A Feature, Not a Bug
Doug Nolan
It’s the type of extraordinary backdrop that flashes “critical juncture”.
Ongoing “Terminal Phase Excess” is the culmination of a historic multi-decade global Credit Bubble.
The post “liberation day” tariff pause rally – fueled by short covering, the unwind of hedges, powerful FOMO, and feverish late-cycle speculative leveraging – stoked epic excess, certainly including the global AI mania and arms race.
Pertinent insight is gained from mortgage finance Bubble dynamics.
While that Bubble imploded during Q4 2008, Credit excess had peaked the preceding year.
Non-Financial Debt growth reached a nominal $692 billion during Q2 2007.
Broker/Dealer Asset ($682bn) and system repo ($436bn) growth peaked during Q1 2007.
Growth in Corporate Bonds reached a record $471 billion during Q3 2007 (record holding until the pandemic).
The S&P500 reached a cycle high on October 11th, 2007.
I point to the June 2007 implosion of two Bear Stearns funds - the High-Grade Structured Credit Fund and the Enhanced Leveraged Fund - as a key Bubble-piercing catalyst.
These funds employed sophisticated CDOs, derivatives, and heavy leverage - an aggressive “cutting edge” strategy that beamed brilliance - until it abruptly blew apart.
As is commonplace during “Terminal Phases,” “sophisticated” strategies that incorporate derivatives and aggressive leveraging rest on the specious assumption of liquid and continuous markets.
The Bear Stearns fund implosion essentially ended the subprime mortgage/derivatives Bubble, crucial Wall Street alchemy that had transformed essentially unlimited high-risk mortgages into (mostly) perceived (relatively) safe and liquid money-like instruments.
The marginal homebuyer lost access to the mortgage marketplace, leaving inflated home prices and throngs of over-levered speculators no place to go but down – a cycle’s worth of masked fraud no place but to be exposed.
Crisis at the “periphery” unleashed contagion that would be revealed as deeply systemic months later.
Importantly, the Fed would slash rates from 5.25% to 2.00% between September 2007 and April 2008.
This extended the boom in AAA GSE-backed MBS, which I have argued only exacerbated “Terminal Phase Excess,” deepening financial and economic crises.
The ongoing global government finance Bubble so dwarfs mortgage finance Bubble excess.
The amount of debt, speculative leverage, derivatives, and economic maladjustment is so far beyond anything previously experienced.
Today’s backdrop is fraught with monumental excess, along with important developing cracks.
As for excess:
October 1 – Bloomberg (Marc Jones):
“Companies borrowed a record $207 billion in the US investment-grade market in September, more than Wall Street’s top underwriter of the debt Bank of America Corp., had expected.
Last month’s haul ranked as the fifth-largest monthly total on record, and the second largest outside the Covid era…
Falling borrowing costs and a seemingly insatiable demand from investors chasing still-attractive bond yields are encouraging corporations to pull forward their plans to raise money to refinance bonds maturing in coming years, fund acquisitions and spend on their capital…
‘We were a bit surprised with how busy September turned out to be,’ Dan Mead, head of the investment-grade syndicate at BofA, said…
‘The mindset from corporate America is shifting to more of a growth story and that will likely lead to perhaps additional CapEx that is further driving the debt financing needs of our issuers,’ said…
Mead, who’s been with BofA for more than 30 years.”
October 1 – Bloomberg (Gowri Gurumurthy):
“The wave of [high yield] debt sales shows no signs of easing as seven more deals for nearly $7b priced on Tuesday, the last day of September, to drive the month’s volume to $57.6b.
That is the third busiest month on record. Four of the top five busiest months occurred between June 2020 and March 2021.
The supply boom was fueled by still-attractive yields, low risk premium - with spreads just eight basis points over the seven-month low of 259…
The torrid pace of issuance made it the busiest September ever.
Yields hit a multi-year low of 6.57% in the middle of September.
For five straight weeks more than $9b was price each week, with week ended Sept. 26 pricing nearly $18b to make it the busiest in five years.
The supply surge drove the third quarter volume to $118b, the busiest 3rd quarter since 2020.
This is also the busiest quarter since the second quarter of 2021.”
