November 11, 2024 • 34 mins
Over the last roughly 15 years, we've seen a migration of certain types of risks outside of regulated deposit-taking banks. Private credit has boomed, shifting lending activity away from the banks. Multi-strategy hedge funds have scooped up a lot of the proprietary trading activity that was banned under the Volcker Rule. On paper, this looks good. It seems like various risks have been removed to less systemic institutions. But does the risk find its way back in? What happens when these outside entities still rely on banks for leverage? On this episode of the podcast, we speak with Steven Kelly, the Associate Director of Research at the Yale Program on Financial Stability. We talk about where risks might lie and how regulators can stay atop of them.
Read More:
Era of Private Credit Returns Beating Private Equity Is Nearing an End
Hedge Fund Basis Trade Faces Scrutiny as Regulators Mull Probe
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Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:02):
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:19):
Hello and welcome to another episode of the Odd Lots podcast.
Speaker 3 (00:22):
I'm Joe Wisenthal and I'm Tracy Allaway.
Speaker 2 (00:25):
Tracy, you know, we do all these episodes about private
credit and obviously hedge funds, multi strategy hedge funds in
particular lately, and of course it all sort of seems
to be part of a bigger story of a bunch
of things that used to happen inside banks no longer
happening inside banks.
Speaker 3 (00:40):
Right, And this has been like a continual process ever
since like the two thousand and eight financial crisis, but
even before that we had like big periods of bank disintermediation,
which we talked about recently on that episode with Hugh
van steinas.
Speaker 2 (00:55):
Totally, there's a lot going on and not all of
these trends date back to the final victual crisis, but
you know, this was obviously kind of an express goal.
I think of the Dobb Frank regulations and just from
my seed sitting here, like, yeah, it seems pretty good.
Bunch of risky stuff like multi strategy hedge funds, et cetera,
seems kind of risky. You can lose a lot of money.
(01:16):
In theory, lending to random middle market companies seems like
you could lose a lot of money. It's like, yeah,
it seems pretty good that it's not happening inside the banks,
and maybe that's good that it's not connected directly to
deposit taking institutions.
Speaker 3 (01:28):
Yeah, And I think given the increases we've seen in
rates over the past couple of years, the fact that
like nothing really broke or exploded in the private credit
market seems like a good sign. But again, it's still
relatively small and it is growing very rapidly, so I
think there are more questions to be asking about this
particular space.
Speaker 2 (01:49):
Well, you brought up something recently on an episode of
Synthetic Risk Transfers where banks sort of offload some of
their credit risk onto third party entities, And that's really
stuck in my head, which is, you know, Okay, so
these third party entities take the risk of the assets
from the banks, but then that's an asset that can
be levered up. And where do you get leveraged, presumably
(02:11):
from a bank, And so I have this like.
Speaker 3 (02:13):
Sort of very circular, isn't it.
Speaker 2 (02:15):
Yeah, And I just have this nagging thing in my
head somewhere it's like, okay, yeah, great, we moved it
all off the banks. There's okay, we're not going to
have another two thousand and eight. But what if the way,
what if in some way it still goes back to
the banks. Yea, and the risk still is there and
it just sort of takes the loop out and then comes.
Speaker 3 (02:32):
It goes into prime brokerage instead of the balance sheet.
Speaker 2 (02:35):
That's a good way to put it. And so like
I'm still like, I'm like, eh, things pretty good, but
maybe maybe there are still some reasons to be concerned.
Can you ever? I guess maybe we could title this
episode like, can you ever really de risk the banking system?
Speaker 4 (02:48):
Oh?
Speaker 3 (02:49):
That's a good one, let's use that.
Speaker 2 (02:50):
Okay, Well, I am really excited. We have the perfect
guest on today's show, someone we've had on the podcast
before and someone we've known and talked to for a
long time. We're going to be speaking with Stephen Kelly,
Associate director of Research at the Yale Program on Financial Stability. So, Steven,
thank you so much for coming back on a lots.
Speaker 4 (03:08):
Great to be back.
Speaker 5 (03:08):
You know, sometimes you guys say literally the perfect guest,
and so I'm old for too on that I've only
gotten perfect guests.
Speaker 3 (03:14):
But well, you coming, we have people who complain about
when we forget to say the perfect guest, but you've
kicked it up to another level and are complaining about
not saying, oh, literally the perfect guest. This is a
new era.
Speaker 2 (03:28):
I do not think that the word perfect does not
actually need any adjectives, right, because either it's perfect or
it's not. It's sort of like the word when people
that call something very unique. It's like either it's unique,
one of a kinder, it's not. So I wouldn't take
that too uh, I would agree with you. I wouldn't
take that too literally.
Speaker 5 (03:43):
I would agree with you if you followed your own Okay, okay,
that's fair enough.
Speaker 2 (03:48):
Stephen Kelly, literally the perfect guest made that correction. I
just should I be like I said, Oh, everything seems fine.
But are the reasons to think and we're going to
get into specific so this is an incredibly broad question,
but just conceptually, are there reasons to think about how
these risks that migrate off of bank balance sheets find
(04:09):
a way to migrate back onto them.
Speaker 5 (04:11):
It's totally valid. I mean, this is part of the
story of two thousand and eight right as there was
this whole shadow banking sector and it looked like risk
had moved, and really it hadn't. The banks brought everything back,
first voluntarily and then involuntarily. So you're asking the exact
right questions. The IMF is now asking these questions and
citing odd lots. I don't know if you saw the
(04:32):
recent Global financi Stability report citing Tracy on exactly this issue.
You talked about the synthetic risk transfers in your intro
and this idea of like, okay, but are the banks
really funding it? I would say, you know, to the
extent we're running risk through another balance sheet. I mean,
the banks really are more protected even if they are
(04:52):
lending to a firm that's taking credit risk, because they
do have that firm's capital and they have that firm's
you know, alleged skill at managing these risks. And so
part of the issue with all the financial crisis stuff
was a lot of it was unfunded. We can get
into synthetic risk transfers, and you had that great episode
about how they're different and they're funded, but broadly, Joe, yes,
you're asking.
Speaker 4 (05:12):
The right questions.
Speaker 3 (05:13):
Wait, okay, I have a very basic question, but what
is actually happening in the financial system when someone puts
money into private credit. So say I'm an investor and
I'm going to invest I don't know, a million dollars
in some private credit fund. What happens to that million dollars?
Speaker 5 (05:32):
Well, first, Tracy, you're probably taking the million dollars from
an allocation towards junk bonds investment grade credit. So that's
step one. I mean, the idea of like private credit
is taking all these loans from banks or is eating
the bank's lunch. We can put a pin in that
for now, and we should come back to that. So
usually that's what's happening, is this is an allocation away
(05:54):
from whether it's other alternatives or other corporate credit. But
the reality is this is deposits move around the banking system.
There's no like people talk about private credit like its
deposits leaving the banking system or it's you know, deposits
are going to non banks. But there is no shadow
bank without a bank. Apollo has bank accounts, Blackstone has
bank accounts. When you transfer money into them, they put
(06:16):
it in their account and then it's lent on to
whomever is receiving the credit, and so you're changing the
nature of the aggregate deposit franchise to the extent deposits
are moving to a different kind of actor. But deposits
can't leave the banking system.
Speaker 2 (06:31):
So we just take it a little step further. Just
to be clear, Okay, I sell some junk bonds. I
decided to allocate a million dollars to an Apollo private
credit fund. They lend the money. Is Apollo further leveraging
that lending up to juice returns or how leveraged are
these funds?
Speaker 5 (06:48):
So what we're seeing is that they're increasingly so it's
pretty scarce so far. And that was part of the pitch, right,
is like Apollo came along in twenty twenty two when
private credit was booming and said, hey, why mean you
guys thought of this? We have like one times leverage,
two times leverage. That's generally sort of the space that's in.
