Whitney Baker at Totem Macro penned an excellent thread this week discussing where the losses are hidden in Private Equity. I asked Claude to summarize the thread and provide additional information where needed:
Private equity (PE) firms have been buying up about 10% of US life insurance companies since 2020. They’re then using the insurance companies’ money (called the “float” – money from premiums that hasn’t been paid out yet) to make risky loans to struggling businesses.
They’re using a private ratings agency to label these risky loans as safer than they actually are. This fake safety rating lets them:
- Hold less cash in reserve (normally you need more reserves for risky investments)
- Legally invest in things they otherwise couldn’t
Many of these loans are going bad – about 10% are already defaulting. The companies that borrowed the money are often unprofitable startups (especially software companies) that can’t actually pay back their debts. Some are even “zombie companies” kept alive artificially.
How the Fed raising rates in 2023 amplified this problem:
- Fed Raises Rates → Government Borrowing Costs Go Up
- When the Fed raised interest rates, it became more expensive for the US government to borrow money
- The government pays interest on its debt, so higher rates mean higher interest payments
- This caused the government’s budget deficit to balloon by 3% of GDP in 2023
- Bigger Deficit → More Treasury Bonds Issued
- To cover this bigger deficit, the government had to issue more Treasury bonds
- These bonds became “fresh collateral” – basically, new assets that could be used as backing for loans
- The RRP Money Gets Unlocked
- There was $2.5 trillion sitting in something called the Fed’s “Reverse Repo Program” (RRP) – think of it as a parking lot for cash
- Normally this money just sits there safely
- But with all these new Treasury bonds available, financial institutions could use them to borrow against in “repo markets” (short-term lending markets)
- PE Firms Borrow This Money
- The private equity firms and their various entities (the “layers of the leverage cake”) were able to tap into this massive pool of money
- They used it to fund more and more risky loans through the insurance companies
Instead of letting the economy cool down (which is what rate hikes are supposed to do), the Fed accidentally created a situation where trillions of dollars flowed into this problematic private equity scheme.
Who Gets Hurt: Foreign banks and insurance companies:
- Foreign Institutions Bought the Debt
- These PE firms and BDCs (Business Development Companies – investment funds that make these risky loans) didn’t just use insurance company money
- They also borrowed money from banks and sold bonds/securities to investors
- Foreign banks and insurance companies in countries like Japan and Germany were major buyers of these securities
- Why Foreign Buyers?
- Japanese and German institutions are from “surplus creditor nations” – countries that save a lot and invest globally
- They’re always looking for places to invest their money
- US securities seemed attractive, especially ones with good (fake) credit ratings
- They’re Holding the Bad Loans
- When these loans start defaulting (which the author says is already happening at 10%+), the value of those securities plummets
- The foreign banks and insurers who bought them will take massive losses
- They Don’t Know Yet
- Stocks of these foreign financial institutions are “at all time highs”
- Meanwhile, US-listed PE firms and BDCs have already collapsed in value
- This suggests the foreign institutions haven’t realized their investments are worthless yet – the losses are hidden in complex financial structures
Foreign banks and insurers thought they were buying safe, well-rated US investments. Instead, they’re holding bags of loans to failing startups and zombie companies. When they finally discover this (mark their books to reality), their stock prices will crash too. It’s like they bought what they thought were AAA-rated bonds, but they’re actually subprime loans in disguise.
In Summary: This is as a massive, ticking time bomb of bad debt hidden inside insurance companies, enabled by sketchy ratings and Fed policy.
Tuna Thoughts 