Private credit lenders’ “opaqueness and role in making the financial network more densely interconnected mean they could disproportionately amplify a future [financial] crisis,” warned researchers from Moody’s Analytics, the Securities and Exchange Commission and a former top adviser to the Treasury Department. This report that will be published later today is one of the most “comprehensive analyses to date on how private credit would affect the broader financial system during a period of market upheaval” according to the Financial Times.
The Boston Federal Reserve also recently wrote a report about private credit funds that raised some alarm about their growing role as a player in debt markets. They believe that “if private credit lending has grown because lenders have been making riskier loans that banks would not make, then aggregate credit risk in the financial system likely would rise. In fact, not only would the financial sector be effectively more leveraged, but the added leverage would be on the balance sheets of riskier borrowers, weakening these businesses’ resilience to shocks and, as a result, rendering the financial system less stable.” One concern raised in this new crop of analyses about private credit is how illiquid it is and how deeply involved insurance has become with it.
If you’re getting 2008-style heebie jeebies from reading those two paragraphs, I don’t blame you.
Before diving into this mess, it should be stressed that private credit’s influence is a relatively new development, and the fact that we do not know as much about private markets as we do about public markets means that coming to any firm conclusions about private credit is difficult. Some of the best equipped financial analysts are just now producing detailed reports about this opaque world, and they are speaking in hedged tones.
That said, the risk here is obvious to anyone who understands how credit dries up in crises or just has a working memory of 2007 to 2009.
Private Credit
This is pretty much what it sounds like. Public debt markets like the bond market unfold out in the open, or through direct loans that show up on banks’ balance sheets, while these debt markets take place behind closed doors, with the IMF finding that private credit largely is fueled by investors from private and public pension funds, foundations and endowments, and family offices and wealth managers. Private credit has grown in large part due to regulations placed on banks after the 2008 financial crisis, which restricted who they can lend to, so private entities came in and filled the gap to lend to highly indebted and more financially unattractive companies who could no longer get a loan from a bank. This market has exploded in size since 2008, growing from $46 billion in 2000 to roughly $1 trillion in 2023.
In one sense, this is an improvement on the pre-2008 status quo. The Boston Fed notes that “private credit funds are less vulnerable to runs because their limited partners are locked up contractually for multiple years, whereas three-quarters of bank funding consists of run-prone demand deposits, almost half of which are uninsured,” but that benefit also makes these private credit funds less flexible and more illiquid. The main problem that private credit has created through filling this vacuum to such a large degree is how interconnected it has become to the banking system it was theoretically supposed to supplement. Instead, the Moody’s, SEC and Treasury researchers warn that it could become a “locus of contagion” in the next financial crisis.
Per the Boston Fed, private credit spreads are wider than bank spreads, so it is “highly unlikely” that private credit loans are more attractive than bank loans. This follows along with the logic that because of new post-2008 regulations, banks lost business with riskier businesses, which were likely picked up by private credit lenders.
Now here’s the central problem and where the potential for contagion lies: all these analyses of private credit find that its investors are “funded largely by bank loans,” per the Boston Fed. We essentially offloaded risk from banks’ balance sheets by regulatory force after 2008, but left the back door open for them to reattach it via their loans to private creditors. The 2008 heebie jeebies at the base of this ask a familiar question: what happens if those riskier borrowers start defaulting on their loans?
TACO Trump
Speaking of risky borrowers who have defaulted on loans before, the president of the United States is the lens through which we can look at the other side of this coin. All these analysts warn that private credit could amplify a financial crisis, not necessarily create it. That’s left to more enterprising doofuses determined to bring back failed 19th century economics.
China’s economy was on shaky ground before Trump decided to blow up the engine of global trade, but there are now signs that the tariffs are creating a deflationary shock for the world’s manufacturer. Trumpers may want to spike the football upon seeing that news, but the tariffs are a form of mutually assured destruction with our largest trading partner, and the OECD just warned that the global economy is set to experience its weakest growth since the early days of the pandemic, led by a sharp decline in US growth from 2.8 percent last year to just 1.6 percent this year and 1.5 percent in 2026. The OECD echoed the Federal Reserve’s concerns, saying that rising inflation from the trade war will prevent the Fed from cutting interest rates this year.
