If “It” is an event causing a riptide of damage to our economy, I don’t see anything horrific anytime soon, but that’s different than saying “we’re good.” You’ve got to stay frosty. We almost never notice “It” until we have been smacked up against the side of the head and wonder what the hell happened,
A couple of weeks ago I wrote a commentary called NIMBY Fails: A Black Swan Moves in Next Door in which I argued that predicting the arrival of a black swan that could materially damage our economy was hard. Separating noise and unserious one-day-wonder type headlines of doom and gloom from meaningfully bad is hard, but perhaps not impossible.
We really should at least try to see it coming.
To try to avoid unpleasant economic surprises and distinguish the painful wheat from the harmless chaff, my favorite metric is investment flows into debt products. If a black swan is going to become meaningfully dangerous to our economy, it’s going to leave droppings in this market. The credit markets, as opposed to our flashy and flighty equity markets are an early warning system for real problems. As anyone in the debt market knows, when your upside is par, risk looms large.
This time, if we suffer, “It” will first manifest itself in the private credit/non-bank lending market and we can only hope that if “It” does, “It” stays there.
So what are investment flows telling us right now? Not much. There’s so much noise in the system, it’s hard to discern meaningful patterns. With hindsight, of course, we may ultimately conclude, like we did following the GFC, that the data we were confounded by today had already metamorphosized itself into a significant pattern, but we just didn’t see it. As I said, bad things tend to surprise us.
None of the obviously troubling things confronting our economy right now manifestly destines our economy to experience significant disruption. Virtually all of the black swan wannabes have been around for a considerable period of time and if they were destined to deliver a financial catastrophe, we’d be toast already. Wars have not been not highly correlated with major economic disruptions in the past. We’ve been running breathtakingly horrific deficits for years while the economy booms. The country seems increasingly ungovernable. Our political class prattles and bloviates, often to no obvious strategic purpose, while actually doing precious little (and even less that’s of any real utility). Inflation is sticky. We worry about the deficit. We worry about AI, about jobs, about tariffs, about the Mets, but none of this seems to matter.
Indeed, we seem pretty self-satisfied. There’s lots of happy talk out there. Moreover, it’s not just the talk, there’s plenty of actual data to suggest the economy is doing quite well. Our stock market is certainly holding up magnificently. Corporate earnings are fine. GDP growth is, well, if not exactly terrific, not bad either and while we continue to worry about inflation and the jobs market, neither are obviously degrading materially as I write this.
There are things out there, of course, that might make someone with a bear-ish disposition a bit twitchy. We don’t really need Dan Brown to give us his decoder ring to make perceptible the imperceptible flaws in the economy because all the bad stuff is hiding in plain sight.
I am also reminded that, in a weird way, an ebullient, bubbly frisson in our equity markets, as we are experiencing today, often seems to presage a collapse. Causation or causality? Far from clear, but remember 2000? 2006? Back even further, the summer of 1929 was a rip-roaring party (“bankers say boom will run into 1930s!”…The World, March 30, 1929). There is indeed some academic research that suggests that amiable credit conditions themselves can contribute to a riptide of risk-off panic as yesterday’s aggression, untethered from any appreciation of risk, turns to fear. Moreover, perhaps it’s enlightening to remember that in the early days of 2007 (a bare 6 months before we clearly were experiencing a serious recession), GDP growth was almost 3.5%, short-term interest rates were 2.5%, employment was holding up and the stock market was in a really good place. That which the Gods bring down they first make mighty?
We certainly are undaunted by all of this in the here and now and seem astonishingly relaxed but might we suddenly have an Emperor’s New Clothes moment? Could it be that markets might suddenly awaken to risk and look at old facts in new ways, concluding what they had been observing with equitable disregard is now the basis of enormous anxiety and distress? Nothing changed, but everything changed?
This brings me back to private credit and non-bank lending. Estimates of non-bank lending in the US are pretty squishy, but they’re in the $3 trillion range. (I’ll take the over.) I saw a recent report suggesting that up to 50% of all CRE debt last year was provided by non-bank lenders. Also, I note a troubling headline suggesting that a significant share of the reserves behind most annuity products were level 3 non-traded, illiquid assets. Note that many (most?) of these annuity products are also in the private credit universe. It’s a big part of our economy. Consequently, problems there will be big problems.
