Is it Happening All Over Again?

Lax risk management, an incurious Federal Reserve, credit rating agency shopping, greed and garden-variety stupidity. Welcome to what could be the next great financial crisis.

Perhaps the quote that will define the next Great Financial Crisis will be this one from an executive at a former lender to the $10 billion fraud known as First Brands.

“You’re not paid to do due diligence in this market.”

There have been three high-profile Private Credit (PC) blowups in the past month. All were due to fraud, and all had telltale signs of problems ahead if anyone bothered to look under the hood. However, in the mad rush to get the deals done and put investor funds to work to earn those sweet management fees, as the First Brands lender said, “You’re not paid to do due diligence in this market.”

The same was true leading up to the 2008 subprime mortgage crisis. No one was looking under the hood of either the borrowers or the lenders. The game plan was to make your money, move on to the next deal, feign ignorance when it all blows up, get a bailout, and let others pay the price.

PC has made significant inroads into a sector of the economy known as “middle markets.” Middle market companies generally have annual revenues between $50 million and $1 billion. According to a recent report from Morgan Stanley:

The middle market represents a significant cross-section of the US economy, accounting for one-third of private sector GDP, $13 trillion in revenue and 50 million workers employed.⁴ Despite this, banks have largely withdrawn from the middle market as they have grown larger via consolidation and more constrained with their lending due to the flood of regulations post the Great Financial Crisis.

PC has filled that void left by commercial banks. In and of itself, investor funds using their capital to provide needed funds for this crucial sector was a good thing. However, it seems like we’ve crossed over to a point where middle market companies have become overleveraged, as the sector is, according to Asset Asset-Based Finance Journal,

… awash in private credit, fueling dealmaking at a breakneck pace as 2025 unfolds. With economic volatility—driven by persistent high interest rates, fiscal uncertainty, and a flood of complex financing—comes a pressing need to stress-test debt capacity … S&P Global Ratings reveals a stark reality: average leverage across its U.S. middle market credit estimate population hit 7x [debt to Earnings Before Interest Taxes Depreciation Amortization] in 2024.

Generally a ratio of 3x is considered relatively safe.

What this means is this vital sector of American business faces enhanced risk of a downturn in the economy and or an increase in borrowing rates. The employment picture in the U.S. economy is already showing signs of softening. A contagion in the middle markets could spread rapidly, bringing unemployment, business failures and sharp pullback in funding for the entire economy.

Then there’s the whole “fraud thing.”

Since we reported in October on the First Brands fiasco, there have been two more high profile private credit blowouts. From the Wall Street Journal:

The lenders have accused Bankim Brahmbhatt, the owner of little-known telecom-services companies Broadband Telecom and Bridgevoice, of fabricating accounts receivable that were supposed to be used as loan collateral. The lenders filed suit in August. They said Brahmbhatt’s companies owe them more than $500 million.

In another recent debacle, BlackRock’s private credit fund TCP Capital Corp valued the debt it extended to Renovo Home Partners to be worth 100 cents on the dollar as late as this past September and by November, Renovo declared Chapter 7 bankruptcy and the loan was valued as zero. From Bloomberg:

It was no mystery Renovo was in a tough spot. In April, lenders had agreed to take losses and convert some of their loans into equity as part of a recapitalization that was
supposed to give the company a chance to turn its business around, the people said. In the third quarter, they also allowed for deferred cash interest payments on its restructured debt, an arrangement known as payment-in-kind, regulatory filings show. Yet at the end of September, funds managed by BlackRock and MidCap Financial were still marking the new Renovo debt at par, which typically indicates investors expect to be paid back in full.

The two biggest Hail Marys in the credit business — debt for equity swaps and deferred interest payments (payment in kind) — were being thrown at this pig, and still BlackRock and MidCap valued the loans to Renovo at 100 cents on the dollar and then valued them at zero in the span of a few weeks. Some — perhaps investors — might call that fraud, too.

Life Insurers and Credit Ratings

In the last Great Financial Crisis, the credit rating agencies S&P and Moody’s played a huge role in letting the whole subprime meltdown happen. Bloomberg News reported earlier this month that the SEC was probing rating firm Egan-Jones.