Also preventing the Fed from cutting interest rates? The largest, most liquid market in the world. It’s hard for the Fed to justify a 25-bps cut from a 4.33 percent Fed Funds Rate when short term Treasury yields are bubbling just underneath it around four percent, and long-term yields are pushing the magic TACO number of five percent. The bond market ultimately sets interest rates, not the Fed, which is why mortgage rates have gone up even as the Fed has begun cutting over the last several months.
JPMorgan’s Jamie Dimon is predicting a “crack in the bond market,” while perpetual doomer Ray Dalio is selling his new book by saying he gives the United States “three years, give or take a year” to avert an economic “heart attack.” While Dalio’s premonitions should always be taken with several grains of salt and Dimon is no stranger to doomerism, there is much more evidence for these familiar kinds of claims these days.
“Those who bemoaned the unsustainability of deficit spending and debt levels seemed to cry wolf — a lot,” wrote President Obama’s former director of the Office of Management and Budget Peter Orszag in the New York Times. “Even as a former White House budget director, I grew skeptical of their endless warnings. Not anymore.”
The deficit is a real problem now. We pay more on interest payments than we do for defense, Medicaid or Medicare. This is a fact of simple math where higher interest rates are colliding with higher debtloads post-COVID crash and creating some pretty scary bills that must be paid by the United States every year. The government must issue more bonds to cover its deficit, which usually raises interest rates. In times of economic growth and prosperity, as Dick Cheney once said, “deficits don’t matter,” because the whole world wants to buy US Treasuries and the debt is a relative figure given how much of the interest the US pays on bonds will go back into the US economy.
But the 20- and 30-year Treasury Bonds are telling a very different story right now, as people do not want to own much long-term government debt, in part because Dick Cheney is wrong yet again and deficits do matter at a certain point. Especially when Trump and Congressional Republicans are trying their hardest to keep long-term yields above the magic TACO number of five percent.
The Crisis
The most obvious source of an economic crisis right now is the result of two major policies by the Republican Party: Trump’s stupid trade war that is slowing economic growth and creating stagflationary dynamics across the globe, and the so-called “big, beautiful bill” the GOP is pushing through Congress. The latter is like pouring gasoline on a fiscal fire, as it will explode the deficit to such an alarming degree that Moody’s downgraded America’s credit as a seeming warning to the GOP of the path they are headed down. It’s so bad that even Elon Musk can see which side of history to scurry over towards to ensure he’s on the right side of it for once.
So add the two together. The Fed and OECD’s fear that inflation comes back when the tariffs really start to sink their teeth into the economy comes true, all while the government has to issue more Treasury Bonds to cover the massive deficit it is running so Republicans can give tax cuts to the ultra-wealthy while taking health care away from poor people. Both of these dynamics will push up interest rates, as the short-term bonds rise due to inflationary effects of the tariffs while the entire yield curve rises because of simple laws of supply and demand pushing all bond yields up.
When interest rates are high, you can scream abundance all you want as you cut red tape, but fewer investments will be profitable in this environment. This is like, the entire theoretical basis for why the Fed cuts or does not cut interest rates, and any economy with high interest rates will slow investment and thus economic growth, which is part of why the OECD and many others are forecasting a slowdown in the global economy for this year and next (at least).
If we get a stagflationary crisis from the trade war aided by a “crack” in the bond market under the weight of the GOP’s bill, it’s not difficult to see how private credit could exacerbate it. Because of the post-2008 regulations, banks hold a lot of Treasuries on their balance sheet as the kind of risk they are allowed to take has shrunk dramatically. Take those unhealthy gyrations in the most important market in the world and combine it with rising defaults of riskier businesses that banks are effectively lending to by lending to their private credit lenders, and now you’ve got a snake eating its own tail in the lending markets while growth stalls, or worse.
The whole point of a crisis is that it comes as a surprise to markets, otherwise markets would not melt down like they do in crises, so predicting one is a bit of a paradox. But there are an increasing number of fires all set in proximity to one another, and a new wave of reports from highly-informed financial analysts are warning that private credit has the potential to combine all these fires into a giant conflagration under the right circumstances. We don’t know what those specifically are due to the opacity of private markets and the uncertainty of the future, but Trump and the GOP seem determined to try to find out.
GET SPLINTER RIGHT IN YOUR INBOX
The Truth Hurts
