HSBC Just Issued A Dire Warning To The Entire Banking System

Speaker A: HSBC just did something that should have everyone in the credit markets asking themselves one very uncomfortable question. If everything is fine in private credit, then why did one of the world's biggest banks just take a huge step back? According to reporting from the Financial Times, HSBC has informed some of its private credit borrowers it's not going to renew their credit facilities. It also says it's pulling some back leverage away from risky private credit funds. There are questions about collateral. In plain English, HSBC is headed for the exit. Private credit has always been marketed as an alternative to banks. But behind the curtain, the banks never really left. They just moved back. One layer, the public sales pitch was private credit stepped in where banks pulled away. But the reality was private credit funds depended heavily on banks for credit lines, for warehouse financing and leverage, lots of leverage that turned ordinary loan returns into attractive looking private market performance. Now HSBC is saying the returns that they get from providing that leverage and the bailout capacity from the credit lines no longer justify the risk. This is huge. The insiders, the people actually funding the machines that's seeing the collateral, negotiating the terms, they keep pulling back. And HSBC is obviously a big one. Meanwhile, public credit markets, like stock markets, are still acting like nothing is happening, nothing is wrong. Junk bond spreads or high yield credit spreads, whatever you want to call them, they remain tight by historical standards. In some measures exceptionally tight. Investors are still accepting very little extra compensation to own what really is risky debt. So we have this strange split screen. Inside the system. Financial players, especially the banks, are moving away. They're pulling credit, they're revaluing collateral. But outside the system, retail money continues to pour in, which we'll talk about why that is and what that does to the actual signal that we're getting in spreads. But this isn't really a contradiction. In credit cycles, the insiders are always the ones who move first. And uh, what the Financial Times reported was that HSBC is halting lending to riskier private credit funds after a series of high profile corporate bankruptcies exposed, you know, weaker underwriting standards across at least parts of the industry. You know, the cockroaches. And for hsbc, that included mfs, which blew up earlier this year. Now the bank reportedly told clients in recent weeks that it's not going to renew certain credit facilities and it's not going to be providing the back leverage to some of these funds. And back leverage is key to them. This is debt that's provided to a lender against its own loan portfolio. The loan portfolio ends up being collateral. The Private credit fund makes loans to companies and then to juice its returns, it borrows against those loans. That borrowed money allows the fund to make even more loans, to increase their asset size and to amplify returns for the shareholders of the funds. And when things are doing good, back leverage makes the numbers look a, uh, ton better. And when the cycle turns though, back leverage turns into pressure. Because now the fund not only has to worry about whether its borrowers can pay, it also has to worry about whether its own lenders will trust the collateral, which, which is the loans that it just made to these corporations. And HSBC is not saying we had one bad borrower, it's saying something far more broad. Certain funds no longer offer enough return for the risk. And even bigger than that, the collateral that they post isn't worth enough to be protection for hsbc. This is a major, major shift. Whatever private credit providers are telling you in public, the banks who see everything because they have the power, they have the funding and leverage money, the banks get to look inside the books that we wish we could. And right now HSBC is looking at them and saying it doesn't like what it's seeing. Now. During the boom, the private credit industry sold itself on control and discipline and above all, superior underwriting. These were not supposed to be sloppy syndicated loans. They were supposed to be privately negotiated deals with stronger covenants, better access to information, and supposedly tighter relationships with the borrowers. But if any of that was really true. But why are banks stepping away right now? And that, that's, it's totally critical. It's crucial. Now Bloomberg has reported that big banks have been raising rates on leverage that they provide to some of these private credit managers. And they've also been marking down individual loans that are posted as collateral, which is always a, uh, big thing. Banks including JP Morgan, Goldman Sachs and Barclays, in addition to hsbc, have, uh, reportedly exercised the right to write down specific assets, the collateral, forcing some of these fund managers to swap holdings out of these collateral pools. This is, this is not a headline default event. It's even deeper than that. This is the funding layer, questioning the values. While the Blue Owls and the John Grays are running around telling you their numbers all work and their portfolios are just fine, the banks who are looking right at those same portfolios are getting the hell away from them. Take the inside information every time. Before we go on with our video today, let me ask you a question. 