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private credit crunch as a potential market contagion

David_Snowball
in Fund Discussions
I'm always struck when two or three people I respect show up, at roughly the same time, worried about roughly the same thing. That happened this morning as I watched the tail end of a QC blizzard that lead Augie to cancel classes for ... oh, the fourth time this century. The arrivals were Leuthold and Richard Bookstaber whose 2007 book A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation predicted, with uncomfortable insight, the 2008 global financial crisis. And both wanted to chat about the same worry: that the current AI frenzy is unwritten, almost exclusively, by private credit. That is, rich people make money appear without resort to public credit markets and all of that pesky transparency stuff.

They seem to share three concerns. First concern: Opacity masks concentration of risk. Private credit has no exchange, no public pricing, minimal disclosure requirements. Institutional investors don't know what their positions are actually worth until they try to exit — and by then it's too late to exit gracefully. This is different from 2008's complexity (structured products hiding risk); it's simpler but potentially more dangerous — just darkness where there should be information.

Second concern: When private credit investors need liquidity, they won't sell what they want (can't — those positions are illiquid). They'll sell what they can: the most liquid positions in their portfolios. Which happen to be the mega-cap tech stocks that dominate the indexes and everyone's retirement accounts. Bookstaber explicitly names this mechanism. Leuthold documents the setup — unprecedented concentration in exactly those stocks.

Possible third concern: The feedback loop runs both directions. Private credit is funding AI infrastructure (data centers, chips). AI boom is inflating the valuations of the tech giants. But those tech giants are also extending vendor financing and cloud credits (Leuthold mentions Nvidia as "world's biggest private credit firm"). If AI disappoints or infrastructure proves overbuilt, the stress hits simultaneously from multiple angles — and there's no circuit breaker because the positions are private, locked up, not marked-to-market daily.

What makes this different from traditional shadow banking bogeymen: It's not primarily about regulatory arbitrage or hidden leverage in the traditional sense. It's about liquidity mismatch meets concentration risk. Investors who can't sell private credit positions will be forced sellers of public equities, and there are only a handful of stocks large enough to absorb that selling pressure, which means those exact stocks (the AI beneficiaries) become the transmission mechanism for private credit stress.

I can't imagine a good way to dodge a crisis that might never occur at a magnitude not easily anticipated, driven by a whole new set of interactions. My impulse, as ever, is toward a long-term asset allocation to recognizes the inherent volatility of stocks, tends contrarian - higher quality, lower valuations - and respects folks like CrossingBridge for their ability to create low downside, low correlation portfolios.

Private credit is mostly outside my circle of competence, however generously you draw the circle, so you might find the original articles worth reading.

For what that's worth,

David
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Comments

  • Old_JoeOld_Joe
    Yet another house of cards, to invent a phrase.
  • DrVenture
    David_Snowball said:

    I'm always struck when two or three people I respect show up, at roughly the same time, worried about roughly the same thing. ...

    I can't imagine a good way to dodge a crisis that might never occur at a magnitude not easily anticipated, driven by a whole new set of interactions. My impulse, as ever, is toward a long-term asset allocation to recognizes the inherent volatility of stocks, tends contrarian - higher quality, lower valuations - and respects folks like CrossingBridge for their ability to create low downside, low correlation portfolios.
    ...
    David

    Yes, this is the conundrum.

    And the only potential answer is cash. But, as stated, "when/if" is the problem. How long do you hold cash in the face of creeping inflation? Based on the thesis, neither bonds nor equities are safe. How close do you fly to the sun? Last week was pretty weird, but now we get a bounce today. Very confusing set of circumstances.

    IRT a similar concern, I have pondered the idea of "fear of missing out" vs plain old fear.

  • Sven
    Today is more like a dead cat bounce.

