Capitalisn’t: Is Private Credit in the Public Interest?

James Grant: Federal overseers of our financial affairs are forever intervening, and the accumulation of these interventions introduces mispricings, distortions that ultimately result in yet additional interventions. And that’s why capitalism isn’t.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Luigi: Bethany, did you know that credit originally comes from a Latin word? The Latin word credere means “to trust.” At the end of the day, lending is an act of faith.

Bethany: Which raises a question, of course. Is credit a good thing?

Of course, it’s the lifeblood of an economy. Without it, people and businesses wouldn’t be able to bet on a future, to finance growth, to acquire an asset that has to be paid over time. But, of course, too much credit is a really bad thing. At the heart of, I think, every financial collapse—at least every one I can think of—is the provision of more credit than borrowers can pay back. Credit, at least in my view, can be either one. It can be a capital-is or a capitalisn’t.

Luigi: Historically, most of the credit was provided through regulated banks. Banks get involved in what is called in jargon the transformation of maturity, which is a fancy way to say that you borrow short, and you lend long, so you’re prone to get in trouble.

That’s the reason why the United States has created deposit insurance, where every deposit up to $250,000 is insured by the full faith of the federal government. You don’t have to worry about it when you put it in a bank.

Bethany: But something called private credit has always existed right alongside the regulated banking system. In simple terms, private credit is just the provision of credit outside of the regulated banking system.

What’s interesting is that since the financial crisis of 2008, private credit in the US has exploded. Estimates of the current size of the business are about $1.7 trillion in outstanding loans. And the Fed, which has called the growth exponential, says that the amount of dry powder—that means money lenders could extend but haven’t yet—has quadrupled since 2014.

Luigi: There are many explanations for this rise. One is regulation after the financial crisis. Because of the excess of the financial crisis, regulators started to put more of a burden on banks. And so, some of that lending took another route and bypassed banks.

Another explanation is the big expansion of private-equity firms and the growth of LBOs. One estimate by the Fed suggests that roughly 50 percent of private credit is used to finance LBOs or expansions of companies that are invested in by private-equity funds. Some of the major providers of private credit are the very big private-equity firms that finance the deals, so there’s potential for conflict of interest.

And there is an increasing demand for investing in private credit. In a world where, at least historically, interest rates have been low, private credit stands to offer a decent return.

Bethany: Does the explosion in private credit presage a real explosion, a financial crisis? After all, as the Fed notes in this recent paper that they wrote on the private-credit market, there’s very little public data available. They wrote, “The scarcity of available data has made it challenging to assess risks in this market.” That reads to me as Fed-speak for “uh-oh.”

Luigi: If we want to make the positive case for private credit—and, by and large, I’m more on that side—number one, we do observe very low defaults. Now, sometimes there is no default because there is renegotiation, but in my view, that’s an advantage of private credit that is available to do this renegotiation.

The other big advantage is that private credit is financed, at least in part, with equity. And so, it’s not subject to all the problems we’re seeing in the banking sector, particularly the problem of bank runs, because even the amount that is not financed with equity is financed with longer-term debt. There is not that mismatch between the timing of the assets and liabilities that creates the problem we described. Overall, there is a positive side of private credit.

Bethany: Yeah, with private credit, because people are committing their money to these funds for long periods of time, they can’t just demand it back. So, you don’t have the same potential for a timing mismatch. While whether or not that’s good for the investors and the funds remains to be seen or is dependent on how good the deals are, it is arguably safer for the system overall because there won’t be these runs on a bank that then has to be saved.

But I will warn our listeners that, overall, I think Luigi and I might have some disagreements on the question of whether private credit is ultimately good or bad.

To discuss the issue and educate us all a little bit more, we wanted to have as a guest Jim Grant, the longtime market and banking-industry observer who writes Grant’s Interest Rate Observer. Grant recently hosted a conference on private credit, and part of the point of the conference was to reach a verdict on the question, “Is private credit in the public interest?”

A lot of the people, the entities, involved in private credit are private-equity firms, and much of the private-credit market today . . . I think I saw the estimate that 80 percent of it is used to finance private-equity deals, which I struggled to . . . The involvement of private equity and private credit, how does that change anything or make you think about it differently?

James Grant: Well, if you are a promoter of private-equity deals, and you are also a lender to said promotions, you’re necessarily going to be looking at the risk and reward of lending in a different way than if you were at arm’s length. I think it introduces the risk of misjudgment or not clearly objective appraisal of risk and reward.