But as we've sort of seen the market mature and
(07:08):
the market grow, like, there's a good reason to lever
these things up. If you're doing effectively bank credit, which
sometimes they are, there's a reason banks are ten times
levered like that that's the way the funding of the
system works, and that provides a whole host of other
benefits to the system. But there's also a cap on
how much unlevered equity is out there. If you think
(07:30):
about what the financial system exists to do, it's to
create as many financial goods for us. What we need deposits,
you know, other kinds of savings on as little equity
as possible. Equity is the scarce resource and it's the
input to the financial systems manufacturing process. And so you
cannot recreate ten x, twelve x, fifteen x leverage from
(07:52):
the banking system on one two x leverage in private credit.
And that's the limit, you know, to your fear, Joe,
that's the limit of how big this thing can grow.
And we're sort of seeing that a little bit is
the bigger private credit grows relative.
Speaker 4 (08:07):
To the economy.
Speaker 5 (08:08):
They're sort of nearing the kink on the funding curve
as far as like what amount of funding is willing
to be locked up as long term assets. Like the
fundamental idea that like on demand par deposits can become
locked up five year equity and a private credit fund
is not real.
Speaker 3 (08:25):
Haven't we seen some private credit funds start to look
at structures where investors can take their money out as well,
like instead of having the five year lockup periods, people
can go in and out as they need.
Speaker 5 (08:37):
Definitely, I mean, the long arc of financial history bends
towards banks, and we've sort of seen private credit start
to look more like banks. In One of the ways
is these sort of interval funds or evergreen funds they're called.
And basically these are just different types of structures that
allow some amount of liquidity in the short term. And
(08:57):
this is very very marginal steps. It's gated, it's limited,
but you know it's gated after a certain percentage. It's
limited by quarter, there's a certain time interval in which
you can get it. It's not deposits yet, but that's
one of the ways which funds have started to bend
towards a banking model in addition to leverage.
Speaker 2 (09:13):
By the way, just speaking of the history of finance,
is that entities try to make illiquid things a little
bit more banked. Like there was a really interesting paper
that came out recently from Tim Barker and Chris Hughes
about the Penn Central bailout and in there, there was
some talk about the history of CDs specifically and how
there at one point there was this really hard lockup
(09:35):
on them, but then entity has found ways to sort
of you could liquidate and sell your right to that CD.
So they always find a way to create liquidity out
of illiquidity.
Speaker 5 (09:44):
Yeah, you can tronch anything with cash flows. To paraphrase
reportentnerial on Meet the Parents, I mean, you can get
anything out of that.
Speaker 3 (09:51):
Speaking of traanging, I wanted to ask one more basic question,
which is this term retranching of risk in the financial
system has come up a number of times. So Hugh
Vansteinas used it in a recent episode. I'm pretty sure
you've used it as well in your writing. Exactly what
risk is being retranched here? Like, give us an idea
(10:12):
of what types of things end up in private credit.
I imagine a lot of it is sort of middle
market stuff, stuff that, to your point earlier would have
been in the junk bond market or the leverage loan
market and is now going elsewhere.
Speaker 4 (10:24):
Yeah, that's exactly right.
Speaker 5 (10:25):
And so I mean I got this term from the GFC,
the global financial crisis literature. I believe it originated with
Gary Gordon Andrew metric and they used it to describe
increasing haircuts in two thousand and eight. So the idea
that you know, you have a triple A asset, you
were haircutting at one percent, but now the market to
resell that collateral is worse. You're more worried about your counterparty,
(10:48):
and so you're going to haircut it thirty percent. You've
sort of retransh what you've decided is triple A, and
a lot of that was driven by market perception of
risk as well as increased market demands from our capital.
What we're seeing in the banking system is a little
bit of market demands and a little bit of regulatory demand.
So obviously BASL three, you know, is looming next to
(11:08):
the maturity wall, and it's sort of saying banks may
have to have more capital. The other thing is investors
depositors are looking for a little more liquidity in banks
than they were pre twenty twenty three. And frankly, interest
rate risk at a certain point becomes credit risk, and
so when rates go to five percent, banks aren't really
(11:31):
like trying to be in the business of managing all
the credit risk at five percent that they were avoiding
at zero percent, and so getting out of that left
tail and sort of retranching by selling things out of
the banking system is sort of the aim. So it's
all those three things at once, and it makes sense
for banks to lean then on prime brokerage and lending
the senior layers of these funds.
Speaker 3 (11:52):
Wait, this reminds me of something else I wanted to ask,
which is I hear a lot about comparative advantages when
it comes to private credit versus banks, in the sense
that private credit might be better at managing certain loans
to your point about higher interest rates? Is that true?
And like, what if that comparative advantage actually look like
(12:12):
Does it just mean the analysts that private credit firms
are like pouring over the paperwork more than a bank.
Speaker 5 (12:17):
Can I think that's right? And I know Joe has
rude the failure of the high touch banks in twenty
twenty three. You know that banks that care about their
customers are the ones that failed. But what that misses
is that community banks didn't fail, and those do the
same thing, and those don't have the attention of the market.
And that's sort of kind of part of the pitch
(12:38):
of private credit as well. Is like, you know, we're
operating under less transparency. Again, we're seeing give on that
as they've sort of been towards banks. But in theory,
this is just a product and they do have some ability.
It's a smaller group, sometimes as small as one to
work with the lenders. We've seen lower default rates out
of private credit versus their competitors and in leverage zones,
(13:00):
but higher losses given to fault So you can multiply
those two things together and come up with some lesser
loss and in that case, you know, it makes sense
to be allocated a private credit.
Speaker 2 (13:27):
You know, what I realized a little earlier in the
conversation is that I actually don't know the difference in
what the shadow banks the quote shadow banks were doing
prior to two thousand and eight, and how their relationship
with real banks was different than the current relationship. I mean,
it's interesting because I remember, you know, one of the
things that was going on, I think summer two thousand
(13:49):
and seven or summer two thousand and eight, it was
like a couple bear Sterns hedge funds, like just hedge
funds that seemed like a really big deal, like seemed
to be systemically important I think City had something maybe
do what was the nature of those quote shadow banks
and how they actually connected to the regulated banks.
Speaker 5 (14:06):
So the short version is that the nature of those
is big banks with strong balance sheets like Bear Stearns
and City put their name all over those shadow banks,
but didn't actually have They weren't funding them themselves, they
weren't actually on the balance sheet of the banks. So
when pressure came in two thousand and seven and nobody
knew this was going to be like a repeat of
(14:27):
the Great Depression, City took all that stuff back on
its balance sheet to protect its reputation. Bear took one
of those hedge funds on back onto its balance sheet.
These banks did not have to take on this risk.
But they're going, Okay, we're going to stand behind our name.
We're going to stand behind our clients who thought they
were buying a Bear Stearns or a City Group product.
And maybe that's a risk today. I don't know, you know, Yeah,
(14:48):
well I was just going.
Speaker 2 (14:49):
To ask because you see these headlines right now now
like JP Morgan is going to get into private credit
and so forth, and so I get the idea that
this is going to be be a separate funding vehicle
be like off balance kind of sounds similar.
Speaker 5 (15:02):
Yeah, I think that's totally a risk. Is there a
world where, you know, Citygroup has to bail out its
Apollo partnership because they put Citygroup's name all over it?
Speaker 3 (15:11):
Maybe maybe Wait, that JP Morgan mentioned just reminded me
of something. But a few years ago, well actually more
than a few years ago, maybe in like twenty fourteen
or something like that, I remember JP Morgan basically complaining
that the prime brokerage business was a lot harder nowadays,
and like the margins were slimmer and stuff like that.
(15:32):
I think that's what they said. And yeah, fast forward
to twenty twenty four and it seems like prime brokerage
is a moneymaker for the big banks at least what
happened there.
Speaker 5 (15:43):
So part of it might just be the growth of
private credit. I mean, it has found a niche. I
would think about it like a product, you know, Like
I said, it's got this middle market like you alluded to,
it's sort of got a different model and there's no
reason that shouldn't exist along the spectrum of bank deposits
to thirty year locked up funding to fund buried treasure
(16:06):
expedition like it exists in that spectrum, which is kind
of an academic answer, but it's true. I mean Mark Rohan,
CEO of a POLLA recently had a comedy, said, you know,
we'll get competed with like crazy, and then what's the
difference between public and private? And I think that's right.
