Private Credit Stress: Will The Fed Backstop Excuberance Again?

The Fed is governed by its dual Congressional mandates of price stability and maximum employment. At times, however, the Fed throws these mandates out the window to protect the financial system. With liquidity and credit stress in the private credit market rising, we must consider whether the Fed might once again ignore its mandates to backstop exuberant markets.

The Fed has a history of cutting rates and boosting liquidity when the labor market and inflation levels don't necessitate action. For instance, in 1998, the Fed cut rates three times in rapid succession and orchestrated a private-sector rescue of Long-Term Capital Management to prevent the hedge fund's collapse from cascading through Wall Street. More recently, in 2019, the Fed injected hundreds of billions of dollars into the repo markets and cut rates when overnight funding rates spiked, but with no immediate connection to inflation or unemployment, as we show below.

To help you evaluate whether rising stress in the private credit market will warrant Fed action, we explain what private credit is, identify the key players, compare the current situation to the subprime crisis, and explain how this stress could prompt the Fed to act.

What Is Private Credit?

The term private credit refers to loans made directly by non-bank lenders. The use of private credit has grown immensely from under $500 billion ten years ago to approximately $1.2 trillion domestically and $1.7 trillion globally. Private credit is one of the fastest-growing sectors of the financial system.

The borrowers are typically companies that cannot access the public debt markets. Often, they are small and mid-cap companies that carry significant leverage. A good number of these companies are the result of private equity buyouts financed with debt.

Among the largest lenders are Apollo, Blackstone, Ares, Blue Owl, and KKR. These private entities create private credit funds and use their investors' capital, along with leverage, to make the loans. These funds charge relatively high interest rates because they have a captive audience. Banks, constrained by post-2008 regulations, are no longer willing or able to provide financing to these companies.

Investor Benefits

The benefits of investing in private credit include:

• High Yields- Due to liquidity, private credit loans offer higher yields than similarly rated bonds in the debt market.   
• Senior Security- Often, these loans are at the top of the capital stack, meaning that in the event of default, they are the first investors to get paid back. Moreover, many of these loans are collateralized, further securing the investment.
• Diversification: Private credit funds diversify by lending to different companies and industries.
• Volatility- Because the loans do not trade daily and are only priced quarterly, they are perceived as having lower volatility.  
• Floating Rate- Most private credit loans have floating interest rates. This structure helps limit price drawdowns when yields rise.  

Investor Risks

The primary risks include:

• Credit Risk- The biggest risk, like all debt assets, is default and a loss or partial loss of principal. This risk is elevated not only because of the borrower's financial condition but also because many private equity funds employ leverage.
• Liquidity- Investors are often unable to sell their holdings due to lock-up periods, which are typically five to ten years. Recently, many funds have been limiting repayments to amounts well below what investors are requesting.
• Floating Rate- Rising interest rates increase the borrowers' rates, thus increasing the risk of default. 
• Lack of transparency- Because the loans do not trade or have a current price, investors have little insight into their value. As a result, debt prices can drop from par to near zero with no warning.

Private Credit Investors

The largest holders of private credit funds are pension funds, insurance companies, sovereign wealth funds, endowments, and family offices. These are generally accredited and sophisticated investors who understand that the yield premium comes at the cost of illiquidity and risk. In many cases, these investors can absorb significant losses without disrupting the financial system.

Systematic Risk

At first glance, $1.2 trillion of private credit debt sounds manageable, as it’s a small percentage of the $55 to $60 trillion total US debt market.  While it's only 2% or so of total debt, an unraveling in the private credit sector can introduce systemic stress to the entire financial system.  

The 2% figure is misleading for several important reasons. The first is concentration. It is heavily concentrated on riskier leveraged buyouts of mid-market and large companies. Moreover, the debt is disproportionately in the software and technology sectors, which are heavily exposed to potential disruption from AI.