Luigi: The surprising thing here is that both private equity and private credit are getting funded by mostly pension funds and maybe insurance companies, basically funded by the same people who should be a bit aware of what’s going on.

If I give my money to Blackstone for a private-credit fund, I want to make sure that they don’t lend to themselves. Conflicts of interest are a problem. So, why are the final investors not putting restrictions on that? They’re not the famous widows and orphans. These should be sophisticated players.

James Grant: Speaking myself as a non-sophisticate, I really can’t explain that, Luigi. I would suspect that many sophisticated people have had their heads turned by the promise of 10 percent and 11 percent and 12 percent interest in a time of a 4.3 percent 10-year Treasury yield. That might be one answer.

Bethany: If you were an advocate for private credit, you might say, look at our track record over the past decade. Defaults have been incredibly low. What would the counter to that be?

James Grant: Well, the past decade has been a splendid time for not having defaults. The market wouldn’t allow you to default, almost. And, furthermore, the market, the private-credit business, is almost designed to avoid explicit defaults. It is organized so that if the borrower finds it difficult to make cash interest payments, why, there is an option to defer cash interest and to add the unpaid interest to the principal outstanding, what is owed.

Some of the advocates of private credit are quick to say: “Look at these tiny default rates. No bank can match what we have demonstrated.” I think the record is not quite what it seems because defaults aren’t measured the same in private credit as they are in the public kind.

If you skip an interest payment, or if you renegotiate the terms of the deal in a private market, you’re likely to find that the rating agencies judge that to be a default. The scorekeeping in private credit is, should we say, less rigorous or more forgiving, depending on how you want to phrase that.

When you compare defaults, private credit versus the public kind or private credit versus junk bonds, it’s not the same. I think that when the cycle ends, and we are through a complete experience of overdoing it and then underdoing that, at the end of that full experience, we will see the default rates are more or less comparable on both sides.

Luigi: But I see this description as actually a positive description of the private-credit market because, at the end of the day, they’re substituting for bank loans. They’re not substituting for bonds. And one of the characteristics of banks that we always advertise is the ability to renegotiate in case of default because default can be very expensive from an efficiency point of view. A lot of opportunities are lost in the default.

Having the ability to renegotiate with the right incentives to renegotiate, I don’t see this as a cost. I see that as a benefit, particularly because we move out the banks from taking a certain amount of risk because it can be destabilizing to the system if the banks have large losses, but if insurance companies or pension funds have some losses for a while, that is not the end of the world.

It seems to me that from an efficiency allocation of risk, it is a good arrangement. There is some expertise involved in renegotiating defaults. I don’t see what the problem is, really.

James Grant: Well, I think the problem—insofar there’s a problem—I think it might be one in packaging and perception. If a salesman from a private-equity firm were to approach a prospective investor and say, “We have generated a default rate, a tiny percentage of that acknowledged by leveraged lenders as, say, the banking system or by junk-bond underwriters,” wouldn’t you think that would be a suitable investment for your pension fund or your life insurance company? What we are talking about here is a form of volatility masking. It’s in the packaging rather than the substance of the quality of the underwriting or the substance of the ultimate investor experience: total returns.

I think what the private-credit people are likely to say when confronted with the claim that they, in fact, are masking the true credit experience in their businesses, I think they would say: “We underwrite to hold for the full length of the term of the loan, for one thing. For another thing, we are not leveraged 10-to-1 as a conservative banking operation is. We are leveraged a little over 1-to-1. We scarcely have any leverage at all. So, we take greater care and due diligence. We have a more rigorous set of legal documents attached to the loan, and altogether, we are better stewards of your capital”—they would say—"than are the storied bankers who are regulated from here to there and beyond.” That’s the pitch.

Bethany: One of the people at your conference said this: “I can assure you that there is a tsunami of terrible, terrible businesses and assets that need to be rationalized.” And so, speaking of this volatility masking, if that’s true, how does this intersect with this tsunami that might be coming at us, and is that experience different in private credit than it is in other forms of lending?

James Grant: That was Dan Zwirn, who manages a salvage, or distressed, fund. He has his eye on the possibilities of making investments in broken balance sheets at much lower valuations than are on offer today.

Dan has it in mind that we have lived through an everything bubble that was created through the suppression of interest rates over the course of about a dozen years, and that the present risen interest rates—that is to say, not zero, but 5 percent plus, plus, plus—these rates are stressing debt-servicing capacities of innumerable businesses that structured their finances on the prospect of ever-lower, negligible interest rates during the money-grows-on-trees era.

