Is Private Credit Risk a Harbinger of a Credit Crunch? [Click eStock]

Concerns Persist for Six Months, but Bond Market Remains Calm

Partial Credit Crunch Possible for Certain Companies and Sectors

Regulatory Tightening on Private Credit Should Be Closely Watched

As MFS, a UK-based specialist in mortgage lending, entered bankruptcy proceedings, concerns surrounding private credit funds have resurfaced. While the risk of a widespread credit crunch in the financial markets remains low, there are analyses suggesting the possibility of a partial crisis.

On March 3, LS Securities provided this assessment regarding concerns over private credit defaults. The firm first highlighted the fact that MFS entered bankruptcy proceedings at the end of last month. Private credit provided by non-financial institutions, unlike banks, does not benefit from fast or transparent sharing and verification of collateral information-something that MFS exploited. MFS issued loans in excess of its own capacity, resulting in potential losses of about 930 million pounds (approximately KRW 1.829 trillion). Subsequently, questions arose over the due diligence of major financial institutions that provided wholesale loans to MFS, leading to a sharp decline in the share prices of major banks such as Barclays and a renewed expansion of concerns related to private credit funds.

Earlier last month, Blue Owl Capital, a US-based private credit manager, suspended redemptions for certain private credit funds. At the end of last year, the consecutive bankruptcies of US auto lender Tricolor Holdings and auto parts maker First Brands brought to light the issue of overlapping collateral in private credit.

Despite ongoing concerns, the US corporate bond market remains relatively calm. Private credit is primarily extended to small and medium-sized enterprises that find it difficult to raise funds through high-yield (HY) bonds. Nevertheless, the credit spread between investment-grade (IG) bonds and high-yield (HY) bonds has remained within the range observed over the past year. In addition, the Senior Loan Officer Opinion Survey (SLOOS) index is below 20%. Typically, when this index exceeds 20%, it is viewed as a signal of a credit crunch. Soohee Cho, a researcher at LS Securities, explained, "Although stock price volatility has increased among software and alternative investment management firms, which are reportedly experiencing redemption requests or a reduction in exposure to private credit funds, stock indices in the financial and tech sectors have remained flat."

Partial Credit Crunch Still Possible

The private credit market has grown rapidly in a regulatory blind spot, but concerns have repeatedly surfaced since last year. This has led to worries about a potential contagion similar to the 2008 global financial crisis or the 2023 Silicon Valley Bank incident. However, LS Securities has assessed that such a scenario is unlikely. Researcher Cho stated, "Given the current capital strength of major financial institutions, banks' exposure to private credit and non-deposit financial institution (NDFI) loans, and the diversification of underlying asset sectors, it is unlikely that ongoing risks in the private credit market will trigger a broad-based credit crunch." However, she added, "Continued noise within the private credit market and the tightening of lending standards by banks in response may result in partial liquidity crunches for certain companies or industries."

Researcher Cho classified the possible stages of a credit crunch arising from the current situation into three phases. Stage 1 is a "storm in a teacup," involving short-term correction and stabilization. Stage 2 is a localized liquidity crunch, and Stage 3 is a full-scale, structural credit crunch.

She explained, "While it is most likely that the situation will end at Stage 1, there is an underlying possibility of progression to Stage 2. If incremental tightening of funding conditions by financial institutions accumulates, there could be partial liquidity crunches in sectors such as small software companies, where recent concerns over fundamentals have increased."

Private Credit Concerns and Regulatory Tightening Should Be Watched

LS Securities emphasized the need to monitor both the frequency and scale of such private credit incidents going forward. The due diligence practices of major financial institutions involved in private credit were also cited as a key area of focus. In addition, attention should be paid to the responses of financial institutions, such as tighter lending standards, changes in the macroeconomic environment including potential US base rate cuts, and the possibility of regulatory tightening for private equity funds (PEF) by governments.

Researcher Cho noted, "Europe has already begun strengthening regulations by implementing the Alternative Investment Fund Managers Directive (AIFMD) 2.0 starting from April 16. In the US as well, discussions on regulating private credit could take place. Any reduction in credit supply by major financial institutions as regulations evolve is also likely to impact the private credit market."

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