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But now let's get back to the rest of our video. Now the mainstream conversation around private credit typically focuses on, as you would expect, credit losses, maybe selective defaults, conversations about pik. But more and more the conversation is switching and turning toward liquidity and collateral, where usually ends up in the downswing of the cycle, especially collateral, which drives liquidity. Private credit loans just don't trade every second like treasury bonds or large public corporate bonds. They're valued using models. Comparable transactions sometimes just flat out assumptions. And they get made periodic marks that can make returns look smooth on the surface and reduce day to day volatility. And that certainly makes investors feel like they own a stable asset, which is largely the point. But smooth marks are only comforting as long as everyone believes in them. If investors start believing the values that causes redemptions to rise, which we're seeing. And if banks stop buying the marks, the leverage increasingly gets pulled back. And once that happens, the fund's economics really start to deteriorate. And this is where private credit becomes truly vulnerable. A fund can tell its investors our portfolio is performing, but if a bank says we don't accept that collateral value anymore, the bank matters first and foremost because the bank is providing the immediate financing. If a bank marks down a loan posted as collateral, the fund may need to post more assets, which is an asset swap. It may need to reduce its borrowing, sell some loans, or even accept even worse terms, which we're seeing. All of these take place in increasing frequency. And all those options, they hurt returns or they hurt liquidity and likely in many cases they hurt both. And this is the hidden pressure point. Private credit funds were Able to generate attractive returns, partly because they used this leverage. Not always extreme leverage, and not always in the same way. But leverage was a critical part of the entire machine. At the borrower level, Companies were leveraged at the fund level, portfolios were leveraged at the system level. Banks, insurance companies, asset managers, private funds, they all became interconnected with, with all of this money flowing around through the system. So when leverage is available, everything expands and it looks great. But when leverage is questioned and everything tightens, then it can get really dicey. And that's why back leverage is not some technical side detail. It's central to the private credit math. And if HSBC is pulling it and other banks are raising rates or marking down collateral too, that means the insiders are no longer pricing the risk the same way that they were before. Downside to the cycle confirmed. And this is happening while at the same time, the public market is still incredibly relaxed and complacent. And that gap is big part of the story. Now compare all of that with what's going on or really what's not going on in publicly traded junk bond spread. Now, spreads are just the extra compensation that investors demand to own riskier assets. And they tell us something about complacency, perceptions of risk, although in this case, increasingly less about fundamentals. In the same way, the stock market is really not about fundamentals either. In fact, the two are also interconnected. When spreads are wide and widening, that means investors are worried. They want to be paid more for all sorts of risks. And when spreads are tight, it suggests that investors are calm, they're willing to accept less compensation. And right now, high yield spreads remain tight. By historical standards, they are nowhere near levels you'd expect if markets were seriously pricing a major credit downside. The reason, as our friend Mike Green will tell you, is passive investing flows. Retirement money chasing stock market returns floods fixed allocation funds, which means the more money comes in, the better the stock market seems to be doing. The more money automatically gets allocated to bonds. And in this competitive, uh, world, that means retail reaching for yield. Think about that. The more stocks get detached from reality, the more that attracts money into junk credit. Not because the opportunity is there or risks are low, but because that's how passive investing works. Equities pull the money in and they mechanically get allocated. And the more that depresses credit spreads, the more it looks like the market is saying there's no risk to putting even more money in. It's a false, misleading signal. Just like stocks retail junk spreads, they're not telling you Anything about the fundamental conditions in the junk bond market. And that creates our split screen. On the one side, banks with direct visibility in private credit and collateral are uh, reducing their exposure. They're running for the exits. And on the other side, broad high yield markets remain priced like defaults will stay contained or not even happen in the first place. That liquidity will remain available and refinancing windows will stay open forever, forever into the future. Those two things can coexist for a while. And they often do. Public markets can stay calm long after private funding conditions begin to deteriorate. Spreads can remain tight because of passive flows, because of yield chasing and reaching for yield. The belief that any weakness will be J. Powell esque short lived. So why are insiders and banks pulling back from private credit in such a big way? And at the same time in public markets? Public markets and public spreads remain tight and complacent. And the answer is simply that the downswing in the credit cycle doesn't move at the same speed for everyone. This is a common feature in credit cycles throughout history. Private credit funding is relationship based. It's collateral based. It's negotiated behind closed doors. Banks get to review specific portfolios. They get to actually look at the loans, they, they look at borrower performance, the covenants, the collateral values, the recovery assumptions, all of it. If they don't like what they see, they can quietly reduce exposure. They can decline renewals like we're seeing the hsbc. They can demand more