Private credit: déjà vu?

I had a discussion recently with a friend  that triggered my interest in digging a bit deeper into current concerns around the private credit market.  His view is that the problems recently making headlines regarding private debt funds are analogous to those that led to the meltdown in the broader collateralised debt obligations (“CDO”) market in 2007, triggering the onset of the Great Financial Crisis (“GFC”), the deepest economic downturn since the Great Depression. 

I am not a structured products expert by any means.  In fact, I know just enough to be dangerous.  For those of you that are more knowledgeable than me about structured products and / or remember the GFC like it was yesterday, please let me know if you see anything in this article that you remember differently, or that you believe is inaccurate.

Having done some work on this topic, I have concluded that while there are some similarities in the lead-up to the 2007-2008 CDO meltdown and today’s nearly $2 trillion private credit market, there are also many differences, enough that in aggregate would make such a cataclysmic meltdown as we saw in 2007-2008 less likely today.  

What are CDOs?

CDO’s are structured products in which assets like loans or mortgages are purchased and restructured into collateralised tranches that are sold to institutional investors.  The tranches of CDOs are rated based on the priority of claims against the collateral, with ratings ranging from AAA (priority claim/best asset coverage, least risk) to B (subordinated claim/worst asset coverage, most risk).  There is usually a “first loss” equity tranche below the debt tranches, attractive to high-return seeking hedge funds (or retained by the structuring agent / bank).     

CDO is a broad acronym for structured products that can be used generically, or can be used to describe a mixed asset pool of collateral.  Two of the more noteworthy CDO structures are:

• Collateralised Mortgage Obligations, or “CMOs”, the collateral of which consists of residential or commercial mortgages, and  

• Collateralised Loan Obligations, or “CLOs”, the collateral of which consists of corporate loans, most involving senior secured syndicated bank debt.

The mechanics of structuring CMOs and CLOs are similar to CDOs, aside from the fact that the underlying collateral is different. 

What role did CDOs play in triggering the GFC?

There is little debate that overzealous growth of structured products was the catalyst that led to the credit meltdown in 2007, which then triggered the GFC.  Although there were issues shared across all types of structured products (like liquidity or lack thereof), the largest problem by far occurred in the U.S. CMO (mortgage) market. 

The early 2000s were characterised by accommodative monetary policy (i.e. low interest rates) to guide the U.S. economy back to growth following the 2001-2002 recession.  With interest rates so low, demand for higher yields drove institutional investors to look increasingly at higher yielding structured products like CDOs.  In 2004, the Fed began to gradually tighten monetary policy, a course it remained on until 2006.  However, by then structured products had caught on as institutional investors became enamoured with yields on products like CMOs and CLOs.  Strong demand even as monetary policy became more restrictive set the stage for the gradual deterioration in the quality of underlying collateral, as originators of residential and commercial mortgages (for structured product portfolios) became overly aggressive by loosening their underwriting standards in order to originate mortgages and loans faster.

The combination of deteriorating and overly lax underwriting standards (meaning weaker collateral), the use of aggressive leverage (even CDOs of CDOs were appearing, or so-called “CDOs squared”), and eventually the fact that there was simply no liquidity when “shit hit the fan”, triggered the start of the GFC.  Could these attributes trigger a similar meltdown today in private credit, like that which occurred in the 2007-2008 period? 

I don’t think so, because I see the circumstances as different.  The major (although not the sole) culprit in the GFC was mortgages via CMOs, not loans via CLOs, although both ended up suffering because of weaker underwriting standards, an erosion in confidence and illiquidity.  This is not to say there are not lessons to be learnt from the GFC, as there are undeniably some parallels, too, that are concerning.  The best way to compare these events is to look at what happened in 2007, and then to fast-forward to where we are today with private credit.

CDOs/CMOs/CLOs in the 2005-2007 period

In 2007 I was working for a large European bank, running the global debt capital markets (“DCM”) division.  My bank, like many other banks in Europe and the US, was heavily involved in the origination, structuring and distribution of collateralised loan obligations, or CLOs.  At the time, the pride of the investment bank was this team, comprised of mathematical whizzes that were operating in the most profitable part of the investment bank.  This team was revered by senior management as they were printing money hand over fist.  DCM and other product lines in the financial markets division could only watch with envy. 