It arose as a product in the years. I mean
it doubled between twenty twenty and twenty twenty three. We
can talk about why, but now they have banking needs.
(16:28):
Like I said, there's no shadow bank without a bank,
and they have banking needs and hedge funds too.
Speaker 2 (16:32):
So my takeaway so far from this conversation is that
some of the questions were asked. Is not that there's
like some big looming risk out there or like oh,
this is a disaster waiting to happen. But mostly these
are all like reasonable questions to be asking about where
at some point risks could merge, or at least where
regulators maybe want to think or try to get ahead
of things. What tools or specific lines of inquiry have
(16:56):
we seen from regulators or things regulators could do, or
like we want to monitor this and I know that's
already you've written about this, But what are the specific
mechanisms and questions and things they could do.
Speaker 5 (17:07):
I mean, basically, so far, what we've seen is they've
just been really annoying to banks. That's a cost, right.
If you talk about why the economics of private credit
makes sense, some of it is that, Okay, the market
demands a lot less capital for certain risks than banking regulators,
and there's some supervision attached to those capital regulations too,
(17:28):
and so to the extent you're making supervision, you know,
just more costly. It's annoying and banks say whatever, you know,
like JPM Yeah, they're doing ten billion of private credit
on balance sheet. That's like they just found that in
the couch cushions and they're doing it. They put out
a press release so they can serve their clients. And
this goes back to kind of what we're talking about
Elier about what the differences between banks and private credit.
(17:50):
Banks being more about managing a deposit franchise, private credit
being more the lending side. But really we've seen from
the Bank of England, from the ECB, from the f
say in Japan, from the FED, they're all starting to
just probe banks about their exposure. They're lending to private
credit funds and prime brokerage. Frankly, but that's step one.
I mean, you hear regulators talk either one we need
(18:12):
more authority to regulate the non banking sector like banks,
or two. You know, the conservative side is, let's be
nicer with Basel three, so you don't push all this
stuff into private credit. The truth is always somewhere in
the middle. Right now, supervisors have just become more annoyed.
Speaker 3 (18:30):
That's a good way of putting it. Wait, I have
a bunch of questions. Okay, One, have you noticed any
like substantial differences in supervisory approaches, Like is the BOE
doing something different to the FED versus the BOJ I
know you said they're all in info collection mode at
the moment, but like there must be some differences.
Speaker 5 (18:50):
So generally this stuff goes better in foreign countries than
it does in the US, particularly the Bank of England.
They have like a system wide stress test now where
they simulate shocks in theory through like the whole financial system.
They're big on macro prudential stuff over there in the US,
like the fact that the f SoC, the Financial Stability
(19:12):
Oversight Council hasn't designated black Rock or its kin as
systemically important under a Biden administration, It'll never happen. And
I'm not saying they should have. I mean the idea
is like they're not doing banking, they have no short
term liabilities.
Speaker 4 (19:26):
Blah blah blah.
Speaker 5 (19:28):
But it just doesn't get that same reception abroad. So
there's more, you know. I think it'll lean harder in
Europe and elsewhere, but for right now, the US is
just kind of like poking at it in the stress
tests and in data collection.
Speaker 2 (19:40):
By the way, you mentioned that, like one of the
binding constraints in the financial system is how much money
is just willing to be locked away on a permanent basis.
This is really, though, where the role of insurers comes in,
because this is money that people put into a pod
and they theoretically expect to get all of it back
maybe at some point over the course of a lifetime,
it's cetera. But that really is a great source of
(20:02):
cash for long term money. Can you talk a little
bit more about like how big that is?
Speaker 5 (20:08):
Yeah, it's huge and growing. I think you're exactly right.
That is sort of a sticky source of funds and
if you hear Apollo talk about there a fine insurance,
it sounds like it's basically unlimited. I mean, they'll say,
like our limit of new private credit is finding good
things to invest in, not the source of funds. And
so we may see a bifurcation across the system of
(20:30):
like do you have an ensure attached to yourself? I mean,
this again goes back to sticky funny. Can you get
bank leverage? Do you have an insure attached to yourself?
I mean the other thing about insurance is that it
still is a savings vehicle, and so there still is
a limit. You know, annuities aren't on demand.
Speaker 2 (20:46):
But they always and they tried to like layer in
stuff so that it looks more and more like an
investment right right for time, and looks more and more
like a mutual fund or something like that. And exactly
so even there the other question, so we're talking about
the distribution of risk across various entities, what about And
I kind of think this might be a core question
from an investor perspective. I guess, the distribution of profitability
(21:08):
and when you look at the profits that come out
of prime brokerge units at banks, how do those stack
up compared to the profits of traditional banking, And is
there a risk that making risky loans setting aside the
risk part is a profitable business And does that ultimately
impair over time how much money what we call banks
(21:28):
can make good question?
Speaker 4 (21:30):
I think not.
Speaker 5 (21:30):
And it goes back to the limit of funding in
private credit. Okay, Like take COVID for example, in the
two weeks after the pandemic really hit in March twenty twenty,
banks increased their business loans by twenty five percent half
a trillion dollars two weeks. They didn't go to market
and issue equity, They didn't go find investors. They are
(21:52):
able to create a posits. That a key stroke, and
that's always going to be the advantage of banks. And so,
like I said, private credit, we're seeing them sort of
get closer and closer to this kink on their funding
curve where all of a sudden, the long term wealth
lock up sources are scarcer, and frankly, we're seeing this
a little bit. Fundraising is falling in private credit, and
(22:13):
we're seeing more institutional investors say like, we're at our
alternatives allocation and now it's all the big push is
retail and again talk about looking more like a bank.
Like that was one of private credit's original promises to
us as well. It's like, oh, this is different, this
is just safe like institutional investors. Now everyone's after the
retail money. How can we make a retail vehicle, How
(22:34):
can we tap individuals etf.
Speaker 3 (22:37):
They are moving into ETFs, which again is another good
example of like putting a liquid wrapper on a bunch
of illiquid assets.
Speaker 4 (22:43):
Right.
Speaker 5 (22:44):
That was the other thing is, oh, private credit doesn't
mark to market once you have an ETF, And we've
seen a bunch of banks and non banks start to
build out their secondary trading desks for private credit. I
mean it goes back to what Marc own said, eventually,
what's the difference between public and private?
Speaker 3 (22:59):
Just to go back to something you touched on earlier,
do you get the sense that regulatory attitudes towards private
credit and banks and the relationship there are starting to
change in the sense that, you know, Joe and I
have talked a lot about how in the aftermath of
the two thousand and eight financial crisis there were deliberate
efforts to shift risk into the shadow banking system. Does
(23:23):
it feel like maybe there's some like change in the vibes,
the regulatory vibes now.
Speaker 4 (23:30):
Not yet.
Speaker 5 (23:31):
I think regulators are looking for sure, it's a matter
of do they find something. I mean, you talked about
this on the episode with Huge Tracy. How when you
ask a private credit investor, you say like, oh, you know,
are you guys eating the bank's lunch now? And they
sort of wax and wane and they say, well, it's
an ecosystem and we're partners, you know, And then they
go in the bathroom. Let's scream in the mirror at
(23:53):
how embarrassing that is. Like it goes back to them
needing the banks for one and two. I think everyone's
sort of happy with the status quo. The question is
the direction of travel, and that's where.
Speaker 4 (24:04):
The risks are.
Speaker 2 (24:05):
I'm just really fascinated by this idea of like the
kink and the funding curve for private credit, because I'm
trying to reconcile that with this idea that at least
from Apollo via all the money that they have for
their insurance vehicle, it sounds like there's still plenty of
money and that they don't need to go out to retail,
that they don't need to make etf that they just
have to find more good deals to employ all of
(24:26):
the premiums they're collecting from insurance.
Speaker 5 (24:28):
Yeah, I think, like I said, we may see some
kind of bifurcation. I mean there's a question about how
popular annuities remain and if rates go lower and all
that stuff, and I don't have a view on that. Yeah,
what we see from other private credit lenders is they're
chasing retail money now because institutional investors are full on
private equity, which isn't given them their money back. You know,
they have hedge fund allocations, they have venture capital allocations,
(24:51):
and they say, hey, we're full on alternatives now. Insurance
is definitely a space where more money can come and
more diversification because it is so sticky and long term.