September 30 – Bloomberg (Rene Ismail):
“Three US leveraged-loan launches occurred Tuesday, pushing the record third quarter’s total even closer to $400 billion.
Today’s deals were modestly sized — led by $500 million offerings from telecom provider VodafoneZiggo and healthcare-laundry firm ImageFirst.”
September 29 – Bloomberg (David Carnevali, Ryan Gould and Pamela Barbaglia):
“A rush of big, bold mergers and acquisitions is lifting dealmakers in an otherwise slower-than-expected market for getting transactions off the ground.
Global deal values have topped $1 trillion in a third quarter for only the second time on record…, thanks to transactions like Monday’s roughly $55 billion take-private of video game maker Electronic Arts Inc. by a consortium including Silver Lake Management.
It means values are now up 27% at around $3 trillion for the year-to-date and on course for their best finish since 2021.”
September 30 – Bloomberg (Anthony Hughes and Bailey Lipschultz):
“Equity capital markets in the US are humming as investment bankers’ memories of the post-pandemic slump are being banished by a standout third quarter for IPOs and growing momentum in convertible bonds.
Companies and shareholders have raised more than $255 billion through the first nine months of the year, the most over the first three quarters since 2021’s boom…
‘It feels like a good springboard into 2026 from here,’ said Eddie Molloy, co-head of global ECM at Morgan Stanley.
‘There were IPOs, follow-ons, converts.
It felt like the first sustained period of normalization in quite some time.’”
October 1 – Associated Press (Michael Liedtke and Michelle Chapman):
“Electronic Arts, the maker of video games like ‘Madden NFL,’ ‘Battlefield,’ and ‘The Sims,’ is being acquired by an investor group including Saudi Arabia’s sovereign wealth fund in the largest private equity-funded buyout in history.
The investors, who also include a firm managed by Jared Kushner, President Donald Trump’s son-in-law, and the private equity firm Silver Lake Partners, valued the deal $55 billion.
EA stockholders will receive $210 per share.
The deal far exceeds the $32 billion price tag to take Texas utility TXU private in 2007, which had shattered records for leveraged buyouts.”
Q3’s perilous Bubble inflation only exacerbated fragilities.
First Brands’ Sunday bankruptcy filing is an important crack.
It is a company that took full advantage of the loosest financial conditions imaginable: “Private Credit,” “fintech”, off-balance sheet financing, structured finance (i.e., CLOs), supply chain finance, invoice financing…
October 2 – Bloomberg (Olivia Fishlow):
“Since First Brands Group filed for bankruptcy with over $10 billion of liabilities, the market has been focused on blows to its broadly syndicated investors and trade finance providers.
Some of the debt has plunged to around 36 cents on the dollar…
But the company benefited from another set of lenders that are now asking to be paid back: Private credit.
These firms gave First Brands its last infusion of cash before its collapse, an unraveling that capped weeks of investor concern about the company’s use of opaque, off-balance-sheet financing…
Sagard agreed to arrange a new $250 million facility for the company in April...
Others were brought in, including Strategic Value Partners, which became the largest lender on the deal…
The largest holder of the loan, listed as Bryam Ridge LLC with the same address as SVP’s headquarters, holds $100 million of the debt…
Private credit firms pitch themselves on the fact they can provide fast funding from only a handful of sources…
Private lenders also have limited options to cash out or sell investments when things go south…
First Brands’ private credit deal was designed to boost up its balance sheet for acquisitions until the company pitched a refinancing of its leveraged loans…
In July, Jefferies Financial Group Inc. was tapped to market a $6.2 billion refinancing for First Brands in the public markets.
But the deal fizzled after investors asked for further diligence…
If that deal had been successful, the private credit loan would have been paid off…
Private credit lenders say they’re owed about $276 million in total...
They’ll have to wait with around 80 other creditors to get paid back.”
October 1 – Financial Times (Robert Smith, Amelia Pollard, Jill R Shah and Eric Platt):
“First Brands Group’s $1.1bn rescue loan faces a legal challenge from a Utah-based private asset-backed finance specialist, which has emerged as the largest known creditor to the bankrupt US car parts company.
Onset Financial — a company in Draper, Utah, that describes itself as a ‘dominant force and leader in the equipment lease and finance industry’ — built up $1.9bn of exposure to First Brands in the years before it collapsed into bankruptcy, according to legal filings.
