In today's episode, we (Joe Fenech & Kevin Swanson) discuss
Summary:
- A deeper look at the private credit ecosystem: we walk through how it functions across private credit firms, banks, investment banks, and life insurers.
- Near-term risks mostly priced in: risks remain around structure, underwriting, asset marking, illiquidity, and redemptions. After a sharp correction, stock prices better reflect these challenges — for now.
- What could drive another leg down: broader-based weakening in credit and the economy—which we are not yet seeing.
- Longer-term risks remain significant: risk to the broader financial ecosystem will emerge when the next credit cycle unfolds.
- Big banks are exposed—but not at the epicenter: unlike prior cycles, banks aren’t at the forefront. We see both risk and opportunity. Banks should use this reprieve to reduce ecosystem exposure and improve disclosures. Small bank (<$50 bil. assets) exposure to this issue is very limited.
- Implications for activism: recent geopolitical and credit events reinforce our view that a concentrated activist strategy carries risk—as targets tend to be weaker institutions and M&A optionality is potentially more limited.
- Positioning through the dislocation: despite elevated uncertainty, our bullish thesis on banks remains intact.
This session is also available on Spotify or Youtube
Transcript
Kevin Swanson:
Hello and welcome to Talking Banks with Joe and Kevin, this is episode 9 and we are following up on our discussion last episode around private credit and the impact its having on the market and investors. But first a quick disclosure.
Disclosure
Joe Fenech and Kevin Swanson are employees of GenOpp Capital Management, an investment advisor that maintains exempt reporting status in the state of Indiana. This podcast represents the views, beliefs, and opinions of GenOpp members and does not assert to be complete. The information presented in this podcast is provided as of the dates indicated and opinions presented may change. You should not rely on this podcast as a basis upon which to make an investment decision. This podcast is not intended to provide and should not be relied upon for tax, legal, accounting, or investment advice. GenOpp’s clients or its members may hold or recommend to GenOpp’s private fund clients the purchase or sale of securities of companies discussed.
Ok, so following up on our last episode -- the topic again here is primarily private credit and what we’re seeing in that market. That’s clearly had spillover effects into the bank sector and bank stocks. And then more broadly, just how we’re thinking about portfolio positioning. There’s always a lot coming at investors, but it does feel like right now there’s more than usual – so we’ll try to frame how we’re thinking about all of that.
So just to quickly recap how we introduced this last time.
The main point we made was that this is bigger than just exposure to software and AI disruption. That’s part of it, but we think the concern runs deeper.
It’s really about:
- The structure of the private credit and private equity market;
- The underwriting;
- The pace of growth over the last decade, much of it in a very low rate environment;
- The marking of these assets, or lack thereof;
- And then the illiquid and opaque nature of it all.
And you’ve seen those concerns show up in the stocks – first in the pure private credit and private equity names, and then more broadly across banks, life insurance, capital markets – really anything with exposure into that ecosystem.
So that’s where we left it. The question now is, so now what happens next?
Joe Fenech:
Yeah, I think that’s exactly right.
Before we get to that question, I want to spend a minute going a level deeper on how this system actually works – b/c I think that’s really the key to understanding what’s going on. If you take a step back, a lot of what we now call private credit used to sit on bank balance sheets. After the financial crisis in ’08 and Dodd-Frank in 2010, a lot of that lending got pushed out of the regulated banking system. Then if you fast forward to around 2020, you started to see the banks creeping back into the system – but not in the same way. In more of a back door sort of way, they’re lending to private credit firms, they’re partnering with them in some cases, they are directly lending in some instances, but overall they’re participating more indirectly.
Then you’ve got the investment banking firms as a middleman of sorts – structuring deals, setting up SPV’s, which helps minimize the capital charges for the banks, they’re helping to move risk around, and in some cases putting their own capital to work.
And then you’ve got the life insurance companies – which are some of the biggest buyers of this product. And that part is really important. There are a couple of reasons they like it. First is the yield – especially in a low rate environment, this was a way to pick up incremental return. But more importantly, it fits their business model. They have long-dated liabilities – policies that may not pay out for years or decades – so they like the long-dated assets to match that. And because of that, at least in theory, they don’t need liquidity. They can ride through volatility and hold these assets over time.
Now, that works – as long as the underlying credit holds up, and you don’t get into a situation where liquidity suddenly matters. So that is basically the flywheel, and the system that we’re dealing with today.
