HIDDEN RISKS IN PRIVATE CREDIT

Credit: Gemini

  

    "Private credit" (PC) is a euphemism for businesses known as "Non-Bank Financial Institutions" (NBFI). These include funds run by Blackstone, Apollo, Blue Owl, and many others. They make loans to businesses that are unable to obtain loans from banks due to their small size and/or higher credit (default) risk. 

    Private credit lenders take in money from many sources including ordinary investors, pension funds, college endowment funds, and wealthy investors all of whom are looking for higher yields than are available in the bond markets. The borrowers are typically not listed on any stock exchange so they have not filed audited financial statements with the SEC that investors can review. Furthermore, their credit risk has not been rated by any of the established credit rating firms. 

    When you invest money in a private credit vehicle, you have no way to know much of anything about the borrowers or assess the risks the PC lender is taking with your money. You are buying a "Black Box" filled with higher risk loans of unknown market value. If you invest in PC, you need to know that they are not your fiduciary. That means they owe no special duties of care to you. They are free to advance their own interests at your expense. Their only duty of care is not to misrepresent material facts or defraud you - a very low bar.

    Because the borrowers' financial facts are not available for your scrutiny, you are entirely dependent on your PC firm to engage in due diligence and accurately report its financial condition to you. If a company that your PC made a loan to is becoming financially stressed, you would expect your firm to "write down" the value of that loan on its books (i.e., mark the loan to its now lower market value) so you, the investor, can keep abreast of the change. Do not count on that happening. 

    There are many ways your PC firm can hide its growing risks and losses from you. One way is to sell the at-risk loan to a related/subsidiary firm at the loan's original value. The acquiring firm carries the loan on its books at its (overvalued) purchase price.  Your firm includes in its reports to you its financial interest in that firm whose asset value is inflated after having overpaid for the loan. This is done to make you believe that the loan has retained its value - when it clearly has not and your firm knows that it has not.  

    Your firm can also sell a bad loan to another PC firm that is more-eager-than-cautious to put its investors' cash "to work" in order to justify the fees it charges to its investors. Its investors unwittingly pay an inflated price for the loan. "Unwittingly" because they have no means to discover that the loan is impaired. 

    Unlike banks, PC lenders are not tightly regulated. They seek borrowers willing to pay higher rates of interest. It is common for PC borrowers to pay interest rates of 10-14% or more. This makes PC lending highly profitable - until the loans start going into default in significant numbers which can be expected to happen when the economy next slumps into a recession. 

    Another downside to investing in private credit firms is a restriction of which most investors are ignorant or have ignored. They knowingly, or unknowingly, agree not to withdraw their investments, except in limited amounts and at limited times. The restriction is in place because the firm's money is tied up in mid-to-longer term loans. Were the PC firm forced to sell its loans to meet large investor redemption requests, it would likely be at "fire sale" prices leading to large capital losses. Some funds permit limited withdrawals, say 5%, but they reserve the right to block (or "gate") redemptions and they have done so. 

Ken Griffin, the founder of Citadel, said in an interview with the Financial Times,

The real issue here is the liquidity mismatch between the retail investor and the duration of the investments. We live in a world where retail investors have become accustomed to having immediate liquidity for their investments...investing in private credit is a different story.... Retail was viewed [by PC firms] as a phenomenal channel from which to raise assets, but did the retail investors really understand the nature of the investment they were making?

 The Growing Risks

    At first blush, it appears that not having banks at risk for sketchy PC loans is welcome news because when those loans start to go bad, taxpayers will not be on the hook to cover the losses as in past crises. But all is not as it appears. That is because banks are big lenders to PC borrowers, directly and indirectly, and in significant amounts. Wells Fargo has $60B in PC exposure, Bank of America $33B, PNC $29B, Citigroup $26B, JP Morgan Chase $22B and Goldman Sachs $21B. Thus, these high risk loans are not ring-fenced from the banking system. As of mid-2025 US banks had made nearly $300B in loans to PC firms. That sum is now far larger.

   PC lending is now about twice the size of the high-yield bond market - but not as large as the 2007-09 sub-prime mortgage loans that nearly brought down the entire banking system. Nevertheless, PC loan defaults would ripple through the banking complex that is already saddled with large amounts of questionable consumer debt (mortgage, credit card, etc.). 

