Private Credit is Blowing Up Right Now and Spreading

We need to talk about private credit. Headlines are blowing up right now. Blackrock has just blocked withdrawals from its private credit fund. Blue Owl just tipped a UK lender into insolvency. JP Morgan is tightening lending to private credit. Morgan Stanley is now saying that default rates are going to reach 8%. And stocks with private credit exposure like KKR are falling off a cliff. Blue Owl is taking a nosedive. Aries is collapsing. And when you hear of risky loans that are being packaged up and sold to investors bleeding over into losses in the overall stock market, it makes sense you start to think this might be the Great Financial Crisis 2.0. So what even is private credit? Who is investing in this garbage in the first place? Why is it blowing up right now? And most importantly for you and I, what kind of impacts might this have on the overall economy and the market? For an overly simplistic origin story, we go back before the Great Financial Crisis. And if you were a business and you needed a loan, you would go to the people who you normally would go to for a loan, the bank. But as we all know, banks got into a little bit of trouble after what they did leading up to the financial crisis. And they were bailed out on the taxpayers back. And so because of that, people were justifiably out for blood and wanted to make sure banks couldn't do anything like that again. So the politicians swooped in and regulated the crap out of the banking industry in the hopes that all of these new rules would stop banks from making the same mistakes in the future. The only problem is you have politicians doing this for political reasons and not necessarily doing things that make the most sense if you consider the consequences two or three or four steps down the line. They're legislators, which means all they do is make laws and oftentimes are ignorant of economic reality. As they say, ignorance is nine tenths of the law. And one of these unforeseen consequences about putting all of these rules and regulations about what banks can lend money for and how much money they can lend to certain things meant that the appetite for borrowing would have to get fulfilled from somewhere else because banks could no longer fulfill one of the main functions in the private economy that they always had. And that is lending to businesses. That doesn't mean demand for borrowing went away. It just means that demand for borrowing went somewhere else. And that somewhere else that they turned to, we now call private credit. And some people call it the shadow banking system. It is simply non-bank lenders. And the most common entity or form of a non-bank lender is going to be an investment company. I'm going to approach you and your buddies and say, hey, give me some of your money. I'm going to take it, put it together into a fund. I'm going to go turn around and I'm going to loan that money to a bunch of businesses. And the great thing is these businesses can no longer go to the banks and borrow money at normal rates. They have to come to us because we're the only ones who can lend to them and we can charge you premium, which means we get a way better return than we would on things like treasuries or corporate bonds. Now, private credit didn't just explode on the scene from the start. It slowly grew over time to the point where it is right now. Part of that was due to the really great returns that investors could get by investing in private credit. Typically, if you want to make decent returns like 9, 10, 11 percent, you're forced to invest in equities. If you want something less volatile, considered safer, you can invest in bonds like U.S. treasuries and then you're looking at 3, 4, 5 percent. Or if you want to go with corporate bonds, maybe you're looking at 1 percent more. But private credit offered a way for investors to be able to get equity like returns, 9, 10, 11 percent, but with the low risk associated with debt, lack of volatility that you would otherwise have with equities. In other words, investors were attracted to something that looked like low risk, high returns. Now, from the borrower's perspective, you might be thinking, why in the world would anybody borrow here? But it's because there's a large group of businesses who are not yet at the point where they can just issue bonds to the public like Apple or Microsoft or Meta or any of the massive large corporations. But they're too big to go to their local bank or get an SBA loan. And so if they want to finance growth and more production, they're going to have to secure debt from somebody else. That's why they turn to private credit. And for a long time, it made sense. Because when you look at the yield on the 10-year treasury, you can see that following the great financial crisis, it was regularly in the 2 percent range. Yes, sometimes it got up to 3 percent, but other times it got as low as 0.5 percent. And so if I was a lender and I wanted to make any decent return on my money, but I didn't want to invest in stocks, I really wasn't going to be able to go after U.S. treasuries and I'm not going to be able to get that much of a premium going for corporate bonds. But a good rule of thumb for what you can get in private credit is about 5 percent higher than the risk-free rate. So if I can invest in 10-year treasuries at 2 percent, then I could invest in private credit and get 6 percent. That's a great deal for me as an investor because that is triple the income that I would have otherwise. And as a borrower, 6 percent is not astronomical. It's not hard money lending. It's not something crazy. It's something that I can afford. When I run the numbers, I can pay my 6 percent and I can still finance production and grow the business. But then 2020 happened. And you can see what we all remember. The Fed crushed interest rates across the curve. The 10-year went down below 1 percent. We entered an age of ZERP and QE. And that forced a couple of things to happen. Number one, there's now no return in traditional bonds. And so money across the board is seeking places where it can make a better return very aggressively. Number two, because of all the money printing, there's a lot more money seeking a great return. And so post-2020, there is a flood of money coming into private credit, chasing those high returns and that seemingly low risk. But this presents a new problem. And that's that there is more money that is chasing private credit than there are borrowers with the appetite to borrow. And so these