This makes the specialist company the biggest known creditor to First Brands, which has now disclosed that it built up almost $12bn in debt and off-balance sheet financing.
Onset’s exposure eclipses some of the biggest names on Wall Street, which are facing the prospect of multibillion-dollar losses in a chaotic bankruptcy process…
In its filing in… bankruptcy court, the… company’s lawyers wrote that ‘First Brands owes Onset approximately $1.9bn’ and that the relationship between the private finance firm and the car parts company ‘dates back to 2017’.
‘When the dust settles, this court will see that Onset was the single most significant provider of liquidity to the debtors,’ Onset’s lawyers wrote.”
October 1 – Bloomberg (Eliza Ronalds-Hannon, Davide Scigliuzzo, Nicola M White and Luca Casiraghi):
“When the auto-parts supplier First Brands Group filed for bankruptcy on Sunday, one name popped up in the documents again and again: Raistone.
The little-known firm helps businesses secure short-term financing as they wait for customer payments to come through or seek to delay paying suppliers.
On Tuesday, the New York-based company let go dozens of its workers as the deals it worked on for First Brands came under scrutiny.
The collapse of First Brands is only the most recent instance of a firm like Raistone facilitating apparently low-risk transactions that have led to problems for companies and lenders in what is known as trade finance.
Late last year, a Raistone competitor, Stenn Technologies, collapsed in dramatic fashion after promoting mundane corporate lending products that proved to be anything but.”
October 3 – Reuters (Stephen Gandel):
“One of the big questions about the private credit boom is how lenders perform in a crunch.
The collapse of First Brands… is especially revealing.
The U.S. auto parts firm appears to have racked up more than $4 billion in opaque debt by tapping a fragmented group of non-bank lenders, including private credit firms, securitized debt funds, and factoring companies…
First Brands, formed through a series of mergers, owned several mechanic-favorite auto parts brands.
Its creditors include at least 517 collateralized loan obligations (CLOs), Cantor Fitzgerald’s private credit arm, and trade finance firms like Raistone.”
September 11 – Financial Times (Robert Smith and Julie Steinberg in London and Eric Platt):
“Patrick James — a little-known businessman who was previously accused of fraud in civil lawsuits that were ultimately dismissed — is the sole owner of FBG, which has expanded rapidly through a string of debt-funded takeovers of competitors.
On top of the more-than-$5bn of debt FBG has borrowed through the loan market to fuel its acquisition spree, the company has raised further financing linked to its customer and supplier invoices from specialist private credit funds.”
The first of many questions: were any of the more than 80 creditors listed at bankruptcy performing Credit analysis?
And that’s exactly the point.
With conditions so loose and liquidity abundant, the marketplace simply assumes companies will continue to enjoy access to new borrowings.
While reports are so far careful not to allege fraud, there appear to be at least a couple billion more liabilities than previously represented – apparently related to off-balance sheet obligations.
There’s fear that seemingly low-risk inventory and “supply chain” financiers face the prospect of the same collateral backing multiple liquidity facilities.
Little known Onset Finance, out of Draper, Utah, with $1.9 billion of exposure to First Brands?
Wall Street completely blindsided?
Are we to assume First Brands is an isolated case or the proverbial tip of the Old Credit Cycle Iceberg?
As noted by Bloomberg’s Chris Bryant:
“First Brands’ bankruptcy might indicate that some corporate capital structures are even more financialized than creditors appreciate; it also raises questions about the quality of their due diligence…
The rapid implosion of a business that until recently had a decent cash buffer shows how companies involved with this supposedly low-risk funding can quickly unravel…”
Stocks of the big “private Credit” players have been under notable pressure.
Over seven sessions (9/24 to 10/2), KKR sank 15.4%, Apollo 12.2%, Areas Management 16.9%, and Blackstone 9.9%.
Not as dramatic yet still notable, over this period (as the S&P500 added 0.9%), Citigroup dropped 5.5%, Wells Fargo 4.6%, Morgan Stanley 3.4%, Goldman Sachs 3.3%, US Bancorp 2.9%, Bank America 2.4%, and JPMorgan 1.7%.
Significantly underperforming, the KBW Bank Index fell 2.2% this week – its worst performance in two months.