    Recently, BlackRock slashed the value of its $25M loan to the e-commerce company Infinite Commerce Holdings to zero three months after listing it at full value. HSBC has taken a $400M hit when it was discovered that its end-borrower, Market Financial Solutions, had engaged in a major fraud in securing its loans. 

    At first, HSBC maintained that it had not loaned money to MFS - in an effort to hide its exposure to the company. While technically true, HSBC had instead engaged in "back-leverage" to a private credit unit of Apollo Global Management which then loaned the money to MFS. Banks can obscure the real borrower by lending to intermediaries ("private credit groups") that then pass the bank's money on to either the true borrower or to a "special purpose vehicle" that then lends the money to the borrower. In the event of a default by the end-borrower, the loss quickly runs back up the chain and hits the lending bank because the intermediaries are often under-capitalized, if not mere shells.  

        The first two sizable hits to PC lenders were First Brands (an auto parts supplier based in Cleveland, Ohio), that filed for bankruptcy in September 2025 with $10B in listed liabilities and far less in very uncertain assets. It is said to have been funded through "opaque [misleading] off-balance sheet financing".  First Brands was followed by its subsidiary, Tricolor (a sub-prime lender and used car retailer) that filed for bankruptcy in the same month - amid allegations of massive fraud in its operations (misappropriation of funds and double pledging of assets to support its loans). JP Morgan's CEO Jamie Dimon warns of more such "cockroaches" coming to light. Barrons recently wrote,

While sponsors insist most of the loans are sound, some estimates project a sharp rise in defaults. UBS recently forecast a 15% default rate, nearly triple recent experience.

    We have read estimates that as many as 18% of PC borrowers are currently in some form of delinquency/default. Dimon wrote in his recent letter to shareholders that losses for lenders to highly indebted companies will be higher than many expect due to "weak lending standards". Lloyd Blankfein, former CEO of Goldman Sachs Credit added, "I don't feel the storm, but the horses are starting to whinny".

    When the dust settles if loan losses are incurred, PC investors will be eager to learn what "due diligence" their PCs engaged in before making their loans. Obviously, not enough. Our guess is "very little" because they were more intent on getting their investors' money loaned out, in order to earn their fees, than ensuring the safety of their investors' money. 

A Look at the US Economy

    President Trump repeatedly states that inflation is down and the US economy is surging ahead. To test that representation, let us first look at recent layoffs. Some of these reflect the replacement of workers with AI agents, others to shrink bloated workforces and yet others were to free up money to pay for soaring capital expenses - especially AI related. This helps to explain why many recent college grads are finding it difficult to secure employment.

Oracle: 20,000 to 30,000 employees laid off (12-18% of its workforce) 

Meta: 8,000 employees (10% of its staff)

Microsoft: 8,000 employees (7% of staff)

Amazon: Following 14,000 layoffs in 2025, another 16,000 are to be let go in 2026

Snap: 1,000 employees

Citigroup: 1,000 in early 2026 with a total goal of cutting 20,000

Morgan Stanley: 2,500 employees

Capital One: 1,100 employees

UPS: 30,000 employees

Nike: 1,400 employees

Disney:  1,000 employees

                    Walmart:  1,000 employees 

General Motors: 1,300 employees

Dow: 4,500 employees

Block: 4,000 employees

HSBC: 20,000 employees

   Let us next look at how the US government is managing its affairs. Horribly would not be an overstatement. Its debt has soared to $39 trillion, equal to 125% of GDP, and its annual interest expense exceeds its defense budget. This chart shows the increased bleeding of the Social Security Trust Fund. Since its inception, benefit payments were fully funded with current wage withholdings. The dotted line shows that without prompt attention, benefits will soon have to be reduced by 23%. Likely outcome? Bus loads of outraged retirees ready to storm Washington. What is Congress doing to address this problem? Nothing.

    

    This chart shows the impact on families of different income levels if benefits have to be cut to match spending with social security tax revenue from wage withholdings. Unsurprisingly, the bottom 50% of families will be hurt the worst because their benefits make up a larger percentage of their retirement income. The percentage listed on the top of each column would be the reduction in their monthly income. No need to hold a go-fund-me campaign for George Soros or Elon Musk.

Is the Stock Market in a Bubble?

