Is the Credit Market Finally Cracking?

Two high-profile bankruptcies in the auto sector, Tricolor Auto Group and First Brands, have dominated headlines in recent weeks. These developments feel timely to us, as we’re currently reading The Credit Investor’s Handbook ahead of our conversation with author Michael Gatto on Restructuring and Distressed Debt 101. Putting on our “teacher” hat, they also illustrate how bankruptcy can mean different things. Chapter 7 (Tricolor) is a liquidation whereas Chapter 11 (First Brands) is a reorganization. 

These bankruptcies already had investors concerned about private credit. But the story got bigger this week, as headlines broke about bad loans tied to alleged fraud.

Yesterday, Thursday October 16th, Zions bank disclosed a $50 million write-off linked to a fraudulent loan. Western Alliance, another regional bank, also revealed exposure to the same borrowers. While many are saying these are isolated cases for now, when paired with the recent bankruptcies in the auto sector, signs point to possible cracks in the system.

A quick recap of the First Brands story (which we discussed last week on the podcast): the company built an auto parts empire through aggressive, debt-funded acquisitions. It recently faced $6 billion of that debt coming due and attempted a major refinancing that would have pushed its debt out to 2030. The company and its banks launched a multi-tranche re-financing that included both senior and subordinated loans — so, first lien and second lien — specifically: a $2.7 billion floating-rate first lien term loan, an €850 million euro-denominated first lien, and a $1 billion fixed-rate first lien. The deal also upsized the “ABL” — an asset backed loan that is usually used to finance working capital to give the company liquidity (think of it as a credit card that is backed by working capital like accounts receivable, inventory etc.) — from $250 million to $500 million. 

Lastly came $1.5bn of second lien debt, which was nearly $1 billion larger than the existing second lien. This was the real sticking point.

Here is the issue.

First lien lenders get first claim to collateral if anything goes wrong. But second lien debt is exactly what it sounds like: it’s second in line. Since first lien lenders take priority, investors really have to understand what assets the company has and what claim they may have to the collateral if anything goes wrong in order to get comfortable lending in that second lien. Investors were already worried about the company’s aggressive use of receivables financing, factoring, and supply-chain finance. In fact, this was something that Apollo was sounding the alarms about (which we’ll cover in our next article below), and which led to them buying CDS to profit from weakness in First Brands’ debt. As the launch date approached, the deal was short by about $1 billion, mostly in the second lien. The market simply didn’t have enough confidence to get comfortable with subordinated exposure beneath so much first lien debt.

The skepticism didn’t come out of nowhere. First Brands had been leaning hard on receivables financing, or “factoring”, which is simply selling your invoices to a lender to get cash now. 

But the real concern was “hidden factoring”, where the same collateral ends up being pledged to multiple lenders. After discovering that, lenders began to wonder how much real collateral was actually backing their loans. Lenders were also worried about off-balance-sheet obligations that made it hard to know how leveraged the company really was. Did the leverage being marketed match the economic reality? Newer investors were calculating true leverage closer to 4x, well above the 2.6x figure in the pitch deck, even with generous EBITDA adjustments. 

Said differently, Leverage = Debt / EBITDA, where EBITDA is our proxy for operating cash flow, but is a non GAAP term where you make adjustments that the lender and company agree upon. If you have debt of $400 and EBITDA of $100, but can make $50 of adjustments, instead of leverage of 4x (400/100), your leverage is 2.6x (400 / 150). 

Additionally, if you then factor in OFF balance sheet items, like supply chain financing where a company’s lenders pay suppliers upfront and collect money later, it may not technically be considered “debt” on the books…but it still is money owed.  If in our example above, we add an additional $100 of that, you might want to adjust your “debt” to $500 to get a clearer picture of the total leverage.

As the deal faltered, First Brands agreed to commission a quality of earnings (QoE) report from Deloitte, a big 4 accounting firm to “assuage investor concerns over financial disclosures, specifically around accounts receivable factoring.” It was already audited by a smaller firm, but investors wanted deeper forensic clarity. By that point, the refinancing momentum had evaporated and confidence was gone. 

And therein lies the bigger story.

This was more than just a failed refi; it was a shift towards investors asking harder questions and walking when the answers aren’t good enough.

Now layer in what’s happening at regional banks. When two lenders take big losses tied to loans with fraud allegations, it spooks the market. It makes investors wonder how many other hidden risks are out there. That’s why bank stocks are down, bond yields are falling, and gold is rallying even more than it already had been (see our newsletter last week). It’s not that these specific loans are systemic. It’s that they add to the feeling that credit quality is deteriorating around the edges.

This is the context in which First Brands matters. A big, “boring” borrower couldn’t refinance because investors didn’t trust the collateral story. A subprime auto lender also went under. Now regional banks are taking credit hits on fraudulent loans. These may all be “isolated” incidents, but they’re part of the same pattern.