And he says that there’s a comeuppance, and that comeuppance is going to take the shape of a credit crisis, and companies that thought they were perfectly financed for an era of zero-percent rates will find that they are disaster-prone. Indeed, they are disaster-bound in an era of normalized interest rates.

Capitalisn’t is a theme of this show. I think we ought to spend a moment on how the socialization of credit risk, which is, I think, the abiding original sin of contemporary finance in America, how this plays out in the private-equity realm. When I say the socialization of credit risk, I mean the too-big-to-fail doctrine. I mean the reliance of people on the proven record of the federal authorities to intervene and forestall credit liquidations, to cut short bear markets, to make things right, to pull the chestnuts of the speculative portion of the community out of the fire that, indeed, was perhaps lit by a Federal Reserve match.

That, to me, is the backdrop for one objection to private credit. And that is what drives private credit: the almost-unspoken assumption, but certainly the prevalent one, that come a time of trial, the private-credit people, who are outside the safety net of the banking world now, of course they will be drawn into it, as were Goldman Sachs, Morgan Stanley, and so forth, in 2008, ’09 and ’10.

We have had 40 years of conditioned belief in the inevitable intervention of the federal authorities to cut short liquidations. To wind up this elongated sermonette of mine, I think this is one of the underpinnings of the private-credit business. That’s what capitalism isn’t, so far as private credit is concerned.

Luigi: But, Jim, I’m very sympathetic about the risk of the safety net being misused to save X, Y, and Z. But honestly, I see this risk minimized with private credit because the reason why people were forced to intervene with the reserve fund, or they felt they were forced to, is because there was a run.

As my colleague Doug Diamond keeps saying, every crisis is ultimately a crisis of short-term debt. The appealing feature of private credit is that they don’t finance themselves with short-term liabilities. They do finance themselves with long-term commitments. And so, I don’t see a run on private credit, and without a run, honestly, I don’t see the risk—now, there’s always a risk—I don’t see the likelihood of being forced to intervene.

James Grant: Oh, there’s always a risk, as you say, as you acknowledged. I would dissent a little from the contention that every single crisis is a result of a mismatch of maturity structures or the existence of short-term debt. You can have a big problem with long-dated assets, and we will know more after the next crisis. But don’t forget, this structure is untested through a cycle, and because it is untested through a cycle, we have no way of asserting that it will survive a cycle.

Luigi: Sure. But with this attitude, we can never try anything new because it’s untested. But what I’m saying is we had plenty of major losses. Think about the dot-com bubble. The losses were large, but it was not a financial crisis. Nobody got bailed out. Why? Because nobody was financed with short-term liabilities.

As long as there is enough absorbent capacity, people absorb the losses. Maybe the insurance companies might be an issue if this is large enough, but I don’t necessarily see this as a crisis that would lead the government to intervene.

James Grant: Well, I mean, I think it depends on what you mean by intervening. The dot-com bubble was not the kind of crisis that led to a collapse of the fractional-reserve banking system. But notice what happened in the aftermath. To pick up the pieces of the stock market in 2001, 2002, what did the Fed do? It cut the Fed funds rate, explicitly with the intention of helping the housing market.

It kept cutting it. It got to zero, from 3 percent to essentially zero. And, lo and behold, 2007, ’08 and ’09 materialized as a result of the distortions wrought through suppressed interest rates. So, I would say that the Fed and the FDIC, the Treasury Department, the federal overseers of our financial affairs, are forever intervening, and the accumulation of these interventions introduces mispricings, distortions, that ultimately result in yet additional interventions. And that’s why capitalism isn’t.

Bethany: I would come at this in a slightly different way—and tell me if you think this makes sense—which is that maybe private credit, in its most basic form, could be as low-risk as Luigi says. But the finance sector never leaves things in their original form, and you’re already seeing all these, let’s call them innovations, around private credit, such as the use of CLOs.

I wanted to read a line from a recent Federal Reserve paper that said this: “First, banks are increasingly partnering with private-credit funds to fund new deals. Second, banks are progressively selling complex debt instruments to private fund managers in so-called synthetic-risk transfers in order to reduce regulatory-capital charges on the loans they make. Such instruments have limited transparency and pose hidden risks to the financial system.”