Kevin Swanson
And we’ve been seeing weakness in the pure private credit and private equity stocks for a while now. A lot of insiders sold last year, and the market was beginning to anticipate issues before obvious cracks started to appear.
And then when First Brands and TriColor went down last fall, you saw it start to spill over as Life insurance stocks reacted and bank stocks had some very rough sessions, and we also had liquidity pressures at the time as QT was winding down, we discussed that at length last fall, that has since improved; But the life insurance and bank sector stocks largely recovered a lot of lost ground in the fall of 25 by year-end.
Joe Fenech:
Right, but this year it’s been a different story. The life insurance stocks, the big banks, the capital markets firms, more recently the regional banks, and of course the private equity and private credit stocks have been pounded pretty relentlessly. And what’s notable is this: the companies with the most exposure to private credit have clearly underperformed. And across those sectors, those names are actually more correlated with each other than with their own peer groups.
Kevin Swanson:
So that leads to some key questions: Could this be systemic? And is this really a credit problem, or is more about the structure of the system and liquidity?
Joe Fenech:
Well, first as a sidebar, the Wall Street Journal has again made a few attempts here in the last week to try to paint the banks as being at the center of the problem. I don’t know if someone at the Journal was turned down for a car loan at a bank, it has to be something, but the Journal has had it out for the banks for awhile now. I think back to when New York Community Bank looked like it was going down in early 2024, and the Journal had run a story not too long before that, in describing some of the issues in commercial real estate, and the headline and I’m paraphrasing here, was that there was $3 trillion of this type of problematic commercial real estate exposure on bank balance sheets across the country. And I remember thinking to myself, really? There’s really $3 trillion of office real estate in major metro markets and then more specifically to the New York Community Bank situation, there’s that level of exposure to rent-regulated multifamily exposure in New York City, where laws were passed 5 years earlier severely curtailing the ability to raise rents? Banks in Wisconsin with commercial real estate exposure in office buildings that are two stories high, with like a dentist’s office on the first floor and an attorney working upstairs, that bank has problematic office real estate exposure akin to what New York Community Bank is facing in New York City? B/c that’s what that Journal headline implied. And that led to a sell off in all banks that were perceived as over-exposed to commercial real estate. It really turned out to be a blessing for us, b/c the first thing we did was go buy all of those supposedly over-exposed commercial real estate heavy banks, and ultimately it was a nice driver of fund performance for us that year. But it was harmful to the extent that we had to spend the next 6 months explaining to generalist investors that had been interested in investing in the bank sector why the fears were overblown.
We’re seeing the same type of headlines now out of the Journal, somehow attempting to subtly shift the blame from the private credit firms where the vast majority of this stuff originated onto the banks. So on Friday, March 13, there was an article with the headline: Why Bank Stocks Are Getting Beaten Up Over Private Credit. And then on Monday, March 16, another headline article, The Blowup That Exposed How America’s Banks Are Entangled In Private Credit.
And look the goal here is not to absolve the banks by any means. I don’t like how the banks have sort of backdoored their way back into this business quietly over the last several years. I think what happened is in the 10 years after the GFC, loan growth was very weak, it’s still weak today, but improving. And this is where the growth was. The banks couldn’t participate directly, so they did it indirectly through these partnerships and intermediaries, and then in the last few years really accelerated the push into this business. And now they have this exposure that they don’t really understand, because in most cases they didn’t originate the credit.
But that’s a key distinction – and I think it’s really the most important point here. In 2008, the banks were at the center of the flywheel. They were the originator of the credit, they did the underwriting, they had the bulk of the exposure, and the other financial sub-sectors were sort of tangential to that through their tentacles into the banking system. Now it’s really the other way around, the banks are the ones that are more indirectly exposed, despite the best efforts of the Journal to paint a different picture and shift the narrative here. And I think for this issue to be systemic or even for it to become orders of magnitude worse from here, I think the banks need to have been more central to this process and have more significant direct exposure to the core problem than they do.
But having said that, the banks have a few problems here. First, my fear is that a lot of these bank management teams don’t know what they’re exposed to and I don’t like the lack of control they seem to have over the process as these credits go bad. It reminds me of the issue we used to see during corporate credit cycles with shared national credits, where the smaller banks would participate in these larger national deals, where they weren’t the lead bank, and the credit would go south and the smaller bank’s fortunes on that credit were tied to the whims of how the lead bank treated that credit, and they were sort of powerless in the process.