private credit funds that were being built and the money was coming in from new investors were being packaged up and they were being sold to new investors, paying out earlier investors, making them whole, which is just spreading the story about how great private credit is. Meanwhile, they have to chase worse and worse borrowers, just trying to get debt to fill up these funds. And then inflation stuck around longer than policymakers thought it would. And interest rates rose. Following Zerp and QE, the feds started raising interest rates to try and get a handle on the inflation that they unleashed. And you can see the 10-year treasury went all the way up to 5% before stabilizing and moving sideways to where it is right now. And many people thought that by now, interest rates would have moved back down, but obviously they have not done that. As of the time of this recording, the 10-year yield is still above 4%. Now you might be thinking, if there is a fund that's designed to pay out a high interest rate, then wouldn't it be better if interest rates went up? Because then that fund could pay out an even higher rate. No. And here's a couple problems with that. Number one, five or 10 years ago, your option was 2% if you wanted to give your money to the government, or triple that to 6% if you wanted to give your money to private credit. But today, you give your money to the government risk-free, and you're getting over 4%, which means that private credit funds have to stick with the premium over the risk-free rate in order to continue attracting investors and stopping withdrawals, which means they have to raise the interest rate they are charging on the debt to the borrowers to about today, 9, 10, 11%. Remember, it's about 5% higher than whatever the risk-free rate is. But even 9, 10, 11% right now is not quite enough to keep investors around because you can buy U.S. treasuries for 4%. So you're a little over doubling the return that you could get with private credit versus before you were tripling or even close to 5Xing what you could get by investing in treasuries. But there's another problem. A lot of these borrowers cannot afford 9, 10, or 11%. They could for a little while, but everybody was banking on interest rates being lower by now. And so a lot of the borrowers are not able to pay back their debt. They're delinquent or defaulting. So not only are the loans inside the funds going bad because the borrowers are having trouble repaying, but also the investors don't really want to keep their money in it anymore because the premium they're getting for the additional risk is just not worth it to them anymore. Both of these problems are compounding on each other because anytime too much money gets taken out of the fund, now the fund has to go call the loans and those loans might not be able to get repaid. This is why you are seeing estimates of default rates skyrocketing, why you're seeing tightening lending standards, why you're seeing companies like Blue Owl tipping people over into insolvency, why you're seeing BlackRock halting withdrawals, because these things can spiral very quickly. And if you allow people to take their money out and people are afraid that if they don't take it out right now, they might not be able to get it in the future, you get a bank run. Everybody tries to go get their money out right now and it causes the thing to happen that people are afraid of. So that's why these funds are limiting withdrawals. Now, here's some good news. Most average people are completely unexposed. Most people's 401ks have mutual funds that are treasuries and stocks. Most people's brokerage accounts are stocks, maybe some mutual funds. Direct exposure by the vast majority of people is essentially zero. Private credit over the years has attracted a lot of institutional money primarily, a lot of ultra high net worth and high net worth individual money. So the vast majority of self-directed retail investors are completely safe here, assuming this doesn't infect other areas of the market, which we'll talk about in a moment. But there is one area that the retail or the small investor does have exposure and it's important to point out, and that is pension funds. So VRS, which is the Virginia Retirement System, recently disclosed a total of $775 million in commitments to three private credit strategies. And that number is meaningless on its own list. You know how big the pension is. It comes out to about 16% of the pension's assets that they are managing, which is a big chunk. It is a dangerously sized chunk. But it's not just the Virginia Retirement System pension fund, it's also the California pension system. CalPERS recently disclosed that they had committed $16 billion across 22 investments over the last 12 months, bringing their total private credit exposure to 3.7% of the total fund. This was as of June of 2025. And they said that time their current target was 8%, which means they're a little over 4% right now on their way to 8%. Again, not a good amount of exposure here. It's pretty heavy. Pension funds just now getting into the private credit game is a huge red flag that we are on the tail end of this. Pension fund managers are notorious for getting in, being the bag holders, getting in late and marking the tops in markets. Not the best investors to follow. This is one reason why anytime any of my friends or family members ever ask me if they should opt for the pension option, if they get a job, especially with a government job that has an option for a 401k, 403b, 401a or a pension, I always say, skip the pension. You want to be able to control your investments. You don't want to hand it over to somebody who's governed by all the rules and regulations and chooses things based off of political ties and maybe some money in their back pocket, things like private credit. And you want control of your lump sum as well if you choose to go somewhere else. In today's day and age, I just don't see really any reason why you would ever opt for a defined benefit plan over a defined contribution plan. You don't control it. You don't own it. So at this point, what is the risk to the overall broader economy? Right now, fairly limited. Morgan Stanley has estimated defaults reach up to 8%. Now, I don't want to say this is contained. However, despite the fact that there are some large institutions with exposure to things that could be 100% losses here, we don't see this type of systemic infection, contagion, massive unrealized losses spreading across large banks, balance sheets. So right