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Dear Fellow Traveler: I received a question from a reader yesterday that sounds simple on the surface, but cuts straight to the complexity of what’s breaking in the market right now.
The logic’s perfectly constructed, and many people in the media approach this question in a very similar fashion. The thinking is simple (but the answer is incomplete)… If the run causes the crash and the gates stop the run, the crash should never occur. Or… when it comes to plumbing… If we just shut the valve, can’t we stop the leak and go home to wait… If only finance worked like a kitchen sink and not like a Vegas casino with better lighting and free alcohol... For months, I’ve been explaining the challenges in the financial plumbing of global markets. How liquidity works, how repo works, and how leverage operates. But this private credit story isn’t just a plumbing problem. This is a straight-up… Fire problem. If you lock the doors to a burning building, you haven’t put out the fire. You’ve trapped the smoke inside, hidden the damage from the outside world, and guaranteed that when the doors do open, what’s left is worse than anyone expected. There are four things to consider here. Let’s… run. 1. Gates Don’t Fix the LoansThe redemption gates offered by money managers only control the exits. They don’t control the credit quality of the assets inside the fund. This is the first real issue at play... Now this isn’t universal to the sector. But if a private credit fund holds loans offered to mid-market companies that struggle to service their debt (and refinance that debt) at current rates, the loans don’t improve because investors can’t leave. The borrowers are still missing payments, and defaults will still happen. AI will still threaten those businesses. Debts will still require refinancing (at higher rates). The net asset value of the fund could and should therefore still decline. The gate is just a guarantee we put on a package to reassure ourselves. It looks official and controlled, but it doesn’t change the product's contents.
Over the last two years, private credit has grown into a multi-trillion-dollar asset class, much of it built on the assumption that liquidity would always be there when needed. Many of these funds report NAV quarterly or with a lag, often based on internal models that we don’t see... They’re typically not marked to market in real time. Instead, they rely on model-based valuations, updated occasionally (more or less like an appraisal process). Investors who are locked in may not know how much value they’ve lost until a long time after the damage occurs. The gate only keeps the money in the fund. It doesn’t keep the losses out. 2. The Gate Is the Real ContagionThis isn’t being explained well enough in the world of finance, unless you’re reading reports from institutional people who are getting to the point that they’re just hilariously dunking on the entire private credit world on LinkedIn. If a large manager like BlackRock or Blackstone were to impose a redemption gate, that would send a bad signal to the market. When that happens… well… Every pension fund CIO, every endowment committee, every insurance portfolio manager, their phones are going off. I’m not saying their job is easy. But they’re usually not sitting in front of a computer all day looking at numbers, and they’re definitely not getting on a Higgins Boat to Omaha Beach. Still, they’re the people who approved private credit allocations over the last five years, and they’re about to get questioned by people above their job level… And they don’t want to get questioned by people above their job level, since they like their jobs. These people now have to call their risk team and ask the same question… How much exposure do we have to investments that resemble what got gated? That sets off several conversations about their cash flows, the money they need to meet future obligations… and what sort of questions will their clients ask, too? This requires that they really look at the numbers, and decide - wait a minute - there is now a lot more risk in the financial system than there was eight months ago (the entire point of this newsletter, by the way.) Rates aren’t coming down. Energy markets are getting way more expensive. The cost of capital is rising while growth is slowing. Maybe some other risk emerges in markets. Suddenly, what looked stable six months ago starts to feel fragile and spooky... How much worse can this get, and should they line up at the redemption window at whatever fund (let’s call it Private Fund X) when the time comes? So, we see other sets of redemption requests hit Private Fund X. And Private Fund X was probably fine two Tuesdays ago. Which is usually how these things work. Everything is fine… until it very much isn’t fine anymore... The Private Fund X risk manager was probably thinking about Opening Day in baseball this weekend, but now they face a queue that they did not expect. So, Private Fund X puts up its own gate. And now you have a pattern. Patterns in finance don’t need panic. They just need alignment. Repricing, meanwhile, doesn’t need a single dollar to exit any fund. It simply needs buyers and sellers of similar assets to look at the gates and decide that the value of private credit is worth less today than it was in February. Once that process starts, funds that haven’t gated are pushing their own triggers. That leads to more gates and more repricing… What people must understand is that dominoes in financial markets don’t need to fall fast. They simply need to fall in the same direction. And, we could sit here and say…”Let’s wait it out… and let’s pretend that these asset prices haven’t come down.” That’s technically possible, but that sure doesn’t sound like a sound financial system, does it? 3. The Leverage Has Its Own TermsNow, while