    Warren Buffet would not touch private equity. For Berkshire Hathaway, he invested billions into T bills. Private equity wants to gain access to dumb money, 401(k) $? If allowed, it would be a disaster.
  • BenWPBenWP
    I also read Bookstabler’s article in the Times this AM and experienced a sense of dread. I really did not understand at the time what the crazies who precipitated the GFC were doing, and I confess to the same ignorance about how private credit represents a threat today. I did inform myself after the fact in the first case by reading Michael Lewis, but my portfolio had long since been severely dented. I’m not sure there’s a place to hide, certainly not on short notice. Obviously, the other risks to the financial system (I.e., a crazy in the WH), don’t require a knowledge of finance to assess, but they are just as serious. Paying vivid attention to the breathing, as in meditating, does offer some respite.
  • WABACWABAC
    I always wonder about the amount of money being talked about. The property-finance debacle involved a whole lot of money. I don't know that private equity/credit amounts to near as much. In this latter case it's a good thing all f this is coming to light before Mom and Pop got sold a load of BS--Blue Sky as my grand father used to translate it for his children.

    Tech has been a boom/bust market for as long as I have been following--we landed in San Francisco in 1979. That's one reason I tend to hold it separately in the taxable where I own four tech funds, or limited to just FMILX in the IRA.
  • WABACWABAC
    I thought of this thread as I read this piece from Fortune.

    The header is:
    Scott Bessent just defined market panic—and accidentally diagnosed the biggest problem with AI
    First, the definition:
    “Markets go up and down,” Bessent said. “What’s important is that they are continuous and functioning. In my 35-year career, when people panic is when you’re not able to have price discovery—when markets close, when there is the threat of gating, things like that.”​

    It’s a tidy, veteran-investor definition of systemic risk. Volatility, he implied, is fine. Volatility is information. The true crisis arrives when the mechanism that produces prices breaks down entirely—when buyers and sellers can no longer reliably find each other and agree on what something is worth.
    So, what's the problem? This is from the author, not Bessent:
    The problem isn’t that AI stocks are dropping. The problem is that nobody credibly knows what they should be worth—which means price discovery, in any meaningful sense, has been severely compromised for years. And that problem is actually worse than the public market selloff suggests, because the most consequential players in AI have never been subject to market pricing at all.

    OpenAI is worth $840 billion—or so its latest funding round implies. Anthropic is valued at $380 billion. xAI at $250 billion. These numbers are not prices. They are negotiated fictions, set in private deals between a small number of investors with massive incentives to mark the sector upward. There is no continuous market, no daily clearing mechanism, no army of short sellers stress-testing the assumptions. There is only the last round, which is whatever the most recent believer agreed to pay. By Bessent’s own definition, this is the condition he fears most: not volatility, but the absence of price discovery entirely.
    That's just about 1.5 trillion bucks.

    I can't wait for the bailout. :-/
  • DrVenture
    We have discussed the myriad economic headwinds elsewhere (inflation, tariffs, jobs, GDP, debt). Now we can add to that: price discovery, private credit illiquidity, what else?

    Maybe each is just a singular issue that may be bad, but add them all together, and...

    At this point in time I view days the market rises as selling opportunities. I never have been more cautiously positioned in my life. Is that about me? Or about real issues percolating?
  • WABACWABAC
    edited March 16
    I have been talking about the comparison to the Great Recession, aside from worldwide impacts, this is what I found on wikipedia under subprime crisis:
    Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45% from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30–35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008.[324] Total retirement assets, Americans' second-largest household asset, dropped by 22%, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total $8.3 trillion.[324]

    Real gross domestic product (GDP) began contracting in the third quarter of 2008 and did not return to growth until Q1 2010.[325] CBO estimated in February 2013 that real U.S. GDP remained 5.5% below its potential level, or about $850 billion. CBO projected that GDP would not return to its potential level until 2017.[326]

    The unemployment rate rose from 5% in 2008 pre-crisis to 10% by late 2009, then steadily declined to 7.6% by March 2013.[327] The number of unemployed rose from approximately 7 million in 2008 pre-crisis to 15 million by 2009, then declined to 12 million by early 2013.[328]

    Residential private investment (mainly housing) fell from its 2006 pre-crisis peak of $800 billion, to $400 billion by mid-2009 and has remained depressed at that level. Non-residential investment (mainly business purchases of capital equipment) peaked at $1,700 billion in 2008 pre-crisis and fell to $1,300 billion in 2010, but by early 2013 had nearly recovered to this peak.[329]

    Housing prices fell approximately 30% on average from their mid-2006 peak to mid-2009 and remained at approximately that level as of March 2013.[330]

    Stock market prices, as measured by the S&P 500 index, fell 57% from their October 2007 peak of 1,565 to a trough of 676 in March 2009. Stock prices began a steady climb thereafter and returned to record levels by April 2013.[331]

