.

Again, sure. But, as we’ve seen in the news, when big, systemically important financial players, as well as retail investors, can’t redeem their investments, they make unsettling noises about it and that spooks the broader market.

—In the last financial crisis, subprime debt was directly linked to a tangible asset that meant a lot to the folks who lived under the roofs of those assets. Not so with private credit.

Agree. At least as far as we can tell, which is the common refrain for each one of these reasons to be less worried.

In other words, you should take some but not much comfort from these rationales. My concern stems less from details like those I just gave you and more from my familiarity with the Minsky Cycle leading to the Minsky Moment. John Cassidy provides a great read on these phenomena here, and I tag along here.

The cycle goes like this. As the economic expansion persists, financial markets begin to “innovate,” finding new ways to make money that are often a reaction to the regulations imposed after the markets blew up the previous expansion. To some, including Ip, this is as it should be: “This is a feature, not a bug: Financial innovation is often an adaptation to regulation. Private credit benefited from postcrisis rules that made bank loans costlier.”

To me, it’s often the start of yet another accident going out to happen.

As the expansion and innovations persist, regulators start to get confused at best and co-opted at worst. This co-opted dynamic is amplified by the Trump admin who is busy clearing the way for private credit and, far worse, crypto, to find its way into your 401(k). As the expansion progresses, risk grows and disseminates, and the “innovations” spread leverage throughout the system, leverage whose risk is systemically misunderstood and thus underpriced.

The Minsky Moment is when the underpriced risk finally becomes apparent, typically through loan defaults. At that point, as Ip says, “Interconnectedness can propagate and amplify losses through the financial system. Banks, securities dealers, hedge funds, Fannie Mae, Freddie Mac and the insurer American International Group nearly collapsed because of their exposure to subprime-linked loans, securities or derivatives.”

Here’s where I land on this: the “don’t-worry-yet” folks make some good points, but this looks, feels, and smells too much like the Minsky cycle that ends badly. The Times reports on a recent Goldman Sachs estimate that if private credit “…default rates spike to 10 percent, it could lead to as much as a 6 percent pullback in gross new lending as private credit firms retrench alongside other financial institutions. That, in turn, could depress inflation-adjusted gross domestic product growth by as much as 0.5 percent, a drag that the economists described as ‘manageable.’”

Perhaps, but for what? We should not assume that the juice is worth the squeeze, by which I mean that the risk engendered by allowing this form of credit to proliferate outside the regulatory perimeter is worth the lending it generates. Private credit isn’t anywhere near as bad as crypto, which has almost no use cases. But given the existing cost and availability of credit within the traditional system, I don’t see the need for unregulated private credit as significant enough to offset the risks it engenders, risks that are starting to surface.

Cycling back to the war notes at the top, don’t we have to worry about right now without elevated financial risk joining the party?!