The Truth About Private Credit and Debt Default Cycles

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[00:00:00]Hello and welcome to analyzing finance with Nick. This video is an excerpt from my meetup I did in San Francisco on March 28th where my colleague from spearhead Murphy McCann goes into what is going on in the private credit market currently and how the stress in the private credit market compares to previous credit cycles and debt default cycles generally. If you have any specific questions about investing or the markets, feel free to reach out to me directly.

[00:00:35]And without further ado, let's get started.

[00:00:39]Hi everybody again. My name is Murphy McCann. I'm a partner of Nick's at Spearhead Advisors and I'm here to talk to you about a topic private credit.

[00:00:48]Just off the top, does anybody know exactly anything about what I'm talking about right now or even what it is?

[00:00:55]Those okay.

[00:00:56]Let me just go through it real quick. We all know what lending is, right?

[00:01:00]Somebody lends somebody else money, right? In the real estate space, sometimes we lend money against people's houses, but in the corporate world, when companies need to get themselves funded, somebody needs to lend them a bunch of money to get started. That debt needs to be repaid. It's different being a debt owner than an equity owner in a company.

[00:01:19]Private credit is a term that people are now labeling to describe usually these days what they're talking about is when private equity firms and non-bank institutions. Typically, when you guys want a loan, you go to a bank, right?

[00:01:35]Well, what's been happening over the last two decades in earnest and especially in the last 10 to 5 years, asset managers instead of banks. So, think about the BlackRocks of the world.

[00:01:48]There's Blackstone. There's a lot of private equity shops. There's the Pimco where I used to be from. They, instead of the banks, are now lending straight to companies. There's no bank in the middle. So, if you can just kind of get that picture in your head, what's been happening is that there's a lot of reported defaults in all of this lending that's been going on. So, we instead of banks doing the lending and if anybody's ever borrowed from a bank, you'll know that the banks like to ask a lot of questions. They like to do a lot of diligence. A lot of times their diligence doesn't seem to make any sense. They're just checking boxes and seemingly causing problems.

[00:02:27]So, when companies want money, it's really nice actually to be able to go to an asset manager who kind of understands and isn't beholden to all the same rules that a banks that banks are. So, and what's happened in all of that activity are a few bad things and what's happened is that a lot of the loans that were made by these firms and again, these are firms with a lot of talented individuals, but a lot of these loans are kind of turning sour.

[00:02:57]They're missing their payments, defaulting and we will talk more about that, but it's gotten a lot of news attention in the news lately and like I appreciate with Nick's debunking doomers, I would like to just put more facts around this for everybody to understand better because there are a couple of implications. You might see some scary headlines. You might read some scary articles and mine is always just to kind of arm you with more facts and more context so that you can think about it yourself.

[00:03:27]So, with that in mind, what I want to do is talk about a couple of credit crises that we had in the last 25 years. The first one was in the early 2000s. It was a corporate credit crisis.

[00:03:42]It what came on the back of the tech bubble, but the tech bubble didn't necessarily cause it. So, what happened in 2002 and the years leading up to it is a confluence of things. What it resulted in was has anybody heard of Enron?

[00:04:02]Okay, so Enron, has anybody heard of WorldCom?

[00:04:05]Fewer hands. Enron and WorldCom were the two biggest bankruptcies in corporate history. I think even to this date, if I'm not mistaken. If that isn't 100% true, it is 95%. Sorry, I Lehman Brothers trumped it. I was talking like non-bank. The the global financial crisis separate deal. Yes, Lehman largest, then but before that nobody had ever seen a $30 billion bunch of debt go belly up. That was shocking to a lot of people.

[00:04:36]And so you had these corporations, Enron and WorldCom.

[00:04:42]And the backdrop to that, how was this able to happen? There were mostly banks involved and they issued a lot of corporate debt, so they issued bonds, right? And a lot of times those bonds a lot better researched than other types of debt. But what happened was accounting rules back in those days were not nearly as tight as they are now. And Enron and WorldCom committed fraud, let's not be you know, they did commit fraud, but they used some really tricky financial accounting rules to kind of hide the problems that were on their books. They used these tricks to inflate their earnings. Enron did one of the things that they did was to basically book, they would enter into long-term contracts. Typically, you're supposed to recognize the revenue as you earn that revenue over the time of the contract.

[00:05:32]Enron was booking it all in the same quarter that they booked the deal.

[00:05:36]Right? So you can see how you would be jacking your revenues from doing that.

[00:05:39]But what I'd like to do and again, this is just as context, I would just like to say that there were a lot of accounting a lot of accounting gimmickry that was going on during that time. So bad that it took down an entire There used to be a company called Arthur Andersen.

[00:05:56]Has anybody heard of Accenture?

[00:05:58]Accenture was the surviving part of Arthur Andersen. Arthur Andersen spun off Andersen Consulting Arthur Andersen used to be one of the top accounting firms in the entire world barring none.

