Private Credit Risks Explained, Oil Surges Above $100 | The Weekly Wrap

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Steve Eisman (0:55)

Here we are with a war on and oil prices are above $100. Oil has an outsized impact on prices. There is now a fear that if the war lasts a long time, inflation and inflationary expectations will climb. There is no doubt in my mind that a credit cycle is emerging. The US has not had any kind of credit cycle at all since the great financial crisis, which is why many commentators think we are on the cusp of one. We are overdue.

Hi, this is Steve Eisman, and this is another edition of The Weekly Wrap. This is for the week ending March 20th, but recorded Thursday night, March 19th. Like last week, the war in Iran dwarfs all investment considerations. As of the end of this week, the Straits of Hormuz remain closed. The Trump team is promising to open up the straits soon, as China is backchanneling to allow passage for Chinese flagged ships, and other countries are aligning transponders as Chinese adjacent, hoping for safe passage. Oil prices remain well above $100, and the S&P 500 index is down 4% for the year now, and NASDAQ is down 5%. Here we are with a war on, and oil prices are above $100. So of course, there are rumors that the federal government is about to intervene in oil markets to drive the price down. On Monday, Treasury Secretary Besson responded to those rumors. He said that the administration had no plans to intervene in oil markets, and probably does not have the authority to do so even if it wanted to. In times of uncertainty and market volatility, conspiracy theories gain prominence. I remember that during the great financial crisis, there were days when the market would rally back, and I would hear from many friends I know that they had heard that the federal government was intervening in the equity markets, and that was the reason for the rally. Now, I like a good conspiracy theory, too, but the federal government intervening in equity markets never impressed me as being true. Not because it could not happen, because if it did, it would leak, and no leaks ever occurred. Normally, in times of uncertainty, investors will seek safety and buy US treasuries, thereby causing interest rates to go down. Not this time. Since the war began, the yield on the 10-year treasury has climbed from 4 percent to 4.3 percent. Not terrible, but still in the wrong direction. Investors have been selling stocks and treasuries. Now, why have interest rates gone up? It's all about oil prices climbing above $100. There is now a fear that if the war lasts a long time, inflation and inflationary expectations will climb. Oil has an outsized impact on prices. It affects the price of plastics. It also impacts the price of food via the cost of fertilizer. The Green Market's North American Fertilizer Price Index has climbed from $700 per short ton before the war to $1,000, a 43% increase. Also, to offset the increased cost of jet fuel, airlines will be raising prices soon, which would impact summer travel. Bottom line, if the war ends quickly, the long-term impact on inflation will be negligible. If, however, the war lasts months, the US will develop inflationary pressures. In uncertain times like these, it's a good time to review major investment themes. So leaving aside the war, in my view, the major risks in the market are, one, will AI investments generate sufficient returns to justify the hundreds of billions being spent on AI infrastructure? And two, is a credit cycle emerging? Will it impact private credit? And if it does impact private credit, what type of loans will display problems? We've discussed the issues involving AI many times before, and we'll continue to do so. Briefly, the major long-term issue is whether all this AI infrastructure spending will produce returns that justify the hundreds of billions being spent. Critics like Gary Marcus, who we interviewed in January, argue that it does not. However, those criticisms are not stopping AI spending. This week at NVIDIA's Annual Developer Conference on Monday, CEO Jensen Wong said he expects purchase orders between the Blackwell and Vera Rubin chips to reach $1 trillion through 2027 So despite all the criticisms, AI spending continues at a tarred pace. And I know there are critics out there who believe that AI spending will just stop, just like internet infrastructure spending stopped during the recession of 2001 Yet, at this point, there are just no signs of AI spending slowing down. Now let's take some time to review the private credit issues and what has happened so far this year. What is private credit? And why is it so top of mind suddenly being discussed constantly on CNBC? First off, private credit operates largely in private. That's the name. Information flow is almost non-existent until problems develop. And this is why it has not been the focus of attention until now. Problems now are developing. Traditionally, private credit has been a business-to-business model. In other words, large institutions are lending money and taking measured risks to fund business development. This has been a very lucrative model for business lenders. And where there is money to be made, there