But there's a limit to that, and it may be
that to the partners go the spoils furnitures.
Speaker 2 (25:06):
Tracy, I don't understand why doesn't every investing firm Heaven Insurance.
I mean, this is like Brookshire Hathaway, right, they just
collect all those premiums and they have all this money
that they can invest. It seems like such a big
advantage to Heaven Insurance and I know various hedge funds
they have their reinsurance thing is kind of similar. It
seems like such a huge advantage, Like you.
Speaker 3 (25:22):
Should suggest it, Jack, we should have a make a
sales pitch a deck.
Speaker 2 (25:26):
Like why would you be an investor without an insurance company?
I don't really get it.
Speaker 3 (25:29):
The one thing I was thinking about, though, is just
going back to this lack of deals point. It kind
of feels like if you can't put your money in
good deals, like if you can't get a big enough
volume of those deals, then the temptation is presumably to
try to eke out more returns from the ones you
do get and apply of leverage. And that's again like
(25:49):
where some of the risks could come from. That's not
a question, that's just a point I will continue on.
Speaker 5 (25:55):
Is that correct?
Speaker 3 (25:57):
One thing I wanted to ask is you're obviously folks
on the financial stability aspect of all of this, but
I feel like there's been some macro impact from private
credit as well. And if you think about, you know,
financial stability is tied very much to fundamental economics, and
if the economy is good, then probably you're not going
(26:17):
to see a bunch of banks blowing up and that
sort of thing. But what are you watching in terms
of like the real world impact of private credit.
Speaker 5 (26:26):
So there's absolutely a risk. It's almost a trope now
to say, like this stuff has not seen a downturn.
Private credit has not seen a downturn, and I don't
know what's going to happen to it in a downturn either.
So sorry, that's a terrible answer, But there obviously is
like a credit crisis type of risk to this, in
the same way there is for leverage lending, which you
know has held up well in the past. That's maybe,
you know, a good analogy. I think part of this
(26:49):
talk about stability. Private credit was really there to offset
the bank's hung loans problem in twenty twenty two, so
rates go from zero to five. Banks are sitting on
a ton on billions of dollars of hung loans, most
famously Twitter, and they're in the news again talk about
the benefits of being private Like everybody knew Morgan Stanley
(27:09):
had that Twitter a loan, like, so private credit was
really there to take a lot of deals and they
did a lot of refinancings in twenty twenty three. That
problem is sort of worked through on the bank side,
and now we're seeing the banks come back, and we're
seeing private credit do payment and kind modifications, do extend
and pretend type things. So the sort of longer part
of higher for longer, you know, it's like it goes
(27:31):
back to what I said about interest rate risk becoming
credit risk. We're sort of seeing that in private credit.
So in that sense, like it's nice that we have
these two side by side systems that can sort of
cushion each other, but as we've seen there increasingly becoming one.
Speaker 2 (27:45):
I have one last question. It has nothing to do
actually with private credit, but I figure you're here and
I think you might have some thoughts on this topic.
We did an episode probably about two months or so
ago about stable client and we saw recently Stripe made
a one point one billion dollar acquisition of a stable
coin companies. There are some I think issues related to
(28:08):
financial stability related to stable coins, because anytime you have
an asset or a product that's pegged one to one
against the dollar, we all, you know, we can talk
about money markets all the time, but actually have like
a separate question than financial stability related to stable coins.
Do you, as a researcher in how the financial system works.
(28:28):
Take them seriously as something that will be important for
payments in the financial system going forward.
Speaker 5 (28:35):
I'm going to hit you with another trope, which is
that I think the tech is good, the product is not.
I think this is another area where the big banks
will win. I mean, it'll be it'll be a stable
coin technology, but like now we don't actually experience ACCH
versus you know, fed wire versus whatever else. It'll be
that it's the right technology, But the ultimate question is
(28:58):
payment in what? And you don't want the answer of
that question to be USDC, like you want it to
be a deposit that.
Speaker 2 (29:05):
I mean, I guess. My thing is, like, you know,
I actually buy kind of the argument from the stable
coin advocates that like it solves a lot of problems
with tech interoperability, that it could never you will never
get a sort of blockchain type solution from all the
big banks working together because of you know, lack of
trust or whatever it else. Like I buy that, but
(29:27):
I guess, like I guess to your point, specifically, I
don't know how big ultimately that demand will be, especially
since you put it away from most payments in most
of the world, these things are pretty abstracted away. I
would I don't know most I don't want to like
jump to conclusions because I know there are underdeveloped banking systems,
but for much of the world, for much of the
(29:48):
wealthy world, a lot of these problems are completely seem
abstracted away.
Speaker 5 (29:52):
The other challenge is to go find a bunch of
safe assets to invest in. You know, if you're replacing
trillions of dollars of payments, you have to go find
a bunch of safe facets. And that's why we run
this through banks, because they don't have to find safe acets.
They can back to positive.
Speaker 2 (30:04):
Yeah, Stephen Kelly, thank you so much for coming on AVAS.
Speaker 4 (30:08):
That was great.
Speaker 2 (30:08):
You answered a bunch of questions. I think that, least
in my head had been lingering for a long time.
Speaker 4 (30:13):
Thanks guys.
Speaker 2 (30:27):
Steven is so good. He's so clear.
Speaker 3 (30:29):
Yes he is. It's always good to catch up with him.
I mean, I do think like the circular nature of
the leverage is obviously a concern. Again, like we're talking
about relatively small volumes right now, but it feels like
it could become problematic at some point.
Speaker 2 (30:46):
It's interesting. I kind of forget when I think about
two thousand and eight and two thousand and nine, how
much of those first like tremors, I guess of the crisis.
We're literally you know, non banks. And I think you know,
people ever talk about those bear Sterns hedge funds that
blew up. Yeah, that was the start, but that was
like really kind of I mean, there was the quant quake,
(31:07):
what was that late two thousand and six, and that
was sort of freaked the market out a little bit,
But then it was really like those bear Sterns hedge funds,
and then you know, you mentioned the city line and
just this idea that they had these banks, they had
these off balance sheet vehicles, probably for many of the
reasons that you know, the same reasons that shadow banks
or private credit or multi strategy hedge funds exist today,
(31:28):
less capital intensive vehicles, and then they felt the need
to bring them on maybe for reputational reasons. I think
that's like a really interesting history that gets forgotten about.
Speaker 3 (31:37):
No, you're absolutely right, and money market funds as well.
When they broke the book. You know, the other thing
I was thinking about was just this idea of again
liquid wrappers on ill liquid assets and I kind of
think like the ultimate expression of shadow banking has to
be someone putting an etf rapper like private credit.
Speaker 2 (31:57):
It's so perfect. They always find a way to do that.
They always find we're going to get the ill liquidity premium,
and then we're going to still give you the liquidity.
I think one of the most important points that Steven makes,
and I've heard him make it before, is just this
idea that the key scarcity in the financial system is
cash that's willing to be locked up, right, cash that's
(32:19):
willing to not be sold in an instant or in
a demand deposit. And so there is therefore then this
natural constraint on how much, say a private credit firm
could take away from the banking system, because in the end, banks,
as we know, as you mentioned, are very levered. How
do you recreate that leverage? How do you satisfy the
financing demands of the real economy given this constraint and
(32:43):
locked up capital. I think it's just a really important
concept to keep in mind.
Speaker 3 (32:47):
Yeah, all right, well, shall we leave it there.
Speaker 2 (32:49):
Let's leave it there.
Speaker 3 (32:50):
This has been another episode of the All Blots podcast.
I'm Tracy Alloway. You can follow me at Tracy Alloway and.
Speaker 2 (32:56):
I'm Jill Wisenthal. You can follow me at the Stalwart Fellows,
Stephen Kelly at Stephen Kelly forty nine, follow our producers
Carmen Rodriguez at Carman Arman, Dashel Bennett at Dashbot and
Kell Brooks at Keilbrooks. Thank you to our producer Moses ONEm.
