Wall Street's big banks are upping the bets against the health of part of the North American financial system

BarcelonaThe concern in the United States financial industry about the viability of some private credit investment funds has led Wall Street's major banks to bet on financial instruments that either cover losses in case of fund failure or allow for downside speculation. Major North American financial institutions have created a public index in recent weeks that allows investors to know the price of these new speculative instruments.

North American major banks have lent $1.2 trillion in recent years to private credit entities, or private credit. These investment funds act de facto as shadow banks, as they provide loans to companies of all kinds.

Several private credit funds have suffered massive withdrawals of money in recent months from their investors, who did not see the viability of their operations clearly. This investor exodus caused a small panic in the US financial sector, as some of the private credit companies are managed directly or indirectly by large financial companies or have close ties with them through loans.

In this regard, critical voices towards the private credit sector have multiplied. In recent years, these funds have increased both the volumes of money they lend and their activity, which has raised alarms throughout the financial industry about whether they are artificially inflated due to having been too broad in their approach to providing easy credit. A few weeks ago, John Waldron, president of the Wall Street giant Goldman Sachs, joined the critical voices towards the sector and reminded investors in these funds that they are precisely that, funds, and not banks from which they can withdraw their money whenever they wish.

Banks opt for swaps

In any case, doubts about the sector explain that now the big financial corporations of Wall Street are looking for ways to cover themselves. The financial instruments chosen are credit default swaps (CDS), very common products to do what in the specialized jargon is called hedging, that is, to financially cover the risk of suffering losses in an investment. In other words, CDS act similarly to insurance.

Thus, when a company buys an asset, such as stocks or real estate, or when it makes a specific investment, it contracts a CDS to recover the money in case the investment does not go well. In this way, it can ask a bank to create these swaps which, in case of default of the investment in question, will allow it to recover the money (all or at least part, depending on the contract) invested. In return, the investor pays the bank a premium every certain time, just as an insurance customer pays an annual or monthly fee for car or home insurance. The difference, obviously, is that swaps are designed to cover losses of millions of euros and, therefore, the premiums are also very high.

The main difference with normal and current insurance that everyone can contract is that, since they are financial instruments, they can be bought and sold. Furthermore, a company can create a CDS on an asset it does not own, which insurance also does not allow: we cannot contract home insurance on a house that is not ours, but a company can create a swap to cover the default of an asset it does not have, for example, company stocks.

This element makes them speculative financial products: when a company suspects that a sector or another company may do badly, it has the possibility of buying a CDS hoping to collect it when the default occurs, without any need to have invested in the business in question. In fact, this method is what, during the 2008 financial crisis, some investors used – like the renowned Michael Burry– who had been able to predict that in the United States there was a real estate bubble and that the financial system had levels of exposure to this market that could cause its collapse.

A new index

With growing instability in the private credit sector, major North American financial companies have set the machinery in motion to cover possible defaults of private credit funds with swaps. As reported in April by the British newspaper Financial Times, banks such as JP Morgan Chase, Citigroup, Morgan Stanley, or Barclays have invested in CDS that would be activated in the event of a default by some of the main private credit funds, most of them controlled by financial giants specialized in speculative operations, such as Blackstone, Apollo, or Ares Management.

The demand for these CDS is, in fact, large enough for the financial consulting firm S&P Global, which compiles some of the main indices of the North American stock market, to have created a new index, called CDX Financial, which tracks the value of these swaps. The market is not small and also includes instruments to cover losses in case of default by funds linked to insurers, large banks, regional banks, or credit card companies.