Do Recent Defaults Signal a Coming Credit Crisis?

A succession of high-profile defaults connected to bankruptcies and fraud allegations have raised questions about the health of credit markets, centered around the rapid growth of the $1.1 trillion US private credit market.

The collapses of car parts manufacturer First Brands and auto loans company Tricolor in September led to fears that poor-quality loans could have a wider impact on financial markets. Then, weeks later, two regional banks announced write-downs on loans they had made to a commercial real-estate firm.

“With each successive credit event that comes to light, it becomes harder to say that these are all totally unconnected. But at this stage, we would still very much come down on the side of these being idiosyncratic events and not credit-type events,” says Spencer Rogers, a credit strategist in Goldman Sachs Research.

The fact that all of the recent defaults have included allegations of fraud or accounting manipulation suggests that they aren’t simply a consequence of worsening economic conditions and weakening credit quality, Rogers adds.

We spoke to Rogers about how markets are reacting to the defaults, the shifting structure of debt markets, and his team’s forecast for credit.

Are recent defaults a canary in the coal mine for credit markets?

In the last 30 years, every major credit default cycle has coincided with a recession or a major industry shock. Our US economists continue to forecast 2% GDP growth for this year and more than 2% next year, which is very much trend GDP growth—not at all indicative of a recession. Until we get a material weakening in economic growth, it would be hard to get a full-blown credit default cycle.

And there are also a few other measures. There hasn’t been a recent increase in the amount of money banks are setting aside for loan losses. If we look at broader consumer and small business bankruptcies as reported in the US court system, we haven't seen a material pickup there either.

We aren’t seeing any of the indicators that would normally signal the onset of a broader default cycle. That gives us more confidence in treating these recent events as idiosyncratic.

Has the growing interconnectedness of credit markets made them more vulnerable?

Since the end of the global financial crisis, we’ve seen a slow retrenchment by banks away from lending directly to consumers and businesses. Instead, there's been an increase in banks lending to so-called “non-depository financial institutions.”

Let’s say a private credit company raises a $1 billion fund. Typically, the entities that are investing in these private credit funds are life insurers, pension funds, endowments, wealthy individuals—all of which are long-term committed capital. In that sense, the rise of private credit should be very non-systemic, because the sources of capital are all long-term, committed, locked up capital—not runnable capital like bank deposits.

But that fund might then go to a bank and take out a $500 million line of credit that they can use to add a little financial leverage to the portfolio and juice returns. That's the linkage that people get concerned about. But the banks are the most senior creditor in this situation, and so in this example, the fund portfolio would have to experience 50% losses before the banks would ever experience any loss in this scenario, which is excessively high for a portfolio of secured loans.

People point to the fact that banks do have a lot of loans outstanding to these non-depository financial institutions as a sign of the interconnectedness of credit markets. I still think that the structure of these loans has kept systemic risk low.

How have markets reacted to these events?

This is playing out most clearly in the share prices of business development companies (BDCs)—funds which make direct loans to small- and medium-sized companies. BDCs are one of the few public-facing windows that we have into the private credit world, and their stocks trade on the market in real time.

One of the larger BDCs announced on their earnings call in August that they were marking down a large position in their portfolio. That piqued everyone's interest, and it was followed by a sell-off in BDC equities. The bankruptcies and fraud allegations in September and October accelerated the rout.

And by now, a large gap has opened up between the market value of the BDCs and their net asset value (NAV). That means one of two things is going to happen: Either BDC equities are going to rally to bring the market value and the NAV back in line or the market is expecting that, over the coming months, these companies are going to have to mark down some of their positions.