Duration Is Not a Defense - I
Private credit inside life insurers, and why a thirty-year promise doesn't make a seven-year loan any safer - Duh!
Do not start a conversation with me that begins with “long duration, therefore safe.”
The earnings season is always a nightmare to live with. The euphoria of the banks rallying as if there is no care in the world is nauseating. And here is why: Bloomberg reported that banks worldwide are bolstering their use of SRTs to free up capacity for new lending.
As we plow through earnings season, we are speaking with sources deep within the insurance-private credit space. Which brings us to a whole new level of cluster mess.
Here, we want to highlight exactly what is being done - as told by a big private credit firm, ARES 0.00%↑ portfolio manager, in an interview he gave recently.
“There’s an efficiency that comes from doing things on a pooled basis. You know, if I’m an insurance company and I go out and I make, you know, 100 or 1000 or 5000 loans in a particular area, right.
And any one of those things has a risk of default that’s contained in that RBC charge. If I hold those at the balance sheet, you know, without any structure around it, you know, I’ve got a certain level of risk, but it’s generally fairly punitive for the insurance company and not not capital of, efficient for them to make those kind of loans.
If I pull those things into a structure, you know, the risk of the entire portfolio defaulting at the same time is effectively negligible, right? It’s you got the law of large numbers, you’ve got diversity, you’ve got all those kind of things. And so a certain amount of that portfolio then becomes IG and becomes very ratable. And you still can hold a residual position in the pool if you want to hold the entire pool.”
PCs KNOW WHAT THEY ARE DOING. THEY ARE AWARE OF THE RISK.
RISK IS BEING MOVED TO THE MIDDLE CLASS (INSURERS).
Let us translate that: The loans are the same loans. Pooled and tranched, a large share of them becomes investment grade and ratable (this is MENTAL) , and the capital charge falls accordingly. Nothing about the borrowers changed. The wrapper changed.
Now, I agree with our analyst when he said, “pooling is a mixed blessing; if your pool is full of crap, it doesn’t matter how much water you’ve got in it to dilute it. Once some know there’s poop in that water, they won’t get in… or, in this case, they will get in because there’s poop in it.”
On that smelly note, what our analysis argues is this:
We have read two credible bodies of work that reach opposite conclusions about the same sector. One reports that private credit is roughly 6% of life insurer general-account assets, and that insurers holding more of it show no higher estimated insolvency risk. The other argues that private equity has rebuilt life insurers into holding vehicles for affiliated private credit, and that the state guaranty fund system pushes the resulting downside onto competitors and, in most states, onto taxpayers.
They are not contradicting each other on the facts. They define the exposure differently, they study different populations, and the quantitative work is fitted to a history in which this exposure barely existed. Now, the industry defense leans on duration matching, the idea that a long-dated liability makes a long-dated illiquid asset safe to hold. That keeps an insurer from having to sell at a bad price. It does nothing about a borrower who stops paying.