Thain: Next Financial Crisis Could Come From Unregulated Lenders

Aug 6 2015 | 6:26pm ET

Former Merrill Lynch CEO John Thain has voiced concerns that the origins of the next financial crisis could come from the online & peer-to-peer lending activities of hedge funds, private equity firms, BDC’s and other unregulated entities. 

Thain, who is now CEO of financial holding company CIT Group and was a partner at Goldman Sachs before running Merrill, made the remarks in a recent television interview. 

The private lending space, sourced both online and off, has exploded in recent years as banks pull back from traditional lending, especially to small- and middle-market companies, as a result of increased regulatory burdens, higher capital ratios and the unfavorable economics of servicing smaller loans. 

As a result, alternative investment capital has flooded the private lending space, with hedge funds, private equity firms and even high net worth individuals filling the void. They’ve been further emboldened by technology that makes it easier than ever to pair a lender and a borrower together for transactions. Meanwhile, lenders are discovering that there are advantages to custom structures that are highly personalized to their particular businesses.

Thain’s concerns revolve around the tendency for the riskier loans to end up with the least regulated lenders. “If you wanted to worry about the next crisis, you would worry about that space because that’s where the more leveraged, the more risky pieces are going,” Thain was quoted by Bloomberg as saying in the interview. “They are not going into banks.”

Instead, lending platforms and private lenders like hedge funds are taking the risk of less credit-worthy borrowers. Although everything seems fine now, with default rates low and demand for credit large and growing, a switch in the cycle could be decimating to these firms and the assets they hold, according to Thain.

There is a certain irony of a financial establishment insider and consummate Wall Street insider fearing the risks of unregulated lending entities when the tightly regulated ones still nearly brought the financial world to its knees. 

Thain became one of the faces of Wall Street excess when he famously included a $35,000 toilet in a $1.2 million office remodeling as Merrill was cutting thousands of jobs, and accelerated some $4 billion in executive bonuses just days before Merrill’s sale to BofA.

The bank eventually needed a massive government bailout to handle’s Merrill’s $27 billion in crisis-related losses. 

Others in the traditional banking industry will undoubtedly echo Thain’s concerns as these new entrants command a growing segment of the corporate credit market. Yet managers active in the space note that risks may not be as high, or as poorly understood, as Thain believes.

Direct lenders often undertake considerably more due diligence on potential issuers (and their collateral), can move far more rapidly in case of problems, and create highly customized structures with yields that properly reflect their risk.

Accordingly, and in contrast to Thain's concerns, a growing number of alternative investment managers are betting that these types of lenders will come through a credit downturn in better shape than traditional ones. 

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