Private Credit Withdrawal Limits Echo 2007 Subprime Warning Signs

Private-Credit Funds Cap Withdrawals, Stirring Echoes of 2007 Subprime Lock-Ups

• Some private-credit funds have quietly gated withdrawals, the WSJ reports.
• In 2007 a French bank froze subprime-linked funds, the first tremor of the global financial crisis.
• Private credit has ballooned from niche to $1.5 trillion in under two decades.
• Loans are opaque, lightly regulated and increasingly held by banks via warehouse lines.

Are today’s liquidity curbs a benign hiccup or the first crack in a new fault line?

NEW YORK—The quiet decision by several U.S. and European private-credit funds to limit investor withdrawals is triggering flashbacks among veterans who watched BNP Paribas halt redemptions on three mortgage funds in August 2007. That single notice—initially dismissed as a Gallic footnote—proved the opening act of the worst financial meltdown since the Great Depression.

Private credit, a corner of Wall Street that writes direct loans to mid-sized companies, has grown from roughly $90 billion in 2005 to an estimated $1.5 trillion today, according to industry tracker Preqin. The asset class now eclipses the high-yield bond market in size and supplies an estimated 15 percent of all corporate borrowing in the United States.

Yet unlike syndicated leveraged loans or publicly traded junk bonds, these credits rarely trade, valuations are infrequent, and the funds that hold them often give investors quarterly—or even monthly—liquidity. When too many clients ask for cash at once, managers must either sell loans at fire-sale prices or impose redemption gates. Both routes end badly for investors and, potentially, for the banks that provide them leverage.

From Fringe to Fixture: The Private-Credit Boom

Private credit scarcely existed before the 2008 crisis. Banks dominated middle-market lending, packaging loans into collateralised loan obligations (CLOs) and distributing them to insurance companies and pension funds. Post-crisis regulation—Basel III, the Volcker Rule, and stress-test capital surcharges—sharply increased the cost of holding riskier loans on bank balance sheets.

Into that void stepped asset managers. Blackstone, Apollo, Ares, KKR and scores of boutique firms raised dedicated pools of capital that promised floating-rate coupons of 8 to 12 percent, well above yields on comparably rated bonds. Pension funds starved for income in a decade of near-zero rates allocated aggressively; insurers counted the illiquidity premium as a way to match long-dated liabilities.

Between 2010 and 2022 assets under management in private credit compounded at 18 percent annually, Preqin data show. The sector now accounts for roughly one in every six dollars of non-investment-grade corporate debt outstanding. “We have effectively privatised a large slice of what used to be banking,” says Patricia Mosser, director of the Columbia University Initiative on Central Banking.

Yet the structure differs from traditional bank lending. Funds typically borrow short-term from banks via warehouse lines, then refinance into longer-term CLOs or hold loans to maturity. Investors in the funds—pension plans, university endowments, wealthy individuals—expect periodic liquidity even though the underlying credits may not mature for seven years.

Opacity Advantage Turns Liquidity Trap

Because private-credit loans are not publicly rated or traded, managers value them using internal models, often only quarterly. That opacity can delay recognition of credit stress, allowing funds to report steady net-asset values while public markets gyrate. When economic conditions deteriorate, however, the same opacity makes it hard to sell loans quickly, forcing managers to gate withdrawals to avoid forced sales at deep discounts.

The pattern mirrors the 2007 subprime episode, when mortgage-backed securities whose prices were quoted only by internal models suddenly became impossible to value once trading dried up. “The lesson of 2007 is that when liquidity evaporates, the first movers win and everyone else gets stuck,” notes Daniel Tarullo, former Federal Reserve governor and now professor at Harvard Law School.

Regulators have noticed. The Federal Reserve’s November 2023 Financial Stability Report cautioned that “open-end funds holding illiquid bank loans could amplify stress by gating redemptions, potentially forcing fire sales and transmitting shocks to the banking system.” The Bank of England echoed the concern in December, noting that UK banks have more than £120 billion in exposure to private-credit funds via committed credit lines.

Why Redemption Gates Could Spread

Gates are not merely a technical footnote; they are the mechanism through which liquidity risk becomes systemic. When a fund blocks withdrawals, investors in rival funds re-assess their own exposure. Those who sense trouble may pre-emptively redeem from other pools, forcing additional gates. The dynamic, known in academic literature as “liquidity hysteresis,” can freeze an entire asset class within weeks.

We saw the pattern in 2007-08: BNP Paribas in August, then Sentinel Management the same month, soon followed by funds run by Countrywide, Ameriprise and finally a cascade across money-market mutual funds after Lehman Brothers failed. Each gate validated investors’ worst fears, accelerating outflows elsewhere.

Private-credit funds today are smaller and less interconnected than prime money funds were in 2008, but they still rely on bank-provided leverage. A survey by the Alternative Investment Management Association finds 62 percent of private-debt managers use warehouse lines; 28 percent roll loans every 30 to 90 days. If funds cannot refinance, they must sell loans or draw on backup credit facilities—often provided by the same banks that finance their warehouses.