And so, even if private credit in its most basic form might be very benign, the financial system never leaves anything in its most basic form because there are so many ways to make money by making it more innovative. Is that where part of the risk might come from?

James Grant: Yes. Every good idea on Wall Street is finally driven into the ground like a tomato stake. This is from “The History of Business Cycles,” a Harvard Business School essay in 1933. “The history of business cycles shows this stage of prosperity in general is marked by an ever-increasing inefficiency. So, in the field of security investment, the buying public reach for yield and investment bankers under stress of competition issue securities of higher yield, greater risk, and poorer quality."

We’re seeing this competition now between banks on the one hand and private-credit lenders on the other. The problem, when it develops—and I’m sure there will be a problem—may not be among the private-credit people. It may be among the bankers who were competing with the private-credit people to snag deals that they would not have been able to do, had they stuck to their own standards of underwriting.

Let’s not forget, the purpose of private credit is to facilitate leveraged structures. Eighty-three percent or so of the loans go to facilitate LBO promotions. One question is, can these companies afford to pay the freight? A lot of the lending was done in 2021, 2022, when money still grew on trees, and they borrowed at zero plus 3 or 4, and now they’re paying at 5 plus 5, or 10 or 12 percent.

There is all manner of possibilities how this can go wrong, and the people who bear the losses might not necessarily be the better private-credit lenders. They might be somebody else entirely.

I think the fundamental risk lies not necessarily in the structure of private credit, but rather in the consequences of the suppression of interest rates, the distortions there from over the course of a dozen years of misallocated capital. Whether the people who finally have to testify before the inevitable Senate committee are the stewards of the private-credit funds or whether they’re somebody else, we can’t know. We’ll know more in 10 years, 20 years.

Luigi: But, Jim, I’m sympathetic to your view that low interest rates for a long time created a lot of problems, but I think that you cannot blame them on private credit. Given that we had long-term low rates, would you have this risk allocated to banks or to private credit? Private credit, any time of day.

I’m sympathetic to what Bethany says that you need to be careful that doesn’t spill over to banks. That’s what the Fed should do. But otherwise, private credit, for example, responded much better to the rise in interest rates. We’ve seen a bunch of banks go belly up, and we have not seen any private credit go belly up. I think that, overall, private credit over banks any time of day.

James Grant: Private credit is not leveraged. Banks are leveraged 10-to-1. I think we’re coming around to where we started. The record of private credit is distorted by the definition of what constitutes a default in an impairment. They amend and extend the terms of the loan. They add the unpaid interest in a so-called payment in kind to the principal owed.

These are postponements of the final terms and reckoning of the transaction. Now, the idea of extending, the idea of redefining, the idea of amending, all this has its basis, I think, again, in the unspoken view that today’s interest rates are abnormally high, and that we are in for a return to so-called normal rates of about 2 percent in the 10-year Treasury and commensurate decline in private risk rates.

But what if this is a bond bear market? What if rates are not going to go down but only go up? Private credit is exposed to the world of leveraged buyouts and so-called private equity, and what’s to say there couldn’t be a systemic problem in private credit?

Luigi: But I feel that our conversation is mixing two levels. It’s mixing the investment perspective from the public-policy perspective. One question is whether this is a good investment. The other question is whether we should be worried, from an aggregate perspective, whether this is a good thing for capitalism in general or not.

I might be sympathetic with your concern on the first front. Should I advise people to invest in private credit? No. From the perspective of capitalism and the overall system, I don’t care if people have some losses. Capitalism without losses is not capitalism. Some people will get burned because they make stupid choices. That’s what capitalism is about. And I’m not too worried that this will happen, as long as these losses don’t have devastating consequences to the system, or they force bailouts, et cetera, et cetera. And with the provision, will they lead to a decrease in interest rates? Maybe.

But I think that, of all the systems we have today, it is probably the least because if they will be in the hands of banks, we’ll have a bailout tomorrow, and we’ll have a decrease in interest rates and a bailout. Private credit seems to me a very good capitalist choice that returns the responsibility to individuals, and it gives an element of freedom, because let’s say that the Fed has put a lot of restrictions on what banks can lend to. Now, we’re not exactly in an administrative credit situation, but we are going in that direction, in which the Fed decides, you can invest in this; you cannot invest in that.

Having an alternative, to me, is very valuable, not only from an economic point of view but also from a freedom point of view.