More odd lags content go to Bloomberg dot com slash
odd lotche We have transcripts, a blog, and a new
daily newsletter and you can chat about all of these
(33:18):
topics twenty four to seven in our discord Discord dot
gg slash od.
Speaker 3 (33:23):
Logs And if you enjoy all blots, if you like
it when we ask questions about private credit, then please
leave us a positive review on your favorite podcast platform.
And remember, if you are a Bloomberg subscriber, you can
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(33:44):
need to do is go to Apple Podcasts and find
the Bloomberg channel there and follow the instructions. Thanks for
listening
Speaker 4 (34:08):
In
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:19):
Hello and welcome to another episode of the Odd Lots podcast.
Speaker 3 (00:22):
I'm Joe Wisenthal and I'm Tracy Allaway.
Speaker 2 (00:25):
Tracy, you know, we do all these episodes about private
credit and obviously hedge funds, multi strategy hedge funds in
particular lately, and of course it all sort of seems
to be part of a bigger story of a bunch
of things that used to happen inside banks no longer
happening inside banks.
Speaker 3 (00:40):
Right, And this has been like a continual process ever
since like the two thousand and eight financial crisis, but
even before that we had like big periods of bank disintermediation,
which we talked about recently on that episode with Hugh
van steinas.
Speaker 2 (00:55):
Totally, there's a lot going on and not all of
these trends date back to the final victual crisis, but
you know, this was obviously kind of an express goal.
I think of the Dobb Frank regulations and just from
my seed sitting here, like, yeah, it seems pretty good.
Bunch of risky stuff like multi strategy hedge funds, et cetera,
seems kind of risky. You can lose a lot of money.
(01:16):
In theory, lending to random middle market companies seems like
you could lose a lot of money. It's like, yeah,
it seems pretty good that it's not happening inside the banks,
and maybe that's good that it's not connected directly to
deposit taking institutions.
Speaker 3 (01:28):
Yeah, And I think given the increases we've seen in
rates over the past couple of years, the fact that
like nothing really broke or exploded in the private credit
market seems like a good sign. But again, it's still
relatively small and it is growing very rapidly, so I
think there are more questions to be asking about this
particular space.
Speaker 2 (01:49):
Well, you brought up something recently on an episode of
Synthetic Risk Transfers where banks sort of offload some of
their credit risk onto third party entities, And that's really
stuck in my head, which is, you know, Okay, so
these third party entities take the risk of the assets
from the banks, but then that's an asset that can
be levered up. And where do you get leveraged, presumably
(02:11):
from a bank, And so I have this like.
Speaker 3 (02:13):
Sort of very circular, isn't it.
Speaker 2 (02:15):
Yeah, And I just have this nagging thing in my
head somewhere it's like, okay, yeah, great, we moved it
all off the banks. There's okay, we're not going to
have another two thousand and eight. But what if the way,
what if in some way it still goes back to
the banks. Yea, and the risk still is there and
it just sort of takes the loop out and then comes.
Speaker 3 (02:32):
It goes into prime brokerage instead of the balance sheet.
Speaker 2 (02:35):
That's a good way to put it. And so like
I'm still like, I'm like, eh, things pretty good, but
maybe maybe there are still some reasons to be concerned.
Can you ever? I guess maybe we could title this
episode like, can you ever really de risk the banking system?
Speaker 4 (02:48):
Oh?
Speaker 3 (02:49):
That's a good one, let's use that.
Speaker 2 (02:50):
Okay, Well, I am really excited. We have the perfect
guest on today's show, someone we've had on the podcast
before and someone we've known and talked to for a
long time. We're going to be speaking with Stephen Kelly,
Associate director of Research at the Yale Program on Financial Stability. So, Steven,
thank you so much for coming back on a lots.
Speaker 4 (03:08):
Great to be back.
Speaker 5 (03:08):
You know, sometimes you guys say literally the perfect guest,
and so I'm old for too on that I've only
gotten perfect guests.
Speaker 3 (03:14):
But well, you coming, we have people who complain about
when we forget to say the perfect guest, but you've
kicked it up to another level and are complaining about
not saying, oh, literally the perfect guest. This is a
new era.
Speaker 2 (03:28):
I do not think that the word perfect does not
actually need any adjectives, right, because either it's perfect or
it's not. It's sort of like the word when people
that call something very unique. It's like either it's unique,
one of a kinder, it's not. So I wouldn't take
that too uh, I would agree with you. I wouldn't
take that too literally.
Speaker 5 (03:43):
I would agree with you if you followed your own Okay, okay,
that's fair enough.
Speaker 2 (03:48):
Stephen Kelly, literally the perfect guest made that correction. I
just should I be like I said, Oh, everything seems fine.
But are the reasons to think and we're going to
get into specific so this is an incredibly broad question,
but just conceptually, are there reasons to think about how
these risks that migrate off of bank balance sheets find
(04:09):
a way to migrate back onto them.
Speaker 5 (04:11):
It's totally valid. I mean, this is part of the
story of two thousand and eight right as there was
this whole shadow banking sector and it looked like risk
had moved, and really it hadn't. The banks brought everything back,
first voluntarily and then involuntarily. So you're asking the exact
right questions. The IMF is now asking these questions and
citing odd lots. I don't know if you saw the
(04:32):
recent Global financi Stability report citing Tracy on exactly this issue.
You talked about the synthetic risk transfers in your intro
and this idea of like, okay, but are the banks
really funding it? I would say, you know, to the
extent we're running risk through another balance sheet. I mean,
the banks really are more protected even if they are
(04:52):
lending to a firm that's taking credit risk, because they
do have that firm's capital and they have that firm's
you know, alleged skill at managing these risks. And so
part of the issue with all the financial crisis stuff
was a lot of it was unfunded. We can get
into synthetic risk transfers, and you had that great episode
about how they're different and they're funded, but broadly, Joe, yes,
you're asking.
Speaker 4 (05:12):
The right questions.
Speaker 3 (05:13):
Wait, okay, I have a very basic question, but what
is actually happening in the financial system when someone puts
money into private credit. So say I'm an investor and
I'm going to invest I don't know, a million dollars
in some private credit fund. What happens to that million dollars?
Speaker 5 (05:32):
Well, first, Tracy, you're probably taking the million dollars from
an allocation towards junk bonds investment grade credit. So that's
step one. I mean, the idea of like private credit
is taking all these loans from banks or is eating
the bank's lunch. We can put a pin in that
for now, and we should come back to that. So
usually that's what's happening, is this is an allocation away
(05:54):
from whether it's other alternatives or other corporate credit. But
the reality is this is deposits move around the banking system.
There's no like people talk about private credit like its
deposits leaving the banking system or it's you know, deposits
are going to non banks. But there is no shadow
bank without a bank. Apollo has bank accounts, Blackstone has
bank accounts. When you transfer money into them, they put
(06:16):
it in their account and then it's lent on to
whomever is receiving the credit, and so you're changing the
nature of the aggregate deposit franchise to the extent deposits
are moving to a different kind of actor. But deposits
can't leave the banking system.
Speaker 2 (06:31):
So we just take it a little step further. Just
to be clear, Okay, I sell some junk bonds. I
decided to allocate a million dollars to an Apollo private
credit fund. They lend the money. Is Apollo further leveraging
that lending up to juice returns or how leveraged are
these funds?
Speaker 5 (06:48):
So what we're seeing is that they're increasingly so it's
pretty scarce so far. And that was part of the pitch, right,
is like Apollo came along in twenty twenty two when
private credit was booming and said, hey, why mean you
guys thought of this? We have like one times leverage,
two times leverage. That's generally sort of the space that's in.
But as we've sort of seen the market mature and
(07:08):
the market grow, like, there's a good reason to lever
these things up. If you're doing effectively bank credit, which
sometimes they are, there's a reason banks are ten times
levered like that that's the way the funding of the
system works, and that provides a whole host of other
benefits to the system. But there's also a cap on
how much unlevered equity is out there. If you think
(07:30):
about what the financial system exists to do, it's to
create as many financial goods for us. What we need deposits,
you know, other kinds of savings on as little equity
as possible. Equity is the scarce resource and it's the
input to the financial systems manufacturing process. And so you
cannot recreate ten x, twelve x, fifteen x leverage from
(07:52):
the banking system on one two x leverage in private credit.
