There is a storm in the teapot

Recently, the “teapot storm theory,” which once wreaked havoc on a whole host of financial bigwigs, has begun to quietly gain popularity again on Wall Street.

Put simply, what the “teapot storm theory” actually discusses is the risk factor. If the risk is confined within a particular industry and the overall risk remains manageable, it is described in a vivid way as “a storm in a teapot”; but if the risk has grown so large that even the teapot lid can’t be kept down, it is called “risk spillover,” and at that point what you need to be wary of is systemic risk.

In the history of the United States, “storms in teapots” have happened often, and “teapot explosions” have occurred more than once or twice. The 2008 international financial crisis was the toughest one since the beginning of the new century. It’s just that compared with 2008, this time the “teapot” did not show up in the mortgage market—it was lying low in a more hidden corner: the U.S. private credit market.

Retail funds under Blue Owl Capital froze redemptions; Blackstone’s flagship private credit fund encountered record-high redemption requests; BlackRock wrote down the face value of a loan to zero within 3 months and announced restrictions on redemptions for its $26 billion HPS corporate credit fund… A string of “technical adjustments” that major private equity funds insist are “not worth overinterpreting” made the market faintly sense the familiar scent of an oncoming storm.

According to the definition of the U.S. Federal Reserve System (hereinafter referred to as the “Fed”), the so-called private credit refers to a financing model in which non-bank institutions such as asset management companies and private equity funds provide funding directly to companies that are unable or unwilling to obtain loans from traditional banks. Its most obvious markers are two: first, the entity issuing the loans is not a bank, but a non-bank institution; second, the nature of the loans is tilted toward high risk—at least it does not meet the lending requirements of traditional banks. At the operational level, private credit typically features characteristics such as terms negotiated privately, floating interest rates, and longer tenors, and it does not enter public markets for trading. This means that investors mostly need to hold the loans until maturity; there is neither continuous quotation nor an active secondary market.

In plain terms, if the public offering market is likened to a big retail store with clearly marked prices—where you can trade at any time under standard contracts—then the private market is more like a “private club” that is open only to certain people and does not publicly disclose “service items” or its fee schedule. From the moment it was created, it has had two fatal weaknesses: lack of transparency and poor liquidity. Because there is no public trading and no continuous quoting, valuation basically relies on the individual risk preferences of the fund managers. If the models they use are just slightly more aggressive, or if the data they use is just slightly more lagged, the valuation can deviate severely. The International Monetary Fund once pointed this out plainly in a report, saying that “low transparency and valuation lag in private credit” would cause risk to “accumulate more and more in places you can’t see.”

More importantly, many private credit arrangements also include “payment-in-kind” (PIK) provisions, meaning that when a company has no money to pay interest, the interest can be “capitalized” by rolling it into the principal. The result is that the short-term “book cash flow” not only does not show pressure, but may even look better than before—in substance, however, it is merely pushing risk further into the future.

Today, the size of this “private club” is already too big to ignore. According to data from Morgan Stanley (often called “Big Morgan”), the market size of the private credit industry has grown from about $2 trillion in 2020 to about $3 trillion by the end of 2025, and is expected to reach $5 trillion by 2029. Among them, the U.S. domestic private credit market accounts for an absolute “big chunk,” with its size fluctuating between $2 trillion and $2.3 trillion depending on the statistical coverage.

Also, according to a report by JPMorgan (often called “Small Morgan”), the current market size of private credit is already close to that of the publicly traded high-yield bond market. The latest trend is that private credit is no longer limited to providing loans to small and mid-sized enterprises. With the expansion of transaction scale and the diversification of collateral types, large asset allocators increasingly view it as “a mainstream investment option equivalent to high-yield bonds and leveraged loans.” The market has begun, with intention, to match corresponding private credit products to nearly all publicly offered credit products. The report warns that blurring the boundary between public and private credit will bring “enormous risk.”

Ironically, private credit is actually a “byproduct” of risk management.

After the outbreak of the 2008 international financial crisis, the United States began to push regulatory reform, rolling out multiple laws and regulations and industry standards, such as the Dodd-Frank Act. These legally binding texts not only set explicit requirements for banks’ capital adequacy ratios and leverage ratios, but also require regulated entities to conduct stress tests on banks on a regular basis. From that moment on, banks’ high-risk lending business was, in theory, effectively put on pause.