James Grant: Yeah, nobody is saying, Luigi, that there should be no losses, quite the contrary. The trouble, I think, one of the troubles with present-day finance is that the Fed is afraid of losses. It lives in terror of this thing it chooses to call deflation. Ben Bernanke was especially, I think, culpable on this point.

Yes, we want people to innovate in finance. We want them not only to take risk but to bear risk. And the trouble with capitalisn’t is that the people who take it don’t bear it.

Luigi: Bethany, what did you learn from Jim?

Bethany: I thought some of his points were really interesting, including the idea—which I hadn’t really thought of—that part of the risk of private credit is that it creates a race to the bottom within the banking industry. As everybody fights to make the same loans, the natural inclination in competition is to make the terms of the loans weaker and weaker. That was a risk of this that, while not strictly a risk of private credit, was one that I hadn’t really thought about. What about you?

Luigi: I think that he’s a curmudgeon, by and large, in the sense that I think he’s smart, and he pointed out some real issues, like the one you pointed out.

But I think that his view of the world is a pre-1930s view of the world. He would like to go back to a world where deposits are at risk, back to a gold standard, a world of extreme financial instability because historical evidence suggests that that was a world of extreme financial instability.

In the name of that principle, he’s willing to say that nothing else works, and I think his nihilism is heading straight to a centralization of the credit function because if, at the same time, you don’t think that individual agents, including pension funds, insurance companies, are capable of making their allocation decisions and taking responsibility for their allocation decisions, then I think we should go to a soviet allocation of credit because that’s what capital markets are about.

Bethany: Well, that’s a depressing conclusion, and I do see what you mean. I do think that Grant’s view is very intellectually honest and consistent. In other words, I can’t call him on inconsistency within it, but I’m not sure that in our modern society after . . . what is it? How many years ago was the Federal Reserve created? Over a century of, effectively, the system that we’ve had now, even though the FDIC was obviously created later, but I don’t know that we can go back to something . . . to an unstable banking system or to a banking system that doesn’t have the involvement of the federal government.

Luigi: Yeah, I recognize that he is consistent and consistently wrong, by and large. I think that you might have idealized, or he might have idealized, that system. I think that system was not working well at all. I think the idea of providing some safety to ordinary people, so they don’t have to worry about whether their deposit might disappear the next day, is a good idea.

The question is how to do it in a way that minimizes what we economists call moral hazard. And most people say that people can abuse the system, and no system is perfect, but I think he’s going too far in search for perfection.

Now, he might be right. The Fed, with its loose monetary policy, has dampened incentives and created complacency. I think that that’s absolutely correct, but I see private credit as, by and large, a movement in the right direction that doesn’t solve all the problems, but at least the movement is in the right direction. I think that he was unwilling to recognize even this movement. He said that anything is doomed to fail.

Bethany: Well, I think we’re almost discussing three different things here. One is the ideal way for an economy to provide credit and the ideal structure of a banking system. And on that, I’m actually not sure. I probably need to put some more thought into what I think is workable and what I don’t think is workable.

I think we were also discussing the Fed in the last couple of decades and whether the Fed is truly an independent entity, and I am more on Grant’s side in that, for sure. I heard Jay Powell speak at Stanford recently, and he made a big deal about how independent the Fed was, and it came right on the heels of the Fed not signing on to this climate-change push that the European Central Bank is.

And I thought, but is the Fed independent if the Fed is the servant of the market, and every time the market freaks out, the Fed has to get involved in order to stop asset prices from crashing? I worry about what the Fed has created with the market’s dependence on it, and I think it’s a big issue going forward.

Then, the third thing, which I think is part of the other two issues but also a little bit different, is whether private credit, in and of itself, is a good or a bad thing. On this, I think you and I disagree, and I hope that this isn’t just my reflexive cynicism toward private equity.

If private credit were a pure thing on its own, I would agree with you wholeheartedly. It’s not that I care how much money capitalists are making on it. That’s not my problem.

My issue with it is that I think it does leak back into the regulated banking system. One, because everything, every form of lending that’s supposed to be outside of the banking system, just like subprime lending in the run-up to the financial crisis, inevitably finds its way back into the regulated banking system.

There were already these quotes in the Federal Reserve paper about the ways in which banks are increasingly partnering with private-credit funds. And so, I think if there is a collapse, we’re going to find out that, somehow, the regulated banking system is bearing a lot of this risk, or at least some of this risk.

I think the other part that bothers me is that private-equity funds and providers of private credit will absolutely ask for a bailout. They won’t say: “Oh, we’re outside the regulated banking system. We’re supposed to be outside the safety net. Let’s just bear our losses.”

