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Mary Louise Kelly (3:00)

It'S consider this from NPR. When companies need a loan, traditionally they would turn to a bank. But increasingly they are turning to financial firms that are not really banks but have a lot of cash. This is called the private credit market. It has exploded in the past 15 years. It's now valued at around $2 trillion. But what happens if those loans aren't backed up. Natasha Sarin is president of the Yale Budget Lab. Natasha Sarin, welcome.

Natasha Sarin (3:30)

Thanks so much for having me.

Mary Louise Kelly (3:31)

So you wrote a piece. This was for the New York Times, and the headline, which I loved was how Bad is Finance's Cockroach Problem? We are about to find out. Unpack that for us. Who were the cockroaches in this scenario?

Natasha Sarin (3:46)

So the cockroach I can't take credit for because it comes from Jamie Dimon, the CEO of JPMorgan Chase, as he was commenting on something that many of us who aren't deep in the finance industry may have even missed over the course of the last many weeks, which is that two auto related firms went bankrupt over the course of a few weeks in September. That in and of itself is not necessarily all that interesting. They're relatively small firms. But what is kind of interesting and pretty important is that there are a lot of allegations of fraud associated with those two particular bankruptcies and a lot of concerns that after these firms failed, it turns out that they had borrowed much more money in ways that were ultimately pretty opaque and kind of hidden even from their own investors than people had previously realized.

Mary Louise Kelly (4:44)

So just take a step by step through this. You said these are two firms. Are they firms we've heard of? Who were they? And just tell me a tiny bit of the story.

Natasha Sarin (4:52)

Yeah, these are two auto related firms. One is a company that is called Tricolor. Tricolor was a company that is one of the largest subprime auto lenders and used car retailers in Texas and California. And its business model is a lot about lending to people who either have no or very limited career credit history.

Mary Louise Kelly (5:17)

And what's the other one?

Natasha Sarin (5:18)

The other one is a company that's called First Brands and you probably haven't heard of it, but they make all types of different car parts.

Mary Louise Kelly (5:26)

So we're not talking Ford, we're not talking gm. What is it that you see happening that has you so worried?

Natasha Sarin (5:34)

So one piece that's interesting is about the way they were ultimately borrowing. And it turns out that they were borrowing in part from traditional banks and public markets, but they were also borrowing in part from private markets and from these private credit firms. And importantly, when they ultimately went bankrupt, it had to do with learning more about the fact that these firms had allegedly committed fraud by doing things like offering the same collateral to multiple people who lend it to them. And that type of opacity such that the lenders themselves didn't even realize how leveraged. How much borrowing these two particular firms had done is A feature of what you can see happening these days in private credit markets. But because of regulation that we did in the aftermath of the financial crisis, it is happening much less in public markets and much less in banks.

Mary Louise Kelly (6:38)

Okay, so We've mentioned the 2008 financial crisis a couple of times. What is it you see that feels the same as 2008? What is it you see that maybe is not parallel? Start with what's the same.

Natasha Sarin (6:51)

Yeah. And Andrew Bailey, who runs the Central bank of England, said anyone watching these two particular bankruptcies, like alarm bells, should be going off if they were anywhere near the 2008 financial crisis. We are starting to see the same kind of slicing and dicing of literally everything. Think car loans, think leases on AI data centers. Think of bills that are owed from plastic surgery patients. Literally everything. And turning it into allegedly relatively safe slices of financial securities. But the other piece is there too. We're also starting to see really significant lending, and it's happening very substantially in these private credit markets.

Mary Louise Kelly (7:35)

So to things that should be different, should feel different. From 2008, there were all these regulations and changes that went into effect to make sure we never had a meltdown like that. Why are these firms largely exempt from all those changes?

Natasha Sarin (7:51)

So in response to the financial crisis, we did a lot of regulating. And the result of that regulating was that traditional financial institutions, so your bank is doing a lot less of this risky lending than they were doing historically. Coming in to fill that void are these private credit firms. And the argument the private credit firms are making about their business model is actually they are better positioned to do this type of lending. And the reason they say that is because they're not reliant like banks are on bank depositors who can get flighty and get nervous and then ultimately flee and lead to a bank run and then a cascade of bank runs that brings down the whole financial system.

Mary Louise Kelly (8:34)

So, bottom line, how worried are you about these private credit firms?