The professionals in the structured finance team were the most highly renumerated people in the investment bank, which I suppose they should have been since they were contributing an outsized portion of the profits.  This team’s function was to buy (or originate) loans, apply some voodoo economics in structuring a pool of these loans into marketable securities, and shovel the tranched securities out to end investors.  Of course, during the structuring phase – between the time that the loans came in the front door and went out the back – the structuring team benefitted from the benevolence of the bank to provide huge amounts of capital to support the loans whilst they were on the bank’s balance sheet (or residing in bank-sponsored warehouse conduits), waiting for the magic to occur so the end-product could then be distributed to investors.  The ability to warehouse collateral was an advantage for large banks, since it provided the capacity to play in this lucrative market and offered attractive returns on capital.  From the structured finance team up the hierarchy to the bank’s most senior management, all of the participants and “hanger ons” were seduced by the enormous profitability of these products.  Even if they were aware of the risks, they were probably considered unlikely tail risks.  The thought that the structured finance market could all come crashing down so violently probably never crossed their minds.  That is, until it did. 

The beginning of the end

The CDO/CLO value chain was extensive and global, consisting of loan originators, rating agencies, structuring banks, and end investors located around the world that lapped up the attractively-priced bonds spurting out of the backend of the value chain.  This all worked splendidly so long as the machinery from start to finish was functioning in unison.  Banks loved the structured finance business because they could originate loans and not pay too much attention to the creditworthiness, since the loans (or mortgages) would quickly be repackaged and sold via collateralised bonds.  Rating agencies loved the business, as it provided lucrative fees in a rapidly growing market.  Investors were keen because they would pick their risk tranche of the CDO/CLO – ranging from AAA down to B – and get paid generously vis-à-vis other similarly rated assets.  Law firms were generating loads of fees from structured finance, too.  Generally, profit margins were fat and players across the entire value chain were beneficiaries of the status quo remaining just as it was. 

However, it was clear in retrospect that the participants were wearing blinders.  The systemic risk was growing quickly as the market grew, meaning that a problem anywhere along the value chain would affect all parties, resulting in a domino effect that in fact proved to be the case. 

Some might believe that the beginning of the end can be blamed on the Fed for being too accommodative for too long in an effort to stimulate growth following the bursting of the “dot.com bubble.”  The Fed did not start to increase the Fed Funds rate until mid 2004,  a tightening bias that they continued until late 2006.  However, by mid-2006 cracks were already beginning to appear in the credit markets, most notably in the US residential mortgage market as delinquencies and defaults began to increase.  According to the IMF, mortgage delinquencies 90+ days increased every quarter from June 2005 (3.9%) to June 2007 (8.6%), and skyrocketed thereafter.  Again, this is not surprising in retrospect.  During the mid 2000’s, subprime mortgage products – like “no money down mortgages”, the proliferation of no upfront fees and off-market teaser rates, and mortgage approvals with virtually no borrower income verification –  became increasingly common.  Even though the quality of the underlying collateral was deteriorating during the mid-2000s, CMO’s boomed because there was such strong demand for the institutional tranches of CMOs.  Structuring banks really didn’t need to concern themselves too much with the integrity of the underlying collateral because the mentality was simply “in the front door and out the back”.  End investors didn’t seem to care too much either, so long as the security they purchased had the appropriate rating from Moody’s and Standard & Poor’s.  As far as loans (for CLOs), higher interest rates starting in mid-2004 meant that borrowing costs for companies were increasing and coverage ratios were weakening, adding to growing concerns about overly aggressive underwriting standards in the syndicated loan market as originators/structuring banks tried to keep pace with demand.

There were similarities between CMOs (mortgages) and CLOs (loans), although the underwriting standards of loan collateral – commercial loans to companies rather than residential mortgages to consumers – were not as aggressive as in the CMO market.  In fact, based on data I found, it appears that delinquencies in the syndicated loan market never approached those in the residential mortgage market, and ultimately, recoveries in loans meant that actual losses were in fact de minimis when all was said and done.   Even though the collateral was clearly more creditworthy, trouble in the CLO market had some dangerous similarities to the CMO market as the crisis deepened, certainly as far as liquidity evaporating and buyers of end tranches effectively disappearing.  In essence, the correlation of perceived risk caused the structured products market to experience a wholesale collapse as liquidity dissipated and the entire market came crashing down. 

