Private Credit Bubble Burst...What You Must Know!

What is private credit? That's what I'm here for, guys. What is private credit? Yeah, there's a couple of different terms that can be used interchangeably, which kind of gets confusing. I mean, shadow banking, private credit, direct lending. When you talk about private credit or shadow banking, it's basically relending that's done by financial firms that are not regulated banks. So traditionally speaking, I mean, that's who made loans, right? You put your money in a bank, they had some funds, they relented out to the rest of the world. Loans were made by the banking system. But after 2008, which basically shut down the banks as effective intermediaries throughout the economy, over time, throughout the 2010s, these non-banks started to fill in the void that was left behind, usually lending to the riskier borrowers. Because after 2008, banks only wanted to own US treasuries or Fed bank reserves. They didn't want to own anything risky, which left a huge market opportunity out there because the risky parts of the economy deserve credit too. In fact, that's where most economic growth comes from. And so a lot of Wall Street types said, well, if the regulated banks aren't going to do it, why don't we do it? All we really need to do is be really good at gathering money. We'll find seed investments, we'll get loans in place, we'll get leverage done. We know how to navigate the repo markets. We'll take all the money connections that we have and we'll start relending these funds into the more riskier parts of the economy because nobody else is going to do it and there's tremendous opportunity there. So throughout the 2010s, the shadow banks started to become more and more prevalent across the financial system, but it really took off in 21 and 22 with everything else. I mean, everything you guys have been talking about in real estate, private credit was another parallel bubble to what happened in the real estate sector. So a lot of shadow bankers said, 21, 22, it's inflationary, it's red hot, this is going to be great forever. And they lost their frigging minds. Just like in any bubble, human nature is undefeated. Every bubble in history looks exactly the same when you drill it down to the most fundamental level. It starts out with a good idea, shadow banks providing credit to risky parts of the economy, and it just goes way too far because people just get caught up in it. You rationalize away risk factors. More often than not, it's really just recency bias. Good example of that is subprime mortgages. In 2000s, people may not remember, but up until 2006 and 2007, subprime mortgages didn't generate losses. We went through the dot-com recession in 2001, and the loss rates on subprime mortgages were basically flat. And so people thought, hell, this is great. We can charge extra interest and extra return, and we just do a ton of these subprime mortgages because there's no downside. There doesn't appear to be any downside. You just get wrapped up in the bubble behavior. Same exact thing in private credit, which is mostly lending from these shadow banks, which are just investment funds. So again, they get money from seed investors, from wealthy individuals, from institutions. They borrow money in repo. Some of them are levered. Some of them are not levered. There's various forms put up. And then they take that money and re-lend in private credit, mostly to these smaller, medium-sized companies. So a lot of it is corporate credit, not necessarily consumer credit, but corporate credit, which adds another layer of complications because corporate credit is highly susceptible to macroeconomic cycles. So in 21, 22, everybody's convinced it's going to be great forever. They said, let's just lend to everybody. As much money as we can possibly get, we'll generate these awesome returns. We'll promise everybody that wants to be an investor. You can get high returns for very little risk. What's not to like about this? And then the problem with it is they kept going further and further into risky lending, assuming even as the economy started to slow down, we started to see cracks in the system. Europe fell into recession late 22 and early 23. And all the private credit providers said, well, it's OK. It's just a short-term bump. We're still going to lend our asses off into all these risky situations because it's going to get better tomorrow. I mean, Jay Powell says the economy is strong and resilient. So let's just keep going. And they got further and further into that tunnel vision, recency bias, rationalizations. And before you know it, it was just a cesspool of garbage lending, as Jeffrey Gundlach called it. What do you mean by write-down, just so we can be on the same page, Jeff? Or what does Ken mean by that? The write-down is when you take an asset that you value at usually par or some kind of premium, and then you have to mark it down to what its real value is or really what somebody else will pay for. That's really what it comes down to, is what is the true value of everything. But they're not carried as delinquency. They're not reported as delinquent because of what's called selective defaults, which gives these shadow bank credit providers the option of getting interest payments in payment in kind, or PIKs, it's called, where a borrower defaults. They stop paying you cash interest. So to keep the loan current, you just add the interest payments onto the principal and mark it as if it's a performing loan. And so what we've seen is a lot of these selective defaults, which, I mean, like everything else, they have a legitimate purpose. I mean, there are definitely cases where a borrower just needs a little bit more time to work themselves out, and then the loan will cure itself down the road. When you see PIK or selective defaults used in widespread fashion, it's no longer a legitimate purpose. Its purpose is to hide the scale of distress in these portfolios. And that's what we've seen, certainly in the private credit space among these business development companies, the publicly traded funds that everybody's