Will the growing troubles in private credit precipitate a broader financial crisis? As a veteran of the 2008 subprime lending meltdown, I’m extremely hesitant to say no. Nonetheless, I don’t think it’s likely.
First, the biggest writedowns so far have been associated with outright fraud — a phenomenon that, troubling as it may be, isn’t likely to be pervasive. If the companies in question, First Brands and Tricolor, hadn’t pledged the same collateral to multiple counterparties, they would have failed much earlier with much smaller cumulative losses. Thus, most writedowns will probably be less severe if and when they happen.
Second, private credit funds are more resilient to panic than the funding vehicles of the 2008 crisis. One of the key vulnerabilities in 2008 was the use of short-term borrowing to finance long-term illiquid investments. This caused fears of losses to become self-fulfilling: Investors pulled funding, forcing liquidations that drove down asset prices far below intrinsic value. Private funds, by contrast, typically have the contractual right to limit quarterly withdrawals to a small proportion (e.g., 5%) of assets. This mitigates such pernicious fire-sale dynamics.
Third, the economic context isn’t as bad. Granted, if the war in Iran caused oil prices to reach $200 per barrel and stay there for some time, it could generate economic stress comparable to the nationwide decline in US housing prices that triggered the 2008 crisis. But we’re not there yet.
All that said, private credit can still get ugly. Now that investors are aware of withdrawal limits, they’ll have a greater incentive to always ask for the maximum, requiring further asset sales that will depress returns — which, in turn, will encourage more withdrawals. Worse, funds will likely sell their best assets first to minimize realized losses, leaving behind the most problematic holdings — and giving investors yet more incentive to get out sooner. Judging from the recent spate of redemption requests, this adverse feedback loop has already begun.
