Recent bankruptcies from companies like First Brands and Tricolor have raised alarms, prompting comparisons to cockroaches indicating a larger infestation or a canary in a coal mine signaling danger. The financial markets tend to obsess over a single topic at any given time, and currently, that topic is the string of episodes in sub-investment grade credit, particularly private credit.

The private credit sector grew significantly after the 2011 global financial crisis as money managers stepped in to provide loans when banks were limited. This new capital created more competition, which inevitably reduced some of the lenders' original advantages. For years, the investment environment was mostly benign, meaning the private credit market was never truly tested. Now, with several high-profile bankruptcies and allegations of fraud, people are beginning to see cracks.

Cases have emerged involving companies using the same collateral for multiple loans, lending to buyers without credit scores, and borrowing on the basis of fabricated receivables. This has led to the question of whether a few isolated instances are hinting at an ominous trend. Howard Marks notes the market's tendency to overreact.

In real life things fluctuate between pretty good and not so hot, but in investors minds they go from flawless to hopeless.

However, these events are not necessarily the beginning of a major trend or an indictment of the entire sub-investment grade debt market. Defaults are a regular occurrence. In the high-yield bond market, over 2% of bonds by value have defaulted in a typical year. With thousands of issuers, a few dozen defaults in a normal year should not be surprising. Instead, these recent events are a reminder that the higher yields on this type of debt exist for a reason: they carry credit risk. This underscores the constant necessity for credit analysis skills, even when their importance isn't apparent during good times.

Security prices fluctuate much more than the intrinsic values of the underlying companies. The main reason for this is the extreme volatility in how people feel about risk. This sentiment follows a predictable cycle.

In good times, when the economy is strong and markets are rising, investors become complacent and risk-tolerant. The prevailing attitude is that taking more risk leads to more money, and potential worries are dismissed. The fear of missing out on gains becomes the dominant concern, leading to less due diligence, aggressive bidding for deals, and a general lowering of standards.

Eventually, the economy turns down, and people lose money. The sentiment swings dramatically in the other direction. Risk aversion takes over, and the new refrain is to avoid risk at all costs. Now, negatives are exaggerated, positives are ignored, and investment standards become highly elevated. This recurring rollercoaster of psychology is a central theme in finance.

History does not repeat itself, but it does rhyme.

Good times lead to carelessness, which results in flawed investments made without an adequate margin for error. These mistakes are then exposed during bad times. As financial historian Edward Chancellor wrote, citing an 1865 observation, panics don't destroy capital but instead reveal how it was previously wasted on unproductive projects. This is summed up in a great banking adage: the worst of loans are made in the best of times.

This environment also creates the perfect conditions for fraud. Economist John Kenneth Galbraith introduced the concept of the 'bezel', which is the wealth that fraudsters or embezzlers appear to have created. This inventory of fraudulent wealth grows during good times when people are relaxed, trusting, and money is plentiful. In such periods, rather than thinking something is 'too good to be true,' people are more likely to ask, 'how can I get in on that?' When a depression hits, money is watched with suspicion, audits become meticulous, and the bezel shrinks as frauds are uncovered. Given the long period of economic growth and rising markets, it shouldn't be a surprise if a bumper crop of frauds is revealed in the years ahead.

Today's financial issues are not typically systemic, meaning there is nothing wrong with the fundamental "plumbing" of the financial system. Instead, they are systematic, which Howard Marks describes as a regularly recurring behavioral phenomenon. Imprudent loans and business frauds often occur in clusters because investors and lenders, who are supposed to be risk-averse, sometimes fail to exercise discipline, especially during good times.

A recent case in point is First Brands, an auto parts supplier that filed for bankruptcy, drawing attention to the private credit market. The company's problems stemmed from its borrowing against receivables. In a departure from the normal practice of factoring, some payments from retailers went to First Brands for forwarding, rather than directly to the financial institutions that bought the receivables. This allegedly allowed First Brands to sell the same receivables more than once and retain some payments.

The company also used aggressive off-balance-sheet financing, creating complex obligations that ballooned to several billion dollars. Their total obligations were revealed to be $11.6 billion, far exceeding the previously disclosed $5.9 billion. A creditor's lawyer remarked that $2.3 billion had simply vanished. Oaktree's research uncovered numerous red flags even before the bankruptcy filing, including a short operating history with massive sales, a secretive owner, a history of litigation, and unusually high profit margins.

So how does a company like this attract financing? In private credit, initial investment decisions often rely heavily on information from bankers and auditors, as companies may not file public disclosures. The full picture is often nuanced before a crisis, and it's not a single "aha" moment that reveals the truth. Instead, superior credit analysis involves second-level thinking. It requires assembling individual snippets of information into a mosaic that leans toward a conclusion based on a preponderance of the evidence. The key is to be early in detecting credit defects. If you reach a negative conclusion at the same time as everyone else, the price will have already reflected the bad news.