Amid coast-to-coast floods, shutdown and credit woes lap at economy’s shores

(Originally published Oct. 14 in “What in the World“) Treasury Secretary Scott Bessent warned that the government shutdown is starting to affect the economy.

The federal government shut down early this month when the legislative deadline for funding it ran out with Democrats refusing to pass a Republican bill that would allow healthcare subsidies to expire at the end of the year, raising health costs for millions.

The potential threat to the economy from car-parts company First Brands’ bankruptcy, meanwhile, continues to grow. The company’s CEO is being replaced by one of its restructuring advisers. One of First Brands’ creditors said in a court filing last week that as much as $2.3 billion in assets had “vanished.” Among the company’s problems is that First Brands was securing credit by offering its receivables as collateral but pledging the same invoices as collateral for more than one loan. That’s eerily similar to the kind of credit fraud that helped create both the mortgage crisis of 2007 and China’s own credit debacle.

Concerns are rising that First Brands’ failure could puncture a bubble in so-called private credit, or non-bank lending, that could in turn imperil the real economy. Private credit in the U.S. has been booming in the much the same way non-bank lending exploded in China, creating a credit bubble there that is still suffocating China’s economy. China’s shadow banking boom was led by property developers and banks trying to skirt government efforts to rein in excess credit to the property sector. The boom in U.S. private credit appears to have been led by private equity companies as well as investment banks.

The logic of private lending is that the lenders know business, so who better to assess whether a business can repay its loans? But assessing risk is what banks do, using models to assess not just the risk of an individual business repaying, but how broader industry and economic trends may affect that business and the many other borrowers the bank has.

That’s why, as discussed in this space last week, the International Monetary Fund has been so concerned about the shift in credit away from banks after global regulators moved to clip their wings after the global financial crisis. Not only do non-bank lenders like pension funds and private equity firms not have the same understanding of systemic risk that banks are supposed to have developed (and still screw up even so), but they don’t have banks complex methods of ensuring that they remain solvent should that risk throw one or even dozens of their borrowers into default.

As explained back in March, 2023:

As early as 2016, the International Monetary Fund noted that post-crisis regulation of banks had prompted a shift in finance from banks to bonds, which in turn shifted the job of allocating capital around the world to non-bank players. Instead of banks, an armada of insurance companies, pension funds and asset managers like Blackrock and Citadel Securities—in other words, all our savings vehicles beyond ordinary bank deposits—filled the void and became big lenders and market makers in their own right.

This sector of largely unregulated credit is often referred to as “shadow banking,” and one country that has battled it for years is China, where banks and other finance companies have used nonbank financing to keep funds funneling into the nation’s property sector in defiance of official efforts to curtail it.

In theory, spreading these intermediary roles among more players reduced systemic risk, since if any single insurer, pension fund or asset manager made a bad bet and failed, they’d be smaller and have less impact on the overall system than if a huge bank failed. Sound familiar? It should: it’s more or less the same argument for how mortgage-backed securities were supposed to reduce the risk of a housing-market collapse.

But the smaller non-bank financial intermediaries, the IMF noticed, tend to behave as a herd, taking bigger risks on a less diversified range of investments. That means they’re all more likely to run towards the same exit in the event of a fire. And because regulations allow them to take bigger risks with less visibility of other investments, they’re more sensitive to changes in interest rates, not less. As a result, when interest rates rise, banks reel in credit and shrink their balance sheets, but “nonbank financial intermediaries contract them more than banks.” Worse, they reel in their credit much more quickly than banks, too.

The IMF has worried about the particular risk this poses to mutual funds. While an individual fund’s manager may not feel the need to panic in the event of an adverse event, the same cannot be said of the fund’s investors. If they, like SBV’s depositors, panic en masse and begin a wave of redemptions, the fund’s manager might have to start dumping the fund’s assets, thus triggering a wider tsunami of selling and a shortage of liquidity in smaller markets for stocks and bonds.

First Brands’ bankruptcy already touches its underwriter, the investment bank Jefferies (which may be out $715 million to the company), as well as private funds operated by Swiss bank UBS, private-equity giant Blackrock, and a string of smaller private lending players like CarVal and Ellington Management. Even First Brands’ customers, Ford and GM, were apparently lending it money.

Speaking of slow-rolling disasters: a powerful nor’easter is hitting the U.S. east coast, threatening New England with floods. A tropical storms, meanwhile, has lashed the desert southwest. Tropical storm Priscilla hit the parched deserts of Arizona, Southern California, Colorado, Nevada, and Utah, causing floods across the entire region.

Priscilla arrived just as residents of Alaska were cleaning up from the damage caused by Typhoon Halong over the weekend. Climate change is creating more severe and uncharacteristic weather patterns, leading to more extreme storms and rainfall.