Another Major Market Risk to Watch: Excessive Amount of Hidden Debt

Last week, we looked at two major risks growing in the economy — the commercial real estate market and a potential credit crunch.

Today, we’ve got another risk for you. Except this one is lurking in the shadows. It’s all around us, and it’s even more difficult to see.

It’s called shadow debt — loans held by non-regulated financial institutions.

• This includes private lenders and private equity investment firms — whose share of total debt has increased in recent years.
• Bankers, regulators and other finance professionals interviewed by Bloomberg see this as a major area of concern.

“Warning signs are developing in what is a completely unregulated segment of the financial markets with substantial amounts of hidden leverage and opaqueness,” per VGI Partners Global Investments (BBG).

What’s the problem? You can’t see it or regulate it — and there’s lots of borrowing involved — the perfect recipe for a financial crisis.

The amount held in these institutions has more than doubled since the last financial crisis.

In the past few years, and during other periods of low interest rates, private equity firms loaded companies with cheap debt to juice up their returns.

Now that interest rates are rising, companies are struggling to pay that debt, leading to defaults and losses to their lenders.

The financial system is a stack of cards

According to Bloomberg, today’s loans are modest compared to the types of leverage before the ‘08 financial crisis — but any major unforeseen event could pressure the entire ecosystem.

On Sunday, the European Central Bank Vice President said, “the banking sector in Europe is sound and resilient…”

• But the concern is among non-banks — who “took a lot of risks” when interest rates were low.
• And that “potential vulnerabilities can come to the surface” in monetary policy change (i.e., rising rates).

Several high-profile fund managers and US Fed members have voiced concerns with shadow banking — and banks and investors have pulled away from the sector in recent months. But like other major risks, it’s near impossible to predict.