I have said that gating and its patterns aren’t explained well… Well, leverage is hardly explained at all… and even I struggle at times to articulate it whenever I’m on camera, with my brain shutting off for a second as I try to explain how leverage works in private credit. I’ll have edited this answer four times today… Private credit funds are not operating just on equity. They use credit facilities and warehouse lines to increase leverage. You may want to drink some caffeine while I explain this… Or something stronger, depending on how much you like your current portfolio. So, Credit Fund X might have $1 billion in investor capital but may deploy roughly 1.5x to 3x its equity capital, depending on the structure of its credit facilities. This leverage is what generates those magical returns and high yields that make private credit so attractive to institutional investors (and retail as well). Everyone loves leverage in financial markets when the Fed is accommodative, volatility collapses, and equity markets roar higher. But leverage is an absolute killer on the way down in financial markets. Leverage is patient on the way up and merciless on the way down. Those credit facilities have their own margin triggers and covenants. Credit Fund X could lock its investors in… It can’t restrict lenders providing financing, who can enforce covenants or margin requirements. If the bank yanks the facility or demands that Credit Fund X offer more collateral, the fund has to sell assets to meet the margin call. They can primarily get money from two sources. New investor money coming in… Or by selling assets. The problem is that new investors aren’t likely to put money into a fund that just gated other investors. So, selling is the most logical direction. However, they’d be trying to sell into a market where every other fund is selling the same thing, and buyers know the sellers are desperate. (See the phone call scene in Margin Call and how quickly asset prices deteriorate when the word is out on a fire sale.) This was the fire sale that gates were supposed to prevent. Investors can’t run. Leverage doesn’t need permission. 4. In the End, Gates Will Kill the ProductNow, I reference Margin Call a lot… It shows how institutions think… and how they survive. In a critical scene, John Tuld tells his team to liquidate their mortgage-backed securities (MBS) portfolios. He knows that much of this is worthless, but he justifies selling at “market prices” to “willing buyers” so that they “may survive.” The lead trader explains that if he does so, his fund will never be able to sell to any of these people again. So, to compensate for that, the trading team receives bonuses for dumping their positions, partly because selling worthless assets will ultimately destroy the relationships they had built with counterparties over the years.  Well, private credit and MBS have some similarities and major differences. But the core thing that matters in the end… is trust. Let’s say that this fund survives and the loans do recover. The net asset value may recover. So, the manager sends out a letter on nice paper with a tasteful font that… It doesn’t matter because the trust between the customer and manager may be gone. Once the investor has been told they can’t access their own money, the relationship doesn’t just change. It breaks. Yes, it’s easy to say, “But this is what the investor signed up for… in semi-liquid assets with long-term investment horizons.” You’re assuming that people read the terms. People don’t really read the terms. They read the yield. The rest is just paperwork they assume someone else understands. Managers know this. New allocations can quickly dry up, and existing investors may submit standing redemption requests every quarter. They aren’t asking for their money back just because they need the money; they’ve learned that access isn’t guaranteed anymore. Credit Fund X could face a slow death spiral of declining capital, deteriorating assets, and no new money coming in the door. This pattern occurred in several real estate and credit funds after 2008. The gates went up, and the funds did survive the initial panic. But then they spent the next three to five years liquidating positions at discounts while their investors swore they’d never buy back into those funds again. Of course, they did invest in these types of funds again, because yields were high and memories are short. So, now we are back, baby… with history rhyming like always. Why It MattersI remind you that two Bear Stearns hedge funds effectively froze redemptions in June 2007 due to their exposure to subprime mortgages. At the time, Federal Reserve Chairman Ben Bernanke suggested the problems in subprime were likely to be “contained.” And the logic was similar that gates would contain the problems, asset prices would recover, and all we needed was time. Redemptions were restricted, but leverage pressures still forced liquidations. Funds were liquidated, and the losses were significant. Gates don’t contain the fire. They tell everyone where the fire lives. The reader who asked the question is correct: gates can slow investor withdrawals, similar to withdrawal restrictions and suspension mechanisms used during historical panics like 1907. The damage is in loan quality and in the leverage linked to it. Repricing is what can really trigger this. This is what happens when liquidity tightens across the system. The illusion of stability disappears, and everything that depended on it starts to reprice at the same time. And when everything reprices at the same time, there’s no exit that isn’t crowded. Gates don’t contain the fire. They show you exactly where it lives. And once you see it, you won’t forget.
Stay positive, Garrett Baldwin 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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