This is the likely patient zero of a credit risk off stampede. Look, I realize there’s been lots of noise around private credit recently (I’ll use private credit here to include all of non-bank lenders and those who invest in debt products). Much of its notoriety has been focused on unsecured lending to sub-investment grade corporates with a little bit of fraud as the cherry on the worry sundae. This has triggered some handwringing, but I see that anxiety is more headlines and less analytics. I’m not talking about dumb lenders and venal borrowers, I’m thinking about the design features of the underlying structure of private credit market writ large. As I’m sure some wag stuck in my head a while back, today’s design features are tomorrow’s design flaws when intolerable stresses are added to the system.
Private credit doesn’t have cheap, sticky and federally guaranteed deposits on which to rely at the bottom of their capital stack. Their capital stack is composed of tranches of equity expecting rather nice returns and a considerable amount of back leverage, making those equity returns possible. Both the equity and the back lever are fast money. If something goes wrong, all of that will try to run for cover. While the denizens of the private credit market have linked arms and continue to courageously assert that all is well, and perhaps it really is at the moment, it’s vulnerable.
Market participants have gotten awfully comfortable that the equity will be there for the long run, that there’s an endless supply of fresh money that investors are looking to put to work. They’ve gotten comfortable that back leverage is forever. The reality, of course, is that none of that is true.
Is there evidence that the Emperor is naked? Perhaps not yet, but the private credit market is struggling to be worth its NAV. The gating problem in the retail private equity space is not getting better and prices of publicly traded private credit are soft and some (perhaps not all) credit vehicles are struggling to recharge their equity. Warehouse lenders can withdraw from their leverage positions. Warehouse lenders have baked into their deal documentation protocols to mark assets and withdraw leverage even if on a casual reading of the documents it appears that neither of those two things are possible. (Trust me, I drafted hundreds of these documents). If we see the warehouse lenders which provide back leverage tighten credit standards and begin to mark their books and if it becomes apparent that conversations amongst the banks is that there are existential problems with level 3 assets, we’ve got a problem. If all that happens in a hurry, then we risk a discontinuity in our economy. Right now, the mem on the street remains “Don’t worry, all is fine. Don’t think about that stuff that bothers you at 3:00 in the morning. It’s an illusion.” I hope they’re right.
If we could only comfortably believe that in the event private credit were to become a dumpster fire, it would be bad but not catastrophic because it would be contained and only those who invested seeking those particular high returns would be burned. The problem is that it’s unlikely to be true. The problem is contagion. Contagion is real. How might that happen? Well, for instance, if level 3 assets are broadly marked, dry powder will evaporate, the banks that supply the warehouses that private credit needs to support their business model will be withdrawn. Banks, overexposed to private credit, begin to wobble. Interbank lending will be suppressed, causing more wobble in the banking sector (but they’re all money-good assets, said those running SVP…a correct but fatally inapposite observation). The banking sector will retreat; both the banks that are directly impacted and those that are simply watching the circus from the sidelines will enter a risk off crouch. The economy contracts.
If you think that problems that might occur in the private credit market will stay there and not affect the broader economy, I suggest you go back and take a look at the GFC. I distinctly remember assuring my boss that the problems in the resi market would never affect the commercial lending market because we had collateral. That turned out to be one of the dumber things I’ve ever thought (and, regrettably, said out loud).
Remember the old ditty, because it’s true…for want of a nail, the shoe was lost and ending, of course, with a dead king,. Contagion is real. We can find that a calamity can be triggered by the tiniest thing.
Look, it may all be fine. Indeed, that’s my base case. We may skate along the edge of risk and find that…nothing bad happens. But, for the moment, my watchword is to carry on but be very careful, with eyes wide open for evidence that the heterodox data set we currently see might begin to cohere into something truly bad. For all of us in the CRE lending space, remember what happened last time.