Natasha Sarin (8:39)

I think in some sense, it's a little bit early innings for us. The thing that I'm always nervous about is, you know, what happened in the aftermath of the financial crisis is we took important steps to bring under the regulatory umbrella a lot of lending that ultimately turned out to be riskier and more damaging than we had previously anticipated. And it's sort of concerning that. You see these private credit firms themselves, as they advertise themselves, explicitly saying an advantage that they have is they're not subject to those regulations and they're not subject to those types of improved prudential standards and so I'm pretty nervous that if you have a bunch of financial activity that's ultimately happening in the shadows, eventually, once we get a downturn, and when invariably the economy will worsens, you're going to be in a situation where those private credit firms, which by the way, are reliant on money from ordinary people, just like banks, because they're heavily reliant on things like premiums from insurance companies that they purchase, they're going to be in a situation where losses on the financial markets and losses by these financial credit firms are ultimately going to fall to regular people.

Mary Louise Kelly (9:54)

Let me put to you a counter argument. Scott Bessen, the Treasury Secretary, he has a very different take. He says the growth of private credit shows that financial regulations after 2008 are too tight. Direct quote. He says we need to make capital more risk based. What's wrong with that argument?

Natasha Sarin (10:15)

I think the challenge with that argument is it in some sense ignores the history that we have well experienced over the course of not just the last financial crisis that we had in this country, but every financial crisis that has existed in this country and in other countries, which is ultimately when you're in a situation where you have too much leverage in a system and financial institutions that are ultimately incredibly interconnected. And that, by the way, is the case even with these private credit firms. Because now you're starting to see banks invest in these private credit firms. And so it's in some sense like despite there being not directly the originators of this new risk lending, they're tied into this whole pool of potential risk. And so while I'm sympathetic to the idea that by regulating one sector of the financial market, you've had risk go in to other sectors. My response to that isn't we should deregulate a sector. My response to that is we need to think about how we have a regulatory umbrella that is more all encompassing of the types of activities that are happening all over our financial system.

Mary Louise Kelly (11:26)

How much are ordinary people at risk of being caught up in all this? 2008 was about a lot of things, but among it was ordinary people's mortgages. I know you have been thinking about 401ks potentially down the road being caught up in this private credit. The riskiness that you see totally and.

Natasha Sarin (11:44)

You saw over the course of just the last few months loosening with respect to the possibility that 401ks can be invested in some of these alternative asset classes and in private credit in ways that they haven't been historically. Historically. And you're also seeing private credit in Some sense, when you hear the word private credit, you think private. And so it sounds different to you than a bank or public markets. But the challenge is, where is private credit ultimately getting the dollars that are coming its way to invest? And those dollars are coming from things like pension funds. Those dollars are coming from things like private equity firms buying insurance companies. And when you buy an insurance company, you owe money to ordinary people, the policyholders of that insurance company. And so a little bit what makes me nervous about this moment is I do not think ordinary people or even very sophisticated academics who consider these questions or really anyone outside of these private credit firms has a full understanding of the ways in which the market is ultimately connected to the rest of the financial system. As a result, ordinary people's dollars are on the line just like they were in 2008.

Mary Louise Kelly (13:05)

So what can we do as we see the train coming down the tracks? What can be done now by the government, by Congress, by the administration to try to prevent it from going off the rails?

Natasha Sarin (13:16)

Now, one thing that gives you a little bit of optimism about this moment and a little bit of hope that we won't find ourselves in exactly the same type of crisis that we have historically is exactly this point about the matching of incentives. So private credit firms themselves are incredibly incentivized to do lots of diligence about the types of lending that's happening at their particular firm and to try and understand the nature of the interconnected indebtedness to that we've been describing. And so it's not really in my view that the idea that these incentives are well aligned, that's good. And in fact you saw some private credit firms actually short exactly these two auto related firms because they had some suspicions based on their understanding of this market, which is very deep, that maybe all was not exactly right. But I don't think you can rely on the industry to self regulate in that way. I think you really have to have a deep conversation about the fact that we've seen really rapid growth in a really constrained time span in the private credit market. And Congress needs to think about ways in which to better regulate these markets. And we as sort of consumers need to do our own due diligence about the ways in which our dollars are ultimately exposed to potential risks down the road.

Mary Louise Kelly (14:38)

Lay the traps for the cockroaches to bring it, to bring it home.

Natasha Sarin (14:43)

We'll do our best.

Mary Louise Kelly (14:45)

Natasha Sarin, thank you so much.

Natasha Sarin (14:46)

Thanks so much for having me.

Mary Louise Kelly (14:48)

She is president of the Yale Budget Lab. This episode was produced by Erica Ryan and Alejandra Marquez Hanse with audio engineering by Andy Huether and Josephine Nyonai. It was edited by Adam Rainey and John Ketchum. Our executive producer is Sami Yenigun. It's considered this from npr. I'm Mary Louise Kelly.

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