The Insight: Conversations – Performing Credit Quarterly 1Q2023

Episode Summary

Executive Summary: Oaktree’s Armin Panosian and Howard Marks argue that the long era of easy money created fragile capital structures, weaker covenants, and maturity/liquidity mismatches that are now surfacing as defaults, bank stress, and distress. They see tighter bank lending, growing private credit, and higher-for-longer rates as setting up a multi-asset distressed opportunity.

Main Topics: End of the easy-money era (Priority: 5/5): The speakers say years of low rates and abundant liquidity encouraged aggressive leverage, weak protections, and optimistic underwriting that are now reversing. Silicon Valley Bank as a case study (Priority: 5/5): SVB is presented as a classic asset-liability mismatch: short-term deposits funded long-duration securities bought at low yields, which collapsed when rates rose and withdrawals accelerated. Banks pulling back from lending (Priority: 4/5): Banks are reducing commitments to large leveraged loans after 2022 losses and unstable loan-distribution markets, especially for syndicated deals. Expansion and consolidation in private credit (Priority: 4/5): Direct lending/private credit is positioned to absorb financing demand left by banks, with large, disciplined managers likely gaining share while weaker managers are weeded out. Rising defaults and distressed opportunities (Priority: 5/5): Higher rates and refinancing hurdles are expected to drive more defaults, bankruptcies, and asset repricing across floating-rate and highly levered borrowers. Higher-for-longer rates and policy uncertainty (Priority: 4/5): Marks and Panosian argue rates may stay materially above pre-2022 levels, with debt-ceiling-driven Treasury issuance possibly pushing yields higher. Psychology and cycle risk (Priority: 3/5): The conversation emphasizes that complacency and the belief that risk is absent are themselves the biggest risks, and that market psychology may shift further toward distress.

Key Arguments: Easy money drives weak underwriting: lower spreads, weaker covenants, and higher leverage become acceptable because lenders fear missing deals more than losing money. SVB failed because deposit liabilities were short-term while assets were long-duration fixed-rate bonds; rising rates created mark-to-market losses and then a liquidity spiral. Bank lending capacity is constrained by prior syndicated-loan losses, weak investor demand for loan takeout, and balance-sheet caution, reducing their willingness to commit to new deals. Private credit is poised to fill the gap left by banks, but competition should be strongest among large, disciplined, multi-cycle managers with robust underwriting. Direct lending will likely continue growing rapidly, but the sector should professionalize as weaker, more aggressive firms are forced out by poorer performance and capital pressure. A distressed cycle is already beginning: refinancing at today’s rates may require much larger equity checks than deals underwritten in prior years, causing stress for borrowers with old capital structures. Floating-rate borrowers are more exposed than fixed-rate borrowers because rising base rates immediately raise interest expense and pressure cash flow. A broad rise in Treasury issuance after the debt ceiling is resolved could push yields higher and create additional stress for rate-sensitive assets. The market may be underestimating the persistence of higher rates and the breadth of the coming adjustment across real estate, corporates, and credit markets.

Data Points: SVB size: $220 billion - Howard Marks cites the bank’s collapse over three days as an example of how fast modern bank runs can happen. Banks on the hook for syndicated lending in early 2022: $60 billion - Armin Panosian says banks were committed to large volumes of loans just as market conditions changed sharply. Losses on banks' balance sheets from syndication process in 2022: $3 to $4 billion - Panosian says banks lost money from “moving fee” lending/syndication activity. Historical high-yield default rate (1978-2008 average): Just over 4% - Howard Marks cites this as the long-run normal default rate before the easy-money era. High-yield default rate (2010-2019 average): Closer to 2% - Marks argues easy money suppressed defaults below historical norms. Direct lending market size before GFC: About $250 billion - Panosian uses this to illustrate how much the asset class has expanded. Direct lending market size today: Approaching $1.5 trillion - He says the market has grown substantially and is still expanding. High-yield bond market size today: About $1.5 trillion - Panosian says direct lending is nearing the scale of high-yield bonds. Broadly syndicated loan market size today: About $1.5 trillion - Panosian compares direct lending’s scale to the syndicated loan market. Typical leverage in older broadly syndicated loans: 5x to 6x total debt to EBITDA - Panosian says many loans were originated at leverage levels that now look too high. Refinancing equity requirement under current market conditions: About 60% equity check - Marks describes how a new deal today may require much more equity than one originated during easy money. Equity requirement in older deals: About 40% equity check - Marks contrasts current conditions with prior easy-money underwriting. Typical loss given default in broadly syndicated loans: 25% to 30% - Panosian says current losses could exceed historical norms because leverage is higher.

Pivotal Quotes: "“The worst of loans are made in the best of times.”" — Howard Marks: Marks uses this to explain why easy-money periods produce the riskiest lending behavior. "“The riskiest thing in the world is the belief that there’s no risk.”" — Howard Marks: He closes by warning against complacency and arguing that market psychology often swings from confidence to distress. "“There are shocks still possible.”" — Armin Panosian: He uses Silicon Valley Bank to show that even after years of stability, sudden failures can still occur.

Implications: Expect tighter bank lending, more refinancing stress, and greater opportunity for large private-credit managers. Higher rates and weaker structures should drive defaults, distress, and consolidation across credit markets.