October 3 – Bloomberg (Georgie McKay):
“Beneath the surface of what’s been a remarkably resilient US economy, a series of small shocks in the world of consumer credit have combined to rock companies that service the most financially vulnerable Americans.
Auto lender Ally Financial Inc. tumbled 13% during a nine-day losing streak.
Fintech lenders Upstart Holdings Inc. and Pagaya Technologies Ltd. sank more than 20% in the same span.
Digital payments company Affirm Holdings and lender Bread Financial Holdings Inc. suffered similar fates.
Even Capital One Financial Corp., one of the nation’s largest credit card issuers, lost 7%.
The selloffs have been fueled by isolated events that have alarms over the health of low-end consumers blaring.
The collapse of Tricolor Holdings Inc., which built its business selling used cars and making loans to lower-income and undocumented immigrants, suggested subprime lending stress.”
October 3 – Bloomberg (Steven Church):
“The trustee overseeing bankrupt Tricolor Holdings is investigating possible wrongdoing by the subprime auto lender before its collapse in order to raise money to pay creditors, a lawyer said in court...
The company’s business ‘appears to be a pervasive fraud of rather extraordinary proportion,’ Charles R. Gibbs, who is representing the trustee, told the judge overseeing the company’s liquidation.
‘Initial reports from these reviews indicate potentially systemic levels of fraud.’”
First Brands’ bankruptcy filing followed subprime auto lender Tricolor’s by a couple weeks.
First Brands’ stability was apparently impacted by tariffs on auto parts imports, while immigration and deportation issues hit Tricolor – underscoring the risk Washington policymaking poses to an inherently fragile Credit system.
The government shutdown comes at an especially inopportune juncture.
I appreciated both Financial Times (Robert Smith and Harriet Agnew) headlines:
The original: “Short Seller Jim Chanos Predicts More First Brands Fiascos in Private Credit” and the replacement, “Jim Chanos Slams ‘Magical Machine’ of Private Credit After First Brands Collapse.”
Jim Chanos, of short selling and Enron fame, knows accounting chicanery and Credit cycles as well as anyone.
His First Brands comments are worth sharing:
“I suspect we’re going to see more of these things, like First Brands and others, when the cycle ultimately reverses, particularly as private credit has put another layer between the actual lenders and the borrowers.”
“Chanos likened the near $2tn private credit apparatus fuelling Wall Street’s lending boom to the packaging up of subprime mortgages that preceded the 2008 financial crisis, due to the ‘layers of people in between the source of the money and the use of the money’.”
“Privately owned First Brands’ eschewed the more public bond market in favour of borrowing money through so-called leveraged loans.
It also raised billions of dollars through even more opaque financing backed by its invoices and inventory, which was often provided through private credit funds.
‘With the advent of private credit… institutions [are] putting money into this magical machine that gives you equity rates of return for senior debt exposure,’ he said, adding that these high yields for seemingly safe investments ‘should be the first red flag’.”
“His short thesis against Enron was fuelled in part by the realisation that executives at the group were managing SPEs [special purpose entities] that engaged in complex transactions outside the purview of its corporate balance sheet.
In contrast to Enron, First Brands’ financial statements were not publicly available.
While hundreds of managers of so-called collateralised loan obligations had access to its financial disclosure, they had to consent to non-disclosure agreements to receive the documents.
‘The opaqueness is part of the process,’ Chanos said.
‘That’s a feature not a bug.’”
“A Feature, Not a Bug.”
I would contend that opaqueness is integral to the “private Credit” process.
As Chanos stated, “We rarely get to see how the sausage is made.”
And this lack of transparency, including market pricing, seems to serve borrower and lender alike during boom times.
As we now see with First Brands, it comes back to bite hard.
In analysis dear to my analytical heart, Chanos likened the subprime mortgage Bubble to today’s “private Credit” boom:
“Layers of people in between the source of the money and the use of the money.”
This is such a critical point: risky lending, with its high rates, presents the opportunity for “layers of people” to profit from the wide spread between the cost of funds and the elevated rates “subprime” borrowers are willing to pay.
These “profits” entice more lenders and additional layers of profiteering, in the process expanding system Credit Availability and growth.
