The private-credit mess won't lead to a financial crisis like 2008's, says top IMF official

By Greg Robb

Uncertainty over which banks had large losses from underwater subprime mortgage securities led to the collapse of Lehman Brothers in 2008.

Private credit is a top vulnerability in the global economy, but comparisons to the financial crisis of 2008 are misplaced, the top IMF official watching over financial markets said in an interview with MarketWatch.

The comment from Tobias Adrian, who heads the IMF's Monetary and Capital Markets Department, comes after months of debate over the risk posed to the global financial system by private-credit issues. Private-credit providers extend financing to companies in relatively opaque transactions, and the practice has boomed over the past few years. Now worries about loosened underwriting standards and banks' exposure to private credit have helped to inspire a rush for the exits among investors in private-credit funds, forcing asset managers to limit redemptions.

The concerns that losses from the $2 trillion private-credit market will damage banks in the same way as subprime mortgage debt did are overblown, Adrian told MarketWatch. "We don't have to worry about banks at this point," he said.

Opinion: Private credit not only won't spark a financial crisis - it may be more stable than your bank

Bad mortgage debt led to the near-collapse of the U.S. banking sector and fueled the 2008-09 global financial crisis. In the lead-up to that downturn, investors did not know which banks held the losses from pools of underwater subprime mortgages when the housing market collapsed.

The backdrop for the meltdown was that the issuers of those mortgage securities paid no attention to the credit quality of the underlying assets after they sold them to banks and other financial institutions.

Today, in the private-credit market, "incentives are better aligned," the IMF's Adrian said. Firms that have originated the credit are retaining the vast majority of credit-risk exposure and are "actually very engaged in terms of monitoring and potentially restructuring the loans if there are any challenges," Adrian said.

Another distinction is that exposure to private credit among insurance companies and pension funds - keys to ordinary Americans' financial security - "remains very small," Adrian said.

At a press conference, Adrian said that private-credit default rates were in the range of 2%-3%. If there were a global deterioration of the credit cycle, defaults would rise to 4%-6% - and that would be manageable for financial markets, he said.

While a growing number of individual investors have been asking private-credit managers to return their money, funds can limit withdrawals, which helps contain systemic risk. Only about 15% of the $2 trillion private credit market can be redeemed, he said.

"If more of this sector were to become redeemable, that would certainly impact the broader assessment, but today we think that the systemic risk is certainly contained in that sector," Adrian told reporters.

Geopolitical conflict and risk

Still, the financial system is facing other threats. In its latest report on financial-market stability, released Tuesday, the IMF said global financial risks are elevated as a result of the war in the Middle East; the longer that conflict continues, the greater the risk of a significant market selloff.

Read more: The U.S.-Iran war dealt a big blow to the global economy. The IMF tells us how bad it could get.

The good news, according to the report, is that global financial markets entered the year in a position of strength and have functioned well since the war began on the final day of February with Israeli and U.S. airstrikes on Iran.

"We're not in a state of the world at the moment where financial conditions are very tight relative to history," Adrian said. The tightness of credit is at present "not a major headwind to economic activity."

"Compared with earlier crises, there is still a considerable margin of safety," the IMF report said.

But the longer the war drags on, the higher the likelihood of rising systemic risks.

The IMF has developed three scenarios for the war's impact on global markets.

The base case, or most likely scenario, is a "benign" outcome, in which there is some decline in output and some increase in inflation from the war, but the global economy can digest it. Financial markets should continue to function well in this case, Adrian said.

The second scenario puts inflation pressures higher, forcing central banks to raise interest rates. That would spark inflation, then dampen growth.

The third, more severe, scenario is one in which financial conditions tighten in a meaningful way and vulnerabilities kick in, generating nonlinear behavior.

The second and third options are less likely than the first, he said.

One vulnerability is that, in recent years, bonds and equities have tended to sell off in tandem. In the past, longer-term bonds typically rallied when equities sold off. Now, for asset managers and investors, portfolio allocations to stocks and bonds have changed. Even gold has been selling off. "There is a search for safe assets, but it is not clear what [those are]," Adrian said.

Another risk is that nonbanks, including hedge funds, could be forced to sell assets in a downturn, and derivatives-market activity could act as an accelerant in a selloff.

"So far, so good in this episode of the Middle East war," Adrian said, "but these are vulnerabilities we are watching closely."

-Greg Robb

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