And that's the limit, you know, to your fear, Joe,
that's the limit of how big this thing can grow.
And we're sort of seeing that a little bit is
the bigger private credit grows relative.
Speaker 4 (08:07):
To the economy.
Speaker 5 (08:08):
They're sort of nearing the kink on the funding curve
as far as like what amount of funding is willing
to be locked up as long term assets. Like the
fundamental idea that like on demand par deposits can become
locked up five year equity and a private credit fund
is not real.
Speaker 3 (08:25):
Haven't we seen some private credit funds start to look
at structures where investors can take their money out as well,
like instead of having the five year lockup periods, people
can go in and out as they need.
Speaker 5 (08:37):
Definitely, I mean, the long arc of financial history bends
towards banks, and we've sort of seen private credit start
to look more like banks. In One of the ways
is these sort of interval funds or evergreen funds they're called.
And basically these are just different types of structures that
allow some amount of liquidity in the short term. And
(08:57):
this is very very marginal steps. It's gated, it's limited,
but you know it's gated after a certain percentage. It's
limited by quarter, there's a certain time interval in which
you can get it. It's not deposits yet, but that's
one of the ways which funds have started to bend
towards a banking model in addition to leverage.
Speaker 2 (09:13):
By the way, just speaking of the history of finance,
is that entities try to make illiquid things a little
bit more banked. Like there was a really interesting paper
that came out recently from Tim Barker and Chris Hughes
about the Penn Central bailout and in there, there was
some talk about the history of CDs specifically and how
there at one point there was this really hard lockup
(09:35):
on them, but then entity has found ways to sort
of you could liquidate and sell your right to that CD.
So they always find a way to create liquidity out
of illiquidity.
Speaker 5 (09:44):
Yeah, you can tronch anything with cash flows. To paraphrase
reportentnerial on Meet the Parents, I mean, you can get
anything out of that.
Speaker 3 (09:51):
Speaking of traanging, I wanted to ask one more basic question,
which is this term retranching of risk in the financial
system has come up a number of times. So Hugh
Vansteinas used it in a recent episode. I'm pretty sure
you've used it as well in your writing. Exactly what
risk is being retranched here? Like, give us an idea
(10:12):
of what types of things end up in private credit.
I imagine a lot of it is sort of middle
market stuff, stuff that, to your point earlier would have
been in the junk bond market or the leverage loan
market and is now going elsewhere.
Speaker 4 (10:24):
Yeah, that's exactly right.
Speaker 5 (10:25):
And so I mean I got this term from the GFC,
the global financial crisis literature. I believe it originated with
Gary Gordon Andrew metric and they used it to describe
increasing haircuts in two thousand and eight. So the idea
that you know, you have a triple A asset, you
were haircutting at one percent, but now the market to
resell that collateral is worse. You're more worried about your counterparty,
(10:48):
and so you're going to haircut it thirty percent. You've
sort of retransh what you've decided is triple A, and
a lot of that was driven by market perception of
risk as well as increased market demands from our capital.
What we're seeing in the banking system is a little
bit of market demands and a little bit of regulatory demand.
So obviously BASL three, you know, is looming next to
(11:08):
the maturity wall, and it's sort of saying banks may
have to have more capital. The other thing is investors
depositors are looking for a little more liquidity in banks
than they were pre twenty twenty three. And frankly, interest
rate risk at a certain point becomes credit risk, and
so when rates go to five percent, banks aren't really
(11:31):
like trying to be in the business of managing all
the credit risk at five percent that they were avoiding
at zero percent, and so getting out of that left
tail and sort of retranching by selling things out of
the banking system is sort of the aim. So it's
all those three things at once, and it makes sense
for banks to lean then on prime brokerage and lending
the senior layers of these funds.
Speaker 3 (11:52):
Wait, this reminds me of something else I wanted to ask,
which is I hear a lot about comparative advantages when
it comes to private credit versus banks, in the sense
that private credit might be better at managing certain loans
to your point about higher interest rates? Is that true?
And like, what if that comparative advantage actually look like
(12:12):
Does it just mean the analysts that private credit firms
are like pouring over the paperwork more than a bank.
Speaker 5 (12:17):
Can I think that's right? And I know Joe has
rude the failure of the high touch banks in twenty
twenty three. You know that banks that care about their
customers are the ones that failed. But what that misses
is that community banks didn't fail, and those do the
same thing, and those don't have the attention of the market.
And that's sort of kind of part of the pitch
(12:38):
of private credit as well. Is like, you know, we're
operating under less transparency. Again, we're seeing give on that
as they've sort of been towards banks. But in theory,
this is just a product and they do have some ability.
It's a smaller group, sometimes as small as one to
work with the lenders. We've seen lower default rates out
of private credit versus their competitors and in leverage zones,
(13:00):
but higher losses given to fault So you can multiply
those two things together and come up with some lesser
loss and in that case, you know, it makes sense
to be allocated a private credit.
Speaker 2 (13:27):
You know, what I realized a little earlier in the
conversation is that I actually don't know the difference in
what the shadow banks the quote shadow banks were doing
prior to two thousand and eight, and how their relationship
with real banks was different than the current relationship. I mean,
it's interesting because I remember, you know, one of the
things that was going on, I think summer two thousand
(13:49):
and seven or summer two thousand and eight, it was
like a couple bear Sterns hedge funds, like just hedge
funds that seemed like a really big deal, like seemed
to be systemically important I think City had something maybe
do what was the nature of those quote shadow banks
and how they actually connected to the regulated banks.
Speaker 5 (14:06):
So the short version is that the nature of those
is big banks with strong balance sheets like Bear Stearns
and City put their name all over those shadow banks,
but didn't actually have They weren't funding them themselves, they
weren't actually on the balance sheet of the banks. So
when pressure came in two thousand and seven and nobody
knew this was going to be like a repeat of
(14:27):
the Great Depression, City took all that stuff back on
its balance sheet to protect its reputation. Bear took one
of those hedge funds on back onto its balance sheet.
These banks did not have to take on this risk.
But they're going, Okay, we're going to stand behind our name.
We're going to stand behind our clients who thought they
were buying a Bear Stearns or a City Group product.
And maybe that's a risk today. I don't know, you know, Yeah,
(14:48):
well I was just going.
Speaker 2 (14:49):
To ask because you see these headlines right now now
like JP Morgan is going to get into private credit
and so forth, and so I get the idea that
this is going to be be a separate funding vehicle
be like off balance kind of sounds similar.
Speaker 5 (15:02):
Yeah, I think that's totally a risk. Is there a
world where, you know, Citygroup has to bail out its
Apollo partnership because they put Citygroup's name all over it?
Speaker 3 (15:11):
Maybe maybe Wait, that JP Morgan mentioned just reminded me
of something. But a few years ago, well actually more
than a few years ago, maybe in like twenty fourteen
or something like that, I remember JP Morgan basically complaining
that the prime brokerage business was a lot harder nowadays,
and like the margins were slimmer and stuff like that.
(15:32):
I think that's what they said. And yeah, fast forward
to twenty twenty four and it seems like prime brokerage
is a moneymaker for the big banks at least what
happened there.
Speaker 5 (15:43):
So part of it might just be the growth of
private credit. I mean, it has found a niche. I
would think about it like a product, you know, Like
I said, it's got this middle market like you alluded to,
it's sort of got a different model and there's no
reason that shouldn't exist along the spectrum of bank deposits
to thirty year locked up funding to fund buried treasure
(16:06):
expedition like it exists in that spectrum, which is kind
of an academic answer, but it's true. I mean Mark Rohan,
CEO of a POLLA recently had a comedy, said, you know,
we'll get competed with like crazy, and then what's the
difference between public and private? And I think that's right.
It arose as a product in the years. I mean
it doubled between twenty twenty and twenty twenty three. We
can talk about why, but now they have banking needs.
(16:28):
Like I said, there's no shadow bank without a bank,
and they have banking needs and hedge funds too.