talking about, Blue Owl, KKR, Blackstone, BlackRock, rising selective defaults, which only reinforces the message, which is everybody's assumptions from a couple of years ago, they're not panning out. And if you're stuck in these funds, you're worried about you're going to be left holding the bag when the entire system needs to reset its valuations, which is going to happen at some point. It has to happen. When he was asked about private credit, he said, yeah, there's going to be some losses. Then he said, it's not going to be a systemic problem, but there's going to be some losses, which, I mean, at this point, I think everybody knows. So the real question isn't whether or not there's going to be losses, it's who's going to be left holding the bag and what happens in between now and then when everybody finally settles it out. Can you walk everybody through what that means? Because basically it says they're basically trying to eliminate a run on the bank essentially, right? It is. It's a slow motion run on the bank. And it's absolutely stunning how big it is. That's the one positive. If you're looking for a positive, that's one positive, and how these funds are set up. Unlike a regulated bank, like say back in the 1920s, 1930s, when we had the Great Depression, the collapse there, there was nothing stopping depositors from going in and cleaning out the bank. These shadow banks or these investment vehicles have in their contractual language the ability to limit investor withdrawals. So if you have an enormous number of investors come in and say, I want my money back, they can say, well, no, you agreed to leave it in the fund for a long period of time, just for this type of situation, so that these funds are not forced to sell their assets at discount rates, which then leads to the bigger problems. But even still, it started last fall, really last August and early September. Tricolor came out, which was a subprime auto relender. They're also engaged in a whole bunch of fraud, which nobody caught. First Brands was another one, same exact thing. And these cockroaches, as Jamie Dimon called them, what's important about them is not the scale. These are all really small in the grand scheme of things. But what it showed was that all of these relenders didn't do their homework. They didn't do basic underwriting. Again, bubble type of behavior. You just do volume, volume, volume, because everybody's making money. There's no downside. And as more and more people began to realize there was basically no underwriting in Tricolor, there was a freaking spreadsheet with two different columns and two different sets of books, and nobody looked at the spreadsheet. It was there for years, and nobody looked at it until finally the thing blew up. So either way, the point is people are starting to wake up to the fact that, oh my God, there was this bubble here the entire time. These lenders we thought were doing the absolute best as far as underwriting and due diligence hadn't really done the basic stuff, which makes it even more dangerous. And so quite naturally, as some of these cockroaches started to produce small losses, investors said, oh crap, there might be more here. Give me my money back. And so it started with UBS around November, a couple UBS funds, one that was directly involved in the First Brands fraud that lost money in that fraud, which then triggered a run on another fund, which UBS promptly shut down, which suggested they were getting hit with lots of investor withdrawals. It just escalated from there to where now it's become a regular occurrence. Blue Owl is right at the top of the list. And these are huge funds. What Blue Owl reported a week ago was that one of their biggest funds, the flagship credit fund, there was about 30 some billion dollars in assets in the fund, got hit with 20% withdrawal request, 22% withdrawal request, which means investors wanted 22% of the fund value taken out. Now, of course, they said, no, we're not going to honor that. We'll just do the contractual minimum. But it just goes to show the degree to which it really is a slow motion run, has enveloped the entire private credit space from what is largely institutional investors. That was the key signal from what Blue Owl reported last week. You get in your mind when you talk about a bank run or any kind of run like this. It's overly emotional, overreactions among individual investors who are just like, crap, I looked at Bloomberg today or I looked on CNBC, I need to get my money back. No, in a lot of cases in 2008 was the same too. It's institutions who have either these bureaucratic mandates or these hard limits that they need to live up to. And they're the ones who really generate the difficulties for these funds because they can't be around in a fund. They can't be invested in a fund that is becoming questionable. That's really how you turn an asset class that is relatively decent into something like toxic waste. There really weren't a lot of money losses in subprime mortgages in 2007, 2008. I mean, there were a few, but it really wasn't a lot. What killed the system was the lack of ability to revalue everything and make everybody want to stick around to see how it plays out. And that's really where we are today. That's why you keep hearing people making these 2008 comparisons because we're in a situation where people are nervous. People see that there are going to be losses and we are not getting any information about the scale of losses, who's going to end up taking them, how much they're going to be, when it's going to take place. And so quite naturally, institutions as well as individual investors react as any person rashly would. If I get my money out, I'm going to get my money out. Why should I take the chance of getting stuck with something that I don't want to? Because everything that's happened since this first showed up last summer has only reinforced all of those fears and big concerns. And it's even worse than that because all of these shadow bankers and private credit providers, the only thing they ever say is, we don't know what's going on. We