    The net worth of U.S. households and non-profit organizations fell from a peak of approximately $67 trillion in 2007 to a trough of $52 trillion in 2009, a decline of $15 trillion or 22%. It began to recover thereafter and was $66 trillion by Q3 2012.[332]

    U.S. total national debt rose from 66% GDP in 2008 pre-crisis to over 103% by the end of 2012.[333] Martin Wolf and Paul Krugman argued that the rise in private savings and decline in investment fueled a large private sector surplus, which drove sizable budget deficits.[334] [bold emphasis added by yours truly]
    Until I see larger numbers from private credit/equity and AI, I'm thinking more of a nasty bear market and recession that won't be fun for most people. Or, maybe we get stagflation if the war drags on.
  • DrVenture
    I am definitely not expecting a GFC style crisis scenario. But, a "nasty bear market" is something I'd like to avoid excess exposure to.
  • a2z

    i dont expect another GFC...but a first order review does not dispute another such crisis :

    - since the GFC, if you want to remain a licensed bank, regulations have progressively cut riskier lending (which is why bank loans had a great run since interest rates reversed)
    - since then, smaller bank mismanagement has proved less hazardous (svb)
    - all of the riskiest loans have gone to private and shadow banking, which have grown 10x
    - we expect the % and scale of risk much higher now than pre-GFC : accumulated through mkt highs, meme and spac stocks, crypto deregulation, (and of course disastrous gop geo-economic policy)

    so instead of calling it blackswan, lets go with self-inflicted harm by donald duck.

    image
  • MarkMark
    To my childlike, naive eyes private credit/equity and AI look to be pretty much like bitcoin (or choose your preferred meme coin) minus the bright gold trinket.
  • AnnaAnna
    Mark said:

    To my childlike, naive eyes private credit/equity and AI look to be pretty much like bitcoin (or choose your preferred meme coin) minus the bright gold trinket.

    There aint no trinket.
    I used to call AI, bitcoin and tulip the trifecta. Add private equity in, what do I call it? quadfecta? Of course, until the quadruple whammy plays out. Or maybe just triple wammy. Which of the four turns out a winner?
  • DrVenture
    I suspect that the AI trade has gotten out of hand. But, it will likely produce real results at some point, even if it corrects. And it definitely is driving a lot of spending. Bitcoin will not likely go away, either. But, it certainly doesn't "produce" anything. Tulips ae fine for the garden. Private equity seems like a potential problem, waiting to erupt. Especially, against a backdrop of uncertainty.

    I remember my macro uncertainty in both in 1999 and 2006/2007. I feel similarly now. But, it took more than a year (1-3 years) from the initial warnings, for the chickens to come home to roost.
  • gman57
    I keep reading/hearing about circular investing. AI companies investing in other AI companies who invest in those same AI companies propping each other up. Billions given back and forth to each other in the name of growth. Somebody at some point is going to be left holding the bag.
  • David_Snowball
    In Japan, the structure is called Keiretsu. It's an interlocking, interdependent structure that emerged during the post WW2 occupation, a successor to the family-owned conglomerates model. The keiretsu (a) helped build the post-war "economic miracle" and (b) helped build the bubble that popped in the late '80s, trigger "the lost decade."

    History does not repeat itself, but sometimes it does rhyme. Or so I'm told.
  • a2z

    both japan and s.korea are slowly transforming via listing reforms basically aimed at book value and equity metrics.

    included are the conglomerates, in many ways similarly shaped by history and culture.
    this is a very apt time to learn certain advantages of industrial capacity designed to efficiently shift from consumer to defense (for self and exports). asianometry and other good references exist.
  • ShostakovichShostakovich
    Just a few months ago, I became frustrated with a storied credit shop who refused to provide me info with which I could purchase their private credit fund through a broker. I dropped off all comms with them. Perhaps it will prove to be my benefit.
  • DrVenture
    I am left wondering why private credit? Isn't nearly anything that you might want available in an existing public credit offering? HY, MBS, corporates, EM, pick your poison. Wants some additional leverage? Juice it up with any of the CEFs.

