Private credit is moving into consumer finance, including credit cards and “Buy Now Pay Later”, a risky form of consumer finance. This migration comes with structural instability.

Why the risk migration?

The causes are simple. Banks pulled back from marginal consumer lending due to the pressures of regulations and capital requirements. Private credit, far less regulated, is receiving new cash injections notably from retail. The vacuum left by one is filled by the other. The high yields and the larger margins certainly justify the appetite.

That shift is now well documented by central banks and regulators. The Federal Reserve and the Boston Fed have both highlighted the scale, opacity, and growing systemic relevance of private credit.

Where the problems are

• Lack of capital buffers: banks treat consumer loans as a lending activity. They must put their own capital against it. Private Credit funds treat the same loans as investments. The risks are entirely borne by their investors.
• Risky asset composition: the investments include unsecured lending, BNPL structures, specialty finance platforms, and other consumer-linked cash flows. They behave very differently from senior, sponsor-backed corporate loans. They notably deteriorate faster and are far more sensitive to macro stress.
• Model risk: theoretical valuation models for these assets take those factors into considerations, and banks provision those mark-to-market losses as soon as unemployment deteriorates.
• No equivalent safeguard: funds do not have the same obligations. There are no equivalent testing and provisioning, and so no buffer and no transparency.

Valuation will migrate from model- to market-driven

As the asset class matures, the loans can be resold, and a secondary market for private credit is emerging. These transactions are meant to provide liquidity; they also introduce price discovery. A new valuation methodology follows: mark-to-market.

Kinetics

Funds can very much value those loans ‘at-market’, at theoretical, or with any mix in-between, at their discretion.

The gap between modeled assumptions and realizable prices can widen quickly. There is no guarantee that loans will be re-marked accurately or fast enough.

If history is an indication, the likely behavior is a slow accrual of losses. Funds do not want to show losses to avoid redemptions.

What scenario will eventually unfold?

Our economy is based on lending and is therefore cyclical. It is not a question of if, but only of when.

At the first bout of unemployment or economic slowdown, consumer loans will diverge materially from reported NAVs.

As we saw with real estate derivatives, perception can shift suddenly. Those consumer loans may go from AAA to C before anyone knows where the losses truly sit. Funds will eventually announce sudden, large losses.

Retail investors will be surprised; the feedback gloom will accelerate the downturn.

Structural risks

Private credit’s appeal rests on the perception of stability, predictability, and low volatility. Consumer credit is all but stability. The migration of consumer risk from banks to private credit is a source of systemic instability.

What to do?

Valuation methodology, disclosure, and risk governance are critical.

Can we trust our regulators for this? Let’s say that a deep review of the risks and regulatory framework is probably ‘not the current priority’.

Most likely, sudden losses will be followed by litigations, finger pointing and, eventually, regulatory changes.

We’ve never seen anything like this before, have we?

Sources

• Federal Reserve, Private Credit: Characteristics and Risks The Fed – Private Credit: Characteristics and Risks
• Boston Fed, Could the Growth of Private Credit Pose a Risk to Financial System Stability Could the Growth of Private Credit Pose a Risk to Financial System Stability? – Federal Reserve Bank of Boston
• CFA Institute, Private Credit’s Surge Has Investors Excited and Regulators Concerned Private Credit’s Surge Has Investors Excited and Regulators Concerned – CFA Institute Enterprising Investor
• McKinsey & Co: The next era of private credit The next era of private credit | McKinsey
• Macfarlanes Private Capital Solutions: The growth of asset-based finance in private credit markets The growth of asset-based finance in private credit markets | Macfarlanes Private Capital Solutions
• StarMountain capital: The Rise of Private Credit Secondaries Private-Credit-Secondaries-White-Paper.pdf