Oh My F**king God, They’re Doing It Again

According to Bloomberg, UBS and other firms have been exploring structures that package stakes in private-credit funds into bonds. Because perpetual private-credit vehicles do not fit neatly into conventional ratings models, bankers are looking to add insurance “wrappers” that allow portions of the deals to inherit the insurer’s stronger credit profile. The resulting paper can then be marketed as investment grade, even though the assets underneath remain opaque, illiquid private-market investments.

This is apparently considered innovation. I just hear Anthony Bourdain explaining CDOs during The Big Short over and over again.

An insurer guarantees a tranche against losses, the tranche receives a better rating, and other insurers can buy it while setting aside dramatically less capital. In the example described, an A2-rated tranche could require less than 1% in regulatory capital, compared with a charge that could reach 30% for a direct investment in a private-credit fund.

Nothing says “rock-solid asset” quite like needing several lawyers, a ratings agency, an insurance guarantee and a regulatory-capital loophole to explain why it is safe.

The comparison with 2008 is not merely rhetorical. Before the financial crisis, Wall Street packaged mortgages into residential mortgage-backed securities and collateralized debt obligations. Those securities were divided into tranches, and ratings agencies assigned extremely high grades to senior portions based on assumptions that nationwide housing losses would remain limited and geographically dispersed.

Then Wall Street added another layer of genius: credit-default swaps.

Insurer AIG’s Financial Products division sold enormous amounts of CDS protection on mortgage-related securities. These contracts operated much like insurance, promising payment if the protected securities suffered specified credit losses. AIG collected fees up front and initially posted little collateral because everyone treated the company’s high credit rating as a substitute for cash.

The crucial clarification is that AIG’s traditional state-regulated insurance subsidiaries were not simply writing ordinary homeowners policies and accidentally destroying civilization. The catastrophe grew largely inside AIG Financial Products, an inadequately regulated derivatives business that used the broader AIG organization’s pristine rating to guarantee complex financial bets.

But that rating was the magic wand.

As mortgage values deteriorated and AIG was downgraded, its counterparties demanded tens of billions of dollars in collateral. AIG did not have enough readily available cash to meet those calls. Suddenly, the institution that had promised to insure everyone else’s balance sheet needed the federal government to insure its own. The same rating that had made the contracts appear safe became the trigger for the liquidity crisis once it disappeared.

On September 16, 2008, the Federal Reserve authorized an initial loan of up to $85 billion to keep AIG from collapsing. The government received a 79.9% equity interest in exchange. The support was later expanded and restructured through Treasury investments, additional facilities and special vehicles created to remove mortgage securities and CDO exposures from AIG’s balance sheet.

Total commitments commonly associated with the rescue eventually reached roughly $180 billion. The CFTC later described the intervention as about $600 for every American alive at the time.

AIG had more than $1 trillion in consolidated assets in mid-2008 and sat at the center of a sprawling network involving major banks, retirement plans, commercial-paper markets, municipalities and other insurers. Federal Reserve officials concluded that a disorderly failure could have caused severe losses across financial institutions and further reduced the availability of credit to households and businesses.

In other words, AIG did not merely make bad investments. It sold protection so broadly that its own failure threatened to detonate the institutions that believed they were protected. The insurer had become the bomb.

And now, less than two decades later, Wall Street is again using insurance guarantees to turn difficult-to-rate credit exposure into highly rated securities.

What could possibly go wrong besides the exact thing that already went wrong?

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The modern structures are not identical to AIG’s CDS book. Today’s private-credit wrappers may be smaller, more collateralized and subject to different contractual and regulatory safeguards. There is no evidence that the current market has already created an AIG-sized hole.

But the rhyme is deafening. The underlying private credit assets are dogshit, as I’ve written about on this blog non-stop. The engineering is complicated. Ratings play a central role. Capital requirements become lighter after the transaction is rearranged. Risk migrates from the original lender to insurers, annuity providers, pensions and other institutions promising money to ordinary people decades from now.

The fund-finance market is estimated at somewhere between $1 trillion and $1.75 trillion, up from only a few hundred billion roughly a decade ago. That puts its expansion in the same broad neighborhood as the pre-2008 boom in structured subprime finance.

Private-credit managers need liquidity because exits have slowed, old investments remain stuck, and some borrowers are repaying existing loans with still more debt. Meanwhile, insurers and annuity companies are hungry for yield and attracted to structures that turn higher-risk fund exposure into favorably treated investment-grade paper.

It is a beautiful ecosystem. Private funds need money. Insurers need yield. Banks need fees. Ratings agencies need business. Regulators need to remain comatose. Everyone gets exactly what they want until the whole thing winds up bending over the average taxpayer, saver or retail investor somehow.

One particularly obvious danger is concentration. When an insurer wraps multiple securities, every buyer begins relying on the same corporate balance sheet. A downgrade of that insurer could cause many wrapped tranches to be downgraded simultaneously, potentially triggering forced selling across portfolios at precisely the moment markets are least able to absorb it. It’s like a high school test where everyone copies off of the same person who fails the test, causing the rest of the class to.

The structures also make it increasingly difficult for regulators to trace where the final losses reside. Researchers have warned that repackaging risk adds “structural complexity and opacity” and can amplify contagion when one link fails, as the Bloomberg report notes.

Once again, Wall Street is not eliminating risk. It is relocating it, obscuring it and reducing the amount of capital held against it. And once again, the entire arrangement is encouraged by the understanding that the Federal Reserve will respond to a sufficiently large accident with emergency lending, asset purchases, liquidity facilities and whatever alphabet soup is necessary to keep asset prices from discovering consequences.

This is the lesson Wall Street learned from 2008: not that leverage and opacity are dangerous, but that they should be spread widely enough to qualify for federal protection.

Make a reckless bet by yourself and you go bankrupt. Make the same bet through enough banks, insurers, pensions and retirement accounts and you become systemically important.

The Fed has spent years turning moral hazard from an embarrassing side effect into a rational business model. Every rescue lowers the perceived cost of the next gamble. Every emergency facility teaches markets that liquidity risk is temporary. Every rapid intervention tells executives that the real objective is not avoiding catastrophe, but making sure a catastrophe would be too politically expensive to tolerate.

So the structures get larger. The collateral gets murkier. The ratings get friendlier. The capital cushions get thinner. The chains of counterparties get longer.

Then everyone acts stunned when one downgrade causes twelve institutions to discover they were all holding the same risk.

We are not preventing the next crash. We are steadily assembling the mother of all crashes while congratulating ourselves for distributing the explosives more efficiently. And when it finally happens, the people who designed it will explain that nobody could possibly have seen it coming.

Except, of course, anyone who remembers 2008…or who is unlucky enough to sit next to me at an airport bar when I have 3 hours to kill and feel talkative.

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