Those whose memories stretch back to 2008 will remember that second-order effects can be just as lethal as the more immediate impact of a financial crisis. Much has been made of the ongoing turmoil in the oil and gas markets this week, but this could now be compounded by another subprime crisis, resulting in a fusion of the situation in the late-2000s and the 1973 oil shock.

This is a very real scenario. The subprime crisis of the present age is private credit, a market estimated at €2-3 trillion — larger in nominal terms than the subprime mortgage market 20 years ago. Bloomberg reported this week that JPMorgan and Goldman Sachs have started to offer hedge funds a way to short private credit. The two banks have assembled baskets of listed companies which are exposed to private credit.

As happened two decades ago, European financial institutions are among those listed as being exposed to the risky section of the market. In the 2000s, it was the legendary “dumb Düsseldorf banker” on the receiving end of this. Today, it’s clear that the financial institutions in question have a strong exposure to software companies. This is the sector that has been among the worst affected by artificial intelligence, which exposed the software-as-a-service business model as unsustainable. Financial crises result from maelstroms of interacting events.

This bubble won’t exactly burst tomorrow: these things tend to run for a long time before they pop. JPMorgan, for instance, has been reducing its own private credit portfolio of $27 billion since September. Investors have started to apply for redemption of their private-sector managed funds. This is the problem with chasing returns by going off-market: when the panic sets in, everybody wants to get out at the same time, and the fund managers then limit redemptions.

The hedging strategy consists of total return swaps — financial instruments that separate the ownership of an asset from its financial flows. As with the famous credit default swaps used during the financial crisis, the betting occurs through synthetic versions. For those not familiar with complex financial instruments, this idea was captured in the casino scene for the film The Big Short. Here, one person places a bet in a game of blackjack, prompting others to bet on their hand, creating a chain. Credit bubbles occur in different stages. The synthetic CDO (collateralised debt obligation) was a late-stage phenomenon before the whole thing burst. We may now be looking at a similar process.

This is an edited version of an article that first appeared in the Eurointelligence newsletter.

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Wolfgang Munchau is the Director of Eurointelligence and an UnHerd columnist.

EuroBriefing

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