BREAKING Private Credit s Lehman Moment Just Happened

Underscoring the global nature of private credit and the credit cycle, one of India's largest junk borrowers just decided it's going to delay the cash interest and principal payments on one of India's biggest junk bonds. But who is it that owns these junk bonds? Well, some of the biggest names in private credit like Cerberus and some of the biggest global banks like Deutsche Bank. Now, this bond is not going to bring down either of those. In fact, that's not what we're really looking for here, not a failure of Deutsche Bank becoming the next Lehman. Instead, what we're looking for, more importantly, signs of the credit cycle as well as the downside consequences from it, the dreaded credit crunch. That's what we're really after here. Now, to this day, 18 years after Bear Stearns and Lehman Brothers, everyone keeps looking for the next one. That's not what we're really talking about here with private credit, the bubble, now the bust. Banks themselves are not going to go belly up like they did during that fateful year of 2008. It's not that we would expect a bank to fail because of private credit, nor one of the household shadow bank names like BlackRock or Blackstone. But a smaller shadow bank? That's well within the realm of possibilities. And the question you need to ask is, what would that do to the entire monetary and financial ecosystem? So we're already seeing, again, signs of concerns that's showing up places like repo, where expectations are rising that repo rates might see a significant spike by summertime. And that's already in addition to treasury bills that are being valued quite richly compared to investment considerations alone. And I'll go over what both of those mean and what's really going on right now. But even if leveraged private credit does progress into stage three, and we're at stage two right now, and there does get to be a fair amount of wider monetary disruption due to it, the focus on failing banks or even just failing shadow banks somewhat misses the point. Those are just signals that big things are going wrong, and it's what's going wrong and what that means, which ends up being the vastly more important part of this. Now, bankruptcies, they make a huge splash, and that's what everyone remembers. But even if Deutsche Bank does not become the next Lehman Brothers, and there's little chance that it will, that doesn't mean that the system itself overall can't lead to some really big-time downside consequences. And what are those consequences, if not for the next Lehman Brothers? That's where the term credit crunch comes in. And more importantly, when a credit crunch becomes what economists call a unit root. That's what we're really after here. Private credit, shadow banking, unit root, credit crunch. And I'll explain what all these are. And what did the most damage in 2008 wasn't Lehman Brothers itself. It was the credit crunch which developed from the systemic breakdown of which Lehman, Bayer, AIG, Wachovia, all of them, they were symptoms. They were symptoms. The permanent impairment to the banking and money flow which came afterward, that's the thing. You don't need a big name failure to suffer from a crunch. And that's what the focus needs to be right now, particularly since this thing is indeed global. It's not just contained to the US or Europe. In fact, we were reminded of that just recently when India's Shapoorji just came out with, quote, India's biggest private credit borrower and issuer of one of its largest ever junk bonds has just reinforced this point. Holders of a high yield note issued by a unit of the infrastructure conglomerate unanimously agreed to let the company delay paying principal and interest to June 30th, people familiar with the matter said. The notes are held by a number of global private credit funds, including Cerberus Capital Management, Vardy Partners, Davidson Kempner, and of course, Deutsche Bank, the one that's most heavily exposed to private credit around the world. Now, group representatives, it's back to the Indian firm, told some investors earlier this month that the company was considering a potential offering about $2.6 billion equivalent of dollar and rupee denominated bonds, according to people familiar with that matter. They also said that the proceeds would be used to refinance the Goswami debt that just got extended. And, oh boy. Not only does this anecdote remind us of the global nature of a credit cycle, it also serves as another milestone in that same downturn. This is one of the clearest signs of the reverse slope to the cycle, Ponzi scheme borrowing. That's when troubled debtors really start to borrow money just to pay back the old investors. It's an obvious sign of distress, particularly if or when it ends up being some of the bigger borrowers and gets to be more common among them and to many of their smaller peers. You can't keep extending and pretending if the money starts to dry up. And if these businesses can't keep convincing new lenders to lend to them, then the old lenders begin to pile up losses, or at the very least, they pile up PIK, which I'll get to, and more selective defaults. But after enough of those take place, investors, the entire system, start to get wise to it, which only feeds into more downside of the cycle. Risk aversion grows, new money stops flowing in, and then you get to the more systemic parts of the system. Stage two becomes stage three. Before we go on with our video today, let me ask you a question. 