Stage One of a Credit Collapse: Assessing the Current Expansion

Every major financial collapse of the last century has followed a predictable five-stage sequence. Today, those stages are visible again, offering a practical early-warning framework for investors. The pattern is not a theory; it is a repeatable sequence of market and credit conditions that has preceded the largest losses in modern history. The sequence begins with a credit explosion.

Stage One is defined by debt growing faster than the real economy. When credit expands at this pace, borrowing fuels asset purchases, pushing prices higher and prompting more borrowing. That feedback loop can look like prosperity, but it is a trap. In 1929, margin lending soared as ordinary buyers borrowed to magnify gains. In 2007, risky home loans were packaged into complex securities. In 2000, corporate debt swelled as unprofitable companies chased growth. Today, the headline margin debt figure near $750 billion understates the true leverage. Add securities-based lending, derivatives exposure, and corporate debt ballooning to over $10 trillion, much of it used for stock buybacks, and the real burden is much higher. Total debt as a percentage of GDP is higher than at any recorded point in U.S. history.

This is the hallmark of the current expansion: easy credit, rising asset prices, and an illusion of wealth. The setup is supported by expansionary dynamics. Monetary easing by the world's major central banks is now in progress, and corporate health remains solid, with strong earnings and improving leverage expectations. This environment has underpinned a confident outlook, with some analysts projecting a "Goldilocks" scenario of stable growth and disinflation.

Yet the thesis is clear: the current expansion exhibits Stage One characteristics, but its sustainability is now being tested. The key question is whether leverage is outpacing fundamental growth. The supporting factors-healthy corporate balance sheets and monetary easing-are real, but they are also the very forces that can amplify the credit explosion. The vulnerability lies in the feedback loop itself. As long as credit growth outstrips the real economy, the system builds up the very debt that will eventually trigger the next stage of the sequence. For now, the expansion continues, but the foundation is being laid for a future reckoning.

Evidence of Stage One: The Data on Leverage and Concentration

The theoretical framework of a credit explosion must be tested against the hard data. Recent figures from the Federal Reserve's Shared National Credit (SNC) program provide a clear snapshot of current conditions. The total value of large, syndicated bank loan commitments has grown to $6.9 trillion, marking a 6% year-over-year increase. This expansion is not a sign of financial caution; it is the engine of Stage One.

The danger lies in where this credit is flowing. The report reveals a striking concentration of risk. While leveraged loans make up nearly half of all SNC commitments, they account for a dominant 81 percent of the "non-pass" loans-those rated "special mention" or "classified" that demand management's close attention. This means the growth in debt is heavily skewed toward the riskiest category, amplifying systemic vulnerability even as aggregate credit quality appears stable.

This expansion occurs against a backdrop of already elevated aggregate leverage. The national debt-to-GDP ratio remains historically high, creating a foundation where new private credit can compound the overall burden. The data shows a credit market where growth is accelerating, but the composition is deteriorating. The system is not just borrowing more; it is borrowing more in the most dangerous forms. This is the operational definition of a credit explosion in progress.

Confirming the Pattern: Indicators of a Liquidity Illusion

The data confirms the pattern of a credit explosion, but the true test of its sustainability lies in market dynamics. Here, a critical divergence is emerging. While stock markets have experienced recent volatility, credit markets remain stable and bullish. This stability, however, may be the hallmark of a liquidity illusion-a historical precursor to collapse.

The illusion works like this: even as central banks tighten and their balance sheets shrink, the system can bleed liquidity slowly, without immediate price consequences. The mechanism is the dominance of leveraged loans. These instruments are the most sensitive to rising rates and economic stress. When they are the primary driver of credit expansion, as they are today, the entire cycle becomes more fragile. A small shock can trigger a cascade in this high-risk segment, quickly spreading to other corners of the market.

This sets up a dangerous setup. The stability in credit markets contrasts with the instability in equity prices, creating a potential divergence that can mask underlying stress. Investors may be lulled into complacency by the calm in bond and loan desks, while the stock market reflects growing fears about growth. This is the operational definition of a liquidity illusion in action.

From a broader perspective, this environment fits the "Red-zone" concept of overheated credit markets. As Harvard's Robin Greenwood notes, this measure combines credit expansion and high asset prices to predict crises. The current expansion in leveraged loans, concentrated in the riskiest category, is a textbook example of overheated credit. The system is built on borrowing that is acutely sensitive to change, while the market signals of stress are being absorbed in a single, stable asset class.

The bottom line is that the system is not just borrowing more; it is borrowing more in the most vulnerable form. This builds a hidden fragility. The stability we see today may be the calm before the storm, as the very structure of the credit expansion ensures that any reversal will be sharp. For now, the illusion holds, but the conditions for its collapse are being set.

Catalysts and Risks: The Path to Stage Two

The system is now in a state of high tension. The vulnerabilities of Stage One are clear, but the expansion continues. The critical question is not whether a collapse is coming, but what will trigger its transition from a latent risk to an active process. The watchpoints are specific and forward-looking.

First, monitor the health of corporate credit. The high-yield bond market is the canary in the coal mine. The ICE BofA High Yield Master II OAS measures the extra yield investors demand for holding risky corporate debt. A widening spread signals growing fear of default. For now, the market remains stable, but any sustained increase would be a primary indicator that the liquidity illusion is cracking and that the credit explosion is beginning to reverse.

Second, watch the quality of the underlying loans. The Shared National Credit report shows the percentage of "non-pass" loans-those needing management attention-declined last year. This was driven by new lending, not a real improvement in borrower health. The real danger is a reversal of this trend. If the percentage of problem loans begins to rise, it would confirm that the aggressive expansion in leveraged loans is starting to deteriorate the credit foundation, a classic sign of stress in the system.

Finally, the path of monetary policy is the master catalyst. The market expects the Federal Reserve to cut rates, but the pace and magnitude are uncertain. As noted, we expect the Fed to continue cutting rates, though less aggressively than markets initially predicted. A slower, more cautious easing path than priced in could quickly dampen risk appetite and make the high levels of existing leverage more burdensome. Conversely, a faster-than-expected easing could provide a temporary reprieve. The key is the divergence between policy reality and market expectations, which will dictate the flow of capital and the sustainability of current leverage levels.

The bottom line is that the system is balanced on a knife's edge. The catalysts are not distant threats but measurable indicators that are already in motion. A widening high-yield spread, a rising non-pass loan percentage, or a policy pivot that surprises the market could all serve as the spark. For now, the expansion holds, but the conditions for its collapse are being set by these very dynamics.