Recent defaults in the private credit market and the risk of a 2008-type crisis

We have had two large defaults in the private credit market in the last few weeks - First Brands and Tricolor. Both might be at least partly down to fraud. The private credit market has grown exponentially over the last 15 years – to now around $3 trillion of assets globally. The 2007/2008 crisis started with defaults from fraud – so it is worth looking into whether we might see something similar happen now.

In some scenarios, these recent defaults might mean nothing - and private credit will continue its trajectory of growing rapidly (and supporting economic growth). But in another scenario, this could be the start of a 2007/2008-like credit markets crisis - which then turns into an overall economic crisis.

Some possible scenarios:

1. Isolated defaults, no problem. These are just two isolated defaults. Some defaults are expected - as with any kind of lending.
2. A few more defaults, no problem. There will be a few more companies that have large private credit borrowings that default. These will be managed, some losses will be booked, but private credit will continue fine.
3. Many more defaults, private credit problems, but economy fine. The private credit markets experience a flight - with end investors (pension funds, insurance companies, high net worth individuals, banks, hedge funds, etc.) liquidating their private credit positions. There could be a government response - increasing regulation on private credit lenders (as we saw with structured credit in 2008). Banks would also likely suffer losses – with banks also being lenders to many private credit borrowers – as is the case for First Brands and Tricolor. The economy is fine - there is a reduction in credit available from private credit lenders but banks and public bond markets are able to cover most of this borrowing need.
4. Major economic disruption. Private credit contracts quickly, and other lenders are not able to take their place - so money in the real economy materially contracts. It gets much more difficult for companies to borrow and stock markets fall. This then results in lower total spending in the economy - resulting in lower GDP and higher unemployment. There would likely be a quick monetary policy response which could reduce the size of economic disruption.

We do not know how things will play out. We expect things will be fine (scenarios 1 or 2), but think that there is a non-zero risk of scenario 3 or 4 – and so companies should take steps now to make sure they are not vulnerable in these cases.