The Wrap | New Year 2026: Lower Interest Rates, Higher Defaults

“Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark: 'I wasn't worth a cent two years ago, and now I owe two millions of dollars.”

― Mark Twain, The Gilded Age

January 1, 2026 | This week in “The Wrap,” we feature a special comment focused on the past year and our expectations about what to expect in 2026. The past year was mostly about markets adjusting to President Donald Trump, but 2026 is likely to be more about the investing world learning to ignore the White House. And don't miss our new weekly podcast with Julia La Roche this Saturday.

Does the Fed Lower Rates? Yes, but...

First and foremost, what is going to happen with the Fed in 2026?  Much less than most people imagine. That's why Fed governors have 14 year terms, with appointments staggered so one new term begins every two years, ensuring independence. Over the past year, the Trump Administration has made a great fuss about implementing radical changes at the central bank and lowering interest rates to ~ zero.  But will it actually happen? Probably not.

The Federal Reserve is widely expected to lower interest rates again, but most forecasts point to just one more cut in early 2026. Some observers expect to see more changes in policy by the Federal Open Market Committee as Jerome Powell ends his term as chairman.

But here's the big question: Will then Governor Powell retire or will he remain on the Board through the end of his term in January 2028 to block the Trump agenda? Powell has declined to say whether we will remain on the Board. And even if Powell does retire, will Fed policy change substantially? Our view is no.

The truncated term of Governor Steven Miran ends in January and the assumption is that President Trump will fill this vacancy with a new chairman. But even with a new chairman, President Trump’s ability to dictate Fed policy will be limited. And whoever Trump selects will betray him as soon as the Senate confirms the nomination.

As we noted in an earlier missive, the new FOMC starting in 2026 is likely to be more hawkish and less inclined to accede to the demands of President Trump. Regardless of whom President Trump appoints chair, the Fed Chairman must run the FOMC by consensus or fail. Fed chairs who lose FOMC votes usually resign the next day.

More important, if the Republicans lose control of Congress next November, then President Trump immediately becomes a lame duck and will likely face impeachment by Congress in 2027. Trump's ability to demand policy changes from the Fed or other parts of the government will be diminished greatly. 

Regardless of what happens politically in Washington, though, the new Fed chairman is likely to oversee some significant changes in how the Fed manages its open market operations and other areas, a policy issue controlled by the Board and particularly the Chairman rather than the FOMC. One big change we expect to see under the new Fed chairman is in the size of the Fed’s balance sheet.

The table below from Bill Nelson at Bank Policy Institute shows the astronomical increase in bank reserves orchestrated by the Fed's Washington staff since 2008. Since the great financial crisis, the required level of reserves has gone up several orders of magnitude? Really? And don't forget to read our essay in The International Economy, "How to Really Reform the Fed."

“The Fed stumbled into a floor system in September 2008 when its emergency lending followed by three rounds of QE boosted reserves far above the level the banking system needed, pushing the federal funds rate below the level the IORB rate,” Nelson writes. “It is worth emphasizing that the objective of QE is to reduce long-term rates by buying long-term assets; the resulting increase in reserves is an incidental side effect.”

Of course, the Fed has been buying mostly short-term Treasury debt, an implicit admission that the role of the central bank is to monetize Treasury issuance rather than stimulate the economy. The fiscal realities of the federal debt has forced the Fed to conform its purchases to the maturity profile of the Treasury debt issuance, mostly T-bills. Fed purchases of Treasury debt subsidize the deficit with more inflation, but do little to help housing or the economy. Read our latest column in National Mortgage News (“A mortgage wish list for 2026”). 

Worries about the deflationary effects of a debt crisis cause the Fed to err on the side of too much QE and an overly big balance sheet, thus the incredible increases in the estimates of Fed staff as to the "required" level of reserves. Our earlier concerns about liquidity stress in the US markets turned out to be correct, but the Fed buried the mounting liquidity problems in private markets at the end of 2025 in lots of short-term cash. Meanwhile, LT interest rates for Treasury bonds and residential mortgages rose in the second half of 2025 due to massive government debt issuance. 

Veterans of the emerging markets are familiar with the syndrome of central banks buying short-term government debt. Of course, the United States is the oldest emerging economy in the world. But the current regime shows strong historical antecedents of cronyism and patronage politics that extend back to before the Gilded Age, the most corrupt period in American politics.

