After the 2008 crisis, banks outsourced the riskiest section of investment to what is called “Private Credit,” i.e., loans extended to corporations by non-banks (hedge funds, all sorts of “special vehicles,” etc.). Not bound to disclosure, those entities took high risk as if there were no tomorrow. Thus, private credit is that part of the financial system which is most exposed to subprime debt. This arm of the financial system has started to crack in the last months. The latest warning on the coming blow-up is coming from Scope Ratings, which issued a report April 9.
“Several indicators are signalling credit erosion today. Notably, the share of loans using payment-in-kind (PIK) structures has risen to 11% up from about 5% earlier in the decade, according to industry estimates,” Karl Pettersen, Co-Head, Scope Corporate Ratings, wrote.
“Payment in kind” often refers to loans or bonds where interest isn’t paid in cash regularly. Instead, it’s added to the principal, so the total debt grows over time. That is because the borrower is short on cash.
Although insisting that the situation is different from the Great Financial Crisis, since “direct exposure sits more with insurers, pension funds and asset managers” rather than with banks, Pettersen admits, “The greater risk is that investor jitters over private credit lead to lower valuations, which, alongside tighter lending, could spill over into other asset classes. Such a correction now risks being disorderly and would hit weaker issuers the hardest and could exacerbate a downturn in the credit cycle.”
Institutional investors turned private credit lenders also “transmit stress directly to the real economy.”
