The US administration under George W. Bush did not only wage unnecessary, deeply scarring wars in the Middle East, it also launched the “American Dream Downpayment Initiative”, a policy encouraging mortgage lending to low-income households, minority borrowers and first-time buyers. Other than today, Republicans under Bush still felt some moral responsibility for the poorer parts of society.
As those of us old enough to remember will know, the idea to mortgage-loan to lower-credit borrowers did not go well. Banks and the mortgage guarantors Fannie Mae and Freddie Mac were nudged and pressured to lend more generously. Many private sector lenders did not need much encouragement. They happily rode a wave of laxer regulation, creating mortgages of sub-prime quality, which they pooled and sold to others as synthetic securities. To make them digestible for investors and foreign banks, these bonds were beautified with credit-ratings they did not deserve.
When it became apparent that many homeowners, many more than anticipated, were incapable of ever returning the home loans they had taken out, a cascade of foreclosures and bank collapses ensued, resulting in the Great Recession of 2009. We had to witness bank runs reminiscent of the Great Depression. Large institutions had to be bailed out with taxpayers’ money and, despite all monetary largess extended by central banks, the global economy tanked and did not recover for years.
The bankers who had created the mess went unharmed. Connections to the sex offender Jeffrey Epstein proved more harmful to them than their recklessness as CEOs of systematically important banks. But it resulted, at least for some time, in more stringent bank regulation, forcing large lenders to hold more capital against their lending exposure. As those banks withdrew from growing their credit portfolios, less regulated non-bank financial institutions jumped into the breach. Private credit, linking institutional investors and creditors directly, became a booming industry.
This new type of lending promised higher returns in a low-interest rate environment and seemed to heal the original sin of banks as we had known them for millennia.
Banks are traditionally funded by account holders’ deposits, which cost little if any interest payments. They transform these idle funds into loans for consumers and businesses. This is considered beneficial for the economy. To do so, they operate with a statistical experience of daily ins and outs.
But the risk of a bank run, the panicky withdrawal of all deposits at once, was the banks’ Achilles heel. Loans are a long-term investment. Deposits are very short-term. They can be withdrawn at first demand. Stringent regulation (after the Great Depression and its bank runs), state guarantees for all depositors and central banks acting as a lender of last resort seemed to have put worries about bank collapses at ease. Until 2009.
Private credit looked like a good solution. Lending was not funded by fickle depositors but by sophisticated investors willing to lend until maturity. Funding and lending periods were perfectly matched, making runs theoretically impossible. For investors in private credit such investments are not only lucrative, as they typically yield higher interest rates than bonds or treasuries, but soothingly safe.
Private credit (PC) accounts for its loans nominally: 100 units lent are worth 100. The market price of underlying loans is not really relevant as they are held to maturity when investors are repaid. When interest rates or credit ratings change, and bonds are repriced, a private credit remains the same. This lack of volatility is attractive too.
What started with institutional investors like pension funds, endowments, foundations and wealthy individuals seeking higher returns has developed into a $1.8 trillion industry, increasingly offered to retail investors too. The US has permitted PC to be included in its 401(k) retirement saving plan, for instance. But we all can chose to include this asset class in our investment decisions. Investment trusts in the UK, business development companies in the US and an array of publicly quoted open-ended funds or exchange-traded funds (ETFs) can be bought by retail investors like us. Should we?
It is a rule of thumb that offerings to retail investors are only made when the going gets tough. Private equity, commodity traders, law firms, crypto ETFs are going public and marketed to the ‘man in the street’ when ‘sophisticated investors’ or partners in limited liability partnerships already get cold feet. So some caution is asked for.
As if to prove my point, a couple of events have recently soured sentiment towards PC. Tricolor, a US fund financing car loans, collapsed, prompting Jamie Dimon, the legendary CEO of JP Morgan, to muse: “When you see one cockroach, there are probably more.”
Then came the successful release of Anthropic’s agentic AI coder, Claude Code. It devastated the share performance of software companies and ravaged their credit standing. According to some estimates, 18% of PC funding had been directed to software companies and those loans now look increasingly shaky. Over and above, banks providing backup finance and leverage to PC are tightening their lending conditions, collateral is being downgraded and interest rates are rising.
As a result, publicly-traded PC funds have tanked and investors in non-tradable funds (NTFs) want to dash for the exit. PC funds are either publicly traded, or non-tradable, hence private in the stricter sense of the word. To allow for some liquidity, non-traded funds offer investors to repurchase five per cent of outstanding shares per quarter. In last couple of months, triggered by the abovementioned events, more investors in NTFs want to get out than the maximum, statutory allowance. Excess demands of $4.7bn were rejected. And publicly-traded funds dropped below their accounted Net Asset Value (NAV), some quite dramatically. Two funds managed by Blue Owl, a market leader, dropped to 78% and 67% of their NAV. FS KKR Capital, a $3.1bn fund, lost to almost half its NAV. PC is worth less than it claims.
Having experienced the subprime crisis of 2009, investors quite understandably have started to wonder whether the trouble with PC might yet again put the banking system in danger. After all, banks may have reduced their lending but became fond of lending to the PC lenders. (It is as if regulation would determine that banks risking their capital are worse credit officers than PC managers who put others’ money at risk.)
By most accounts, banks’ PC lending is not significant. The overall exposure of all major US banks to PC does not exceed $500bn, or 1.5% of their assets. Who knows? At that time, subprime engagement was also modest.
Yet, in comparison to the fallout we can expect from the Iran war, it is perhaps irrelevant to worry too much about banks’ lending to lenders. The future will show which of those creeping dangers will materialise first. Once interest rates go up and “the tide goes out, we will see who was swimming naked” (Warren Buffet, investment legend).