You are a free subscriber to Me and the Money Printer. To upgrade to paid and receive the daily Capital Wave Report - which features our Red-Green market signals, subscribe here. Seriously, What's "Private" Credit?Remember when banks were actually banks? I can't say I do anymore. Funny...
Dear Reader: Here in Tahoe, there are a handful of casinos. I went down to the Harrah’s to make a quick bet on the All-Star Game while I was here (took the over on runs). While I was there, a man walked away from a Blackjack table to the bar. He was smiling. Happy… It seems he’s won. Now… Imagine for a moment that I approached this man… And I found out that he hadn’t won. Instead, his clients had won, and he was taking his cut. Imagine him telling me: “I don’t gamble with my own money. I take other people’s money. I charge them fees to use it. Then I play Blackjack for them. If I win, I keep a cut. If I lose, well… it wasn’t my money to begin with.” You would think this is insane, right? It turns out that what I just described is a business model tied to Private Credit. And it’s an industry that's growing at a rapid pace... The Great Banking ContradictionMy grandmother was born in 1908. So, I imagine she saw many things. Two World Wars… the Great Depression… nine younger siblings… the post-War boom, all the way up to the George W. Bush administration… She witnessed countless bank failures in the 1930s, too. But I’d bet she’d laugh if I told her that today’s banks believe that lending is less attractive than collective fees today. That banks… are no longer banks… What do I mean? Walk into JPMorgan (if you dare) and ask for a $500 million loan. They can lend you that money. However, Basel III regulations and stress testing have made it more profitable for them to disclose this information to you…
The traditional banking model has been in place for centuries. But capital constraints made direct lending less attractive than origination and syndication in today’s financial system. And that’s created a whole new headache... Enter Private CreditPrivate credit happened when banks opted for fee-based origination instead of lending to businesses... The process goes like this. Private equity companies, such as Apollo and Blackstone, raise capital from pension funds and wealthy individuals. They then turn around and lend that money to companies at 9-14% yields. That’s much higher than the 6-8% for investment-grade yields generated by corporate bonds. And naturally, pension funds and wealthy individuals love higher yields (especially when the Federal Reserve and other entities bail out loans, as they have over the last few years, with more quantitative support and less price discovery). Now, private credit is booming. The industry has surged from under $500 billion in 2013 to $1.7 trillion today… with projections hitting $2.5 trillion by 2027. And while you might be champing at the bit to get involved (yes, it’s champing), there are a few things that don’t go into the marketing brochures. Like: Nearly all middle-market lending is floating rate, tied to SOFR. When SOFR jumped in tandem with Fed rate hikes, debt service costs skyrocketed. This has happened in the last few years. Next, private credit operates with minimal oversight. This isn’t managed or monitored by the Fed; instead, it relies on a handful of academics using models and equations to determine if the system is becoming overleveraged. These funds often use 2X to 4X leverage via credit facilities and CLO-type structures. Banks get stress-tested. Private credit funds file paperwork and call it a day. So, when you see credit-related Closed-End Funds fall out of the sky, that’s a leverage issue and the possibility of a brewing credit event. Just be cautious. Next, most borrowers are non-investment-grade, private equity-backed, or collateral-poor firms that traditional banks wouldn't touch. So, sweet dreams there… Finally, redemption terms create nasty liquidity mismatches. Many funds impose multi-year lockups or quarterly limits. When Blackstone's BREIT hit redemption gates, investors discovered what "flexible" really means. Meanwhile, even my favorite closed-end fund in the space, FS Credit Opportunities Corp. (FSCO), got hammered in April after our momentum signal turned negative. We were witnessing a possible credit event… and FSCO (with its 11% yield) cratered from over $7.10 to about $5.60 in just a few days. Thank you for the policy shift and the insider buying boom. I bought more at the bottom… The Coming ReckoningIt’s still early in this game. And while the parallel between 2008 isn't perfect, it rhymes. Hell, look at what happened to the publicly traded vehicles in the first week of April. And that was without a prolonged credit event… that was just a few days. The same goes for what happened last August with the collapse in the Nikkei. In 2008, banks packaged mortgages into opaque CDOs. Today, it's private credit funds packaging loans to questionable companies. The Financial Stability Board and the IMF note that private credit exhibits risk characteristics similar to those of pre-2008 lending structures. The difference: when this implodes, pension funds and endowments take the hit directly, not taxpayers. However, everyone will ultimately end up paying in a debased currency to bail out the entire system. We've pushed $1.7 trillion in risk into shadow banking, characterized by less oversight, increased leverage, and borrowers who couldn't obtain traditional bank loans. Not all private credit is predatory. Some funds are well-collateralized. But the sector's growth has created systemic risks that regulators barely understand. The irony isn’t lost on me. These regulations were designed to make banking safer. Instead, they incentivized a parallel system that is now one interest rate shock away from proving that "private" credit can become public problems… fast. Stay positive, Garrett Receipts…
About Me and the Money Printer Me and the Money Printer is a daily publication covering the financial markets through three critical equations. We track liquidity (money in the financial system), momentum (where money is moving in the system), and insider buying (where Smart Money at companies is moving their money). Combining these elements with a deep understanding of central banking and how the global system works has allowed us to navigate financial cycles and boost our probability of success as investors and traders. This insight is based on roughly 17 years of intensive academic work at four universities, extensive collaboration with market experts, and the joy of trial and error in research. You can take a free look at our worldview and thesis right here. Disclaimer Nothing in this email should be considered personalized financial advice. While we may answer your general customer questions, we are not licensed under securities laws to guide your investment situation. Do not consider any communication between you and Florida Republic employees as financial advice. The communication in this letter is for information and educational purposes unless otherwise strictly worded as a recommendation. Model portfolios are tracked to showcase a variety of academic, fundamental, and technical tools, and insight is provided to help readers gain knowledge and experience. Readers should not trade if they cannot handle a loss and should not trade more than they can afford to lose. There are large amounts of risk in the equity markets. Consider consulting with a professional before making decisions with your money.
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