Speaker 2 (16:32):
So my takeaway so far from this conversation is that
some of the questions were asked. Is not that there's
like some big looming risk out there or like oh,
this is a disaster waiting to happen. But mostly these
are all like reasonable questions to be asking about where
at some point risks could merge, or at least where
regulators maybe want to think or try to get ahead
of things. What tools or specific lines of inquiry have
(16:56):
we seen from regulators or things regulators could do, or
like we want to monitor this and I know that's
already you've written about this, But what are the specific
mechanisms and questions and things they could do.
Speaker 5 (17:07):
I mean, basically, so far, what we've seen is they've
just been really annoying to banks. That's a cost, right.
If you talk about why the economics of private credit
makes sense, some of it is that, Okay, the market
demands a lot less capital for certain risks than banking regulators,
and there's some supervision attached to those capital regulations too,
(17:28):
and so to the extent you're making supervision, you know,
just more costly. It's annoying and banks say whatever, you know,
like JPM Yeah, they're doing ten billion of private credit
on balance sheet. That's like they just found that in
the couch cushions and they're doing it. They put out
a press release so they can serve their clients. And
this goes back to kind of what we're talking about
Elier about what the differences between banks and private credit.
(17:50):
Banks being more about managing a deposit franchise, private credit
being more the lending side. But really we've seen from
the Bank of England, from the ECB, from the f
say in Japan, from the FED, they're all starting to
just probe banks about their exposure. They're lending to private
credit funds and prime brokerage. Frankly, but that's step one.
I mean, you hear regulators talk either one we need
(18:12):
more authority to regulate the non banking sector like banks,
or two. You know, the conservative side is, let's be
nicer with Basel three, so you don't push all this
stuff into private credit. The truth is always somewhere in
the middle. Right now, supervisors have just become more annoyed.
Speaker 3 (18:30):
That's a good way of putting it. Wait, I have
a bunch of questions. Okay, One, have you noticed any
like substantial differences in supervisory approaches, Like is the BOE
doing something different to the FED versus the BOJ I
know you said they're all in info collection mode at
the moment, but like there must be some differences.
Speaker 5 (18:50):
So generally this stuff goes better in foreign countries than
it does in the US, particularly the Bank of England.
They have like a system wide stress test now where
they simulate shocks in theory through like the whole financial system.
They're big on macro prudential stuff over there in the US,
like the fact that the f SoC, the Financial Stability
(19:12):
Oversight Council hasn't designated black Rock or its kin as
systemically important under a Biden administration, It'll never happen. And
I'm not saying they should have. I mean the idea
is like they're not doing banking, they have no short
term liabilities.
Speaker 4 (19:26):
Blah blah blah.
Speaker 5 (19:28):
But it just doesn't get that same reception abroad. So
there's more, you know. I think it'll lean harder in
Europe and elsewhere, but for right now, the US is
just kind of like poking at it in the stress
tests and in data collection.
Speaker 2 (19:40):
By the way, you mentioned that, like one of the
binding constraints in the financial system is how much money
is just willing to be locked away on a permanent basis.
This is really, though, where the role of insurers comes in,
because this is money that people put into a pod
and they theoretically expect to get all of it back
maybe at some point over the course of a lifetime,
it's cetera. But that really is a great source of
(20:02):
cash for long term money. Can you talk a little
bit more about like how big that is?
Speaker 5 (20:08):
Yeah, it's huge and growing. I think you're exactly right.
That is sort of a sticky source of funds and
if you hear Apollo talk about there a fine insurance,
it sounds like it's basically unlimited. I mean, they'll say,
like our limit of new private credit is finding good
things to invest in, not the source of funds. And
so we may see a bifurcation across the system of
(20:30):
like do you have an ensure attached to yourself? I mean,
this again goes back to sticky funny. Can you get
bank leverage? Do you have an insure attached to yourself?
I mean the other thing about insurance is that it
still is a savings vehicle, and so there still is
a limit. You know, annuities aren't on demand.
Speaker 2 (20:46):
But they always and they tried to like layer in
stuff so that it looks more and more like an
investment right right for time, and looks more and more
like a mutual fund or something like that. And exactly
so even there the other question, so we're talking about
the distribution of risk across various entities, what about And
I kind of think this might be a core question
from an investor perspective. I guess, the distribution of profitability
(21:08):
and when you look at the profits that come out
of prime brokerge units at banks, how do those stack
up compared to the profits of traditional banking, And is
there a risk that making risky loans setting aside the
risk part is a profitable business And does that ultimately
impair over time how much money what we call banks
(21:28):
can make good question?
Speaker 4 (21:30):
I think not.
Speaker 5 (21:30):
And it goes back to the limit of funding in
private credit. Okay, Like take COVID for example, in the
two weeks after the pandemic really hit in March twenty twenty,
banks increased their business loans by twenty five percent half
a trillion dollars two weeks. They didn't go to market
and issue equity, They didn't go find investors. They are
(21:52):
able to create a posits. That a key stroke, and
that's always going to be the advantage of banks. And so,
like I said, private credit, we're seeing them sort of
get closer and closer to this kink on their funding
curve where all of a sudden, the long term wealth
lock up sources are scarcer, and frankly, we're seeing this
a little bit. Fundraising is falling in private credit, and
(22:13):
we're seeing more institutional investors say like, we're at our
alternatives allocation and now it's all the big push is
retail and again talk about looking more like a bank.
Like that was one of private credit's original promises to
us as well. It's like, oh, this is different, this
is just safe like institutional investors. Now everyone's after the
retail money. How can we make a retail vehicle, How
(22:34):
can we tap individuals etf.
Speaker 3 (22:37):
They are moving into ETFs, which again is another good
example of like putting a liquid wrapper on a bunch
of illiquid assets.
Speaker 4 (22:43):
Right.
Speaker 5 (22:44):
That was the other thing is, oh, private credit doesn't
mark to market once you have an ETF, And we've
seen a bunch of banks and non banks start to
build out their secondary trading desks for private credit. I
mean it goes back to what Marc own said, eventually,
what's the difference between public and private?
Speaker 3 (22:59):
Just to go back to something you touched on earlier,
do you get the sense that regulatory attitudes towards private
credit and banks and the relationship there are starting to
change in the sense that, you know, Joe and I
have talked a lot about how in the aftermath of
the two thousand and eight financial crisis there were deliberate
efforts to shift risk into the shadow banking system. Does
(23:23):
it feel like maybe there's some like change in the vibes,
the regulatory vibes now.
Speaker 4 (23:30):
Not yet.
Speaker 5 (23:31):
I think regulators are looking for sure, it's a matter
of do they find something. I mean, you talked about
this on the episode with Huge Tracy. How when you
ask a private credit investor, you say like, oh, you know,
are you guys eating the bank's lunch now? And they
sort of wax and wane and they say, well, it's
an ecosystem and we're partners, you know, And then they
go in the bathroom. Let's scream in the mirror at
(23:53):
how embarrassing that is. Like it goes back to them
needing the banks for one and two. I think everyone's
sort of happy with the status quo. The question is
the direction of travel, and that's where.
Speaker 4 (24:04):
The risks are.
Speaker 2 (24:05):
I'm just really fascinated by this idea of like the
kink and the funding curve for private credit, because I'm
trying to reconcile that with this idea that at least
from Apollo via all the money that they have for
their insurance vehicle, it sounds like there's still plenty of
money and that they don't need to go out to retail,
that they don't need to make etf that they just
have to find more good deals to employ all of
(24:26):
the premiums they're collecting from insurance.
Speaker 5 (24:28):
Yeah, I think, like I said, we may see some
kind of bifurcation. I mean there's a question about how
popular annuities remain and if rates go lower and all
that stuff, and I don't have a view on that. Yeah,
what we see from other private credit lenders is they're
chasing retail money now because institutional investors are full on
private equity, which isn't given them their money back. You know,
they have hedge fund allocations, they have venture capital allocations,
(24:51):
and they say, hey, we're full on alternatives now. Insurance
is definitely a space where more money can come and
more diversification because it is so sticky and long term.