[00:06:12]And they went down completely. All the partners lost all of their retirement savings when it was discovered that Arthur Andersen was helping the Enrons and the WorldComs of the world cheat on their books. So, this was a really big deal. It led to the biggest to date bankruptcies ever seen.

[00:06:32]There's parallels to the private credit market. There's things that happen kind of in the overall lending space where people are allowed to cheat. It's somehow mastered or otherwise covered up and we end up with a debt problem because people are allowed to borrow money that they probably shouldn't have been able to borrow.

[00:06:49]So, that's context piece number one.

[00:06:53]The second one that everyone I hear ought to be very well familiar with is the global financial crisis and the mortgage meltdown that we had in late 2000. So, 2008 is when a lot of it came to a head.

[00:07:08]It's when Lehman Brothers went down.

[00:07:10]Almost the entire banking sector in the United States went to actually globally.

[00:07:15]It almost took down the entire banking sector where and I'll tell you what happened.

[00:07:21]Very similar to the other instance where problems were being masked by the system that was doing the lending. And so, in the mortgage market, what was happening is you had a lot of dirty mortgage age loan agents. Most of them barely made it out of high school.

[00:07:39]They would find ways to people's files to get them through. Back in the day, the really smart people were able to edit, you know, images on Adobe, right? To change numbers, to change income numbers, say maybe. And so, that was part of what was going on. The other thing that was masking it was actually a lot of good news was that the housing market at that time was going bananas.

[00:08:04]We had 2 years in a row, I think it was '04 and '05, where we had the entire US property market go up 25% 2 years in a row, which is pretty unheard of, right? Think about your house being worth 50% more after you buy it 2 years later, right? So, that hit a lot of problems, and the way that it did that was people, you know, you buy your house for $500,000, it goes up 20% in a year, and you say, "Oh my god, my house is now worth $600,000.

[00:08:37]I only borrowed 300 to get into it or 350 or whatever. I'm going to go to my mortgage banker because I want to buy a Porsche, and I know that I can actually, because my house is worth more, I actually refi my loan, pull out another hundred or so, and I got that Porsche covered, plus whatever rims I want, etc., etc., and and you're laughing. He's laughing because he's, you know, it's happened even more recently. People do the same thing now with the recent property run-up. So, that's part of what was hiding it. So, a borrower who couldn't pay that mortgage for the life of the loan said, "Hey, I'm going to get out in a year because my house went up." And he pays off the mortgage. It looks like he was a stellar borrower, but in reality, he may not have even been able to afford that. And so, the entire landscape was masking potential uh the biggest problem, which is that a lot of the borrowers could not afford their monthly payment.

[00:09:37]Hiding that fact was, you know, there was a lot of things that people did to try to hide that fact. So, what happened was you march forward a bunch of years, a lot of people stack up a lot of debt.

[00:09:49]The Fed wants to start raising rates, and what happens was a lot of people refied into these cheap adjustable rate mortgages that came with a very, very low rate. Part of the reason they got into that house they couldn't afford was that they gave them a teaser rate of 2% and when mortgage rates were really somewhere around six.

[00:10:08]So, it looked like he could make the payments, and then when the Fed started raising rates, he couldn't make them.

[00:10:13]So, you take all those problems, and then you multiply it by the size of that market. So, the mortgage market and the amount of mortgage debt outstanding at the time of the crisis, let's just say it was somewhere between 10 and 15 trillion dollars.

[00:10:35]It's a very large number. And if you cut it down, certain subsets were still really large. And you look at the world globally, the whole world was doing this at the same time. So, it was a very, very, very large problem. Compared to Enron and WorldCom, which combined had less than 200 billion worth of debt.

[00:10:54]So, this is a much larger problem. It took down almost took down Fannie and Freddie. It basically took down Fannie and Freddie.

[00:11:01]It took down almost every bank in the United States and globally as well.

[00:11:06]Very, very big problem. So, again, the similar theme, there's a lot of things that are masking what was really going on, which is people couldn't afford their mortgage payment.

[00:11:15]Now, let's fast forward to today in the private credit issue that we have. Or, let's just talk about the environment because we haven't really seen all the facts coming down the pipe.

[00:11:25]You have people that are lending money to companies using their lending criteria is totally up to them. It's not like they want to throw money away, but they're able to loosen their what we call credit standards or lending standards or whatever you want to call them.

[00:11:46]They lacks their a little bit lax on that. They also are dealing with potentially unaudited financials. You're talking about smaller companies that are not SEC registered. These are not traditional filers where there's a lot of scrutiny on their books. A lot of them do get their books audited, but it isn't you're not talking about the same level of scrutiny as when you go issue a bond in the public markets, right? Let's just put it that way. Information we'll just call it not necessarily a lack of transparency, but a heck of a lot less transparency.