UBS Chairman Colm Kelleher flagged early signs of “huge rating agency arbitrage in the insurance business,” while the Bank for International Settlements pointed
to potential “inflated assessments of creditworthiness” by small ratings agencies last month. Egan-Jones has billed itself as the most prolific grader in the private market and last year rated more than 3,000 private credit investments — all with about 20 analysts.

But don’t worry! A company rep said it “remains in good standing” with regulators and is “dedicated” to serving clients, who happen to be the private credit fund managers. Maybe that’s the problem, guys!

We reported in July that Private Equity firms such as Apollo, Blackstone, KKR, and Brookfield were snapping up life insurance companies to get at their steady premium income and annuity businesses. They refer to their insurance company holdings as “permanent capital.” Life insurers have also been engaging in pension risk transfers, taking corporate pensions over, another rich vein of permanent capital. A good deal of this permanent capital goes into their PC funds. The insurance companies rely on rating firms to manage their risk, or perhaps more importantly, their regulators rely on the ratings to judge the creditworthiness of insurance companies. This is the “rating agency arbitrage” Colm Kelleher referred to. From the Financial Times:

What you’re seeing now is a massive growth in small rating agencies ticking the box for compliance of investment,” said Kelleher, who stressed that regulators were failing to get a handle on the industry even as they were pushing for faster economic growth. “If you look at the insurance business there is a looming systemic risk coming through because of lack of effective regulation,” he said.

In a separate article, the Financial Times noted that Egan-Janes’ ability to issue more than 3,600 ratings last year (and another 3,400 so far in 2025) with only about 20 analysts makes it “the most prolific grader of loans to individual businesses.”

Those analysts must be pretty busy.

Meanwhile, at the Fed…

After being about as incurious about the potential risk posed by PC as they were about subprime circa 2006, the Fed seems to have finally woken up — sort of — since May 2024, when Chairman Powell and other Governors began to address private credit, if only to downplay the risk.

From May 8-20, 2024:

• Governor Lisa Cook: “Private credit funds appear well positioned to hold the riskiest parts of corporate lending. These intermediaries generally use little leverage and are organized as closed end funds, which means that investors cannot withdraw the funding supporting the investments.”

• Chairman Jerome Powell: “…many of the lending structures are not subject to a run in the way that banks have traditionally been. Their funding tends to be from limited partners who have their investment locked up for many years … It’s not obvious to me that at this point it’s a net loss to financial stability.”

• Michael Barr, vice chair for supervision: “One of the things that we see in the current structure of the private credit market is that most of the funds themselves are not highly levered entities. And today, at least, they are in a form that faces no run risks, so the investors in those funds can’t exit. They’re closed-end funds.”

All seemed to have taken the attitude of no bank runs, no problems.

The Fed’s tune changed a bit in its Financial Stability Report released November 7, after the First Brands and Tricolor blowups, pointing out that:

Isolated bankruptcies of an auto parts supplier and a subprime auto lender as examples of risks from opaque off-balance-sheet funding, potentially amplifying spillovers to banks and nonbanks.

There have been two more bankruptcies (Broadband Telecom/Bridgevoice and Renovo Home) since they published the report, so maybe not so isolated? Maybe the Fed is starting to wake up but has the die already been cast?

What the Fed does not seem to be addressing is that while banks have cut back their direct lending to middle markets, they have ramped up their lending to private credit who in turn lend to middle markets. As we noted in our report on First Brands, banks have loaned more than $300 billion to private credit funds, much of it to middle market PC funds. Additionally, PC’s sister private equity (PE) has invested in approximately 15,000 middle market companies, and as we know, PE funds a percentage of each purchase with debt raised through bank funding.

The Fed is missing the possibility that middle market companies are overleveraged, and if so, could there be a reverse crisis that hits Main Street first and banks second, creating a doom loop?

Powell’s, Cook’s and Barr’s comments in 2024 showed a lack of concern for a systemic event because PC is backed by investors in structures, as Cook said, “organized like closed end funds.” However, what if a lot of those investors happen to be life insurers? Large insurers have blown up before on bad financial product investments. Executive Life went under in 1991 after gorging itself on junk bonds. I have to imagine that a major blowup in the life insurance, annuity provider sector could snowball into something quite systemic.

Blunders followed by blowups followed by financial crisis, potentially followed by bailouts? I wouldn’t bet against it.