collateral, which we're seeing more often through these dealer networks, or they can stop providing back leverage altogether. Public credit can be supported by flows even as private funding becomes more cautious. The narrow set of buyers, the passive allocation most of all. The that momentum can keep headline junk prices high while underlying risks build and even get revealed in credit. The version of that is tight spreads. Tight spreads don't necessarily mean there's no risk. And sometimes tight spreads mean investors aren't demanding enough compensation for the actual risk. And that's especially true when the banks and the insiders are moving the other way. If a major bank like HSBC says we no longer like the risk adjusted return on lending to these funds, while at the same time retail investors are still buying junk credit at tighter and tighter spreads. You gotta ask who is more likely to be seeing the real collateral? The retail investor mindlessly plowing into a 6040 fund or the bank deciding whether to finance a private credit fund's loan book. Now that doesn't mean the bank is always right. Banks always make mistakes. They made plenty in 2007. And they have definitely made plenty here in the cycle that we're going through. But when banks begin de risking after years of aggressive growth, that is information. It is valuable information that the market, the wider market, shouldn't ignore. Now, the key phrase and what's reported about HSBC is the bank saying that the returns it's getting from lending to private credit sources is no longer justified by the risk. That is a substantial change. When a bank says we were fine before, but now we start to see things that we don't like, the risk calculation has changed. You know, that's a big deal because it's not just going to be hsbc. That's exactly what a credit turn sounds like. Not a panic, not collapse, no dramatic press conferences, just a big bank deciding that the compensation is not enough anymore. Literally not worth its trouble. That is insiders voting with their balance sheets. And HSBC is not the only sign. Other banks reportedly raise rates on leverage. Some have marked down loans used as collateral. JP Morgan being a big one. Fund managers swapping assets and collateral pools. Insurance companies and other major asset managers. They've talked about moving up in the credit quality. Apollo being a big one. They're holding more cash and preparing for choppier conditions. Again, ignore what they say in the marketing deck. Watch what they do with their actual money and capital. If they believe the opportunity was as attractive as advertised by all the private credit providers themselves, they would be expanding their exposure to these risky funds to these shadow banks. They would extending more leverage. They would be competing aggressively to finance these portfolios. Instead, HSBCs and the others, the insiders are pulling back. And this is where retail investors need to be careful. The danger is not just owning private credit directly. The danger is owning risky credit more broadly speaking at prices that assume nothing serious can ever happen. Recency bias. As private credit begins pulling back from borrowers and that stress can spill into public credit too. That's always been the wider danger. Because these same companies operate in the same flat beverage economy and within the same debt ecosystem. They face all the same challenges, whether it be input costs or consumer demand. A stressed private borrower may not be in a high yield index, but the financing conditions affect comparable companies everywhere. Retail investors often arrive late in credit cycles because the yield looks good after the rates have already risen. They buy the coupon, not the credit risk. They assume income equals safety. But credit losses don't care about the coupon. And if spreads widen enough, the mark to market losses can overwhelm months or even years. Of extra yield. The liquidity risk is hidden until everyone asks for liquidity at the same time. So the big story is not simply the HSBC is reducing exposure to risky private credit funds and stepping back and revaluing collateral. The real story here is our split screen, the contrast between what appears to be two different markets, but looking at the same market and the same general market from different perspectives. And which perspective do you want to buy? The insiders are pulling back. The outsiders are still pricing calm. HSBC is limiting credit lines, refusing some back leverage and reassessing whether the returns justify the risks. The, the returns from exposure. Other banks have reportedly raised the cost of leverage and marked down collateral. Private credit managers are dealing with redemptions, a lot of redemptions. Liquidity management questions are growing. Valuations are coming under fire. Meanwhile, high yield spreads remain tightened, historically tight in some cases. That means public credit markets are still not demanding much compensation for the possibility, the growing possibility of that. The private credit cycle is indeed turning. And that's exactly how these things usually go. The warning does not begin with a default rate. It hits funding, it redoes collateral. It's the insider saying, we don't like what's going on here. And that's exactly what HSBC is telling us. The only question is whether retail investors notice what's going on before it spreads. If you enjoyed this video, I've got another one for you where, uh, I go into the methodology that I use here at Eurodoll University, why it's so unique, why we depend upon these esoteric signals and curves and such, and why the mainstream doesn't. Why did the mainstream go off in a different direction? Plus, at the end of this video, we talk about, uh, using this information in an investing context, a portfolio management context. The link is on the screen for you to follow.