[00:12:19]And the other thing that I think is wrong, one of the other things wrong with the environment generally speaking, is that these asset managers are actually paid to lend the money, right? If I put money if money gets raised in a private equity fund, that manager doesn't necessarily get paid until he deploys the capital.

[00:12:42]And this is kind of a similar problem to the other scenarios as well when you had mortgage bankers making tons of commissions on for making loans, but again, this is all contributing to an issue where we now have a private credit market focused on kind of middle-sized businesses of where the debt is currently outstanding is about a trillion dollars. So, not nearly what we saw in the mortgage situation, but a lot more than what we saw in 2002.

[00:13:11]And what we're seeing a lot now are headlines about these funds not allowing redemptions. So, think of putting your money into a fund, the manager says, "Hey, you can't have your money today cuz I can't really figure out what the fund is worth. So, there's issues, right? I've given you some context around this, right? It's actually potentially it's like a fairly big deal, but I don't think it's as near nearly as catastrophic in terms of size as the other as the mortgage issue that we had in 2008.

[00:13:47]And but there are some real live consequences that could impact us somewhat.

[00:13:54]You want to know first of all how many retail investors, guys that are our size, are impacted, you know, based on So, if you take the total debt outstanding and you take what one of the aspects of this debt So, I'm skipping around a little bit, but one of the aspects of this debt is that certain borrowers and and debt packages are allowed to pay in kind. Pay in kind is PIK. People call it picking.

[00:14:24]Paying in kind means is hey, I can't pay you my interest payment in cash cuz I haven't made enough. I'm going to just increase my debt amount with you. My debt amount now just increased by the amount of the interest payment. So, that's paying in kind. It's called picking. And the estimates are out there that there's somewhere between Let me look at the exact stat.

[00:14:50]There are I want to say a number like 16% of the loans out there are actually picking, are actually paying in kind.

[00:15:03]So, it's not it's definitely not nothing. If you try to estimate what the damage is on people's balance sheets sitting here today, the whole lot. You would say that if everything that's picking is going to default, you're going to have to go through bankruptcy and figure out what's left and get some percentage of that debt back when they finish their bankruptcy proceedings. The total damages from that is whatever, 16% * 75% or you'll get 25% back of that. So, 160 you get 40 million out of the 160. So, you lost 120 billion.

[00:15:40]That would be the total damage to everybody's balance sheet and not just retail, but like the whole sphere. And retail is supposedly around 30% of that.

[00:15:51]So, out of that you end up with about I calculated about 36 billion of damage to people's personal >> Just for context. savings. The total size of the private credit market is about a 10% of the size of the mortgage-backed securities market. Correct. So, like this is like about maybe 10% of the problem with the systematic risk versus 08. So, Yeah.

[00:16:16]>> It would be a problem, but it wouldn't be like a crisis.

[00:16:21]Yeah.

[00:16:22]So, if retail investors took a $36 billion hit to their overall savings, in the context of the 36 or sorry, 36 billion hit, they actually represent about People's total savings are about 35 trillion. So, 36 billion 36 trillion, you're about 10 basis points, which isn't that big a deal.

[00:16:47]So, you can kind of push that to the side as like, you know, we're not having that kind of a major meltdown. But, I will tell you that as things get tough for these companies and the economy is tough and lenders have been, you know, they've had their nose bloodied by this. Their reputations aren't quite what they were and they have to go back to their investors and talk about what great lenders they are.

[00:17:12]What ends up happening is that the lending standards end up tightening. So, and where this, you know, one place where this is going to rub potentially a little bit versus the market is in the data center business. We've got, I mean, hundreds of billions being deployed into the data center industry, and there's estimates that we're going to put to work 1.5 trillion.

[00:17:36]People are saying that there's estimates that half of that could get funded through debt markets.

[00:17:42]Maybe not necessarily all of it, and that kind of makes sense from an overall corporate perspective. You typically fund things from a corporate perspective, half equity, half debt. So, 750 billion is now going to get a little bit harder to raise. The question is how much harder is it going to going to be to raise? What are the lending standards going to be?

[00:18:00]Usually, it means that small companies looking to get into the data center business are going to have to kick in more equity. You're just not going to be able to borrow if you have a $100 million project, you originally thought you're going to be able to do 50% in debt, now you may only be able to do something less than that in debt. So, it'll have a rub. I don't think it's fatal at all to this business. If you think about the data center business and the build-out that's going for the entire AI infrastructure, including all the software, I mean, that is going to be a trillion and a half dollars is actually very, very, very easily funded by all the major tech companies just out of their free cash flow. So, I don't see it as a really big deal there. I just gave you a giant speech about maybe something that you didn't know a lot about. Hopefully, I'm arming you though with the ability to say, "I'm not sure that that's such a big deal."

[00:18:53]Because there might be some sort of a lot of fear noise in the press about it, but you understand a little bit more context around it.