   The next chart reports past market highs when the concentrations of leading stocks reached or exceeded 40% of total market capitalization. The left-most line shows what happened to the "Nifty-Fifty" "can't lose" stocks in the 1960s, the light blue line when Japanese stocks soared to record levels in the 1980s, the red line the tech boom of the 1990s, and the right-most line is today's AI "Big Ten". Each of the prior bubbles ended in grief for investors. 

    We are always assured by financial industry pundits that "This time is different so don't be alarmed" just as investors were previously assured. Historic financial wisdom: "You'll never go broke taking profits." Note that each time those who held their stocks despite growing risks (HODLers - "Hang On For Dear Lifers") suffered more than ten years of subsequent losses. Consider taking some profits while you still have them.

Source: Bank of America via Bonner Private Research

Rising Price Inflation

    The challenge facing wage earners around the world is the relentless rise of prices due to the universal debasement of fiat currencies. This chart reports on some of these costs (general CPI, housing, medical care, hospital service, tuition, and day care) affecting US working families - together with projected price rises (dotted lines) over the next ten years. Should these projections prove to be correct, workers will be demanding large wage increases that will, in turn, exacerbate price inflation of goods and services. 

Source: Goldman Sachs

    We previously noted the high percentage (50%+) of workers living precariously "paycheck to paycheck." This causes enormous stress that adversely affects one's health and wellbeing. Interestingly, a recent survey reported that 41% of households making more than $300,000 per year and 40% of households making more than $500,000 are also living "paycheck to paycheck". This has a different cause that is known as "lifestyle creep," allowing their personal expenses to rise faster than their high incomes based on the belief that they are rich and can afford to spend without care. 

    It was recently reported that price inflation in the US hit a three-year high. Here is a chart reflecting recent "PPI Final Demand" price increases.  PPI reports on the costs incurred by producers. When their prices rise, retail prices are sure to follow. Note the monthly, skyrocketing, surge (blue line) resulting in large part from the US's Iranian adventure. 

Source: Wolfstreet.com

    How are US consumers doing? They are busy running up household debt they will have increasing difficulty in repaying because all of their monthly costs are also rapidly rising.

Source: Wolfstreet.com

    Many recent college graduates are struggling to find jobs and also trying to deal with their staggering student loans. Loan balances total $1.65 trillion and defaults are rising. 

Source: Wolfstreet.com

The Iran War Is Creating Global Chaos

    Either Trump's advisors failed to advise him of the huge risks associated with attacking Iran or they accurately advised him of those risks and he ignored them. The unfortunate result is that the Hormuz Strait is closed, Iran is pummeling Gulf countries infrastructure with missiles and drones, and essential goods have been bottled up in the Gulf for many weeks, with no sign of relief. 

    Oil, natural gas and refined fuels (diesel, jet fuel and gasoline blends) are not flowing out of the Gulf and national reserves in many developed markets are falling to dangerous levels, and where still available are double or more the cost. Fertilizers and their feedstocks were desperately needed for the spring planting season but are now in short supply and at much higher costs assuring rising food costs. Helium is critical for electronic chip production and MRI machines. Its supply is quickly shrinking and is soaring in cost.  Sulfur and sulfuric acid, needed in mining and many other industries is in increasing short supply and at much higher cost. Should the Gulf remain closed for many more weeks, many economies will be devastated.

    England, the EU countries, Japan, South Korea and China are major importers of Gulf oil and gas. Their industries will suffer badly without supplies promptly resuming. Iran damaged critical infrastructure in numerous Gulf states including oil and gas production and export facilities and water desalination plants. It will take a long time (several years in some cases) to get some of those facilities back on-line.

    We are not a military strategist but it appears that Trump is without any leverage over Iran to bring this war to a halt - except Iran's oil infrastructure which he has not threatened because many US allies are major importers of Iranian oil and gas. That leaves him with nothing but bluff and bluster because he is not prepared to invade Iran and suffer large casualties before next year's mid-term elections. At this point it looks like a stalemate with Iran holding the developed world hostage.

    An odd development is that while global economies and trade are seriously threatened and inflation is rising, US stock markets are reaching new highs. The evident explanation for this is investor belief that the war will soon be over, as Trump repeatedly announces. Should that not come to pass, the markets may be in for super-sized losses. No-one knows how, or when, this war will resolve, but betting the ranch on a quick end is very high risk. 

 

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