The Mark Twain quote at the top of this comment pretty much sums up the past year. The impetuous and impulsive regime led by Donald Trump is careening headlong into a generational reset of credit metrics and asset valuations, a maxi market correction that may be memorialized in textbooks alongside the great financial crisis of 2008.

By 2028, we will be two decades since the collapse of the US financial markets and primed for a new deflationary episode, this time led by corporate credit and the dissolute US Treasury. We expect to see the situation with corporate credit worsen in 2026, setting the stage for a sustained residential housing market decline in 2027-28. And nobody in the Trump White House, who generally get their news about the economy and financial markets from Newsmax, even suspects the approaching danger.  

Cracks Widen in US Credit

Last year we saw concerns about the private credit and private equity markets begin to surge, but the best is yet to come. Credit is slowly rolling over in the US markets, one reason why equity markets around the world are likely to outperform the US in 2026. Under-utilized banks have fed the two-headed mania in private credit and private equity caused by quantitative easing in 2020-2023 with loans to non-depository financial institutions (NDFIs).

Source: FDIC/WGA LLC

Equity allocations have seen significant shifts toward foreign markets since early in 2025, with a notable trend emerging early last year showing a major rotation out of the U.S. equities. Fund managers have been slashing U.S. stock holdings by the most on record as the Trump/AI/crypto narrative fades. AI bellwether Nvidia Corp (NVDA) has lost ground in the past month but is still up 40% YTD or 2x the S&P 500. But NVDA is no longer an automatic buy.

In a lagging sign of the times, Masayoshi Son led SoftBank (SBTBF) just agreed to acquire data center investor DigitalBridge for $4 billion, CNBC reports. The deal is expected to close in the second half of next year. In a typically upbeat statement, Son said the deal “will strengthen the foundation for next-generation AI data centers.”

SFTBF was up almost 200% in November, but got crushed by concerns over AI spending by large tech players like Oracle (ORCL). The chart below from YahooFinance shows NVDA, SFTBF and the S&P 500. NVDA is up 1,330% over the past five years and is by far the best performer, but SBTBF reflects the manic investment style of Masayoshi Son.

Source: YahooFinance

The strong rally in silver and gold, and the weakness of crypto tokens, are leading the decline in US fortunes when it comes to the equity markets. Literally dozens of crypto ventures have failed in the past year, notes Comsure. Crypto exchange collapses have led to $30–50 billion in investor losses, the UK consultancy reports. But the greater concern is the mounting backlog of corporate insolvencies, a real and growing danger that could push the US into recession even as short-term interest rates fall.

According to statistics released by the Administrative Office of the U.S. Courts, annual bankruptcy filings totaled 542,529 in the year ending June 2025, compared with 486,613 cases in the previous year. Business filings rose 4.5 percent, from 22,060 to 23,043 in the year ending June 30, 2025. Non-business bankruptcy filings rose 11.8 percent to 519,486, compared with 464,553 in the previous year.

The growing number of individual and corporate insolvencies are part of a rebound of a long-term trend of falling defaults. For more than a decade, total bankruptcy filings fell steadily, from a high of nearly 1.6 million in September 2010 to a low of 380,634 in June 2022. Total filings have increased each quarter since then, but like loan default rates, they remain far lower than historical highs.

Like credit metrics, the statistical measures of default reflect a growing tendency for negotiation rather than formal events of default.  Some estimates suggest that 1 out of three insolvencies are restructured out of court. As the chart below illustrates, cash accrued but not collected is over $100 billion, but banks are avoiding taking possession of foreclosed real estate (REO).

Source: FDIC

One way to measure the stress building in private equity and credit is the poor performance of lenders to private businesses. Long-term equity returns for business development companies (BDCs) have been hammered since the middle of 2025 and now are running at a negative 4% vs up 16% appreciation for the S&P 500, KBW reports.  The chart below shows the VanEck BDC (BIZD) ETF vs the S&P 500.

Source: Google Finance

“Short sellers are taking note of rising signs of stress within the private credit market, and using publicly traded BDCs to signal that outlook,” notes our colleague Nom de Plumber from his perch high in the world of large bank risk. Banks have substantial exposures to private equity, but most of the risk is borne by private lenders lower in the credit stack. Or at least that is what many bankers believe.

PIK or “Payment-in-Kind” refers to a mystical financial arrangement where interest or dividends are paid with additional securities, goods, or services instead of cash, allowing companies to conserve cash flow but increasing debt principal. PIK is commonly seen in high-risk sectors like leveraged buyouts and venture debt, with examples including PIK Notes and PIK Interest. But there are literally thousands of private equity financed companies now using PIK to avoid default.