But while banks started to “hold back” on lending, companies’ borrowing needs did not disappear—especially those middle-sized and small companies with high leverage and small scale that even lacked eligibility to issue bonds, which had to take a different route. As a result, high-risk financing demand started to “move house” collectively: it shifted from banks’ balance sheets to private funds’ balance sheets. A report by the Austrian central bank points out that strict regulation after 2008 made banks even more reluctant to lend; private credit simply “stepped in to fill the financing gap,” and high-risk lending thus completed the “debanking” process in a logical and orderly way.

In the following period, a large shadow banking system began to grow. Pension funds, insurance companies, sovereign wealth funds, and even an increasing number of individual investors put their money into private credit funds, which then “fronted” loans to companies. Meanwhile, banks—constrained by regulation—were not idle either; they quietly provided “back-end leverage” for private credit through ways such as credit facilities and asset-backed financing instruments. All of this looks very much like the subprime mortgage crisis back then: risk appears to have been transferred out of the banking system, but in reality it only changes the “line items” on the balance sheet; risk never truly disappears. It is merely moved from the banks’ “main hall” to the “backyard” of non-bank institutions, yet remains tightly intertwined with the overall financial system.

In the past two years, multiple Fed rate hikes and interest rates staying at high levels have made the balance—already held together with difficulty—even more fragile. Because private credit largely uses floating rates, as soon as the benchmark rate rises, companies’ interest expenses inevitably increase as well. At the same time, the rate of profit growth at many companies has slowed, even turning negative; companies able to cover interest out of profits are becoming fewer and fewer, so the “debt snowball” keeps rolling bigger and bigger. To make matters worse, the breakthrough development of artificial intelligence is pressuring the private credit segments heavily weighted toward traditional software and technology services. When the market starts to doubt whether software companies that rely more on the wisdom of engineering teams can still make money, the stock prices and valuations of those relevant companies fall sharply, which in turn causes the value of the underlying assets of private credit to shrink as well. Data from Fitch shows that in early 2026, the U.S. private credit default rate had risen to 5.8%, far higher than the 2% to 4% range in the prior years.

Thus, a chain reaction began spreading from the asset side to the funding side: deterioration in underlying asset quality led investors to demand redemptions one after another; as more investors sought redemptions, funds had to sell assets to realize cash. But private credit has never had an active secondary market. Once sell-offs become concentrated, asset prices are bound to suffer a substantial discount. To avoid being forced into a vicious cycle of dumping assets, multiple institutions including Blackstone, BlackRock, and Morgan Stanley have shut the “gates,” setting caps on the proportion of quarterly redemptions at “5% or 7%,” with any amount beyond the cap either carried forward or redeemed on a proportional basis.

The issue the market is most concerned about right now is whether risk will “burn back” into the traditional banking system, flowing along this invisible chain of funds from the shadow banking system.

In response, stress tests conducted by the Fed and multiple other institutions have produced relatively “reassuring” conclusions. The Fed’s research shows that as of the end of 2024, U.S. large banks’ commitments to lend to private credit institutions were close to $95 billion, with actual drawdowns of about $56 billion. Although the growth rate is rapid, it remains a small share of banks’ total assets. The Fed believes that even under extreme scenarios, even if private credit institutions make a large draw on their credit lines, the impact on banks’ overall capital adequacy ratio and liquidity coverage ratio would still be limited, meaning the banking system “can handle it.”

Morgan Stanley’s research also holds that the overall leverage ratio of U.S. companies has not surged in a systemic manner; the problems facing private credit reflect more changes in the “credit intermediation structure,” rather than a loss of control of leverage across society as a whole.

In short, these institutions all believe that while localized risk clearing is inevitable, under the baseline assumption of a soft landing for the U.S. economy, the likelihood of risk spillover—or its evolution into systemic risk—is not high, i.e., “the storm is still in the teapot, and the lid is still on the teapot.” But the market clearly has doubts. From investors continuously applying for redemptions to an ever-growing number of funds starting to restrict or freeze redemptions, both sides are using tangible cash flows to stage a “vote with your feet.”

For global financial markets, this “teapot” is not only rattling under the pounding of the storm, but has also shown signs of cracking. Whether it will eventually shatter into pieces scattered everywhere—and whether it could even hit the entire financial system—remains hard to say. This depends not only on changes in market confidence, but also on external factors such as the global economic environment, trends in high-tech development, and geopolitical conflicts. In addition, whether the U.S. financial system can find a new balance between relaxing regulation and controlling risk is also a question worth sustained attention. (Author: Sun Changyue; Source: Economic Daily)