The second is transparency. Private credit is priced quarterly by managers using internal models rather than market prices; thus, credit stress can build without market visibility, at times resulting in sudden, large price adjustments.  To wit, the graphic below courtesy of Bloomberg:

Along the same lines, as we wrote in Fitzpatrick: Soros CIO Warns Of A Reckoning:  

A third risk is that, in some cases, the insurance company, investors, and private credit funds are a single entity. Over the past decade, the largest alternative asset managers acquired life insurance companies and converted them into funding vehicles. For example, Apollo bought Athene, KKR purchased Global Atlantic, and Brookfield acquired American Equity. These insurers collect annuity premiums from American households and invest some of those premiums into private credit originated by their parent companies. This circular arrangement benefits everyone when all is going well. But the risk ultimately lies with individuals who depend on annuity income for retirement.

Comparing Bubbles: Private Credit vs. Subprime:

The instinct to compare recent private credit stress to the 2008 subprime mortgage crisis is understandable, but the comparison is not straightforward. There are meaningful similarities and differences.

Similarities

• In both cases, credit was extended aggressively, with underwriting standards gradually loosening as competition for deals intensified.
• Similarly, the assets were opaque — subprime mortgages were bundled into CDOs that obscured the underlying credit quality, while private credit loans are valued quarterly using models rather than observable market prices.
• In both cases, the risk was funded through entities that could withstand some risk and volatility. This creates the appearance of stability; however, in 2008, the risk concentration was not fully appreciated until stress arrived.

Differences

• Subprime was a consumer credit problem — it threatened the financial security of ordinary American homeowners directly and immediately. Private credit is primarily a corporate credit problem, concentrated in leveraged buyouts of businesses rather than household balance sheets.
• Subprime was embedded in the banking system through exposure to CDOs, creating direct contagion channels to systemically important institutions. Private credit sits largely outside the banking system, in private funds with locked-up capital — meaning there are no depositors to run and no repo lines to pull — which is a genuine structural advantage over 2008.

The critical difference, in our opinion, is the insurance company’s entanglement. As we noted earlier, insurance companies owned by the asset managers are the largest holders of private credit.  These insurers collect annuity premiums from ordinary American households and invest those premiums into private credit originated by their parent companies. While this capital makes private credit structurally safer than bank funding, the retirement savings of mom-and-pop investors are at risk.

Why the Fed Would Cut Rates

The Federal Reserve will not hold a press conference and announce it is cutting rates to protect private credit investors.  However, they would respond to the consequences of private credit stress, especially if those consequences are severe enough to affect the economy or the banking sector's financial stability. This could happen in three ways, as follows:

If private credit stress leads financial institutions to pull back on lending, small and mid-market companies that rely on private credit for their financing needs will find capital scarcer and more expensive. Tightening financial conditions slow business investment and put upward pressure on unemployment, giving the Fed legitimate cover to ease.

The second is the wealth effect. If insurance company balance sheets are impaired by private credit losses, regulators will force capital raises or asset sales, which could negatively impact the broader financial markets. Additionally, when insurance policyholders face uncertainty about their annuity values, their consumption behaviors change. Reduced spending by a large enough cohort of retirees and near-retirees results in weaker consumption, slower growth, and again a justification for Fed easing.

The third is the financial stability channel. If stress leads to a crisis of confidence with the systemically important banks or financial markets, the Fed would respond with QE and lower rates.

Summary

Private credit is not subprime. It is better structured, less leveraged, and better capitalized. Most importantly, it is not the domain of the major banks. However, it is larger, opaquer, and more deeply entangled with retail beneficiaries. At $1.2 trillion domestically, it is comparable in size to the entire high-yield bond market.

The Fed will not cut rates directly because of private credit stress. But if that stress morphs into tighter credit conditions, weaker consumption, or threats to the broader financial system, the Fed will cut rates.

The more important question for investors is not whether the Fed responds, but whether rate cuts would be sufficient to address a problem that is, at its core, about credit quality rather than credit costs. Cutting rates makes borrowing cheaper, but it does not improve the status of impaired loans.

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