As institutional investors pulled in their horns, warehoused collateral including subprime mortgages and corporate syndicated loans began to pile up on the balance sheets of structuring banks.  Because of a general lack of transparency, banks quickly became concerned about other banks’ creditworthiness. This caused the overnight interbank lending market to completely seize up.  Such overnight funding was commonplace and ordinary, essentially the lifeline of banks day to day.  However, when this market stopped functioning, this quickly led to severe problems for structuring banks (and non-banks) involved in CDOs.  And this quickly led to contagion in nonbank financial institutions, asset managers and end investors, and then into the broader economy, setting off the GFC.  Clearly, central banks and governments had no choice but to step in. 

You might recall that as U.S. financial institutions lost their access to funding, the news spread quickly and harshly, first forcing Bear Sterns to sell itself at a “fire sale” price to J.P Morgan in April 2007.  Markets continued to tighten, and as the summer progressed, the next most vulnerable institution came into focus – Lehman Brothers.

The Federal Reserve is responsible for ensuring there is ample liquidity in the banking system to ensure that banks do not fail.  However, like Bear Sterns, Lehman Brothers was not a bank.  With their funding gone and having no access to the Federal Reserve, Lehman’s balance sheet was in shambles and external financing completely dried up.  The only hope was a rescue of Lehman by a banking consortium or by the federal government, recognising that the failure of Lehman would create incalculable contagion into other regulated and unregulated financial institutions.  Lehman had few friends, and to the shock of many, the U.S. government elected to stand by while Lehman unravelled and then failed. 

With investor confidence severely eroded and the spillover of the financial crisis quickly spreading to the real economy, the federal government and the Federal Reserve now had little choice but to step in to stabilise markets and try to restore investor confidence.  The fiscal and monetary tools employed as policy responses were clever and ultimately effective, as financial markets stabilised.  However, the damage was done as far as the U.S. (and global) economy, which would eventually heal but only with the passage of several years. 

Did the GFC sow the seeds for the growth of the private credit market?

The simple answer to this question is “yes”.  The use of unconventional monetary policy and revamped (tighter) regulatory policy during and after the GFC spurred the expansion of the private credit market.   The Federal Reserve – along with many other central banks around the world – tightened their regulatory capital requirements for banks, both in terms of requiring them to have more regulatory capital and by introducing risk-weighting of assets.  This effectively reduced the leverage of banks, and hence their lending capacity, leaving a gap in the market for (unregulated) private credit investors.  Moreover, global central banks kept interest rates at 0% for many years and engaged in quantitative easing (effectively yield curve control) by purchasing government bonds to manage yields at the long end of the curve.  With investors earning poor (artificially low) returns on bonds throughout most of the 2010’s, they were lured into taking more risk by turning to equities – which flourished throughout most of the 2010s – or investing in other higher-yielding credit alternatives to traditional bonds. 

This response to policies put in place to address the aftermath of the GFC made sense.   Governments and central banks were hell-bent on trying to save the global economy and to (re)stimulate economic growth, which was poor (especially outside the U.S.) for many years after the GFC.

The growth of private credit

Private credit existed for decades, but it was mostly an investment grade market consisting of un-rated (but implied) investment grade companies (borrowers/issuers) selling long-term fixed-rate debt to mainly large U.S. life insurance companies (investors).  The U.S. private placement market  – as it is known – is a market providing long-term fixed-rate financing for companies that wish to avoid the public markets.  Accessing debt in the public markets comes with plenty of baggage.  Public bonds require critical mass for liquidity purposes (usually a minimum of $500 million for investment grade companies), more extensive disclosure to satisfy the SEC, and two public credit ratings. 

Aside from the traditional private placement market, the other lesser known area of private credit that existed before the GFC was mezzanine funds, which targeted small and middle-market companies.  Mezzanine funds would provide subordinated debt located in the capital structure below senior secured bank debt.  Mezzanine debt would come with high coupons and often warrants to provide investors with juicy yields (in the high teens), a return representing the risk of a subordinated, unsecured investment in a company’s capital structure.

The seeds for the growth in private credit as we think of it today began after the GFC, as discussed above.  Private debt / credit funds evolved as appetite of middle market companies and investors developed quickly in response to significantly restricted bank lending and artificially low yields.  Many middle-market companies found themselves cut off from bank financing due to their (low) credit quality, and they were too small and / or were private companies, meaning that these companies could not access capital in the public debt (i.e. the bond) markets. 

