Legendary investor Mohamed El-Erian unpacks how a private credit crisis could play out in markets

• Mohamed El-Erian sees a dangerous chain of events potentially emerging from the private credit sector.
• The famed former invesment chief of PIMCO laid out how he sees a crisis unfolding as liquidity concerns grow.
• In his bear-case, the US could face a lending crunch and a recession as issues in the sector spread.

Jitters in the private credit market have the potential to morph into into something more serious that could mimic the chain of events that led to the collapse of Bear Sterns in 2008, according to Mohamed El-Erian.

The famed economist and former co-chief investment officer of PIMCO has been keeping a close eye on the private credit space in recent months. In his view, the market is flashing a handful of worrying parallels to the events that led up to the Great Financial Crisis — and there's the risk of a contagion event that could play out in a similar way to how subprime mortgage loans upended the financial system nearly 20 years ago, he told Business Insider in an interview this week.

"It's very important to try to interrupt this process before it gathers steam," El-Erian said, outlining how a crisis could play out in private credit.

Here's a chain of events he thinks is possible:

1. Liquidity fears begin to snowball

The first phase of a potential credit crisis is unfolding in real time, El-Erian said, adding that concerns about liquidity could quickly spiral into concerns about the solvency of some private credit firms.

Jitters in the private credit market first began last fall, when subprime auto lemnder Tricolor Holdings and auto parts company First Brands, collapsed.

At the time, markets wrote off the failures as idiosyncratic, but anxiety over liquidity in the private debt space has since swelled, as Blue Owl, BlackRock, Cliffwater, and Morgan Stanley have limited investor withdrawals for some private credit funds amid a wave of redemption requests.

El-Erian drew comparisons between the current market climate and the summer of 2007, when BNP Paribas froze some securitized debt funds. Other funds on Wall Street followed, leading to a liquidity crunch that eventually led to the collapse of Lehman Brothers and Bear Sterns the following year.

In a LinkedIn post earlier this month, El-Erian said the withdrawal had the makings of a "classic contagion phenomenon."

Eventually, even the "best funds" will be contaminated by panic, El-Erian told Business Insider.

"It starts with one fund, Blue Owl, and the next thing we know, other funds start putting up gates. We see that encourages investors to try and take more money out," he said.

2. Banks pull back on lending

Banks could add to liquidity concerns by stepping back from making loans.

Investors are already beginning to see this play out as well, El-Erian said, pointing to reports earlier this month about JPMorgan reducing the amount some private credit firms are able to borrow.

Eventually, the lending crunch spread to other parts of the economy, El-Erian said, suggesting that firms with little exposure to software loans — one area of particular scrutiny in private debt markets — could also be affected.

"Banks all step back, become much more protective. It's harder for companies to get loans, even though they have nothing to do with the problem at all," he said.

3. The credit crunch could cause a demand shock

There's a chance that the lending crunch produces a "financial accident," El-Erian said, referring to an event similar to the last financial crisis.

Should there be a financial accident, that could significantly tighten financial conditions and leave everyday Americans unable to borrow. The result could be an economic "demand shock" — a slowdown of business activity that pushes the economy into a recession, El-Erian said.

"It's the so-called risk-off trade that impacts everything," he said, adding that fragilities in the sector were one reason why he recently raised his odds of a US recession to 35% from 25%.

Most loans in the private credit sector are not distressed, but Wall Street is still fixated about the health of the private debt market, with warnings about the sector's future piling up. Lloyd Blankfein, the former CEO of Goldman Sachs, and Richard Bookstaber, a Wall Street veteran who called the last financial crisis, are among those who have recently flagged private credit issues as a concern.

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