In the modern banking system, those who decide whether lending money to a company is a good idea are rarely those who end up holding the bag if something goes wrong. That credit underwriting is increasingly distinct from holding credit risk may seem like a classic principal-agent problem, leading to no one conducting true due diligence. But, perversely, it could actually result in a sturdier financial system.
This debate is playing out following two recent high-profile corporate bankruptcies: Tricolor, a Texas subprime auto lender, and First Brands, an Ohio car parts maker. Earlier this week, at a Financial Times conference, executives of major private capital firms said that the two blow-ups implicated the lending practices of the traditional banking sector more than the racy growth of alternative lending, citing the significant ties of Tricolor and First Brands with big, legacy Wall Street financial institutions.
Rather than a binary narrative that sees either banks or asset managers as the irresponsible party, the current situation is best understood as a window into the modern credit value chain. Risk, elevated or not, is increasingly diffused across multiple types of institutions, which reduces the incentives for deep due diligence on the borrower.
JPMorgan this week said it would write off $170mn of exposure to Tricolor, which the latter had used to fund loans to its used-car customers. Those loans were eventually bundled into hundreds of millions of dollars’ worth of tranches with different credit ratings and sold on to asset managers and newfangled insurers, illustrating how debt that was conceived in a bank can end up in the private credit ecosystem. Jamie Dimon expressed embarrassment at the bank’s Tricolor loss but, for a company with a $846bn market cap, it is barely a blip.
Similarly, First Brands’ corporate loans were underwritten by big banks like Jefferies, and then sliced up into collateralised loan obligations, and in some instances business development companies. CLOs and BDCs to many count as “private credit”, but their assets were birthed in a traditional bank.
As for Jefferies, it has said its potential direct loss exposure to First Brands lies in minor interests in CLOs it sponsors and, separately, in a subsidiary asset manager. In other words, while Jefferies was responsible for extending the original loan, nearly all of the loan itself has been cast off.
Portfolio diversification for stocks — the idea that adding incremental, less correlated equities could reduce risk while keeping returns high — was good enough to win a Nobel Prize. Credit securities are now sliced up and spread so widely that one or two off-chance disasters typically should not threaten collapse for any single bank or fund. But, before they breathe a sigh of relief, they’d better be sure that due diligence shortcomings are truly exceptions and not widespread.