It seems to us that these one off fraud situations that we’ve seen over the last several months have caught the bank management teams completely by surprise, as though they didn’t even know they had the exposure they did to the credit, and in some cases these are big exposures we’re talking about. And unlike in non-regulated sectors where there’s an ability to kick the can and not mark your book, you don’t have as much leeway to do this in banking. So you see these situations develop and immediately the banks are writing these things down and taking losses. And then the industry collectively in talking about NDFI exposure and attempting to explain it away has sort of leaned on this mantra of well, the stuff we do, the categories we’re in have never had a loss so we’re fine, despite this stuff being sort of a black box.
And so what I would advise as a bank investor to bank management teams is two things: First, take this scare as an opportunity to reduce exposure to private credit or just more broadly, credit that isn’t underwritten by you and go through your loan committee and underwriting process. It’s not relationship business, you’re not going to get credit from investors for the additional loan growth because it’s going to get outweighed by the opaqueness we talked about and the credit risk. And second, improve the disclosure. I want to hear that the credit exposure you have has been underwritten with the same level of care as your directly originated portfolio. I don’t think it will be sufficient to say, the vast majority of our NDFI exposure is to capital call lines and mortgage warehousing so we’re fine. And I don’t think it matters if the exposure is in an SPV structure or some fund and the disclosures aren’t adequate, if that’s the case, then why are you in that, and if you are and you can’t tell me what it is, then conservatively, I need to discount that when I’m considering your overall credit risk. You have tentacles into something that we think is going to drive the next credit cycle, and if we’re right about that, we care a lot more about that risk than we do about the benefit you’ll see from a few extra points of loan growth over the next few years.
And so again, these problems on the whole don’t need to be all that significant for them to present major issues for the stocks. I think every time you get one of these situations, like MFS in London, or First Brands or Tri Color last year, you have the potential for the banking index to take a hit, we’ve seen multiple 4-5-6% down days for the entire banking index b/c of these one off situations over the past 6 months, and I think unfortunately that’s going to continue to be the case, which on the one hand presents opportunity b/c again the level of overall exposure doesn’t warrant that type of reaction, but it’s also going to lead to investors avoiding banks that have exposure and disclosures that don’t allow people to get their arms fully around the problem. So it’s both a risk and an opportunity as I see it.
Kevin Swanson:
I would just further emphasize that despite the volatility that this has introduced, we really do see it as an opportunity as well, b/c just like with the commercial real estate issue from a few years ago that Joe mentioned earlier, the majority of banks don’t have any exposure to these assets. Within the group of public banks we look at, this is an issue for the too big to fail banks and the larger regionals. There are just a handful of banks under $50 billion in assets that have any exposure whatsoever to any of these areas you’re seeing the headlines. So when the index sells off 4% in a day because a few large regional banks have exposure to First Brands for instance, that sell-off takes the smaller banks with no exposure down with it. And so that’s an opportunity, you just need to be able to stomach the volatility.
Joe Fenech:
100%. And so that brings us back to the question of how serious are these problems for the financial system overall and is there another leg down from here for the pure play companies in private credit and private equity, and by extension, the banks and these other impacted sectors. And what I would say to that, it’s not impossible, there is always potentially another shoe that can drop, and certainly things could still develop with the war and the implications from that for credit and the economy, but based on where we sit today, it’s probably unlikely that we see this explode right now into a major credit problem for the economy.
So I think to this point, the problems that we’ve seen speak to a somewhat flawed underwriting structure, and idiosyncratic credit issues, so for instance, Tricolor was a subprime auto lender that catered to immigrants and people with very limited credit history. And so you can point directly to the change in immigration policy and overall struggles in subprime auto more generally in a higher rate environment that led to a problem in that business. Now, what that exposed, per news reports, and we don’t have all the info yet, was an underwriting structure that raised some eyebrows, with allegations of double pledging of assets in the situation with First Brands for example, and then more recently with MFS, with speculation about potential collateral shortfalls. And it provoked the thought that if that was the common denominator in terms of underwriting and structure, was this practice more widespread?
