The world is facing a triple-headed risk monster: the Iran war, an AI meltdown and a private credit collapse on the scale of the 2008 financial crisis.
The trio are often discussed separately, but are intertwined and prone to amplify each other.
Private credit has financed many of the software companies whose business models are in danger of being made redundant by advances in AI.
As JP Morgan boss Jamie Dimon warned last week, AI can be exploited by bad actors and poses security risks to the financial system. It also gobbles vast amounts of energy, making it dependent on affordable and reliable supply, something that is clearly in jeopardy.
I warned a few weeks ago that the situation in the Middle East and volatile markets could exacerbate the risks surrounding private credit.
Higher oil prices will feed into inflation, keeping interest rates higher for longer. Corporate earnings may suffer and the risk of defaults will rise correspondingly.
Looking ahead: The thought of world leaders and central bankers having to navigate the complexities of a financial rescue with Donald Trump thrown into the mix defies contemplation
Andrew Bailey, the Bank of England governor and a veteran of the Great Financial Crisis, has confessed to sleepless nights over the combination of an energy shock, volatile share and bond markets, and a private credit plunge.
He draws parallels between the private credit market and the sub-prime mortgage sector of 18 years ago.
These are not exact. Private credit is a relatively small part of the financial system. Unlike conventional banks, providers don’t take deposits from small savers, so there can be no bank ‘runs’ as happened with Northern Rock, when frightened depositors queued in the street. Private credit funds have put caps on withdrawals, so panicked investors can only take out a limited amount.
Once the ceiling has been reached, investors are ‘gated’ – in other words, their money is trapped, though some funds have allowed some leeway. Nor do the providers of private credit, whether they be hedge funds or other non-bank lenders, have a government backstop in the same way as banks. In theory taxpayers are not on the hook.
None of this is tremendously reassuring, however. It does not rule out a crisis that could infect the wider financial system and drag in the wider public. One route through which this could happen is insurance companies. Several private credit operators own insurers, which has given them access to money belonging to policyholders.
And the idea that curbs on withdrawals are an impregnable barrier fails to convince. It is starting to look a bit King Canute, given that, according to the Financial Times, a tidal wave of investors tried to retrieve $20billion from private credit funds in the first three months of this year.
If the situation deteriorates, terrified and angry investors are unlikely to respond meekly to having their money trapped: funds must expect rebellions and court challenges.
The over-arching threat is a breakdown of trust and confidence in the whole system, similar to that in 2008.
A further fear is whether the US, under Donald Trump, would once again play the role of lender of last resort to the world, as it did in 2008, thereby saving the financial system from even worse harm.
The thought of world leaders and central bankers having to navigate the complexities of a rescue with Trump thrown into the mix defies contemplation.
If a disaster does happen, and let’s hope it does not, we may not be able to count on the safety nets we had in the Great Financial Crisis.
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