The graph below shows the growth of assets under management in the U.S. focused on private credit capital since 2010 (via Perplexity).

Whereas the industry was initially comprised mostly of specialised private credit funds focused on middle market loans to address borrower needs post-GFC, it was not long before private equity firms, hedge funds and assets managers recognised the appeal of the new asset class of private credit, and they piled in, too.  Today, it is hard to find a large asset manager or a large private equity firm that is not involved in private credit.

Moreover, the diversity of private credit funds as far as focus has also grown along with assets under management and investor appetite for private credit exposure, as you can see in the graphic below.

Private credit thrives post-pandemic

Having withstood what could have been a reversal of fortune at the time of the pandemic, private credit – much like the global economy generally – recovered in a remarkably fast time, certainly much faster than most people expected.  Similar to the GFC, the policy response to address the pandemic in 2020 was to introduce substantial amounts of monetary and fiscal stimulus at the time to right the wobbly economic ship.  This initially worked brilliantly although in retrospect it is clear that central banks were too slow to tighten monetary policy to see off inflation-in-wait after the period of accommodation.  Although global economies suffered an inflation hangover, this was dealt with as central banks tightened monetary policy.  Still, another round of post-COVID nil interest rates and QE made private credit assets look all the more attractive (similar to the post-GFC period), not to mention the positive effects of high inflation on top line revenue growth for companies.  Before we knew it, anyone and everyone in the financial markets had to be touching private credit in some form or another, as growth proliferated.

What does the private credit market today have in common with the CDO/CLO market?

There are several shared attributes between private credit today and the CLO market in the late 2000s, but not enough to make me squirm, at least not yet.

Collateral quality (the loans):  Although all structured products were painted with the same brush at the time of the GFC, the most severe problem was clearly with subprime mortgages (CMOs), not syndicated corporate loans (CLOs).  Underwriting standards for mortgages became extremely lax as already discussed since “in the front door, out the back” was the dominant theme.  Corporate loans certainly also experienced a deterioration in underwriting standards as appetite for CLO debt boomed, and then faced higher delinquency and write-off statistics as the economic recession deepened in 2008-2009.  However, once the dust settled, it was clear that the write-downs/losses in mortgages supporting CMOs were much more severe that the write-downs in loans supporting CLOs.  Even at the peak of the cycle, defaults in CLOs were only 8%, and the actual losses – at least for rated tranches – were actually close to nil.

In this respect, CLOs withstood stress much more effectively than residential mortgages, even though structured products more broadly were the whipping boy of the GFC.  Keep in mind that most CLO collateral consisted of syndicated loans, which were senior and secured, meaning the most protected from loss.  Today, private credit funds focused on direct lending lend much more aggressively across the entire capital structure, willing to get paid for risk well beyond just the senior secured debt component.  In general, this makes private credit more susceptible to losses when the economy slows.

There is also the issue of marking the assets in a private debt fund to-market.  Unlike in the public markets, private credit assets are not regularly marked-to-market.  In fact, my limited observation is that unless a particular high profile borrower gets in trouble, private credit funds simply carry their assets at par value, or 100 cents on the dollar.  It is only in limited cases, e.g. the failures of First Brands and Tricolor, when private debt funds mark down certain loans to troubled borrowers.  The opacity in the “market” value of loans in direct private lending funds clearly presents valuation risks, although I suspect there are plenty of institutional investors involved in private credit that are more than happy to close their eyes and pretend everything is fine……until it is not!

Originating assets:  As the capital available for CLOs grew in the mid-2000s, and as private credit funds have grown since 2010, structurers / asset managers have had the same driving motivation – grow their assets under management (“AuM”) and originate as many loans as possible to maximise the fund size.  Private credit funds have to originate loans (i.e. generate assets) to get paid for the costs of managing their funds, which compensates them for their expertise and value-added.  This can of course lead to a conflicted view on the issue of growth trajectory of AuM versus quality of loans.  This potential issue has not been tested since the proliferation of private debt funds really took off, aside from an  increase in defaults during the early stages of the pandemic.  Even though the pandemic downturn was sharp, it was also short.  The effect on private debt funds seemed to be minimal, and private credit seemed to outperform bank debt and high yield bonds during this troublesome period.   Private credit funds came out of the pandemic relatively unscathed, continuing to grow rapidly.  This undoubtedly keeps the pressure on private credit fund managers to identify viable opportunities and to invest, so they can deploy the capital that they have raised.   The hope of course is that this does not result in overly aggressive underwriting decisions and lax risk management, but I suspect more time will be needed to fully understand and evaluate this.  