The easy access to Credit will promote spending and investment, with resulting economic activity only emboldening aggressive lenders, financiers, and risk-takers.
Over time, an enterprising Wall Street will cultivate an extensive infrastructure that provides relatively cheap finance to even the most marginal borrowers.
As always, Credit is self-reinforcing, with this era’s risky “subprime” variety dispensing rocket fuel.
So long as borrowers can borrow more, delinquencies and charge-offs remain manageable, lending profits appear robust, and the cycle seems robust.
Simple enough.
Looking ahead, things are incredibly complex.
Trouble at the mortgage finance Bubble “periphery” (subprime) in 2007 initially bolstered the “core” (i.e., AAA GSE MBS).
The Fed aggressively slashed rates, while confidence in federal backing of GSE securities (MBS and debt) held firm.
Those powerful forces for months impeded the full force of contagion effects.
Moreover, the craziest excess was generally contained within mortgage Credit and housing construction.
While there were clearly imbalances and major distortions, the U.S. economy did not suffer today’s degree of broad and deep structural maladjustment.
The “periphery” of “Private Credit” – of leveraged lending more generally – is today acutely vulnerable to waning confidence, risk aversion, reversal of financial flows, and deleveraging.
“Subprime” consumer and business lending is increasingly suspect, thus susceptible to a problematic tightening of lending standards.
But might AI rapidly evolve into “private Credit’s” “core”?
Does momentum associated with the historic AI mania today somewhat buffer the “private Credit” and leveraged lending complex – while providing the critical system Credit growth necessary to temporarily impede “periphery to core” contagion effects?
“The First Brands Disaster Began With Business as Usual.”
“First Brands’ Fallout Exposes Risks of Lending Private Debt.”
“First Brands Probing Billions of Off-Balance-Sheet Financing.”
“UBS Funds Face Half-Billion-Dollar Exposure to First Brands.”
“Millennium Takes $100 million Hit in Collapse of First Brands.”
“Leveraged loan default rate jumps as First Brands takes fast track to bankruptcy.”
“Lender Clash Over First Brands Collateral Spotlights Off-Balance Sheet Risks.”
“CLOs see $2B of exposure to bankrupt First Brands debt as ‘manageable’.”
While not a major player, First Brands is a microcosm of this historic Credit cycle and perilous “Terminal Phase Excess.”
There’s going to be hell to pay when lending standards tighten, speculative flows reverse, deleveraging commences, and Credit becomes much less freely available.
Arguably, history has never seen so many borrowers – from household Credit cards, auto loans, and mortgages to levered and cash-flow challenged small, medium, and large business enterprises – vulnerable to tightened lending standards.
AI-related Credit might be the proverbial black hole, with the potential to extend an already most protracted Credit cycle and “Terminal Phase.”
But as we experienced with the mortgage finance Bubble, extending the day of reckoning is not to be celebrated.
Indeed, the further burgeoning AI (buildout) finance evolves outside of the major cash-heavy technology behemoths, the greater the risks of a Credit debacle.
On the one hand, so long as the AI mania spell holds, underlying sector Credit quality may not play much role.
The lack of “private Credit” transparency may remain a non-issue.
On the other hand, when the market environment turns south and folks start to fear deteriorating economic, market, and Credit prospects, I expect a much more circumspect view of “private Credit,” leveraged lending, structured finance, and AI-related finance more generally.
Q3 exuberance ensured fading memories.
But early April provided inklings of things – like risk aversion and deleveraging - to come.
This CBB is already too long.
But I’ll conclude with brief comments on unusual market dynamics.
The Goldman Sachs Most Short Index surged another 9% this week, with a notable 17-session gain of 21%.
The underperforming Biotech stocks posted a 7.6% weekly gain.
These moves are indicative of stress on some hedge fund strategies, long/short in particular – indicative of incipient de-risking.
It’s not uncommon for short squeezes and the unwind of hedges to support stock prices even in the face of negative developments – especially near critical market junctures.
Negative developments in Credit and Washington may prove more than fleeting.
Currently, global markets remain over-liquefied and extraordinarily speculative.
It has been about six months of destabilizing excess since April’s bout of market tumult.
Underlying fragilities create mounting vulnerability to market de-risking/deleveraging.
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