Bank Contagion: The Hidden Channel

Bank exposure operates through three main channels: committed credit lines, warehouse facilities, and cross-selling of securitisations. JPMorgan Chase disclosed $29 billion in undrawn commitments to private-credit funds at year-end 2023; Citigroup reported $22 billion. The totals appear modest relative to bank capital, but they rise sharply when indirect exposures—derivatives, prime brokerage, and syndicated leveraged loans—are included.

Moreover, banks frequently purchase the senior tranches of CLOs backed by private-credit loans, counting them as low-risk assets under Basel III. If loan defaults surge, those tranches incur losses just as subordinate tranches did in 2008. “The assumption that senior paper is safe is precisely what collapsed in mortgage securitisations,” says Anat Admati, finance professor at Stanford and co-author of “The Bankers’ New Clothes.”

Compounding the risk, many private-credit borrowers are themselves owned by private-equity firms that employ high leverage. A study by Moody’s Investors Service finds that 41 percent of large buy-outs completed in 2022 carried debt-to-EBITDA ratios above 6×, levels last seen in 2006. If earnings fall, the first creditors to absorb losses are the private-credit funds; if funds falter, banks stand next in line.

Sizing the Shock: Is Private Credit Big Enough to Matter?

At $1.5 trillion, private credit is substantial but still dwarfed by the $11 trillion residential mortgage-backed securities market that detonated in 2007. Yet size alone does not determine systemic importance; interconnections and leverage multipliers matter more. The Bank for International Settlements estimates that every dollar of private-credit loans creates roughly 60 cents of bank exposure via contingent credit lines and securitisation holdings. Applying that coefficient, the effective systemic footprint approaches $2.4 trillion—larger than the entire high-yield bond universe.

History also shows that asset classes need not be enormous to trigger panic. The 1998 collapse of Long-Term Capital Management occurred after a fund with only $120 billion in assets spread turmoil through counter-party exposures. Similarly, the 2019 repo spike began when a single over-levered mortgage REIT failed to roll funding. “What determines contagion is not scale but who holds the risk and how they fund it,” says Nellie Liang, former Fed director of financial stability and now at Brookings.

Regulators therefore monitor private credit through the prism of non-bank financial intermediation. The Financial Stability Board’s latest assessment labels private credit a “medium” systemic risk, citing rapid growth, limited transparency, and liquidity mismatch. The Fed’s 2024 stress-test scenarios included for the first time a shock to leveraged lending, recognising that a 20 percent default rate on private-credit loans could wipe out the common equity of three mid-sized U.S. banks.

Stress-Test Insights

The Fed’s severely adverse scenario assumes unemployment jumps to 10 percent, GDP falls 6.4 percent, and corporate credit spreads widen 550 basis points. Under those conditions, the three most exposed banks—Capital One, Discover and Synchrony—would face combined losses of $37 billion, equivalent to 83 percent of their Tier 1 capital. While the banks would remain above regulatory minimums, the cushion would be thin, forcing them to curb new lending precisely when the economy needs it most.

Private-credit funds themselves would fare worse. The Fed projects a 35 percent mark-to-market decline in leveraged-loan values, erasing roughly $525 billion of the sector’s $1.5 trillion asset base. Funds that borrowed heavily would breach covenants, triggering forced deleveraging. The resulting feedback loop—fire sales depressing prices further—mirrors the dynamic that amplified mortgage losses in 2008.

Could Redemption Caps Trigger the Next Crisis?

The honest answer is maybe—but only if several vulnerabilities align. First, a macro shock—oil spike, geopolitical conflict, sudden rate re-pricing—must raise default rates sharply. Second, investors must lose confidence in funds’ reported valuations, prompting simultaneous redemption requests. Third, banks must simultaneously withdraw warehouse financing, forcing funds to sell into illiquid markets. Finally, the price declines must be severe enough to impair bank capital, prompting a broader credit contraction.

That chain of events is plausible but not pre-ordined. Private-credit funds have increasingly adopted liquidity buffers—cash, revolvers, staggered maturities—to forestall gates. Roughly 43 percent of funds now impose minimum notice periods of 90 days, up from 30 days in 2017, according to Preqin. Some managers negotiate stand-still clauses with banks that delay margin calls during market stress.

Regulators have also absorbed lessons from 2008. The SEC’s 2023 rules for open-end funds require liquidity risk-management programs and disclosure of redemption gates, making it harder for managers to impose caps without advance warning. The Fed’s new standing repo facility provides a back-stop for Treasury collateral, reducing the odds of a wholesale funding freeze.

What Investors Should Watch

Key indicators include fund flow data from Lipper, warehouse line pricing from bank earnings calls, and default rates on middle-market loans tracked by Fitch. A spike in warehouse spreads above 200 basis points over SOFR has historically preceded redemption gates. Similarly, when more than 15 percent of outstanding loans trade below 90 cents on the dollar—currently 8 percent—managers begin to mark down books, prompting outflows.

For now, the consensus among regulators is that private-credit stresses will produce localized losses rather than a systemic meltdown. Yet the consensus in early 2007 was that subprime was also “contained.” As Fed Chair Jerome Powell reminded Congress in March, “the places we do not expect to find stress are often where stress emerges.” The redemption caps are not proof of catastrophe, but they are a reminder that liquidity risk is cumulative—and that the next crisis rarely looks like the last one.