Finance is always alive with risk, but if you had to put your finger on where specifically the next big accident waiting to happen lies, it would be in so-called “private credit”.
So if you can for a moment tear yourself away from the gripping minutiae of an election campaign that seems to have only one possible outcome, read on.
Whenever an area of finance grows very rapidly, alarm bells should start ringing, and this one is growing like topsy.
Last week, Goldman Sachs announced that its asset management arm had raised a further $13.1bn (£10.3bn) for private credit investment, bringing to $20bn the funds it now devotes to this particular asset class.
It’s not alone. Blackstone, KKR, Apollo, Oaktree, Uncle Tom Cobley and all – virtually every money manager of global significance has been piling in.
According to Bank of England estimates, leveraged lending and private credit taken together have roughly doubled in size over the past decade. Within that, private credit has grown even faster – four-fold since 2015 to around $1.8 trillion globally. Given the limited nature of the available data, total exposure is in all probability a great deal higher.
Private credit, or private debt – sometimes also referred to as the “shadow banking” sector – is just a catch-all term for non-bank lending, and encompasses a highly diverse group of both providers and forms of credit.
Since the banking system went belly up in the financial crisis of 2008-10, non-bank forms of finance have ballooned, and today accounts for around half of all UK and global financial sector assets.
Somehow or other, finance always finds a way. When the banks stopped lending, private credit stepped into the breach, partially compensating for the contraction in traditional forms of credit and the mountain of restrictive regulation that was subsequently imposed on them.
Call it the “waterbed” principle of finance; push down in one area, and it merely rises up somewhere else. Regulators always find themselves one step behind. While busy shoring up the system against the last mishap, markets will invariably be sowing the seeds for the next one in less transparent and unsupervised pastures new.
In a recent speech, Lee Foulger, the Bank of England’s director of financial stability, strategy and risk estimated that such forms of non-bank finance have been responsible for nearly all of the £425bn net increase in lending to UK businesses since the financial crisis.
This might of course be regarded as a good thing, in that private debt providers have at least kept credit growing. On the whole, the mainstream banks have therefore welcomed the competition, which has insulated them from further costly writedowns by keeping many struggling companies alive.
Private credit has also provided alternative sources of finance for today’s plethora of tech start-ups, where banks are reluctant to lend given that the vast majority are such enterprises are on a whim and a prayer with a lifespan of no more than a few years.
Prudential regulators are similarly ambivalent; they are only too aware of the risks, but are loath to crack down on an important potential dynamo of growth and a ready source of finance for companies that might otherwise struggle to get it.
Private credit has thus become quite widely seen as both a useful shock absorber and – in an era of suffocating banking regulation – an important alternative to the banks as an enabler of economic growth.
Yet the dangers are all too obvious. What’s really driven the growth in private credit is another of finance’s enduring characteristics – the search for yield.
Ultra-low interest rates have made investors increasingly oblivious to risk as they seek out higher rates of return.
When something looks too good to be true, it generally is, and returns on private credit that can be as high as the mid teens are just that.
With the banking sector once more restored to a semblance of health, most creditworthy companies can again borrow all they want at far lower rates of interest, so you have to ask yourself what kind of enterprise is desperate enough to agree such eye watering debt servicing costs.
Arrangement fees also tend to be punishingly high, providing a further incentive for financiers to promote this form of lending.
Providers insist that the high cost of the credit is a reflection of the elevated nature of the risk, but even so it seems like something of a racket.
One increasingly common practice is “amend and extend” (A&E), in which lenders agree to push back a loan’s maturity, usually in return for an even higher yield. “Payment-in-kind” practices (Piks), where borrowers with poor cash flow issue new debt in order to meet interest payments on the old debt, are also becoming widespread.
This is Ponzi-type lending in which our old friends, the credit rating agencies – star players in the deteriorating standards of risk assessment that led up to the financial crisis – are again frequently complicit by assigning investment grade status.
As one seasoned credit analyst put it to me: “Write 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 the financial services company Morningstar, Blackstone’s recent loss on the sale of 1740 Broadway, a near empty 26-storey office building near Manhattan’s Columbus Circle, was so great that it wiped out several layers of bonds, including part of the top AAA rated tranche.
The $40m loss on triple A-rated credit is the first failure of its kind in this cycle. There will surely be more.
But does it really matter if investors lose their shirts on credit exposures such as this? Or in other words, are such losses systemically important? Well yes, they might be.
It’s perfectly true that the banking system itself is largely insulated from losses in private credit. Banks often lend to private credit providers, but they will almost invariably have first charge on the assets, so are unlikely to be badly impacted even by a widespread private credit bust.
Yet insurers and pension funds are up to their necks in illiquid assets of this sort, with already substantial unrealised losses in some cases. These are highly regulated institutions, but savers may be fooling themselves by thinking their money is safe.
What makes things potentially more dangerous still is that fragmentation of the world economy under pressure from rising geopolitical tension has already badly dented international efforts to secure better standards of global regulation.
The post financial crisis reform agenda has run out of steam and is now all but dead.
The sort of global response to financial meltdown that Gordon Brown was able to galvanise back in 2009, moreover, is very unlikely to fly in today’s far more fractious world.
Even if it were politically possible, governments are already far too fiscally stretched to bail out finance for a second time. It’s as if no lessons at all have been learned from the events of nearly 16 years ago.
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