Kevin Swanson:
But in our conversations with the banks, they aren’t seeing any issues in their originated portfolios. So they have exposure to First Brands for instance, and in some cases they lent directly to the company, and in other cases they have exposure through these SPV structures set up by the investment banks, but they aren’t seeing issues in what we’ll term their core underwritten portfolios, and that’s across the board, on the consumer and the commercial side, from best we can tell.
Joe Fenech:
Right, and so that’s what leads us to think that as of now, this is a problem that relates to underwriting philosophy that gets exposed when you have these one off credit blips. And make no mistake, when we see a credit-led downturn, we think this stuff is going to be a major problem. A major problem. But what you need I think right now for this to be a major problem for the entire ecosystem of private credit, private equity, banks, life insurance, and capital markets, I think you need a downdraft in the overall credit environment and the broader economy. And we just aren’t seeing that. We talk to banks literally every day, at minimum five a week, I just met with 6 of them in one day on Tuesday. And the credit issues just aren’t there, they aren’t seeing them. And to the smaller banks, this private credit stuff is close to being a foreign language, they just aren’t involved at all.
Kevin Swanson:
Yeah, so is in effect what you are saying is that at this point, the issues that we’re seeing playing out in the market primarily relate to, first, questions around loose underwriting and structure around these select one off credits that seem to have idiosyncratic stories to each of them that aren’t really related to each other aside from the concerning similarity in how they were structured? And second, the issues around redemption requests at these funds, questions around whether the portfolios are marked appropriately, and then illiquidity? Is that a fair way to summarize the concern?
Joe Fenech:
I think that’s right. And I don’t want to minimize how serious of a concern these things are. In some respects, they can lead to new and more serious issues, so it becomes a negative feedback loop. But I think if the challenge remains restricted to fund gating and redemptions and illiquidity, which by the way, are all perfectly acceptable responses that are built into the agreements when these funds were set up, whether people read the fine print or not is another issue, but this so far is not a disorderly situation, if that is the issue, and the marks are just too aggressive, but the underlying credit quality for the most part holds up. I think the damage to date in these stocks, give or take, probably adequately reflects those challenges.
I think to see another major leg down, and significant spillover to banking and life insurance, I think you need to see credit deteriorate more broadly, and what happens at that point is the ratings agencies, and let’s be honest, there have been questions around how these credits are rated, but if you start to see credit downgrades, that disturbs the ecosystem in a more meaningful way in the sense that with life insurance for example, there is more punitive capital treatment of these assets if they are no longer investment grade, they’re obviously illiquid, the match funding becomes an issue. And then for the banks, they are recognizing these issues as they happen. That’s when you would see just a tsunami of issues.
And everyone gets hung up on the definition of systemic. But something doesn’t have to be systemic to be potentially really really bad. Remember back to 2023, when you had the liquidity panic, the too big to fail banks were never perceived to be on dangerous ground, they were actually net beneficiaries of the problems we saw in the failed banks. So it was never systemic, but 3 large regional banks still failed, and there were concerns about a potential deposit run on the regionals, so not technically systemic but at that point, who cares, it was still really, really bad.
So unfortunately, I think this is a question of if, not when in terms of this being the next big trouble spot for credit and the economy, we just don’t think that time is now. But it’s like there’s a big piano suspended by a wire, hanging over the heads of the system and the wire holding it all up is still strong enough where the piano just hangs there, it doesn’t fall on you. So if you subscribe to the notion of if not when, then I think if we’re right that the system gets a temporary reprieve here, we think it would behoove banks not to say ok see, everyone overreacted there is no problem here. Instead, take advantage of the reprieve and the scare to say you know what, we’re going to meaningfully improve disclosure and our own internal understanding of what we’re exposed to, we’re going to re-underwrite this exposure as we would our own, and we’re also going to move to reduce exposure to this asset class.
And if not, I don’t think at GenOpp we’re going to be alone among investors in this space in saying you know what, I need to move to banks that just don’t have this piano over their head at all, I don’t care how strong the rope is holding it up. If you can’t help me understand the risk, and you still think this is a good sandbox to play in, you’re going to have an overhang over your stock, and investors like us are just going to stay away, and in the banking sector, the good news is we have plenty of optionality to do just that.