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We thank Monetary Metals for their sponsorship, but now let's get back to the rest of our video. And this is exactly what Deutsche Bank's Ozen Tarman was talking about a couple weeks ago that I highlighted when he said, if not for the Iran conflict, this stuff would be everywhere, all over the front pages, social media, the entire thing. This is really important stuff, but why? That's the point. A lot of people are saying, okay, private credit, some losses, people argue it's not a big deal. If it is a big deal, what does that actually mean? You're going to have proponents that are going to downplay the threat at the same time that critics, those increasingly concerned, myself obviously included, are going to be pointing out all the flaws. Now, one of those critics is Jeffrey Gundlach. Not only did he highlight too much of what he called garbage lending last fall, lending didn't take place last fall, the highlighting took place last fall. Earlier this week, Gundlach took aim at PIK, called payment in kind, which has gone from a limited tool to help keep struggling borrowers in the game and afloat, to one of the most questionable tactics that's seemingly employed way too aggressively and too often, thereby the purpose isn't to help borrowers, it's to obscure just how much garbage there has been and would otherwise already be uncovered. So from Gundlach, quote, he unleashed a storm of criticism this week, seemingly aimed at Red Lobster lender TCW Group, which where he used to work, over how the asset manager is valuing its debt and equity stakes in the struggling restaurant chain. TCW had slashed the value of its equity stake in Red Lobster by roughly 98% while continuing to value at par roughly 56 million of Red Lobster debt held in a private business development company or BDC, which is something Bloomberg reported earlier. The marks suggest that TCW is confident that Red Lobster's overall value remains sufficient to fully cover the loan, which has grown in size as interest accrues in kind rather than being paid out in cash. Now, private credit proponents will point out how this is an extreme and isolated example, but critics like Gundlach are going to counter by noting how prevalent PIK has become and just how opaque pricing of credit assets has turned the industry into a full-blown target and for good reason. The big issues have always been trust and information and the two should go hand in hand. Good information leads to robust trust. As I said, it's not credit losses that lead to systemic problems, it's the lack of trust. But when you start to see too many examples where the information instead shows something very different from previous expectations as I went over in my last webinar, that's when a few one-off cockroaches fuel at the start at least some well-grounded skepticism. Most people are willing to give the benefit of the doubt, especially when they're getting high returns, but that benefit always comes with limits. And once it starts to get stretched too far, the only way to restore functioning markets is for those in question, the private credit suppliers, to begin supplying useful information. Instead, like 2008, what they've been doing is exactly the opposite and Blue Owl being the most prominent example. And so there's every reason to see how that's become the case, where stage two has come from. But what about stage three? Most people want to know, okay, stage two progresses to stage three. What does that mean? Doesn't that mean something like 2008, another Lehman Brothers, banks failing all over the landscape? What is it we're really talking about here? Now that we see that there is potentially a downside, we can argue about how much of a potential that is, but now that we can see there is potentially one that we can't dismiss, what does that actually mean as far as the real economy, the marketplace, and anything else in between? We've been conditioned to think about it along the lines of bank failures, and it's understandable why that's been. For those of us who lived through it, you remember when they announced Bear Stearns was merged with JP Morgan. You know, Lehman Brothers, AIG, especially those came closely together. We associate the crisis with those bankruptcies, but the crisis wasn't the bankruptcies. They were just the most obvious symptoms that a crisis was raging. They didn't cause 2008. Lehman and Bear were casualties of 2008. Now, no one remembers which banks ignited the great collapse in the early 30s. What is remembered are the consequences from the systemic breakdown, and no, I am not saying the private credit bubble and busts, even in stage three, is going to lead to an either 2008 or the Great Depression. That's not what we're talking about here. What I am saying is that what matters is what happens