Leverage:  Leverage can be considered in two aspects: leverage of the underlying assets, and leverage of the pool/portfolio.

• Leverage of underlying assets:  Leverage of the underlying assets in private credit funds depends on the type of loan. For example, the most common type of private debt fund invests in loans to middle-market companies, most of which are implied non-investment grade rated credits (if for no other reason than size, since rating agencies are biased against smaller companies).  Moreover, some of these loans extend beyond the typical coverage parameters of a company’s current and fixed assets, meaning they are partially or totally de facto senior unsecured or even subordinated.  Intuitively, the quality of these private direct loans would seem lower in aggregate than the typical assets held by a CLO, which normally consist of senior secured syndicated loans (“top of the capital structure”) of large companies. Also, keep in mind that not all private credit is direct lending.  For example, some private credit funds focus on securitised assets or infrastructure, which are generally higher quality collateral and are supported by more certain cash flows.

  
  

• Leverage of the portfolio / pool of assets (i.e. embedded leverage):  The nature of CDOs and CLOs is that the rated, collateralised tranches that were structured and secured by the collateral pools were rated based on their expected recovery in the event of a default.  This allowed end investors to choose their desired risk and return, with tranches ranging from AAA (lowest risk, lowest relative yield) to B (highest risk, highest relative yield).  Based on my research, it appears that the leverage in CLOs was around 65% to 70% for the top / senior most AAA tranche, and 10% for the un-rated/bottom tranche which was equity.  This left 20% to 25% of the structure in the middle, which was cut into tranches rated A, BBB, BB and B,  based on the leverage.  Investors could “pick their poison” – lower rated tranches provided juicy returns but higher risk, and vice versa for the senior-most AAA rated tranches.  In essence, leverage in CLOs was built into the capital stack.  In contrast, private credit funds are less leveraged if at all, ranging from no leverage to perhaps one times.  This is where concerns have surfaced with banks increasingly involved in private credit – how much exposure do they have to private credit funds, and what would be the effect on their balance sheets if defaults in private credit funds were to increase (due to an economic slowdown, for example)?  The data is murky still, although banks’ involvement in private credit funds certainly includes a broad array of activities, including things like CLO warehousing lines (similar to the “old days” of CLOs), leverage to the fund, and perhaps even investments in the funds themselves.  Simply put – the involvement of banks today in private credit is not particularly transparent.  Fitch wrote about this on May 5^th, in an article you can source here: “U.S. Banks Increase Private Credit Disclosures Amid Continued Scrutiny”. However, according to the Financial Stability Board, commitments to private credit by banks (drawn and undrawn amounts) are just over 0.3% of U.S. banks’ balance sheets, which doesn’t seem terribly worrisome although it is clear – as the FSB notes – that the inter-relationships and hence vulnerabilities between private credit funds and banks are increasing.

Liquidity: This is the issue that has been most visible in the private credit market recently.  Private credit funds provide limited distributions to their investors for the simple reason that the underlying collateral (middle market loans) is illiquid.  The loans cannot be easily sold if investors want out.  Most funds seem to have an allowed distribution amount of around 5%/quarter.   Given the illiquidity of the underlying assets, this seems rather generous to me.  Private credit funds have a right to “gate” distributions above the permitted amount of quarterly withdrawals so as to preserve the integrity of the underlying collateral, by avoiding “fire sales” of illiquid loans.   Gating by private debt funds like Blue Owl, Cliffwater and Blackstone (real estate fund) have caught the market’s attention recently, along with some isolated cases of borrower fraud. This has cascaded into concerns with the quality of the underlying loans themselves, as investors are increasingly raising questions about the integrity of the collateral.  Investors should recognise that the underlying collateral is not liquid, and when they invest in a private credit fund, the money is locked up because the loans are long-term and relatively illiquid.  Expectations from investors to the contrary as far as periodic liquidity do not make sense, at least not to me.

Conclusion

Drawing parallels to the meltdown of structured products in the 2007-2008 period and concerns facing the broader private credit market today are fair game.  There are issues that might concern people, but generally, I think we are in a better position today to avoid the rampant contagion from private credit funds into the broader economy than those that drove the global economy into a nosedive in the GFC.