is money flowing in. Like private equity firms, private credit firms are non-bank lenders that provide debt financing to companies. The terms private credit and direct lending are often used interchangeably. However, direct lending is just one subsector of the broader private credit market. Private credit has grown exponentially to a $1.8 trillion market. Private credit was only $300 billion 10 years ago and is now $1.8 trillion, so the rate of growth is huge. So why the alarm bells? Mostly because some private credit lenders began to raise funds to support their lending by appealing to retail investors. To raise money from retail investors, private credit provides some quarterly liquidity. And now for specifics. So what are the private credit strategies? First, direct lending, which is primarily an alternative to the broadly syndicated bank loan market. Lending is done directly to companies. Companies can be either sponsored, meaning backed by private equity, or non-sponsored. 80% of US direct lending goes to companies backed by private equity. In other words, direct lending funds transactions where private equity buys companies. Many private equity companies own private credit companies. And we'll talk more about that in a sec. Asset backed finance. Lending is secured by contractual cash flows and related assets. This can be as diverse as mortgages, to auto loans, to leasing, and to receivables. And lastly, opportunistic distress credit. Lending to companies in distress, or other corporate actions such as spinoffs, or companies that are served neither by the direct lending nor private equity markets. Who are the lenders? The lenders are private credit funds. And most private credit funds are owned and operated by business development corporations, BDCs. A BDC is an entity whose business is to make loans. Some BDCs are public companies and some are private. And many private credit funds are operated by BDCs owned by private equity companies. So for example, the largest private credit lender is the Blackstone Private Credit Fund, otherwise known as BCRED, which is a non-public BDC wholly owned by Blackstone, the private equity company, which itself is public. So in one part of the business, private equity buys companies, and in another part of the business, private equity lends money to itself to buy those companies. If that sounds somewhat circular to you, it's only because it is. Now private credit has two major issues. Should private credit funds have been sold to retail investors and is a credit cycle emerging? The two issues are interrelated, but they are not the same. A credit cycle means that losses on loans are increasing. Now there are bad credit cycles, which would be the great financial crisis, and not so bad credit cycles, which would be the recession of 2001 The US has not had any kind of credit cycle at all since the great financial crisis, which is why many commentators think we are on the cusp of one. We are overdue. And before we get to the actual issues, let me make an important caveat. Since the great financial crisis, there has been a kind of competition to see who could predict the next calamity. Every time an issue surfaces, someone seizes on it and argues that this is it. This is the issue that will cause a recession or another crisis or calamity. And then nothing happens, because the US economy is incredibly resilient. Private credit is the issue du jour. I take the issues involving private credit very seriously. But the problems of private credit are still early. This is an emerging story, and it is still too early to tell how bad it will get. Since these private credit loans are not publicly traded, they are by definition illiquid. And there is nothing wrong with that. As I explained a few minutes ago, historically, the investors in private credit funds were large, sophisticated institutions. Nothing wrong with that either. They know what they are getting into, a higher yielding product that is illiquid. Once private credit funds finished tapping the entire institutional world, they decided to seek new investors in the retail world, brokerage clients, 401k plans, etc. And here is where I have a problem. The loans are illiquid. So to create the appearance of liquidity for retail investors, redemptions are allowed, but they are capped depending on the fund at 5% to 7% of assets per quarter. I am sure that all of this is disclosed to retail investors. I am sure that many retail investors did not understand the full implications. Now that redemption levels consistently breach the 5% to 7% threshold, private credit funds have had to get creative or just limit redemptions. One more important detail. Private credit is overexposed to software companies and software company valuations have declined en masse due to AIs impact on the traditional business model of software companies. With respect to the credit cycle question, it bears repeating that 80% of direct lending loans are for buyouts of companies by private equity. And that is why the direct lending industry is overexposed to software companies. Some commentators estimate that 25% of direct lending loans are to software companies. The company's private equity bought from 2018 through 2022