Private credit has certainly been a buzzword this year, as the multitrillion-dollar industry has shown cracks in credit quality, and investors fret that problems in the sector could lead to broader market risks.
One area that has come under some scrutiny is the traditional banking system. The industry has ceded market share to private credit due to burdensome regulations stemming from the Great Recession, yet it still lends to various players in private credit. Investors wonder what will happen if private credit lenders encounter problems. Will that spill over into the banking sector?
After first-quarter earnings, the largest banks in the country provided some disclosures about private credit. Here’s how much exposure JPMorgan Chase (JPM +1.29%), Bank of America (BAC +1.23%), Wells Fargo (WFC +0.88%), and Citigroup (C +0.29%) have.
Image source: JPMorgan Chase.
Understanding what private credit is and where the problems are
Private credit is a broad term, but at its core, it’s non-bank lending from a variety of players, including asset managers, insurers, private equity firms, and business development corporations (BDCs).
It’s grown popular as banks have slowed lending to a wide array of businesses since the Great Recession and as these lenders have offered more customized products. The returns private credit has generated have also been very attractive to investors.
But the key here is to understand that the term private credit is incredibly broad. For instance, there’s warehouse lending, in which a company loans capital to another company that is originating various types of consumer loans, such as mortgages, student loans, and auto loans.
Consumer loans are pooled and typically serve as collateral for a warehouse loan. Other forms of private credit include financial companies borrowing from one another and private equity firms borrowing short term while waiting for funding from their limited partners.
But the area of private credit that is under the most scrutiny right now is direct lending. This is where an asset manager, private equity firm, or BDC makes a direct loan to a company. Many, although certainly not all, of these loans will have a senior position in the capital structure and floating interest rates. Banks may provide a warehouse credit line to firms making these direct loans, known as corporate debt financing or private credit warehouse financing.
Private credit has come under scrutiny because it operates outside the banking system, making it difficult for regulators to get a complete picture of what is happening. Private credit has faced even more intense scrutiny this year because many of these direct loans were made to software companies.
Software stocks have been crushed during the past year amid concerns about artificial intelligence. This has investors worried that these loans will go bad, potentially damaging private credit and, in theory, anyone else lending to or investing in private credit firms. That’s why many private credit funds have received high redemption requests from investors.
Exposure at the big banks
Given all the focus on private credit, the large banks each provided some insight into their exposure to private credit, including overall exposure to non-bank financial loans (NBFI), lending in the corporate debt financing (CDF) sector, and some disclosure on loans to BDCs, which are under heightened scrutiny right now.
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According to a JPMorgan Chase research note from February, a fifth of BDC portfolios are exposed to software, which is more exposure than in the syndicated loan and junk bond markets.
Here’s a breakdown of where each bank stands on the metrics listed above (numbers are in millions):
| Bank | NBFI Loans | NBFI % Total Loans | CDF Loans | CDF % Total Loans | BDC Loans | BDC % Total Loans |
|---|---|---|---|---|---|---|
| JPMorgan Chase | 160,000 | 10.6% | 50,000 | 3.3% | ? | ? |
| Bank of America | 180,000 | 14.9% | 55,000 | 4.6% | <2,000 | 0.2% |
| Wells Fargo | 193,000 | 19% | 36,200 | 3.6% | 8,326 | 0.8% |
| Citigroup | 118,000 | 16.8% | 22,000 | 3.1% | <1,180 | 0.2% |
Source: Bank earnings reports, earnings presentations, and earnings transcripts.
As you can see from the data above, although banks have meaningful lending exposure to non-banks that extend credit, their exposure to corporate private credit extending direct loans to private companies is less 5% across all banks. The amount to BDCs is less than 1%. Although JPMorgan didn’t disclose exact BDC exposure, it’s hard to imagine it being significantly higher than peers’, based on its other disclosures.
Most bank management teams expressed confidence in their underwriting. As I mentioned above, many direct private credit loans hold a senior position in the company’s capital stack. That’s why some investors have previously described private credit as having equity-like returns with bond-like protection.
The loans are high-yielding, often more than 10%, while their senior position means lenders are higher in line to be repaid if a company defaults on its debt. Banks making loans in this niche are also likely to have their own protections in place, adding another layer of safety.
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“Bank of America’s exposure has structural insulation from those first loss positions,” the bank’s chief financial officer, Alastair Borthwick, said on the company’s first-quarter earnings call, when discussing private credit. “For losses to reach us, we believe operating company equity and a substantial portion of fund investor capital would need to be impaired before we would experience losses.”
Private credit concerns are real, but likely not systemic
Banks do have some exposure to the sector, and therefore could face issues down the line. Earlier this year, JPMorgan Chase reportedly marked down some of its private credit loans. Of its $36 billion corporate debt portfolio, Wells Fargo disclosed that 17% of its collateral has software exposure.
However, the large banks seem more conservative, lending to higher-quality investment-grade entities. Citigroup said its $22 billion in corporate private credit loans have incurred no losses over the life of the portfolio. Wells Fargo also said its NBFI portfolio has had virtually no losses for a long time.
Private credit has already seen some cracks, and conditions could continue to deteriorate. But even if they do, as JPMorgan Chase Chief Executive Officer Jamie Dimon said in his letter to shareholders earlier this year, “private credit probably does not present a systemic risk.”
Ultimately, I do think investors should keep their guard up when it comes to private credit. But they don’t need to have flashbacks to the financial crisis. Furthermore, the large banks appear to have prudently underwritten their exposure and should be able to deal with any problems that arise.
