This time is different

In 2000, a similar rise in interest rates popped the dot-com bubble, erasing $5 trillion in tech stock value and sparking a recession. And in 2008, rising rates ignited the housing crisis, leading to $10 trillion in lost wealth and the deepest downturn since the Great Depression.

Yet today, the economy is growing steadily, and stocks are hitting new highs. 

So, if high rates eventually break something in the economy, what could the boogeyman be this time?

Banks have been massively fortified after 2008 by regulations like Dodd-Frank, which clamped down on risky loans and made the traditional banking system much safer. But it also created a massive lending gap for thousands of small and medium-sized businesses, which were now considered too risky for the big banks to touch.

The lending gap was filled by an industry that has exploded in the shadows of the financial world: private credit. You can think of these institutions as shadow banks—and that's what they're often called—because they act like banks, but don’t follow the same rules.

Private credit has swelled from a $235 billion industry in 2008 to over $2 trillion of assets under management today 

These are giant investment firms like Blackstone and Apollo that lend directly to companies with much less regulation and oversight than banks.

So, could private credit be the next boogeyman in this time of high interest rates?

Let’s see how it operates to find out.

These firms raise trillions of dollars from a variety of sources, including public and private pensions, private funds, and insurance companies. That capital is locked up for long periods, meaning it can’t be pulled out in a panic—giving these lenders stability.

They then lend this money directly to businesses—often the very ones considered too risky for commercial banks—in exchange for higher interest payments. Yet it remains largely unregulated and almost completely opaque. Many see that as a red flag, because the parallels to 2008 are hard to ignore.

First, the high-risk borrowers. By definition, these are companies that traditional banks won’t lend to, making them extremely vulnerable in a recession. And because most of these loans have adjustable rates, the rate hikes of the last two years have already put these companies under immense pressure.

This chart shows how easily US companies can pay their debt. Lower numbers mean they’re struggling more—and we’re at the lowest level since the rebound from the 2008 financial crisis.

So, higher-for-longer rates could strain the ability of these borrowers to manage their debt. And we saw the effects of that problem in 2008.

Second, leverage. While these funds are less leveraged than commercial banks were in 2008 by a good margin, they still use borrowed money to finance their loans, which magnifies both gains and losses. They also carry more debt relative to their earnings, which raises their risk exposure and has caused real concern.

Third, valuation uncertainty. The value of these private loans isn’t set by public markets. It’s set by the fund’s own internal models. 

Critics worry these valuations could be hiding significant unrealised losses

Just like the mortgage-backed securities in 2008.

This could potentially hide risk, emphasising that they operate largely in the shadows—hence the name.

But defenders of the industry argue this is a far more resilient and sophisticated model than it’s given credit for. They point to two key differences.

First, locked-up capital. Investor money is committed for many years. This completely prevents a classic bank run, giving funds the stability and time needed to manage through an economic downturn without being forced to sell assets at fire-sale prices.

Second, they are specialist lenders. These aren’t faceless banks. The fund managers perform deep diligence and maintain close relationships with their borrowers. When a company is struggling, they can work directly with them to restructure debt and prevent a collapse—something a traditional bank is less equipped to do.

Is private credit the next financial system break in this era of high interest rates?

The only way we’ll know for sure is during the next economic slowdown—because recessions are where the overleveraged parts of the financial system are truly stress-tested.

The shallow recession of the early 1990s was manageable because there weren’t huge excesses in the system. In 2000, the excess was in overleveraged tech companies. When that bubble burst, it triggered a market crash and a severe recession. In 2007, the excess was in the housing market. What could have been a shallow downturn turned into one of the deepest economic crises in history.

Today, we’re again in an environment of high interest rates—conditions that are historically associated with downturns. If elevated rates trigger a recession in the future, private credit will face its first major test.

The question regulators are watching is whether its strengths—specialist management and locked-up capital—are enough to contain the risk, or if a crack in this $2.1 trillion market will send shockwaves through the entire financial system in a downturn like we saw in 2008—or worse.

At Capital.com, we’ll keep you updated on developments in private credit and major market trends.

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