to the system, not one, two, or several participants within it. What turned 2008 and that crisis into the silent depression was the credit crunch that unleashed and then made permanent. In fact, it was that very thing, which ironically birthed the shadow banking private credit system that we know today that's gone through the bubble and now bust cycle. So, banks are now shadow banks. They're simply engines to circulate money throughout the economy and financial markets too, for that matter. A bank failure can impair that engine, but it can be just as diminished even when there aren't any more Lehmans. What matters is not the specific firm, it's the systemic capacity, which is the main reason why we always talk here at URU about balance sheet capacity. In a way, it was just talked about a couple days ago over at the Bank of England. Quote, we shouldn't be in a situation where this brings down the banking system, but it might cause a private credit crunch in the way we had a banking credit crunch, according to the Bank of England, Sarah Breeden, and what she said at a conference held by the Times in London just recently too. Breeden doesn't expect a repeat of the global financial crisis, which was not financials monetary, but said regulators are looking for echoes of that episode, as we all should be. They are concerned that leverage and lack of disclosure, lack of trust in the private credit market could lead to a downturn with that knock-on impact to the real economy. That's the thing here. And this is a far bigger deal than it might seem. Just in our recent experience, there's a compelling argument that the private credit bubble on the way up, the bubble, saved the United States in particular from going full-blown recession in 2023, particularly after the banking crisis. We got close to it. We stuck with the forgot how to grow recession type, but without those shadow banks and the money that they were providing and relending, it might have been as bad as we saw in Europe and maybe even worse. So the economic consequences from a private credit crunch, they're already nasty. And the longer they stick around, the more damage they do, especially to employment. That's something else that Keene said long ago. Another one of the few things he got right along with the stock market. Deflation. And a credit crunch is a manifestation of deflation. It hits workers the hardest. And that's just what Sarah Breeden was talking about. It's always the little guy who ends up bearing the brunt of deflation. So a private credit bust, even if there aren't any huge newsworthy major failures, a bust which leads to a credit crunch can leave scars all over the system and especially on the labor market, which is exactly why the Bank of England is talking about the possibility here. And a lot of those chances really depend upon systemic liquidity. Another angle on deflation, circulation of money through the system so that circulation of credit can take place and keep the overall economic system as well as financial system well-oiled and well-greased so that everything flows. Everything has to move, including money and credit. When they stop moving, that's where you get the deflation. And why they stop moving, it can be because of something like a credit cycle downturn. Now, we often hear about the term liquidity. I mean, you hear it all the time. What it really means is money flowing through the system, which is terribly important the best of times, but much more so during trouble. You want money to flow through credit because that's how the modern specialized globalized economy works, which puts the reserve currency, which is the Eurodollar, not dollar, at the center of everything. You need the globalized monetary flow. And money can flow from one end of the planet to the other because of it, which is the secret ingredient in the modern prosperity that we all enjoyed up until around August 9th of 2007. When that money flow breaks down, the economy breaks down with the marketplace in the middle. Now, the willingness of market participants, financial participants overall, to take on risk is paramount, which is where the private credit story comes in. They take risks because they seem reasonable. If the system begins to believe they are, in fact, unreasonable due to shadow bankers hiding stress and PIK or depending way too much on mark to myth, then we do have a growing problem. It's not the losses, as I said in the webinar, it's the mistrust. Money flow dries up, which is what deflation really means. And when money flow dries up, then you really get the issues. This is why we pay so much attention to things like repo and other kinds of money flow like FX. It can tell us that when these problems are rising, lack of risk taking that goes along with it, when they're getting serious, and we just got another signal along those lines going back again to repo. So back to Bloomberg here. Traders notched up record volumes in one narrow corner of the U.S. interest rate futures market this week, betting on a spread that reflects potential swings in overnight lending rates. One side of the trade involved futures tied to the secured overnight financing rate or