Kevin Swanson:
And we’ve talked about this before, we have a proprietary scoring system that scores each bank we evaluate on a range of quantitative and qualitative metrics. So it’s not that it’s absolute that we wouldn’t touch a bank with this type of exposure, but the hurdle that that stock would have to overcome to garner a score that would lead us to consider it for a spot in the portfolio, this issue alone would probably make it prohibitive. Joe, any other points you want to make on tactical positioning here from an investment standpoint?
Joe Fenech:
I think you hit on an important point. Because the discussion to this point might seem overly theoretical and that we’re splitting hairs on these points. But here’s where the distinction really matters. If you think, as some of the commentary and analysis I’ve seen would suggest, that this is a huge overreaction on private credit and private equity, you might be inclined on the bank side of things to buy the stocks most impacted by the overreaction, like we did during the commercial real estate scare a few years ago. But that was a fundamental misunderstanding of the exposure and the narrative around it. In that case, the risk was overstated. Here we think the structure is actually more problematic – even if it’s not showing up in the same way – yet.
So while this might not be the big one from a credit perspective, we think it will come at some point, we just don’t know if it’s a year, two years, or ten years. So then if you weren’t already worried about this exposure, this scare should be sufficient to say you know what, that group of banks no longer intrigues me, and you can do that, b/c like I said earlier, the entire group has been hit here, including banks that literally have no exposure whatsoever to this issue. They might not be as down as much as the ones with more direct exposure, but the risk reward dynamic from this point is still much more favorable.
Look, having done this for a long time, there are 3 things that can sink you in banking: credit, capital, and liquidity. And when of those issues is present or you can see it on the medium term or even longer-term horizon, the upside reward is never in my experience enough to offset the potential downside risk.
And not to sound like a broken record, but we’re also going to continue to hammer on this question of activism in banking because we keep getting questions about it. But we think the events of the past few weeks really drive home the point we’ve been making for awhile now on activism in the bank space. Events can come out of the blue at any time – and never has this been more true than in the past 6 weeks. Very few people including us at the start of this year had war in Iran and $100 oil on the docket. Very few people had this AI / software concern and the tie in to private credit and private equity that really sparked this recent panic, and the reason is b/c it’s really really hard to predict these sorts of things.
And when these things happen, it can’t help but put a chill, at least temporarily, on the M&A environment. And not surprisingly, some of the regional banks that were widely perceived to be potential M&A targets, these are banks that also screen poorly on some of the problematic exposures on the credit side that we’ve been talking about. And again, these companies just generally tend to be subpar performers, which is why they’re M&A targets in the first place.
So if something happens that you don’t expect that derails the M&A thesis, you’re concentrated in names that probably will underperform the broader universe of bank stocks in a downturn scenario. And again, the derailment of the regional bank M&A thesis is still not our base case scenario. The M&A angle is still a meaningful component in our view, of an overall bullish bank sector thesis. But if you have a bear case and a base case, and you weight them, the base case probability weighting is a little lower, particularly around M&A, and the bear case odds are a little higher, following the events of the last few weeks, even as the overall bullish thesis remains intact. So our take has been and remains that you can play these themes and we are playing them, as we said earlier, we were in Comerica, we were in Webster when those banks were taken out, but you also want to maintain strategic flexibility in how you manage the portfolio as things evolve.
Kevin, any closing thoughts?
Kevin Swanson:
I think you said it well. Macro risks have clearly gone up over the last several weeks, and then you have the broader financial sector credit risk that has increased as well, I think the geopolitical risk in isolation we’d be seeing as an opportunity to get much more aggressive in our positioning, the credit risk aspect of it though layered on top of the macro though certainly has given us a little more pause, but overall, still a very manageable situation, and again, we continue to see opportunities as stocks have corrected. And overall, the thesis that we’ve articulated for awhile now we think remains intact.
Disclosures:
Of the individual stocks mentioned, our investment fund currently has a position in Fifth Third Bancrop (FITB) which acquired Comerica Incorporated.
The information in this newsletter does not constitute an offer to sell or a solicitation of an offer to buy any security. This information does not purport to be complete, is subject to change, and is qualified in its entirety by the definitive offering documents related to any private fund managed by GenOpp Capital Management LP. All time-sensitive references are made as of the date set forth above, unless otherwise expressly indicated, and there is no obligation to update any such reference. The delivery of this information does not imply that the information is correct and no representation or warranty is made as to the accuracy of any information contained herein. This information is not a recommendation to buy any security and does not constitute any form of legal, tax, investment, or other advice.
