A crisis in the world of private credit may not unfold in the near term, but investors should think about what may happen when the next recession comes along. The Boston Federal Reserve recently published a paper exploring whether or not the surge of dollars into private credit will eventually pose systemic financial risk to the lending industry. While the paper didn't directly answer the question posed, it's important that it was asked at all. The private credit asset class has swelled to about $1.7 trillion . Firms in the industry provide loans to businesses in an environment where banks had pulled back from lending in the face of regulatory constraints. Recently, however, banks have begun providing financing to those same private credit firms in the form of lines of credit. Those lines of credit help smooth out the distribution of capital as private credit firms take time to draw down the investments made by their limited partners. "Our analysis of Federal Reserve and proprietary loan-level data indicates that the growth of private credit has been funded largely by bank loans and that banks have become a key source of liquidity, in the form of credit lines, for [private credit] lenders," the Boston Fed said in its report. "Banks' extensive links to the PC market could be a concern because those links indirectly expose banks to the traditionally higher risks associated with PC loans," the Boston Fed added. Rising risk in the event of delinquencies Banks may expose themselves to rising risk over time if private credit firms take on less secure loans than the banks would normally fund. Ultimately, this could have an adverse effect on the banks' balance sheets. Typically, this becomes more obvious when the economy slows or tips into recession, pushing up both delinquencies and defaults. There are additional questions not yet posed by the Boston Fed's study. For instance, are big banks using leverage to enhance the returns on the credit lines they are extending to private credit vehicles? A similar question can be asked of the private credit firms: Are they using additional leverage so that their investors will reap higher rates of return than would otherwise be available? If the answer is yes, we may be staring at a smaller version of the Global Financial Crisis one day in the future. A familiar story One seasoned lawyer I spoke with, who assists in structuring private credit deals, tells me that the collateral for the bank lines of credit being handed out are the very loans made by the private credit firms. Worse yet, many of these vehicles are so-called " covenant-lite loans " meaning that the lending terms are less stringent than those of more conventional loans. Stop me if you've heard this story before: Leverage on top of leverage, along with lax lending standards and the prospect of financial deregulation could end badly for both banks and investors. By extension, financial markets could also suffer under the very systemic risk the Federal Reserve Bank of Boston is questioning. That can be quite a toxic brew if private credit firms and banks are all doing the same thing at the same time. It would be similar to what financial firms did with collateralized debt obligations prior to the real estate and credit crisis of 2008. For now, there is one meaningful difference: Most private credit loans currently being made are at the top of the capital structure. In other words, these loans made by the private credit firms are collateralized by the hard assets of the borrower. That's known as senior secured debt. That mitigates risk as lenders can seize and sell assets to cover the credit they had extended to firms. With so much "dry powder" in the private credit space, eventually lenders will be reaching for yield by making loans to lower quality borrowers. Those are the loans that go bad quickly during a downturn. Rather than being a diversifier of risk, even if they are syndicated to a wide swath of investors, these loans turn into transmission wires of trouble and travel up the entire financial daisy chain. This is an area that will require constant scrutiny from regulators at the Fed, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and other supervisory powers. The additional risk here is that those very supervisory functions so critical to the safety of the banking system and financial markets are being gutted. We've seen this movie before. Excess capital eventually chases too few deals. Lots of leverage to enhance returns enhances risk, especially as regulators fail to see Wall Street's excesses. This is my first discussion of risk in the private credit space, and the questions being posed will be deemed absurd by executives in the private credit world. Hold onto your wallets: Not everything is as secure as it may seem. —Ron Insana is a CNBC contributor.
