Emerging Credit Market Risks and Jamie Dimon’s “Cockroach” Hypothesis

In the first piece, I noted that although U.S. household delinquency rates are trending higher, the absolute level remains low, so U.S. household spending power is likely to stay reasonably solid going forward. Large banks such as JPMorgan are also building up loan‑loss reserves more aggressively than before and engaging in pre‑emptive risk management, which makes a systemic financial crisis less likely. That said, I highlighted as points of concern the spike in default rates after the resumption of student loan repayments that had been paused during COVID‑19, as well as the continued rise in credit‑card delinquencies. In the third, more recent piece written on September 11, I reconfirmed, using data shared by the head of research at the Bank of America Institute, that Americans’ financial condition remains broadly sound despite pessimistic forecasts.

The second piece dealt with the private credit funds that many experts see as the core of non‑bank risk (some classify this as “shadow banking”, though I do not think that label is particularly appropriate). Their argument is that because the accounting firms appointed by private‑equity sponsors are the ones valuing the corporate bonds held in these funds, the “true price” will only be revealed when the fund matures and the assets are marked to market (typically at about a 15% discount to book value). On that basis, they claim that a so‑called “day of reckoning” is coming, when the inflated valuations of private credit funds will collapse in a chain reaction.

Unfortunately, there are still no clear signs of that happening. The main limited partners (LPs) in private credit funds are mostly pension funds and ultra‑high‑net‑worth individuals, who rarely face urgent cash needs. Occasionally, when the value of listed equities plunges, the portfolio weight of supposedly “stable” private assets rises, which can reduce LPs’ capacity to commit capital or prompt them to request redemptions. But given that global listed equities have performed reasonably well of late, the probability of that scenario is low.

This is the backdrop for the emergence of so‑called “continuation funds”, which neatly align the interests of large LPs such as pension funds—who do not want to crystallize losses right away—and private‑equity general partners (GPs), for whom maintaining external performance metrics is crucial. As an existing fund approaches maturity, the PE firm creates a new continuation fund, transfers the assets from the old fund into it, and LPs receive their interests in the new vehicle. If the assets were sold to an outside buyer, they would have to be marked to market as noted above, but a continuation fund is essentially just moving assets from the left pocket to the right pocket, so there is no need to apply market pricing. Of course, to soothe disgruntled LPs and increase the odds of success for the new fund, the manager will often reduce management and performance fees.

First Brands is a U.S. auto‑parts maker that produces antifreeze, wipers, and brake pads, and in recent years it mainly relied on collateralized loan obligations (CLOs)—a product favored by private credit funds—to finance its expansion. The recently bankrupt First Brands raised about $5 billion (roughly 7 trillion won) through senior and subordinated loans, and its all‑in interest rate, including coupons and original issue discounts, is said to have been around 11% per year. CLOs are structured products that slice securities backed by the same pool of assets into multiple tranches—equity, subordinated, and senior. The asset managers that package CLOs typically invest in the equity (capital) tranche. Because equity investors are the first to take losses when the underlying loans run into trouble, the managers that arranged the First Brands deal have already marked their equity stakes down to zero, while distressed credit funds have seized the opportunity to buy First Brands CLOs at discounts of more than 90% to face value. Distressed funds are credit vehicles that specialize in buying the bonds of companies with low recovery prospects at deep discounts and then working to improve recoveries.

First Brands’ sudden bankruptcy filing came less than two weeks after Tricolor, a subprime auto‑loan originator, filed for bankruptcy, and the banks that lent to Tricolor are now alleging loan fraud. Specifically, they claim that the same collateral pool of auto loans was pledged to multiple banks as liquidity facilities/credit lines—a practice known as double‑pledging. Put simply, after borrowing the maximum 800 million against a 1‑billion‑dollar asset, the company went to another bank, used the same asset as collateral, and borrowed another 800 million, raising debt in excess of the asset’s value. This is clearly illegal, but in private credit deals, only the institutions directly involved share the credit documentation—the legal contracts that spell out loan terms and creditor rights—and they are required not to disclose it externally in order to prevent conflicts of interest. As a result, unlike traditional syndicated loans, the terms of these deals are rarely made public.

After the Dodd‑Frank Act passed in 2008 and capital regulations on large banks were tightened, the private credit market grew at breakneck speed, and limited partners poured increasing amounts of money into private credit funds that promised relatively stable, high interest income. As you can see in the corporate bond spread chart above, the spread between investment‑grade and high‑yield corporate bond yields has shrunk to its lowest level in 30 years. In other words, the extra yield investors demand for taking on higher risk has diminished. Ultimately, this reflects the fact that private credit funds, in their rush to grow and win deals, have accepted increasingly unfavorable terms. There is likely also some bias from the fact that companies that previously would have had to issue junk‑rated high‑yield bonds to raise capital have effectively disappeared from the public bond market. But as noted earlier, because the financing terms of private credit deals are known only to the parties involved, the very legislation introduced to greatly improve banks’ soundness and transparency has, paradoxically, created an environment where it is harder to see where credit risk is actually lurking.

Even acknowledging those side effects, I still believe the Dodd‑Frank Act has ultimately been a success. What I do find regrettable, however, is that as this massive alternative market took shape, policymakers effectively stood by without imposing mechanisms or obligations to collect data for systemic risk management.

The recent “cockroach comment” by Jamie Dimon, CEO of JPMorgan Chase, the largest U.S. bank, is closely related to this backdrop. On the company’s earnings call, referring to the fraud allegations at Tricolor, he said, “When things like this happen, my ears perk up,” and added, “It may not be appropriate for me to say this, but if you see one cockroach, it’s probably right to assume there are many more hiding. Everyone needs to be careful.” This, too, can be seen as part of the same narrative. The problem is that we cannot accurately grasp the (likely unhealthy) financial condition of the companies that have borrowed from private credit funds, and therefore there is little we can do other than wait for episodes like this to blow up.