    Why would anyone buy an utterly opaque, illiquid fund from a stranger?
  • larryB
    @DrVenture. Why? Perhaps because to someone who doesn’t know better it sounds cool. And hubris? After all,,,, most folks would be dollars ahead with the Boglehead 3 fund portfolio. But look at us here.
  • wdzepper
    I am not a fan of either private credit or private equity. Hence I will do what i can to educate friends, family and "where I can" elected officials that they don't belong in retail retirement accounts. Mainly because the fees are too high, the firms make more money than their investors and the investors would have been better off in the public markets. Most of these funds don't do very well compared to broader indexes (incl fees/taxes). They are also largely lightly regulated.

    That said, I don't understand LPs wanting liquidation from these funds anytime they want. The terms when they sign up for them are crystal clear. All of these funds are designed to invest for the term of the fund. If you need liquidity every time there is a market event or some new trend or a geopolitical situation, invest in the public markets or in a CD or a money market fund. No regular retail customer should be anywhere close to these funds. By design, they are meant for accredited investors and should stay that away and also AWAY from mainstream retail retirement accounts (cant speak for the Pension Funds)

  • WABACWABAC
    edited March 18
    Morgan Stanley says AI disruption of software will send private credit defaults surging.
    "In our view, AI disruption will be a meaningful catalyst to drive defaults in direct lending," the bank said. "Despite moderating defaults and benign ratings trend, credit fundamentals of software loans are challenged with the highest leverage and the lowest coverage ratios across major sectors."

    Software has been a key focal point for investors watching the private credit space. Software loans account for around 40% of all private equity-backed loans outstanding, according to one Bloomberg analysis, and software exposure in the direct lending hovers around 20%, Morgan Stanley said, basing its estimates on holdings data of various private debt vehicles.
    I asked Perplexity which companies are indebted like this. Dinky linky.

    TLDR:
    Most of the private‑credit exposure is to sponsor‑owned enterprise software/SaaS platforms, many of which were taken private in large leveraged buyouts from 2020–2025.
    The site it scraped for the info is this one. YADL. Check it out if you want the details. Support a human writer.

    TLDR:
    How did we get here? Simple. From 2015 to 2025, more than 1,900 software companies were acquired by private equity in deals worth over $440 billion. The thesis was irresistible: sticky recurring revenue, high margins, predictable cash flows, high switching costs. Private credit loved lending against those characteristics. Software became the engine of the entire unitranche loan market.

    The problem is that every single one of those assumptions is now being stress-tested by AI. Simultaneously.
    Is Michael Lewis on this yet?

    Once again, I find myself contemplating Repo Man.

    A lot of people don't realize what's really going on. They view life as a bunch of unconnected incidents and things. They don't realize that there's this, like, lattice of coincidence that lays on top of everything.
  • DrVenture
    This is proof of a few things:

    1. Nothing man made lasts forever (software stocks).
    2. Even private credit/equity makes mistakes.
    3. Repo Man is always right!

    "Look at those assholes, ordinary fucking people. I hate 'em." - Repo Man
  • stayCalm
    edited March 18
    wdzepper said:

    I am not a fan of either private credit or private equity. Hence I will do what i can to educate friends, family and "where I can" elected officials that they don't belong in retail retirement accounts. Mainly because the fees are too high, the firms make more money than their investors and the investors would have been better off in the public markets. Most of these funds don't do very well compared to broader indexes (incl fees/taxes). They are also largely lightly regulated.

    That said, I don't understand LPs wanting liquidation from these funds anytime they want. The terms when they sign up for them are crystal clear. All of these funds are designed to invest for the term of the fund. If you need liquidity every time there is a market event or some new trend or a geopolitical situation, invest in the public markets or in a CD or a money market fund. No regular retail customer should be anywhere close to these funds. By design, they are meant for accredited investors and should stay that away and also AWAY from mainstream retail retirement accounts (cant speak for the Pension Funds)

    There are PE/PC fund structures that allow for periodic liquidity. For example evergreen funds that are offered in interval fund format.
  • stayCalm
    Sven said:

    Today is more like a dead cat bounce.

    Warren Buffet would not touch private equity. For Berkshire Hathaway, he invested billions into T bills. Private equity wants to gain access to dumb money, 401(k) $? If allowed, it would be a disaster.