SOFR, a benchmark rate based on the cost of borrowing against treasury securities, that's repo, while the other references the effective federal funds rate, the weighted average of overnight unsecured rates. So long story short here, I know there's a lot of jargon there, but long story short here, very simple. What hedgers are hedging against using what's called a SOFR basis trade is the possibility that over the next three months, SOFR rates will rise back above Fed funds just like they did quite regularly last fall. Now why would repo rates, which is what SOFR is really made from, why would repo rates rise like that? Well, now the mainstream is going to tell you it's all about the Fed and its bank reserve, but all the Fed is going to be doing going ahead is slowing the pace of its not QE bill purchases. It's still going to be buying bills and creating reserves, plus there are going to be a lot more reserves thanks to the government spending money that it doesn't really have, which takes them out of its account, the TGA, it puts them back into the banking system. But all that's irrelevant. Well, when the Fed gives you only the Fed for everything that happens, everyone says it must be the Fed because that's the only way to explain something in money and banking. That's all just nonsense. In reality, it's always risk aversion, dealer capacity, therefore balance sheet capacity. Now, why might those become impaired? Well, one of the potential fallouts is from the energy shock, which threatens to trigger the historical energy shock case, which would be a full blown NBER style recession, especially when there wouldn't be a private credit cushion this time around to keep it from going all the way. But it also might very well be private credit woes themselves. After all, banks are already taking steps to lower collateral valuations to protect themselves from the shadow banks, which is not a good sign for willingness to take risks overall. This stuff is already taking place. Plus, we already saw repo last year. And we're also seeing Treasury bills, as I mentioned in the intro, priced relatively high again, along with dealers, primary dealers in this case, hoarding large amounts for their inventories. They're also hoarding large amounts of coupons and notes, but bills, that's another signal you got to pay attention to. And all of that pointing to the other side of cash flowing or not flowing in this case, which is collateral not flowing. And this is what a higher SOFR rate would mean and what the money market is currently hedging in huge amounts against. And that goes with other signs of money problems, the dollar shock that I've been telling you about, which shows up in offshore parts of the world beyond India's biggest junk bond borrower. So this private credit story, and indeed 2008 itself, it's not about specific firms. Now, those specific firms, when they failed in 2008, as I said, they gave you a sign, a very visible symptom that something big was wrong. But we can have something go wrong without failures, in this case, shadow bank failures. Now, the regulated banks like Deutsche Bank, they're going to be part of this because they're exposed, but this won't be bringing any of the big ones down like we saw 18 years ago. That's not what we're talking about here. What we are talking about is what turns off the money and credit to the wider system, just as important how long it might stay turned off. And then what that deflation unleashes in the real economy where it really counts, which is jobs and incomes. And as I told you in that webinar a month ago, it's not about credit losses. It gets to be about this mistrust. And as we just went over, there is every reason to see why everyone can see with their plain eyes how things aren't adding up. There are all the signs of a credit cycle downturn, and what looks to be a big one, given the garbage bubble which preceded it. And how far that goes, how big it gets, will depend on several factors, including money flow. And the more that amplifies the negative results, the greater the chance not just of a credit crunch wrecking things in the real economy and the markets in the short run, or the intermediate term really, but like 2008, leaving permanent scars, this time on the shadow banking landscape, which would then deprive the real economy of yet another recovery. It's not Deutsche Bank becoming the next Lehman Brothers that we need to worry about because that's not really going to happen anyway. It's the repeat of another permanent crunch, or what economists like to call a unit route, though economists wrongly say unit routes aren't possible. We've already seen that's not true. That was 2008. So the real downside here is not repeating 2008, it's repeating the aftermath. My webinar for March is still available here on the channel. In fact, that's the one I got linked below. And I'll even make the deal, the webinar deal for Eurodown University subscriptions. I'll turn that one back on again if you're interested. But I highly recommend you check that out. And to everyone else, thank you very much for joining me. Huge thanks to Eurodown members and subscribers. And until next time, take care.