We saw that in the financial crisis, when private-equity funds were first in line for CARES Act money, saying . . . They didn’t say, “We’re supposed to be outside of” . . . And you can argue the pandemic was different, but they didn’t say, “We’re supposed to be outside of any government handout.”

They said: “Look at all the Americans we employ. Look at our investors. They’re all pensioners and pension funds. You can’t let this fall apart.”

That’s exactly what they’ll do if private credit runs into trouble. They’ll say, “But all of our investors, it’s all pension funds. You guys can’t let this collapse. You need to come to our rescue.”

And so, what bothers me is that they’re freeloaders because they’re not paying for any of that on the front end. You can argue whether the banking system is paying the appropriate price for its bailout on the back end through deposit insurance and through regulation, but private credit is paying nothing. They’re paying no fees, they’re not being regulated, and they absolutely will ask for a bailout. And that bugs . . . The freeloader aspect of it really bugs me.

Luigi: I think we are absolutely in agreement on the Fed. In fact, the thing you might not know because it’s economics lingo, but when economists talk about the Fed being independent, automatically they say independent from political power. Of course, the more independent from political power, the more dependent you are on economic power. You spotted exactly the weakness of the current Fed. Paradoxically, you would like to have the Fed be a bit more political and a little bit less market friendly.

But let’s go to private credit, and I think, here, our disagreement is legitimate. I see your argument very well. First of all, I want to be very clear that I am worried about two things in private credit. Number one, the opacity, and number two, the conflict of interest. The fact that Blackstone is at the same time managing private credit and private equity, and some of these funds in private credit finance deals in private equity, becomes a little bit problematic to me.

I am 100 percent with you that private credit will ask for a bailout. The question is whether it will receive the bailout. Anybody can ask. The question is whether they have enough political and economic leverage to get this benefit.

I recently had this idea that I’m trying to spread that whenever the Secretary of the Treasury and the Fed invoke the extraordinary circumstances that allow for the systemic exception that allows them to bail out some group of people, they should lose their jobs because at the end of the day, if you have an unexpected systemic problem, who is responsible, if not the chairman of the Fed, who is supposed to regulate the system?

So, yes, everybody can make mistakes. He can admit, or she can admit, that there is a systemic problem, but the person responsible for that systemic problem should lose their job. I think that that would be a sorting condition that makes it a little bit less likely that a lot of people will receive a bailout.

But most seriously, I see the risk of a bailout reduced precisely because with private credit . . . in the sense that what makes the threat point very dramatic is this idea of a run that spreads fast and can be devastating. There is no risk of a run here.

Private-credit funds will suffer some losses in a downturn, but I don’t see them as very different from the losses that private-equity funds got. Last time I checked, and I might be wrong here, private-equity funds did not ask for any bailout during the downturn.

Now, are they trying to lobby to get some favors? Absolutely. But as long as we have some debt in the economy, I prefer that debt be held by private-debt funds rather than by banks or by other institutions that are more subject to a run, and as a result, have a stronger threat point to ask for a bailout.

Bethany: I remember sitting with the head of a big private-equity firm, and he was the first one who explained to me that private-credit funding is essentially matched. Investors are committing their money to the fund for a long period of time, and the loans are made for a long period of time.

I thought, oh, huh, I guess I have to rethink my innate cynicism that this is all some sort of horrible scam because maybe on that level . . . It does make sense. You’re right. And I understand that. I just think, inevitably, somehow, however private credit finds its way into the regulated banking system, it will cause a problem for the regulated banking system that will have to be fixed by government intervention, and the government intervention that fixes it will also fix it for the private-credit people. It won’t matter that private-credit players will have made billions of dollars in fees along the way and become multi-billionaires.

They won’t be asked to give any of that back. They’re benefiting from the largesse of the system, and they’re not paying for it upfront. I still think . . . I hear you. Maybe, somehow, that won’t happen. Maybe there won’t be a major problem in this area.

One thing I would point at to say there will be a major problem is just the incredibly fast growth of private credit, as we talked about a little bit with Jim. There’s almost nothing, no form of debt in the history of banking, that has grown at a really, really, really rapid clip—exponential, as the Fed put it—that has not contained problems. You can’t make that many loans that are safe in that short period of time.

I worry about that, and I think, as you just touched on, I could get to your optimism about private credit if there were more disclosure, and there is some sort of unholy nexus between private-equity funds already.

