Forget The Fraud Fears: The Credit Sell-Off Is A Huge Buying Opportunity

If you've been paying attention to the watercooler talk around the market, you have likely heard the names First Brands and Tricolor – two companies that have entered into bankruptcy proceedings. These failures have been pointed out as part of the reason for the recent decline in prices in private credit and CLOs.

This story has legs, and I think it's something that is worth addressing, along with some commentary about credit risk in general.

What Happened?

Let's start by talking about what happened in each of these situations and what we know so far.

Tricolor

It started with Tricolor, which filed for bankruptcy on September 10th. Tricolor was a used-car seller and subprime auto lender that focused on immigrant communities in the Southwest. 

On Tuesday, September 9th, Fifth Third Bancorp (FITB) first made the issue public with an SEC filing noting a material write-off.

"Fifth Third Bancorp (the “Bancorp”) recently discovered alleged external fraudulent activity at a commercial borrower of Fifth Third Bank, National Association associated with their asset-backed finance loan.

On September 5, 2025, the Bancorp concluded that a material charge for impairment would result from this alleged external fraudulent activity. The outstanding balance on this loan is approximately $200 million. Based on currently available information, the Bancorp currently estimates that the non-cash impairment charge associated with this asset-backed finance loan, which would be recognized in the third quarter of 2025, will be in the range of $170 million to $200 million.

The Bancorp is working with the appropriate law enforcement authorities in connection with this matter. The Bancorp has also engaged third-party advisors to validate the extent of its potential fraud-related losses which will be used in determining the actual impairment charge to be recognized during the third quarter of 2025."

While it was widely suspected, it wasn't until their earnings call that FITB managment confirmed that the company they took the provision on was Tricolor. CEO Timothy Spence said in the Q3 2025 earnings call,

Reported and core results include the impact of nearly $200 million of provision expense associated with the fraud at Tricolor, which marked an otherwise excellent quarter of operating results across NII, fees, expenses and strategic growth.

The day following FITB's 8-K, Tricolor filed for bankruptcy. Bloomberg reported that the Manhattan U.S. Attorney's office was investigating the matter, although no formal charges have been brought at this time.

The Tricolor impact primarily landed on the banks that provide "warehouse facilities" to them. A warehouse facility is a loan that is used to provide cash up front for debt that will later be packaged into an asset-backed security and sold to investors. These banks include FITB, Barclays (BCS), and JP Morgan (JPM).

In the grand scheme, Tricolor wasn't a huge impact on its own, even to the banks that had direct exposure. However, it was a news story that gathered attention. Notably, executives across the impacted banks made comments that they viewed this as a one-off issue in the midst of a generally stable credit environment. 

For example, FITB's Chief Credit Officer said:

I mean, excluding the Tricolor fraud-related issue, I still expect full year charge-offs to land in the midpoint of our original guidance range and assuming no significant changes in the environment based on what I know today, I continue to be very confident that the commercial loss rates return to that mid 30, 35 basis point range in the fourth quarter.

Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM) had the following exchange during the Q&A portion of the earnings call that has received a lot of attention in the media. 

Michael Mayo, Wells Fargo Securities, LLC, Research Division

And so just a short follow-up after Tricolor, again, this is a real tiny drop in the bucket for you guys but have you gone back and looked at your processes and done anything different?

James Dimon, Chairman & CEO

Yes. I mean, Michael, you should assume that whenever something happens, we scour all process, all procedures, all underwriting, all everything. And we think we're okay in other stuff. But I -- my antenna goes up when things like that happen. And I probably shouldn't say this but when you see one cockroach, there are probably more. And so we should -- everyone should be forewarn on this one. And first brands, I put in the same category. And there are a couple of other ones out that I've seen that I put in similar categories. So -- but we always look at these things, and we're not -- I'm nipping in. We make mistakes, too. So we'll see. There clearly was, in my opinion, fraud involved in a bunch of these things. But that doesn't mean we can't improve our procedures.

First Brands

If Tricolor was the kindling, First Brands was the spark that started the attention-getting blaze. You might not recognize "First Brands", but odds are you recognize some of the autoparts brands they owned, like Fram, Trico, Cardone, Autolite, and many more.

