Why is there nervousness in the US financial sector?

BarcelonaA few months ago, the global financial sector began to show signs of concern, especially in the United States, due to the collapse of First Brands, Tricolor Holdings, and the credit fraud cases of regional banks Zions Bancorporation and Western Alliance. Credit panic began to set in in the markets, also on the Old Continent, with stock market declines contagious from Wall Street. Just a few days ago, the bankruptcy of the British mortgage broker MFS (Markets Financial Solutions) also splashed several lending entities, including Barclays and Banco Santander, with a millionaire credit exposure.

The case of First Brands, in October, had already begun to alert the sector: founded in 2013, this company grew through acquisitions to become a global cash-generating automotive parts business, but debt was key to this growth. At the end of 2024, the company recorded $1.1 billion in pre-tax profits, but had $6.1 billion in debt on its balance sheet.

First Brands' debt included approximately $4 billion in bank loans, i.e., credit agreements arranged by investment banks and distributed to large groups of institutional investors, including other banks, asset managers, and collateral loan obligation managers. What was strange and was one of the reasons for First Brands' bankruptcy were the off-balance sheet layers of debt from working capital financing maneuvers; that is, selling customer invoices to investors at a discount to obtain immediate liquidity, having lenders pay suppliers directly to conserve cash, and seeking financing with unsold merchandise as collateral to obtain even more liquidity. Lenders refused to restructure First Brands' debt in September, leading the company to declare bankruptcy on October 5. This is just one example, but even Banco Santander, along with other large American and Chinese banks, was asked to provide information about First Brands for the bankruptcy investigation.

Concurrently, a Fitch Ratings report revealed in October that traditional US banks have lent $1.2 trillion to private credit entities –shadow banking or shadow banking – which could hide millions in losses and cause a new systemic risk. The report detailed that loans from American banks to unregulated financial institutions, such as private investment funds, securitization vehicles, or alternative credit platforms, have quadrupled in the last decade and have gone from 3% to 10% of the total loans granted.

The 'shadow banking'

Private credit funds are similar to investment funds, but they are not exactly the same. To begin with, because funds invest mainly in assets, some in a more diversified way and others specialized in specific sectors. Thus, funds receive money from investors and make it work by purchasing stocks, public debt, corporate bonds, real estate properties, or other assets that generate a return (for example, company stocks involve dividends) and gain value in the markets, so they can be sold at a higher price in the future.

In contrast, private credit entities are essentially dedicated to granting loans to other companies, a task traditionally associated with banking, which is why they are often included within so-called shadow banking, or shadow banking. What differentiates them from banks is that the terms of the loans they grant are better –with lower interest rates– and they tend to accept companies with higher risk as clients. In this regard, they take advantage of being able to have smaller margins because they do not have to maintain as large an office and employee structure as banks and, at the same time, because it is a sector that is not regulated. In statements to ARA, Xavier Queralt, former territorial director of BBVA in Catalonia until 2015, explains that "we are not talking about anything illegal, we are talking about entities that have licenses to carry out activities that we are accustomed to seeing traditional banks do," but which do not fall under banking regulation.

This lack of regulation is key, as it explains some of the nervousness in the financial sector. Private credit companies are not subject to the scrutiny of regulators, such as the Federal Reserve, nor do they have to present accounts like publicly traded companies. Despite the fears expressed by some investors and experts, the situation seems contained for now. The Vix index, which measures volatility in the US stock market –called the fear index, or index of fear–, was this Friday slightly above 29 points, at a level similar to spring 2022, when Russia invaded Ukraine, and well below the 59 of October 2008, when the financial crisis began. The index is affected by all sorts of events that cause reactions in the stock markets, as has been the case this past month with the war in the Middle East.

But why, if a company is dedicated to performing a bank's function, is it not regulated as a bank? Basically because, while a bank lends its clients the money that other clients have deposited with the institution, in the case of private credit companies, what they lend is solely the shareholders' money. Therefore, if the company goes bankrupt, it is not clients unrelated to the business who lose money, but the very investors who decided to create the company.

These types of companies do not operate like normal investment funds. "You know the value of investment funds at 5 in the afternoon and you can exit every day," explains Xavier Freixas, emeritus professor of financial economics at Pompeu Fabra University. That is to say, while an investor can withdraw money from a fund whenever they want, this is not the case with private credit institutions. This is why some, when they have suffered massive withdrawals of money, have been able to at least limit them to avoid running out of funds and having to go bankrupt. "They are debt funds for companies, not so much for individuals, and these funds have limited liquidity outflows and usually have a small print stating that if more than a specific percentage of the withdrawal is requested within a liquidity window, the fund can be blocked, because everything is invested in loans," points out, for his part, Queralt. "It's not like preferred shares, it's designed for professionals and I find it hard to imagine a bank investing in this; it wouldn't make sense," says the former banker. The professor points out the same line: "They are private investors, there is no contagion risk," explains Freixas.

¿Connections with banking?

One of the elements of doubt is precisely that, since they are private and unregulated entities, it is unclear what level of interconnection they maintain with the rest of the financial industry. In the case of Europe, this type of company is not as widespread precisely because financial regulations are stricter, but nevertheless the bulk of investors who put money into these types of businesses are corporate partners, that is, other companies. In the US, some can be private fortunes, but large banks and large financial multinationals, such as BlackRock, have joined the private credit bandwagon. "Since the 2008 crisis, control over banks in Europe has been significantly tightened, directly supervised by the European Central Bank (ECB) – Queralt points out –. New entities, such as Revolut or PayPal, for example, have had to obtain a banking license to operate in Europe," says the financier.

In this regard, the latest cases of private credit funds that have had to freeze investor withdrawals are entities precisely linked to BlackRock, the Wall Street bank Morgan Stanley, or the financial multinational Cliffwater. A sector that moves 1.2 trillion dollars and is closely linked to some of the main players on Wall Street is bound to cause nervousness when it experiences difficulties, even if for now they have only been isolated incidents. "We are in the hands of the bankers' prudence," says Freixas about the connections between traditional banking and private credit.

According to Queralt, there is also an element of effect from the war in the Middle East: "In the US, with all the uncertainty due to the war, investors expect interest rates to rise and choose to withdraw money they had invested to invest it elsewhere," explains the financier. "It is a very limited issue in the US, it hardly exists in Europe," he reiterates.

The nervousness is also due to two other elements that may be related to private credit. On the one hand, the growing buzz among experts that the artificial intelligence boom –currently the only sector growing in the US– is reaching bubble proportions (it is often compared to the tech bubble of 2001), which endangers any company in the financial sector that has invested money in it, whether through direct investments or loans.

On the other hand, the increasingly widespread problems of regional banks, which call into question the solidity of the entire financial system. Jamie Dimon, CEO of JP Morgan Chase – the largest bank in the US – recently pointed out that there was "an excess of credit" in the economy, which can be understood as meaning that a part of this credit will begin to go into default. Dimon himself had already warned, stemming from the MFS case, that recently "cockroaches" were being seen in the financial economy, and "when you see one, there are many more".