So many private-equity deals . . . I’ve heard different numbers. I heard one that was 75 percent in 2021, which I can’t believe . . . but of private-equity buyouts are from one firm to another. It’s within the private-equity complex as a whole.

Then you have, on top of that, it being funded by private-credit funds that are run by the private-equity people, and it’s as if it’s this whole world is disassociated from economic reality. I suppose you could say, Bethany, the stock market can be disassociated from economic reality, too, and I hear that, but there’s just something about the potential for nefarious actions in that, or self-dealing, that I find problematic, especially because nobody, not even the Federal Reserve, can see into it.

I’d feel better if there were more transparency, and the problem with more transparency is that has to come either voluntarily or with more regulation, and the private-credit people say, but we’re private credit, we don’t need to be regulated.

Luigi: To the extent they are investing a lot of pension money, there is a very strong case to make that they should be transparent because at the end of the day, my concern, if I have one, is more on the pension-fund side, that if we have a major shortfall in pensions at the end . . . Especially when we have defined-benefit plans, at the end of the day, we taxpayers are on the hook. We need to have some sense that these people are not making crazy bets.

Bethany: I agree with you wholeheartedly on that, and there was an estimate in that Fed paper we’ve been talking about that public and private pension funds hold about 31 percent of aggregate private-credit-fund assets. In other words, the underlying investors in private credit, a big chunk of them, are just us. That raises the question that you pointed out that, if this gigantic asset isn’t being marked correctly or if there are problems, somebody’s going to have to come to its rescue because it’s pension funds.

It also raises this theoretical or intellectual question for me that you and I have discussed with respect to private equity, too. Why does it get to be private? What’s private about that? If the underlying investors behind the big pension-fund mask are just us, why is that different than the stock market? Why is this private and that’s public? It’s not. It’s all the same people.

At this size, at the size that private equity is and the size that private credit is, in my view, it no longer gets to be private. It just doesn’t. That, I think, is one of my major disagreements with it.

Luigi: Maybe we should have an episode about the entire framework of regulation because this year is going to be the 90th anniversary of the 1934 Securities Exchange Act. It is one of the major pillars of that system and a system conceived in a world that was incredibly different than the world today, because at the time, one of the main reasons to have this regulation was to protect the famous widows and orphans who were not capable of investing in the stock market.

First of all, thanks to increased life expectancy, we have many fewer widows and orphans, but more importantly, much of the investment is not made by individuals directly anymore. It is made through intermediary funds. And so, some of the reasons for regulation that were very compelling in 1934 are not there anymore.

On the other side, there are different reasons, like, for example, the systemic reason that there weren’t a lot of defined-benefit pension funds back in the day. That was not a major issue. Today, it is a major issue, and the entire issue of disclosure should be rethought from the ground up because the world is different. The reason why we want disclosure is different, and the justifications that people are giving or the excuses they’re providing, I think, are not up to standards, in my view.

Bethany: On a more prosaic, less intellectual note from what you just said, everyone understands the fiction that the managers of large pension funds, at least for the most part, are sophisticated investors. That’s the rubric under which this whole thing exists, that it’s sophisticated investors, so they understand the risk they’re taking, and that’s why it gets to be private, but they don’t. They’re just the patsies for the private-equity industry. They’re not sophisticated, and everybody gets the joke, except reality doesn’t get the joke because that’s still the way it works. It still gets to be private.

I would advocate also for just more honesty of the way things actually work in our system, rather than hiding behind these shells that everybody knows aren’t what they’re purported to be.

Luigi: Yeah, but if you push that line enough, then you go straight to where I think Jim Grant was, which is, you shouldn’t have private allocation of credit or even of equity. Why do we have private pensions? Why don’t we have government-organized pensions? Because if you think that all this allocation is just done by patsies who don’t know what they’re doing, it’s a very wasteful activity because it costs a lot of money and doesn’t provide any good. And so, why don’t we just get rid of it completely and have a pay-as-you-go system where you don’t have a big financial system on the side, but you save a tremendous amount of money?

Bethany: I was not going there. Jim might. I don’t know. I was not going there at all. My argument is much more limited, which is that if public-market investors are supposed to be, and people who sell things to public markets are supposed to be, subject to a certain standard of disclosure, then the “private market” should be subject to at least close to the same standard of disclosure because the line between the two is not what it’s cracked up to be. If the underlying investors are the same, then the disclosure requirements should be the same. I’m not going for anything broader than that. That’s it.

