How Bad Could the Private-Credit Crisis Get? Just Look at 1929.

Drexel Burnham Lambert’s Michael Milken, who pioneered the use of high-yield bonds, leaving a courthouse in 1989. (Rick Maiman / Sygma / Getty Images)

Key Points

• Private credit, a new lending source, is drawing comparisons to past financial innovations that led to economic instability.
• The article highlights historical parallels, including margin accounts in 1929 and mortgage-backed securities in 2007, to illustrate potential risks.
• The 2008-09 recession that followed touched every corner of the globe, and its effects lasted more than a decade.

A few months ago, private credit was a novel new lending source that promised to juice profits and 401(k) accounts. Today, private credit is an insidious new form of financial engineering that threatens to crash the economy.

Like most market innovations throughout history, from margin accounts in 1929 to mortgage-backed securities in 2007, private credit—lending by unregulated financial institutions to subprime companies—has two sides.

It can spur the economy by making money available to people or enterprises unable to obtain bank loans, or it can crash the economy by squandering funds on bad credit risks.

“Historically, rapid loan growth at U.S. banks has preceded asset-quality deterioration,” Moody’s writes in a new report warning of banks’ $300 billion exposure to the private-credit sector. “[T]he negative effects…may only become apparent years later.”

The worry is that the recent failures of auto retailer Tricolor Holdings and auto parts manufacturer First Brands Group, both of which engaged in nonbank lending, are the harbingers of more to come— the first “cockroaches,” as JPMorgan Chase CEO Jamie Dimon called them after his bank took a financial hit from Tricolor’s collapse.

“Everyone should be forewarned on this one,” Dimon said.

Even that may not help. It didn’t in 1929.

By the 1920s, the U.S. had strengthened its rickety financial system, which had been beset by bank-failure panics periodically until 1907. The Federal Reserve System put an end to banking’s old Wild West spirit.

That spirit, however, was taken up by stockbrokers, who became middlemen between the banks and investors. An office, a phone, and a stock ticker was all a broker needed, plus a new innovation to lure in customers: the margin account.

In a typical margin account, an investor could put down just 10% of a purchase and the broker would lend the rest, using the securities as collateral. The broker’s operations were funded through bank loans, exposing the regulated financial system to this risky practice.

Everything ran smoothly—as long as the market kept going higher.

On Jan. 7, 1928, The Wall Street Journal wrote that leading brokerages reported record increases in margin loans, with client lists growing by up to 50% in a year.

“[P]ublic participation in the stock market was the sole basis of their high loans,” the Journal reported, adding that the brokerages dismissed worries about the creditworthiness of their clients.

“Leading brokers concur in the opinion that Wall Street never was more healthy,” the Journal wrote. John D. Rockefeller and President Herbert Hoover echoed that view.

Harris J. Nelson wasn’t convinced. As Barron’s Trader columnist, Nelson had for years been warning of rising margin loans. On Oct. 21, 1929, he noted that the ratio of such loans to the total market value of all listed shares had grown to almost 10%.

This “reflects a fundamentally unhealthy technical position,” Nelson wrote, warning it might only be “relieved…by a drastic public liquidation.”

That unhealthy position was exposed a week later, on Oct. 29, Black Tuesday, when the Great Crash—a public liquidation like no other—began.

As stocks plummeted, investors—many who had barely scraped together the original 10%—failed to meet their margin requirements, and brokers were left trying to sell near-worthless shares. That drove the market even lower, and ensured that the banks wouldn’t get repaid, either. The whole structure came crumbling down.

The confidence the brokerages showed in their clients in the run-up to the Great Crash was echoed in the “highly confident letter” used during the junk-bond craze of the ’80s.

A financing tool created by Drexel Burnham Lambert, the highly confident letter was used by corporate raiders during leveraged buyouts in place of the cash banks had refused to lend. The letter promised that, when the time came, the money would be there.

The cash-raising tool would be high-yield bonds. Teetering companies would be saddled with steep debt loads, which many couldn’t sustain, leading to failures and job losses. Meanwhile, the dealmakers walked away with millions.

“The phenomenon,” Ben Stein wrote in Barron’s on May 28, 1990, “basically constitutes an attack on the whole idea of what a bond is supposed to be, and what a free market in finance is supposed to be.”

The junk-bond market grew from $10 billion in 1979 to $189 billion by 1989, when it crashed, taking down Drexel Burnham amid a flurry of investigations and indictments.

After stocks in the ’20s and bonds in the ’80s, real estate in the 2000s saw the introduction of mysterious new debt instruments known as mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs).

MBSs and CDOs offered investors better rates than Treasuries, and often carried triple-A ratings, so were considered safe. But tucked inside these packages were subprime mortgages, sold to borrowers who often had little chance of keeping up with monthly payments.

When the inevitable defaults started piling up, holders of these new financial instruments were on the hook—and just as in 1929, the crash rippled through the financial system.

“AIG, Lehman Shock Hits World Markets,” was The Wall Street Journal’s headline on Sept. 16, 2008, as the storied investment bank Lehman Bros. was allowed to collapse amid subprime-mortgage exposure.

The 2008-09 recession that followed touched every corner of the globe, and its effects lasted more than a decade.

After each collapse, the financial system is once again tightened, and banks are forced to give up some of their riskiest behavior. But there always seems to be someone else to take over the risk, and the banks can’t help but find some way to get a piece of the action.

Today, private credit has once again lured the banks, which are financing nonbank lenders like Tricolor—and exposing them to the risks, as JPMorgan discovered.

We’ve been warned. Hopefully, this time it will be enough to avoid another “drastic public liquidation.”

Corrections & Amplifications
The stock market crash on Oct. 29, 1929, is known as Black Tuesday. An earlier version of this article incorrectly called it Black Thursday. First Brands Group is an auto-parts manufacturer that effectively made nonbank loans to its customers before filing for bankruptcy protection. An earlier version of this article incorrectly called it a nonbank lender.

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