Income from payment-in-kind debt, which allows borrowers to defer interest and can signal an inability to pay with cash, has been rising across BDCs, reaching 7.9% in the third quarter, according to data from Raymond James. In the third quarter, 3.6% of investments across BDCs were on non-accrual status, a designation that indicates a lender expects losses, Raymond James data show.

Like REITs, BDCs are pass through vehicles that must pay out most income. “BDCs still accrue the PIK loan coupons as non-cash income, but lack the corresponding cash to pay the required dividends, to maintain their favored IRS treatment,” NDP notes further. “If they lose that tax treatment, there is risk that such PIK loan coupons become taxable at the BDC level, rather than treated as simply passed through to BDC shareholders for taxation.  Then, the BDCs would lack the cash to pay the IRS, too.”

The growing number of illiquid private equity-backed companies presents a huge problem for Wall Street sponsors and lenders. “Even with interest rates falling and the number of initial public offerings increasing in recent months, it has not made a dent in the industry’s backlog of at least 31,000 companies valued at $3.7 trillion, according to research from Bain & Company,” Maureen Farrell reported in The New York Times. She continues:

“That amount exceeds last year’s record of 29,000 companies valued at $3.6 trillion. Many recent attempts by private equity firms to sell companies or take them public have stalled.... The private equity firm Thoma Bravo has failed repeatedly over the past several years to sell two companies it owns for an acceptable price. Thoma Bravo bought J.D. Power, the consumer analytics company, and ConnectWise, a software company, in 2019 and hasn’t found a buyer for either. This year, in light of the tough market, the private equity firm did not attempt another sale, according to two people briefed on the matter."

Consider an appropriately named example. United Site Services, a provider of portable toilets owned by private equity firm Platinum Equity, filed for bankruptcy with plans to wipe out $2.4 billion in debt and hand the company to senior lenders, Steven Church, Reshmi Basu, and Harry Suhartono of Bloomberg report. They write:

"The bankruptcy case comes less than 18 months after the company reshuffled its debt stack in order to raise cash. Platinum, which acquired United Site in 2017, would likely see its investment wiped out, since shareholders cannot collect anything in bankruptcy unless creditors are paid in full. The company owes secured lenders more than $2.7 billion, court filings show."

We expect to see a growing number of BDCs, private equity sponsors and other parties forced to recognize asset impairments and related losses in the New Year. The backlog of private equity companies using PIK or other means to avoid bankruptcy is going to be cleared out substantially as it becomes clear that merely lowering short term interest rates will not make moribund PE companies attractive to investors. The damage done to the PE sector is massive and could see more than half of all managers unable to raise new funds. These Lame Duck managers will eventually exit the sector once the remaining proceeds of asset sales have been returned to investors.

The Cost of Quantitative Easing

Weakness in the US equity markets in 2026 could contribute to a negative environment for credit that has been years in the making. Moreover, we expect that the steady decline in bank default rates viewed over the past year, an accounting illusion manufactured by bankers, investment sponsors and regulators acting together, will end when it becomes apparent that the Fed is not coming to the rescue of the private equity and credit community.

If we assume that visible default rates on bank loans and private debt are understated by the same monetary excesses and forbearance that caused bankruptcies to fall for a decade, the period ahead is very likely going to involve a painful and extended reversion to the mean in terms of credit expenses. The charts below shows delinquency and loss-given default on $13 trillion in mostly prime bank loans as of the end of Q3 2026. As any bank CEO or chief financial officer will tell you, credit loss rates have been very low for a very long time.

Source: FDIC

Source: FDIC/WGA LLC

Although the Fed's QE program inflated home prices 50% it also took net loan loss rates for banks down to ~ 50% of par in 2021, this compared to ~ 95% after 2008. QE enabled some very stupid and foolish behavior by investors and lenders. These behaviors are only partly described by the nominal level of interest rates because, of course, we must account for leverage in calculating the full scope of the prospectives losses. Lend More Upon Default (LMUD) has concealed the scope of the disaster and even pushed down reported loan default rates, but we suspect that 2026 earnings results will see the benign trend in bank credit defaults come to an end.

In our next issue of The Institutional Risk Analyst, we’ll be looking at the universal banks led by Goldman Sachs (GS) and Morgan Stanley (MS). We’ll also provide our thoughts on financials for 2026 and review the positioning of our portfolio for the New Year. 

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