Cutesy Financial Engineering
Financial magic tricks you won't hear about until it's too late.
If you remember the 2008 financial crisis, you probably remember the disastrous recipe: Wall Street took a bunch of sketchy residential mortgages, bundled them all into a box, and relabeled the box. By doing this, they convinced the ratings agencies that this group of bad mortgages was safer in this box than individually. They can’t all fail at once, right?! It was a neat trick to rebrand risky, illiquid garbage into certified gold, right up until it nearly burned down the global economy.
Well, the alchemists are back.
According to the Bloomberg, Wall Street is currently applying this exact same magic trick to a booming market called “private credit.”
The Problem with Private Credit
Right now, private credit is when people (who have lots of money) lend to mid-sized companies (who need lots of money). It pays a lot of interest, which is great! But the loans are highly illiquid, which is annoying. If the lenders need their money back, they can’t get it out very quickly. They can’t just sell their share of a loan to a regional logistics company on a public exchange. They are stuck.
Meanwhile, pension funds and insurance companies love high interest rates, but their internal compliance rules will only let them buy things that are officially, certifiably Safe. They want investment-grade. They cannot buy your weird, illiquid corporate loans, no matter the yield.
The Insurance Wrapper Trick
So, creative bankers are building new boxes to get past these issues. Here is how you turn illiquid “private credit” into something else:
A bank (in this case, UBS) takes a whole bunch of these illiquid stakes in private credit funds and puts them in a metaphorical box.
They look at the box and realize it still looks a little too risky to get a good grade. So, they call up an insurance company, like Nationwide Mutual Insurance Co.
UBS asks Nationwide, “Hey, if this box catches fire and these loans default, will you pay the losses?” Nationwide does some math, collect a nice premium, and says yes.
UBS takes this newly insured box to Moody’s. Moody’s doesn’t just see the weird loans inside, they see the giant insurance company standing next to the box holding a fire extinguisher. Moody’s blesses the box and slaps a shiny “A2” target rating on it.
This is delightful. An A2 rating means it is officially investment-grade. It is a Safe Bond. The pension fund is now legally allowed to buy it. The original private credit investors can get their money un-stuck. UBS gets a fee for building the box, and Nationwide gets a premium for standing next to it. Everyone is thrilled.
The Looming Catch
But of course, the actual underlying stuff in the box hasn’t changed at all. It is still just a bunch of illiquid loans to mid-sized companies. What has changed is who is holding the risk, and whether people actually know what happens if things go bad.
2008-flavoured dread comes back. If the economy dips and a bunch of these private companies stop paying their loans, the insurance companies have to start writing massive checks.
Worse, if the ratings agencies get spooked and downgrade these A2 bonds from “Safe” to “Risky,” the pension funds will all be forced to sell their bonds at the same time, sparking a panic.
A Brief Detour into Ratings Agencies
To understand how you turn a Weird Thing loan into a Safe Thing, you have to understand ratings agencies like Moody’s and S&P.
In theory, ratings agencies are objective arbiters of risk who carefully study financial products and assign them letter grades. In practice, they are private companies whose business model involves getting paid by the people creating the bonds to grade those exact bonds.
But they are incredibly important, because the entire financial system delegates its risk management to their letter grades. If you are a heavily regulated pension fund, your compliance department has a hard rule: you can only buy things graded “Investment Grade” (like AAA or A2). You are forbidden from buying “Junk.”
The ratings agencies are the gatekeepers. If they bless a box of debt with an A2 grade, trillions of dollars of institutional money is suddenly allowed to buy it.
So, once again, we’ve successfully invented a way to sell risky, illiquid loans to conservative pension funds, except we’ve added two middlemen, an insurance wrapper, and an A2 stamp so everyone feels very respectable while doing it. The alchemy works! I guess right up until someone actually tries to use the fire extinguisher.