But there's a limit to that, and it may be
that to the partners go the spoils furnitures.
Speaker 2 (25:06):
Tracy, I don't understand why doesn't every investing firm Heaven Insurance.
I mean, this is like Brookshire Hathaway, right, they just
collect all those premiums and they have all this money
that they can invest. It seems like such a big
advantage to Heaven Insurance and I know various hedge funds
they have their reinsurance thing is kind of similar. It
seems like such a huge advantage, Like you.
Speaker 3 (25:22):
Should suggest it, Jack, we should have a make a
sales pitch a deck.
Speaker 2 (25:26):
Like why would you be an investor without an insurance company?
I don't really get it.
Speaker 3 (25:29):
The one thing I was thinking about, though, is just
going back to this lack of deals point. It kind
of feels like if you can't put your money in
good deals, like if you can't get a big enough
volume of those deals, then the temptation is presumably to
try to eke out more returns from the ones you
do get and apply of leverage. And that's again like
(25:49):
where some of the risks could come from. That's not
a question, that's just a point I will continue on.
Speaker 5 (25:55):
Is that correct?
Speaker 3 (25:57):
One thing I wanted to ask is you're obviously folks
on the financial stability aspect of all of this, but
I feel like there's been some macro impact from private
credit as well. And if you think about, you know,
financial stability is tied very much to fundamental economics, and
if the economy is good, then probably you're not going
(26:17):
to see a bunch of banks blowing up and that
sort of thing. But what are you watching in terms
of like the real world impact of private credit.
Speaker 5 (26:26):
So there's absolutely a risk. It's almost a trope now
to say, like this stuff has not seen a downturn.
Private credit has not seen a downturn, and I don't
know what's going to happen to it in a downturn either.
So sorry, that's a terrible answer, But there obviously is
like a credit crisis type of risk to this, in
the same way there is for leverage lending, which you
know has held up well in the past. That's maybe,
you know, a good analogy. I think part of this
(26:49):
talk about stability. Private credit was really there to offset
the bank's hung loans problem in twenty twenty two, so
rates go from zero to five. Banks are sitting on
a ton on billions of dollars of hung loans, most
famously Twitter, and they're in the news again talk about
the benefits of being private Like everybody knew Morgan Stanley
(27:09):
had that Twitter a loan, like, so private credit was
really there to take a lot of deals and they
did a lot of refinancings in twenty twenty three. That
problem is sort of worked through on the bank side,
and now we're seeing the banks come back, and we're
seeing private credit do payment and kind modifications, do extend
and pretend type things. So the sort of longer part
of higher for longer, you know, it's like it goes
(27:31):
back to what I said about interest rate risk becoming
credit risk. We're sort of seeing that in private credit.
So in that sense, like it's nice that we have
these two side by side systems that can sort of
cushion each other, but as we've seen there increasingly becoming one.
Speaker 2 (27:45):
I have one last question. It has nothing to do
actually with private credit, but I figure you're here and
I think you might have some thoughts on this topic.
We did an episode probably about two months or so
ago about stable client and we saw recently Stripe made
a one point one billion dollar acquisition of a stable
coin companies. There are some I think issues related to
(28:08):
financial stability related to stable coins, because anytime you have
an asset or a product that's pegged one to one
against the dollar, we all, you know, we can talk
about money markets all the time, but actually have like
a separate question than financial stability related to stable coins.
Do you, as a researcher in how the financial system works.
(28:28):
Take them seriously as something that will be important for
payments in the financial system going forward.
Speaker 5 (28:35):
I'm going to hit you with another trope, which is
that I think the tech is good, the product is not.
I think this is another area where the big banks
will win. I mean, it'll be it'll be a stable
coin technology, but like now we don't actually experience ACCH
versus you know, fed wire versus whatever else. It'll be
that it's the right technology, But the ultimate question is
(28:58):
payment in what? And you don't want the answer of
that question to be USDC, like you want it to
be a deposit that.
Speaker 2 (29:05):
I mean, I guess. My thing is, like, you know,
I actually buy kind of the argument from the stable
coin advocates that like it solves a lot of problems
with tech interoperability, that it could never you will never
get a sort of blockchain type solution from all the
big banks working together because of you know, lack of
trust or whatever it else. Like I buy that, but
(29:27):
I guess, like I guess to your point, specifically, I
don't know how big ultimately that demand will be, especially
since you put it away from most payments in most
of the world, these things are pretty abstracted away. I
would I don't know most I don't want to like
jump to conclusions because I know there are underdeveloped banking systems,
but for much of the world, for much of the
(29:48):
wealthy world, a lot of these problems are completely seem
abstracted away.
Speaker 5 (29:52):
The other challenge is to go find a bunch of
safe assets to invest in. You know, if you're replacing
trillions of dollars of payments, you have to go find
a bunch of safe facets. And that's why we run
this through banks, because they don't have to find safe acets.
They can back to positive.
Speaker 2 (30:04):
Yeah, Stephen Kelly, thank you so much for coming on AVAS.
Speaker 4 (30:08):
That was great.
Speaker 2 (30:08):
You answered a bunch of questions. I think that, least
in my head had been lingering for a long time.
Speaker 4 (30:13):
Thanks guys.
Speaker 2 (30:27):
Steven is so good. He's so clear.
Speaker 3 (30:29):
Yes he is. It's always good to catch up with him.
I mean, I do think like the circular nature of
the leverage is obviously a concern. Again, like we're talking
about relatively small volumes right now, but it feels like
it could become problematic at some point.
Speaker 2 (30:46):
It's interesting. I kind of forget when I think about
two thousand and eight and two thousand and nine, how
much of those first like tremors, I guess of the crisis.
We're literally you know, non banks. And I think you know,
people ever talk about those bear Sterns hedge funds that
blew up. Yeah, that was the start, but that was
like really kind of I mean, there was the quant quake,
(31:07):
what was that late two thousand and six, and that
was sort of freaked the market out a little bit,
But then it was really like those bear Sterns hedge funds,
and then you know, you mentioned the city line and
just this idea that they had these banks, they had
these off balance sheet vehicles, probably for many of the
reasons that you know, the same reasons that shadow banks
or private credit or multi strategy hedge funds exist today,
(31:28):
less capital intensive vehicles, and then they felt the need
to bring them on maybe for reputational reasons. I think
that's like a really interesting history that gets forgotten about.
Speaker 3 (31:37):
No, you're absolutely right, and money market funds as well.
When they broke the book. You know, the other thing
I was thinking about was just this idea of again
liquid wrappers on ill liquid assets and I kind of
think like the ultimate expression of shadow banking has to
be someone putting an etf rapper like private credit.
Speaker 2 (31:57):
It's so perfect. They always find a way to do that.
They always find we're going to get the ill liquidity premium,
and then we're going to still give you the liquidity.
I think one of the most important points that Steven makes,
and I've heard him make it before, is just this
idea that the key scarcity in the financial system is
cash that's willing to be locked up, right, cash that's
(32:19):
willing to not be sold in an instant or in
a demand deposit. And so there is therefore then this
natural constraint on how much, say a private credit firm
could take away from the banking system, because in the end, banks,
as we know, as you mentioned, are very levered. How
do you recreate that leverage? How do you satisfy the
financing demands of the real economy given this constraint and
(32:43):
locked up capital. I think it's just a really important
concept to keep in mind.
Speaker 3 (32:47):
Yeah, all right, well, shall we leave it there.
Speaker 2 (32:49):
Let's leave it there.
Speaker 3 (32:50):
This has been another episode of the All Blots podcast.
I'm Tracy Alloway. You can follow me at Tracy Alloway and.
Speaker 2 (32:56):
I'm Jill Wisenthal. You can follow me at the Stalwart Fellows,
Stephen Kelly at Stephen Kelly forty nine, follow our producers
Carmen Rodriguez at Carman Arman, Dashel Bennett at Dashbot and
Kell Brooks at Keilbrooks. Thank you to our producer Moses ONEm.
More odd lags content go to Bloomberg dot com slash
odd lotche We have transcripts, a blog, and a new
daily newsletter and you can chat about all of these
(33:18):
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Speaker 3 (33:23):
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