now, this does not look like something that could be risking an entire economic collapse. We see mainly some institutions and some high net worth individuals who are at risk of loss here. However, that doesn't mean that we shouldn't expect any sort of political action or bailout to happen here. Remember Silicon Valley Bank? The way that bank failures are supposed to work is that if you have up to $250,000 in your account, FDIC will make sure that you don't lose that. Anything above that, you're out of luck. But Silicon Valley Bank had a bunch of billionaires, bunch of tech people, a bunch of very rich people. Most of the depositors had uninsured deposits in those accounts. Above the $250,000 limit. So they swooped in, they printed the money, and they bailed it all out. Now question, do you remember the First National Bank of Lindsay? Of course not. The First National Bank of Lindsay was a bank that failed in October of 2024. And guess what? That bank did not get the bailout. Again, up to $250,000 in an account. That was insured. Anything above that was lost. Now this bank only had about $7 million. It was above that $250,000 limit. But I'm sure for the couple people who had more than $250,000 in their bank accounts, that hurt pretty bad for them. They're thinking, man, would have been nice to get the Silicon Valley Bank treatment here. But that's not how cronyism works. And so if this does bleed into something much larger than 8%, there's some very big losses with politically connected people. You can expect some sort of political action to happen here. So what are some of those things that could tip it over to that point? One is if the overall economy gets worse from anything, whether oil prices stay too high, unemployment continues to rise, inflation starts to kick back up again, recession hits, markets start showing losses elsewhere. All of these things independently can increase redemption requests, even if it doesn't have anything to do with the fund itself. Because if I need money, I'm going to sell what I can, not what I want to. And if everything else is going bad, I might have to request my money from this private credit fund. Remember how we talked about earlier, redemption requests by itself can cause the funds to have trouble. Now, another thing is that as the debt gets harder and harder to pay, as interest rates stay where they are for longer, the overall economy is slowing and making those businesses have hard times bringing in the revenue or the profits they thought they would, their delinquencies start to rise, their defaults start to rise. And obviously that can turn these funds bad as well. At the end of the day, these problems showing up in private credit are a symptom of over-regulation, a sluggish economy, and the long-term consequences of monetary policy run wild. And you notice that none of those three things had anything to do with free markets or capitalism. These are consequences of removing and restricting free markets, not letting them run wild. So what are the solutions that we might expect if this thing starts to get worse? Number one, I don't think we should expect QE. Both the Federal Reserve and the Treasury have been signaling for a while now, they want to move the Federal Reserve away from managing the economy through their balance sheet. They don't want to be doing QE every time there are some bumps in the economy. They don't want to be expanding the balance sheet. Okay, yes, they are expanding their balance sheet right now, but they've been signaling they want to get away from that. They're actually still selling their mortgage-backed securities. The things they're buying right now are Treasuries only, which means they're not going to be stepping in unless they're directed to by Congress. They're not going to be stepping in and buying these private credit funds, buying anything other than U.S. Treasuries. The next thing that we are likely to not see Despite the extremely unpopular actions by the current administration lately, I think a GFC-style bailout for private institutions and wealthy investors at a time like right now would be virtually a guaranteed midterm loser. So I think there is low risk of a direct government bailout. Number three, I also think it's fairly unlikely that they just sit back and let this ride, mostly because there will be fears, there will be problems coming up from it, there will be people who are financially hurting, even though it's the people who made the bad investments in the first place. So the solution that I think is most likely here, and I know I've said this a million times already, is bank deregulation. This is something that the Fed and the Treasury have been signaling for a long time. I think it's going to happen this year. Not only is it going to solve other problems like interest rates for the government, it would solve this problem as well. Right now, banks have regulations that they set up post-GFC that restrict, number one, how much money banks can lend and where they can lend it. So they are forced to take some of their money, lend it to the U.S. government, buy treasuries, but they're also penalized on their risk limits for how much money they're lending to the U.S. government by buying treasuries, which means they're extremely limited in how much money they can loan to the private economy. The specific regulation I'm talking about is called the Supplementary Leverage Ratio. And again, I know I've been talking about this forever now. I know you're probably bored of it, but as they say, these boots were made for kicking a dead horse. So removing the Supplementary Leverage Ratio will, number one, allow banks to purchase an unlimited number of U.S. treasuries, and it will not count against their risk limits. That also means they can use the full capacity of the risk limits to lend to the private economy. This will drive down interest rates, allow a lot of refinancing and a bank-led bailout of private credit in the economy. Companies that are experiencing this difficulty will flock to the banks and borrow at the lower rates. All that refinancing allows redemptions without losses. And maybe, just maybe, the economy has a smooth sailing through this potential crisis. The companies like Blue Owl and KKR and Ares that are exposed probably have some more downside here. So I wouldn't be trying to catch a falling knife at this point, but I wouldn't be surprised if the bottom is in for them soon. But it all depends on that bank deregulation. As always, thank you so much for watching. Have a great day.