To understand the wave of bank partnerships with private-credit fund managers during the past year or so, think back to the boom in mortgage lending through securitization in the early 2000s. The same forces are at work: a huge demand for finance, limited and costly bank capital and investment bankers’ ingenuity and desire to generate business.
Ultimately, similar dangers are likely to arise too, as this lending machine becomes better at recycling bank capital faster, more debt is created more rapidly and competition fuels higher leverage, rising asset prices and debased standards on who or what can borrow. Personally, I fear the eventual denouement may also be familiar — unless investors keep cool heads and regulators insist on transparency.
Banks hooking up with private credit was a theme of US earnings calls this month. Jamie Dimon, chief executive officer of JPMorgan Chase & Co., talked in detail about the bank’s strategy, while Goldman Sachs Group Inc., Morgan Stanley, and Citigroup Inc. all touched on the subject. Investors and analysts are deeply interested in big lenders’ response to the rapid growth of private credit in recent years and especially in 2023 when many banks big and small were coping with the sometimes-painful effects of the highest interest rates in more than a decade.
The two sides of lending have mostly been seen as competitive: The message from the banks is that they are complementary. Seventeen of the biggest banks in the US and 12 in Europe now have some kind of private-credit linkup, according to management consultancy firm Oliver Wyman. Fourteen of those were completed in the year to September.
Most deals have been with funds that lend to private-equity buyouts or to small- and midsized companies that are underserved by banks. This is riskier, typically sub-investment grade credit and usually goes by the name of direct lending. It accounts for about three-quarters of partnerships, Oliver Wyman reckons, and includes Citigroup’s recent deal with Apollo Global Management Inc. and Lloyds Banking Group Plc’s tie-up with Oaktree Capital Management LP.
The rest come under the umbrella of asset-based lending, which can involve anything from credit-card loans and mortgages to aircraft, industrial equipment and commercial real estate. This is seen as the next big growth area for private credit, particularly in the US where smaller regional banks have been stepping back. Barclays Plc’s deal with Blackstone, BNP Paribas SA’s with Apollo and Societe Generale SA’s with Brookfield Asset Management Ltd. all fall into this category. Asset-backed lending tends to be lower-risk investment-grade credit, backed by large assets that can be hard to resell if things go awry.
Why are banks doing these deals? Part of the answer is both sides need each other. Finding companies and individuals to lend to involves leg work, and banks already have the relationships and staff to do that quickly and relatively efficiently. Some big, well-established credit funds don’t need banks as go-betweens, but the bigger the private lending industry grows, the more help it needs in finding enough borrowers, quickly.
Banks, meanwhile, want fees wherever they can find them; ignoring a whole section of capital markets would be foolhardy. Banks are there to help customers secure funding in whatever way best fits their circumstances, as Dimon put it on JPMorgan’s earnings call. “We are here to give our clients an agnostic view of the world,” he said.
When funding a buyout, for example, JPMorgan can take the company to traditional leveraged finance markets, where it will underwrite the debt then sell loans or junk bonds later. Or it can link the borrower up with private-credit funds if that suits the deal better. Or it can fund the loan itself through its own allocation to private credit, which Dimon said was already $10 billion but could easily rise to $20 billion or $30 billion soon. It can hold those on its own balance sheet, or choose to sell on all or parts of those loans later.
Whichever path it takes, JPMorgan collects fees for arranging the debt and potentially other advisory and underwriting fees. Also — and here’s the rub — all routes help JPMorgan grow its own lending, the only question being whether it’s short- or long-term, and higher or lower risk in terms of capital requirements. It can underwrite the financing, finance warehouses of leveraged loans for other investors to buy later, and lend directly to private credit funds, or other alternative lenders, to help them boost returns to their own end investors.
JPMorgan isn’t alone: All the big US, European and Japanese banks are participating in some or all parts of this growing debt machine. Loans to non-banks are the fastest growing part of the US banking system over the past decade, increasing to almost 30% of all term loans from about 12%, according to research published by the Federal Reserve Bank of New York. Private equity funds, venture capital, hedge funds, private credit, securitization pools and other investment funds comprise more than half of this borrowing.
This is where the parallels with the mortgage securitization boom come in: What the banks are doing is making a senior loan to a basket of different credits, while the riskier, junior slice is held by fund managers, or other non-bank investors. Huw van Steenis, vice-chairman of Oliver Wyman, has called this the “re-tranching of the banking system.” He sees it as a method for banks to slim down their capital needs; I see it as a way to create more debt more quickly and parcel it out through the financial system.
Private credit in all its forms lets banks do the same thing they’ve been doing with mortgages and leveraged finance for years: originate loans, sell the riskiest parts, rinse and repeat. Private credit is just a new way to increase the velocity of banks’ limited capital — how often it gets reused to earn fees and interest in given period — and earn higher returns.
Right now, banks hold a lot of the senior tranches being created — as the New York Fed work shows. But the more that private credit grows, the more they will need others to fund this part, too. Guess who’s stepping in to help? Yes, the biggest private-credit investors again, looking for safer, more senior debt to offer to insurance companies, whether their own, or a third party.
The expansion of this machine is relatively young. Total private-credit assets under management are somewhere between $2 trillion and $3 trillion, depending on how you count it. That compares with $12.5 trillion loans and leases at US commercial banks, according to Fed data. But the pace of growth is rapid. Pension funds, insurers, endowments, family offices and wealthy individuals are putting more and more money into the sector. Then there’s the coming wave of exchange traded funds meant to bring more money into private credit.
The dangers will be in a sudden loss of senior funding at some point — just as it was for subprime mortgages in 2007-2008. There’s already a mismatch between the senior funding supplied by banks, which often has an average life of about three years, and the private credit funds themselves, which have many individual loans with maturities of five years or more.
The bigger questions longer term will be who is ultimately behind the senior debt, how much transparency they have into the underlying portfolios and how quickly can they pull their funding if they get antsy about what’s in them. The higher the proportion that is depositors, commercial paper investors, money market funds or any other short-term funding sources, the more dangerous this whole structure will become.
If this ecosystem keeps generating more debt and faster, with growing competition among investors chasing returns from the riskiest slices, that critical moment will arrive.
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