March thirty-first, two thousand twenty-five

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Positioning the United States (Three): The Fragile Symbiosis Between Private Credit and Pensions

Moral hazard never really left..

If there is one way this cycle most resembles 2008, it is not in the banks or in MBS, but in Private Credit; this time, it is not only larger, but also more concealed.With policy support and institutional exemptions, this system has become a black box that is highly leveraged, lightly regulated, and interconnected with the broader system, while its downstream exposure is the U.S. pension system.

In other words, the housing market certainly has problems too, but from a systemic-risk perspective, by comparison, today’s housing market no longer poses the kind of systemic threat it did back then; the problems in the corporate credit market are more urgent, because its transmission through the financial system is stronger.

If market liquidity runs into trouble, compared with MBS, the Fed is more likely to step in in the corporate credit market—for example, by setting up some kind of long-term liquidity facility to provide support to parts of the corporate sector—rather than returning to the housing market.

The problem with the corporate market is that private credit is expanding very rapidly and has very little transparency, yet it is highly connected to traditional financial institutions. This combination could pose a real risk—and the Fed currently has very little visibility into this area. That is what makes it complicated.

U.S. Treasury Secretary Scott Bessent recently praised Private Credit in glowing terms, for a clear reason: tighter regulation has left banks with severely limited lending capacity, while Private Credit is “more flexible and willing to take risks,” able to fill credit gaps and promote employment and business expansion.

Or put another way, it is precisely because private credit is unregulated that it fills the gap left by bank lending.

One of the new administration’s current priorities is financial deregulation. Bessent has also taken a fairly positive view of Private Credit, because they want to ease regulation of the banks.

The issue with private lending is not whether an unregulated lending system should be opposed. Private Credit can provide financing to companies that banks are unwilling to lend to because of regulatory constraints, and that is reasonable. The key risk here is that they cannot be allowed both to expand freely and to receive a rapid bailout when things go wrong.

This is a classic moral-hazard dilemma. Once the market forms the expectation that someone will rescue high-risk investments, systemic problems will arise not from loans going wrong, but from there being no cost when they do.there are no consequences when things go wrong.

More importantly, private credit is actually a “hidden access system,” not a “truly independent system.” It depends heavily on the banking system for liquidity and leverage and is connected to the banking system itself, while its asset side is directly exposed to pensions, insurers, and institutional clients.

Many Private Credit funds obtain financing from banks through various channels. Pension funds continue to invest in Private Equity and Private Credit, and the latter in particular also provides leverage for the former’s projects, This middle layer of the structure looks “market-based,” but both ends are public-sensitive systems.

The key point is that pension funds have become excessively dependent on Private Credit.It is not that Private Credit is too greedy; it is that pension funds are too hungry. When interest rates stayed at zero for a long time and traditional assets could not meet benefit obligations, pension funds began chasing “unmarked risk” and treating illiquid assets that cannot be valued over the long term as a “source of stable returns.”

And this time, they have bet too much.

On the other hand, pension funds effectively come with a huge “policy put option” built in—for example, the California Public Employees’ Retirement System (CalPERS). Even if its investments failed, would it really be allowed to go bankrupt? Impossible: if these pension funds run into trouble, they will ultimately be rescued through tax increases.

When U.S. public pension funds make large purchases of Private Equity and Private Credit, the issue can no longer be “market-neutral”:Once the problem ultimately erupts in public pension funds, the government will have no choice but to bail them out.

The implicit expectation of a systemic bailout is the greatest source of risk.If the leverage chain behind Private Credit breaks, the consequences will involve not only hedge funds or Family Offices, but also the pensions of tens of millions of civil servants, teachers, and firefighters—the voters.This pattern of turning “systemic risk” into a hostage for policymakers could very well be repeated by PE/Private Credit: “If you don’t bail me out, you’ll have to bail out CalPERS, so you might as well bail me out directly.”

So The key going forward is to watch closely where the regulators responsible for Trump’s financial deregulation agenda plan to build the “firewall”:Should Private Credit be left to bear the consequences, with intervention limited to spillover effects? Or will it be: “To keep things from spiraling completely out of control, we have no choice but to grit our teeth, accept some cost, and directly bail out these private lenders to protect the entire system..”

Ultimately, the most likely choice will still be the “bail out Private Credit first” path.

Although the circumstances differ, the market has already seen a similar move in the case of Silicon Valley Bank (SVB). SVB was not a systemically important financial institution at all, and depositors should have borne the losses themselves. But to maintain confidence in the system, even “non-systemically important” Tech Bros received full protection. If a credit fund really blows up in the future, the Treasury and the Fed are unlikely to stand by,

Private Equity + Private Credit + public pensions form a “hidden systemic-risk loop.” When risk erupts, the authorities are highly likely to use “limited rescue of private actors” to avoid a “full-scale rescue of the public sector.”

Private Credit is not outside the system; it is the new front end of systemic risk.The deeper risk is not leverage or liquidity themselves, but the fact that the market already believes someone will step in when things go wrong. Once this “belief” becomes reality, the market’s original logic comes to an end.

2025.03.31

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Note: Everything in this text is for reference only, does not constitute investment advice, and is not a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for their decisions.