Luigi: I completely agree with you on that. I thought you said that, even with that disclosure, you don’t trust people to be sophisticated and to make decent decisions.

Bethany: But if there’s disclosure, then people like me can come along and see exactly what’s going on and write about it, or maybe not see exactly what’s going on but see enough of what’s going on to be able to enforce some kind of standards. As a journalist, you can’t get, unless somebody gives . . . Unless an LP gives them to you, you can’t get a private-equity firm’s letters to its investors, to its fund investors. You can’t get access to the private-credit markets to see what price deals are being done at and who knew each other and how the deal is being structured. You can’t get access to any of that. It’s completely in the shadows. Even the Fed can’t get access to it. And so, it’s just a disclosure issue to me.

Luigi: OK. On that, we agree 100 percent.

Bethany: Yay.

Luigi: So, you don’t mind private credit as long as it’s not opaque.

Bethany: Yes, exactly. But let me read you two things in the notes I took for this essay, and they’re disjointed, but they give me pause, along with the exponential growth in private credit.

Here’s one from the Fed report: “Banks are progressively selling complex debt instruments to private-fund managers in so-called synthetic-risk transfers in order to reduce regulatory-capital charges on the loans they make. Such instruments have limited transparency and propose hidden risks to the financial system.”

That’s one of the ways the Fed says that private credit could leak back into the regulated banking system. I don’t even know what they’re talking about. I don’t think most people know what they’re talking about. I hope the Fed knows what they’re talking about, but that’s just one example of some of the things that can be happening in the shadows.

And then, here’s one from Jim Grant’s newsletter: “It’s old news to constant readers that, in the best of circumstances, little more than half of a large sample of private-credit borrowers, a collection assembled and analyzed by S&P Global, would generate positive free cash flow in a base-case scenario.”

I can promise you that if half of a regulated bank’s loans weren’t generating free cash flow, the regulators would be on that because they could see it, right?

I suppose you could say in response to that second one, well, that’s their problem. Again, maybe it isn’t, but if the standards under which credit is being extended in private credit are a little looser than what would be done with full transparency, sure, fine. If it’s way more lax than what would be done with full transparency, I don’t think that’s fine, especially because, as we’ve talked about, somebody is making money on it elsewhere.

If a private-credit fund is extending very, very sketchy financing to finance a private-equity deal, but a private-equity firm, maybe run by the same company, maybe run by friends at a different PE shop, is doing the deal and making huge fees on it, then somebody is making money on some part of the transaction in a way that they don’t have to care that the loan that’s being extended is very sketchy. And if nobody else gets to see how sketchy the loans are, again, problem.

Luigi: Yeah. But on the second point, I think that that quote is a little bit misleading because we know that in some renegotiations, these funds accept payment in kind, which is not cash flow, but it’s something in between an interest payment and an equity investment. If you trust these investors to be sophisticated, this is in lieu of a default that could be very disruptive.

With the provision of your full disclosure, et cetera, I don’t necessarily see a problem there. I do see a problem on the first quote where the banks are dumping this complicated stuff because that smells like regulatory arbitrage, but honestly, banks are regulated. The Fed could ask for disclosure, so the Fed should ask for disclosure. There is no justification for the Fed to simply say, “Oh, they have this complicated stuff.” They should be on top of it. If they’re not, that’s their problem. Actually, eventually, it’s ours.

Bethany: Well, it’s not their problem. It’s actually all of our problem if they’re not. But both your points are valid. Both of those things that I listed are also windows and ways for people who care to see inside what’s going on this industry. I think our agreement is probably more important than our disagreement because I see your points. I want more disclosure, more transparency.

Luigi: I agree with that.

Bethany: More things to write about, Luigi.

Luigi: What?

Bethany: More things to write about.

Luigi: To write a newspaper article for you and research for me, that’s the reason why we’re in favor of disclosure.

Bethany: Exactly.

Luigi: We disclose our conflict of interest in disclosure.

Bethany: Yes, exactly. Our conflict of interest in disclosure. And, in my case, I don’t know, maybe I shouldn’t be advocating for more disclosure, since I seem to have based most of my career in writing about scandals. If there’s more disclosure, then there might not be a scandal. Maybe I should be rooting for a gigantic blowup, and private credit will be my next book.

Luigi: Don’t be afraid. There will always be scandals.

Bethany: Yeah, I know. I think that is true, fortunately and unfortunately.