can't imagine why people are withdrawing their funds. Look at our performance. Our performance is solid. Our underwriting is terrific. Characteristics of our portfolio assets are unimpeachable. If that's all you're getting from these guys, of course, you're going to withdraw your money because it's so obviously fake and false. And so it's like everything that's taking place only reinforces the idea that this thing is going to continue to get worse until something really big happens. But the one thing that hasn't happened very much of is the selling. So far, these funds have been able to stave off a lot of forced selling, which has kept at least the prices that we know about within reasonable tolerances. But the more investors withdraw money, the more banks back away, the more institutions back away, the greater the pressure that will be on liquidity that can then lead to the real downside here, which is the selling. So Jeff, everything you just said, I'm an investor, I'm out there, I'm in the trenches, I'm an operator, I'm watching you say all these things. Why do I care about a bunch of billionaires that are losing money right now that invested in these funds and doing whatever? How does that even affect me? Why should I even care about anything you just said, as somebody watching this? Absolutely. Because if you're not invested in Blue Owl or KKR, then really, what would you care? So hedge fund investors and some institutions get their assets handed to them. And so it's too bad for them, right? They chose to ignore the risk, right? They fell for the idea of high returns at low risk. But history shows it's never like that. I mean, 2008, perfect example. What did anybody care about subprime mortgages other than, say, house flippers and those who were subprime to begin with? What ended up happening is it didn't stay with subprime mortgages because the entire system was unresilient. It was fragile, to use the term that gets thrown around here. So the problem here, and there's a couple of different ones that get wrapped up into one. The first problem is a credit crunch. Because as I said from the very beginning, these shadow bankers were one of the few outlets that a lot of smaller and medium-sized businesses had to obtain loans. We're not talking about loans to do stupid crap with. We're talking about loans to fund their operations, like working capital, inventory management, payrolls, meeting payrolls. So they would go, a lot of these direct lenders that are providing short-term credit to these businesses to keep their operations open. So if we have a larger withdrawal and a liquidity pressure on private credit providers, that means the money's going to stop trickling down into the real economy, which means some of these smaller businesses are going to be shut off from working capital. They're going to be shut off from credit flow, from money flow, which will impact their operations. It means rising unemployment. It means more difficulties among businesses to engage in regular commerce. So the economy suffers at the margins from the lack of credit flow. In terms of financial markets, as we know only too well, there's so much interconnectedness throughout the entire financial system. You really don't have a problem, especially if it gets bigger and bigger. You never have a problem that gets firewalled over there. It's not like you can have a credit crisis strictly in private credit in only one segment of that market, and it just doesn't go any farther. Everybody gets walled off and we just leave it over there. Because what ends up happening is, private credit, you start to see some selling there, asset prices get marked down, which then people look at that and say, well, this is price discovery in the corporate segment. What does that do to valuations in leveraged loans? And then leveraged loans, which are another form of corporate credit, those prices start to readjust to what we're seeing over in private credit. And as those prices adjust down here, that reduces the value of collateral, it leads to margin calls, which then creates volatility in those markets. And that volatility then gets reinforced in other asset markets that are taking their cues from what we can see in private credit and corporate credit overall. And it leads to what we saw, for example, last March and April, where even the stock market gets wrapped up into what is, or what really shouldn't be, something that involves the stock market. It starts way over here and ends up way over here. And before you know it, if it goes too far, you've got stocks declining, you've got risky assets declining that have nothing to do with private credit. You've got the economy taking hits from all these small companies that can't hold their employees, so unemployment rises. And as you guys were talking about before I came on, as unemployment rises, what does that do to other markets? So you can't isolate one thing from another, at least you hope you can isolate one thing from another. But if it goes past the point of no return, which is completely unknowable and unpredictable, when it goes too far, there are numerous angles in which it becomes a systemic issue. The positive is that there are definitely ways to off-ramp the situation before it gets that far. The negative here is that we've been in this for seven months now and everything keeps escalating further and further in the wrong direction. Doesn't necessarily mean it becomes systemic, it just means that the chances of it becoming systemic continue to rise rather than diminish. There are trillions of dollars sitting in homeowners equity right now that nobody is touching. That is the lock-in effect. Most people are sitting on 3% mortgages with massive equity and they have no incentive to move. But that will change the second rates come down meaningfully. And that trapped equity will begin to start moving. If you would like a read on when that window will actually open and what it could mean for your deal flow, that's what we're going to be talking about on May 20th. If you'd like to sign up to watch, just register in the link below.