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It was early last month when observers noticed ominous cracks in the facade of one of America’s most important financial markets. Tricolor, one of the largest used-car retailers in Texas and California, abruptly declared bankruptcy. Federal investigators are reportedly looking into whether the company committed fraud by promising the same collateral to multiple lenders.
Shortly after Tricolor cratered, something similar happened to First Brands, a company primarily known for making car parts. Its investors discovered roughly $2 billion in loans not on its balance sheet. That’s when things started getting scary. Fifth Third, a regional bank, said it had lent Tricolor $200 million, nearly all of which it now expected to write off as a loss. Same at JPMorgan Chase, which reported it was out $170 million that it will presumably never see again. At Barclays the figure is nearly $150 million. They’ll survive the loss, but the incident cast into sharp focus a risk that had otherwise lurked in the shadows, growing year by year: a cascade of bankruptcies that triggers a widespread financial crisis.
Tricolor and First Brands had also borrowed from a breed of nonbank financial firms known collectively as private credit, whose workings are much more opaque. Giving voice to a widespread sense that the losses had only just begun to pile up, Jamie Dimon, JPMorgan Chase’s chief executive, warned, “When you see one cockroach, there are probably more.”
The 2008 financial crisis occurred in part because banks and other financial institutions were offering too many mortgages to borrowers who couldn’t plausibly repay them. When enough bad loans began caving in at the same time, they sucked big banks and the rest of the economy into the sinkhole along with them.
Banks today are subject to stricter regulations, which have largely functioned as intended, keeping banks from making as many risky loans. Filling the void has been private credit. Today, firms like Apollo, KKR and Blackstone that manage and invest huge pools of money have gotten into the business of making direct loans, and they’re doing so at staggering rates. Now an approximately $2 trillion market, it is a leading option for many companies and consumers alike.
Private credit firms say they can offer better terms than banks because they are not reliant on depositors who can withdraw their money and flee. But these firms are broadly exempt from the post-crash regulations that were imposed on the banking industry, so they are more able to make the kind of risky loans that brought down the economy the last time around. And they’re not exempt from the damage when those loans go south.
The problem is that often the funds they rely on are not their own. They’re drawn from the money that has been entrusted to them by insurance companies, pension funds and, soon, 401(k)s. As was the case in the run-up to the big crash, these potentially risky ventures may therefore be fueled with the money of ordinary people who have no idea how it’s being deployed.
Another troubling similarity: These not-bank banks, also known as shadow banks, do a lot of what’s known as financial engineering. That means packaging up a whole grab bag of debts — loans to corporations, leases on A.I. data centers, bills from plastic-surgery patients, car loans, anything, really — which are then sliced up and sold as new kinds of investment vehicles.
Because the private and public credit markets are so closely connected, cockroaches in one part of the house will always spread to the other. Lending to risky borrowers has been on the rise for years. It is inevitable that after a period of excess, cases of insufficient due diligence by lenders and indeed fraud will pop up in public and private credit markets alike.
© 2015 Mutual Fund Observer. All rights reserved.
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Comments
"Are you worried about the health of credit markets after the recent bankruptcies and bad bank loans?"
Her response was: "Mostly, these events are about credit due diligence [emphasis added].
There is no way around it.
Having high underwriting standards and a well-resourced research team is important.
At Pimco, we make sure we understand the company, its sources of cash, and how they use cash.
Active credit selection is a key driver of our performance."
I realize that Ms. Pier is "talking her book" but it may be worthwhile to objectively evaluate her response.
It does not appear that any systemic credit issues currently exist which are remotely analogous
to the CDO debacle experienced during the Great Financial Crisis.
This is not to say there won't be cases where credit due diligence was neglected or fraud was committed.
https://www.msn.com/en-us/money/economy/a-6-yield-without-much-risk-this-bond-fund-manager-knows-where-to-find-it/ar-AA1P3XUY