    WB ran a PE shop successfully before he closed it and started the Berkshire journey.
  • stayCalm
    DrVenture said:

    I am left wondering why private credit? Isn't nearly anything that you might want available in an existing public credit offering? HY, MBS, corporates, EM, pick your poison. Wants some additional leverage? Juice it up with any of the CEFs.

    Why would anyone buy an utterly opaque, illiquid fund from a stranger?

    Because the returns and volatility of private credit are different from public credit. A reasonable argument can be made that private credit is as volatile as public credit but this volatility is hidden (volatility laundering is the term for this) due to quarterly marks vs. daily marks and significantly more Level 3 valuations vs. public credit funds.

  • DrVenture
    edited March 18
    Good answers. Are the returns better at the same risk level? Is that sort of info even readily available? I believe we are all basically talking about Joe Public here. No one cares if the wealthy take on unknown risk. My opinion is, if there is a "contagion" it should be limited to those who willingly accept the risk, not those who avoided it. We know that is rarely the case.

    @staycalm you seem to know a bit about this. I do not. Are you an investor in private credit or equity?
  • Observant1
    edited March 18
    "A reasonable argument can be made that private credit is as volatile as public credit but this volatility is hidden (volatility laundering is the term for this) due to quarterly marks vs. daily marks and significantly more Level 3 valuations vs. public credit funds."

    Volatility appears to be low only because private credit is not marked to market.
    I would presume that private credit is actually more volatile due to greater Level 3
    security exposure and more manager discretion regarding setting valuations.
  • yogibearbullyogibearbull
    @stayCalm: There are PE/PC fund structures that allow for periodic liquidity. For example evergreen funds that are offered in interval fund format.

    The funds making the news do have limited periodic redemptions, up to 5-7% per quarter. Problem is that redemptions now are HIGHER than those allowed quarterly. BlackRock made an exception for BCred and allowed extra redemptions, but others have not.

    Few years ago, REITs BReit and SReit also had similar problems and it took a couple of years for those redemption backlog to clear. There was a big fuss in the media then too.

    Actually, this shouldn't even be in the news because their prospectuses clearly mention monthly and quarterly limits. But people who are caught by that rule still complain.

  • Observant1
    "Actually, this shouldn't even be in the news because their prospectuses clearly mention
    monthly and quarterly limits. But people who are caught by that rule still complain."

    Many interval funds allow maximum redemptions of 5% per quarter.
    This information is clearly presented.
    Yet some fund investors choose to whine when redemptions exceed this 5% threshold
    and their redemption requests are denied.
    They should have known that this was a distinct possibility...
  • stayCalm
    edited 12:33AM
    DrVenture said:

    Good answers. Are the returns better at the same risk level? Is that sort of info even readily available? I believe we are all basically talking about Joe Public here. No one cares if the wealthy take on unknown risk. My opinion is, if there is a "contagion" it should be limited to those who willingly accept the risk, not those who avoided it. We know that is rarely the case.

    @staycalm you seem to know a bit about this. I do not. Are you an investor in private credit or equity?

    Yes, the returns on private credit are higher than public credit for the same risk level (see my prior post on reported volatility of private credit funds not being reliable so assume that the volatility of private credit is the same as public credit). CCLFX as an example private credit fund has had fantastic returns. All that said, private credit funds aren't for everyone -- one has to be very comfortable being gated (and all the big boys including CCLFX are gating withdrawals at this time). I've disclosed in prior posts my holdings of private credit and private equity. At this time, I have a very small position in NICHX (gated since about 1.5 years). The second major risk of private credit is that a sizable chunk of assets are valued at Level 3 (basically the underlying assets are valued at what the manager says they are valued and management has an incentive to value it higher vs. lower). L3 valuation is necessary because there is no liquid market for the holdings of private credit funds. So it comes down to -- do you trust the fund manager to fairly value the underlying assets? Clearly at this time, a sizable portion of investors are saying -- Hell No, get me outta here.

    Part of the reason for the current rush to the exits for private credit investors is that the media has been drumming up fear from the latter part of 2025. That said, defaults have ticked up, there have been some very public stories of 100 to 0 write-downs in a single quarter. So there's definitely some smoke out there. Whether it is as bad as portrayed by the media, no idea.

    I don't discount the probability of the event as described in the title of this thread. I don't believe it will get as bad as 2008 GFC (housing market is a lot bigger than private credit) but who knows.
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