First Brands filed for bankruptcy on September 29th. It disclosed that it had $10-$50 billion in liabilities and less than $10 billion in assets after stopping payments to lenders on September 15th. On October 8th, Raistone Capital LLC filed a legal document requesting that the Bankruptcy Court appoint its own examiner, alleging that there was as much as $2.3 billion that "simply vanished" (Case 25-90399 Document 307 Filed in TXSB on 10/08/25 ). The filing alleges:

According to the sworn declarations of the Debtors’ representatives and the representations of counsel, as much as $2.3 billion attributable to Third-Party Factoring arrangements has simply vanished. Notwithstanding the enormity of this potential defalcation, the Debtors euphemistically characterize the missing amounts as the result of mere “Third-Party Factoring irregularities.” No one has apparently been held accountable to date. The Debtors’ Chief Executive Officer and Chief Financial Officer remain in place in both their executive and board positions -- albeit now supported by two “independent” directors who were engaged only shortly before the Petition Date.

In the First Day Hearing, Vincent Indelicato, ESQ. an attorney representing Evolution Credit Partners expressed concerns that collateral for their loan was used as collateral for another lender:

And so very simply put, Your Honor, we stand before you today not just as a lender, not just as a supporter of the business and the capital structure, but also as a victim. Because while we don't have all the facts, what we do know, Your Honor, is that someone, and we don't know who, we don't know why, we don't know when, took our collateral, transferred it to another entity, and then used that same collateral for a loan from another lender. How in the world that possibly could happen within a sophisticated multibillion-dollar enterprise is a mystery to us and to our client. And, Your Honor, while we commend the debtors' professionals for the candor and the transparency that they have exhibited to their stakeholders during this very challenging time, and we have the utmost respect for the debtors' legal and financial advisors, as Mr. Greenberg emphasized, we still have more questions than answers. 

(Case 25-90399 Document 307-2 Filed in TXSB on 10/08/25 Exhibit B Page 40)

Like many companies, First Brands would borrow against its "accounts receivable". When a customer is invoiced, they have a period of time to pay the invoice. So, it is common for companies to use invoices as collateral for loans, providing the cash immediately to the company, and the loan is repaid when the borrower is paid by the customer. For a company like First Brands, where many customers are national retailers like Autozone (AZO) or Walmart (WMT), these loans are considered relatively low risk. AZO or WMT might make them wait, but there is little risk that the invoice will not be paid.

These are the lenders who have voiced concerns during the first day hearing and in Raistone Capital's filing. 

Sunny Singh, esq., a lawyer representing First Brands addressed the issue, noting that it would likely take time to sort out the accounts receivable:

You heard this morning about Mr. Indelicato -- during Mr. Indelicato's comments, their inventory may have been moved over to FBG. So we're not going to figure that issue out today, right? Hopefully we can figure it out in 30 days. My guess is it's going to take longer. But whatever it is, everybody's rights are reserved, and we're not saying this is, you know, inventory that belongs to or the collateral is, you know, property of Evolution. At the same time, we're not saying it's the ABL l enders. It'll sit in an account. Nobody's getting a surcharge waiver. Nobody's getting a 552(b) waiver. And nobody is being subject to senior leave in the SPV debtor boxes, that is, or CarVal. Those are TBD.

(Case 25-90399 Document 307-2 Filed in TXSB on 10/08/25 Exhibit B Page 79)

It could easily be months before we know exactly what happened and what lenders are going to be able to recover.

Public Company Impact

While Tricolor and First Brands both happen to be in the "automotive" category, they are very different parts of the automotive business. The First Brands bankruptcy is being accused of rocking BDCs and CLOs. Although the BDC with the highest exposure is PSEC Capital (PSEC) at $58.9 million and 1.8% of its portfolio invested in a first and second-lien term loan.

CLOs have an estimated $2 billion exposure to First Brands. That sounds like a lot, but an analysis by Pitchbook estimates that the average exposure was 0.24%. This is consistent with a recent report by Fitch, which notes that default exposure among CLOs rose to 0.7% in September. The report was 43% of BSL CLOs (Broadly Syndicated Loan CLOs), having an average of 0.5% exposure to First Brands, making it the largest contributor to defaults. It is worth noting that 0.7% exposure to defaulted loans is still well below historical averages.

