As Neil Young once said about one of his albums, don't listen to this in the morning. It'll ruin your whole day.
Patrick Boyle is back with a video explainer and it's not one of his funny ones. It is, however, one of the be overviews you'll find of the private credit situation and why so many smart people are so worried.
The as-good-as-you're-going-to-get news?
If a fund loses 40% of its value, it’s a tragedy for the investor. But as long as it doesn’t trigger a run on the banks, it isn’t necessarily a systemic catastrophe.
The irony of the democratization of finance is that the average saver has been invited to the table just as the exits are being locked.
The bad news? Pretty much everything else.
[Transcript cleaned by ChatGPT]
Then there’s the sector-labeling trick. A recent investigation by Bloomberg News found that this isn’t just a few isolated incidents — it’s a systemic practice. By analyzing thousands of filings, Bloomberg identified at least 250 different loans worth more than $9 billion where software companies were being creatively relabeled. A struggling tech firm might suddenly be classified as a food-products or logistics business, allowing the fund to hide its true exposure to the tech sector and avoid triggering alarm bells about concentration risk.
Lenders also use liability-management exercises to keep the wheels turning on bad loans. Instead of admitting that a borrower is in trouble, they might allow them to stop paying cash interest and instead add that unpaid interest to the total loan balance — a practice known as payment-in-kind, or PIK debt. It’s a system of “mark-to-magic,” where the only thing being managed is the investor’s perception of risk.
But as we’re seeing with the orderly spiral in the BDC market, perception eventually has to meet reality.
...
The real concern for many regulators today isn’t the banks — it’s the multi-trillion-dollar insurance industry. Life insurers, particularly those controlled by private equity firms, have become some of the biggest buyers of private credit.
Insurance companies are heavily regulated. They’re required to hold a specific amount of capital against their investments to ensure they can pay out claims. Regulators generally view a direct stake in a risky private credit fund as an equity-like risk, which carries a high capital charge of around 30%.
To bypass these rules, the industry has developed a magic trick called a rated note feeder. In this structure, a special-purpose vehicle sits between the insurer and the credit fund. The vehicle issues bonds or notes, which are then graded by a specialist rating agency.
This bit of repackaging allows the insurer to treat a stake in a risky credit fund as if it were a top-rated corporate bond. By doing this, they can slash their capital requirements from 30% to as low as 10%.
The Financial Times recently described these as “black box” products. Insurers are being flooded with pitches for these feeders, often from newer, smaller managers who don’t yet have an established track record. In many cases, they say the rating agencies are grading what is essentially a blank sheet — rating the manager’s reputation rather than the actual loans, because those loans haven’t even been made yet.
One insurance executive noted that buying these notes is akin to giving a loan to a manager while having no idea what’s going on inside the actual portfolio. Insurers are essentially trading visibility and safety for yield, using financial engineering to hide the risk from regulators.
This is what Bill Dudley means when he warns about a slow-motion crisis. Because these losses are hidden from view and the liabilities are long-term, the danger isn’t a sudden explosion. It’s that by the time the situation becomes apparent, it’ll be far too late to fix the balance sheet.
On the bright side, al t least we don't have to worry about any other potential economic crises...
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