Why We Believe Credit Risk is Relatively Low

We've been arguing that credit risk is not particularly high this cycle. We believe that we are in an environment where borrowers are strong relative to what we typically see late in the credit cycle. Defaults are going to increase, and that shouldn't be a surprise since we are coming out of multiple years of super-low default rates. When default rates are essentially none, the only direction they can go is up.

However, if we look at 2005-2007, we saw companies leveraging up; we saw lenders leveraging up. Everyone was taking on more debt. Going into COVID-19, companies were leveraging up, but it was stopped short. The global pandemic forced a lot of companies to proactively manage their balance sheets.

Then, following COVID-19, the leveraging-up period was very brief as interest rates were raised quickly. Over the past three years, we've seen a decline in corporate loans as a percentage of assets for nonfinancial corporate businesses, according to the St. Louis Fed. Source

St Louis Fed

Whether we look at the big picture or we zoom in on individual companies, we don't see excessive use of leverage. The companies that have experienced pressure on their balance sheets have generally experienced it because of high interest rates, forcing them to deleverage as opposed to refinance maturing fixed-rate debt or reduce their floating-rate loans.

The cases discussed today are exceptions in that the debt was considered relatively safe and collapsed quickly. However, in both cases, there is alleged fraud. There will probably be more cases as the economy gets softer. But these aren't the kinds of scenarios that are going to lead to a credit collapse. When companies that were strong start failing and defaulting, that's when there is a real concern in the credit markets.

At High Dividend Opportunities, we remain bullish on credit risk. Our base scenario is that we are heading into a recession that is mild in terms of credit risk – more along the lines of the gradual slope we saw in 2000-2002, than the sudden spike we saw from 2008-2009. Source

St Louis Fed

Opportunities

Our portfolio has exposure to credit risk from a variety of angles. We have BDCs, we have CLO funds, we have debt CEFs, and we have some exposure to banks.

Some of our top ideas to take advantage of the pullback in credit risk are:

1. Ares Capital (ARCC) - yielding 9.3% has pulled back about 10% since this drama started, even though they don't have any exposure to these particular companies. ARCC is a time-tested BDC that has navigated through the difficult environment presented by the Great Financial Crisis, and we have confidence that management can handle any challenges this environment will throw at them. 

2. PIMCO Dynamic Income Fund (PDI) - yielding 14.6% is a fund that invests in a wide variety of debt investments. PIMCO is an elite manager in the space that has demonstrated an ability to take advantage of market dislocations. PDI is still trading at a premium to NAV, but that premium shrank over the last month. NAV is roughly flat, while the price has declined by over 8%:

3. Eagle Point Credit Co LLC (ECC) - yielding 27.5% is a fund that invests in CLO equity tranches. Unlike the other choices discussed, ECC likely does have exposure to First Brands. As discussed above, it is estimated that CLOs had approximately 0.24% exposure to First Brands. Those positions could result in credit losses. However, ECC is trading at a 10% discount to the last reported NAV.

   
   

CLO equity funds typically trade at a premium to NAV. It is a "stick your hand in the fire" type of investment, but we believe the reward is worth the risk. The market has likely overreacted to the downside.

Conclusion

On the other side of the coin, we have agency mREITs and municipal bond funds that have much less credit risk and carry more interest-rate risk. We also have our selection of preferred and bonds, where we have done our own due diligence. 

One reason we don't panic when a sector of the market runs into challenges is that we are always diversified. If credit risk declines, we have agency MBS, municipal bonds, and other investments that aren't exposed to it. 

We will continue to monitor credit risk, because we maintain a comfortable exposure to it. We continue to believe that defaults are likely to remain much lower than many expect, although it is inevitable that companies engaged in questionable activities or accounting are going to be revealed as the economy in general continues to slow down.

The fear of credit risk is a buying opportunity among investments like BDCs, debt CEFs, and CLO funds. 

Make sure that your portfolio is drawing income from a variety of different sources so that you don't have to predict the future to have a strong flow of dividends in your portfolio every month.