The bank last month launched a bunch of credit default swaps in these five hyperscalers, Bloomberg reported, citing sources. Trades occur in $25 million increments — $5 million for each firm’s swaps, the report added.
A credit default swap, commonly known as CDS, is a financial derivative that lets investors protect themselves against the risk of a borrower defaulting on their debt. However, these are often used simply to bet against debt.
Also read: Treason! Nobel laureate Paul Krugman claims people close to Trump behind $580-mn mystery bets before post on US-Iran talks
Let’s take an example. John, an investor, predicts that Company X will soon collapse due to several macroeconomic and internal factors. To monetise on this, he enters into a credit default swap agreement with Bank Y, betting against the bonds issued by Company X. As part of the agreement, John regularly pays a premium to Bank Y. However, within a few years, headlines flash on the television that Company X has defaulted on its loans. While Company X’s equity shareholders panic, John enjoys the compensation he receives from Bank Y as part of the CDS agreement. Put simply, John profited by betting that Company X would collapse and wouldn’t be able to pay back its loans. And this is exactly what is spooking investors now.
Michael Burry’s Big Short
The CDS mechanism became popular at the onset of the 2008 global financial crisis. American investor and hedge fund manager Michael Burry, along with several others, famously bet against the US housing market a few years before the 2008 crash. He bought CDS from several banks, like Goldman Sachs and Deutsche Bank, on mortgage-backed bonds. He paid heavy premiums to maintain the CDS contracts simply on the assumption that the real estate market would soon crash, although headlines touted record valuations, fuelling scepticism among his clients.
However, by late 2006, the cracks in the housing market began to appear – the default rates surged and bond prices wobbled. By 2007, the subprime crisis accelerated, and Burry’s CDS contracts massively rallied in value, earning $100 million for himself and more than $700 million for his investors.
AI bubble ready to pop?
Now, CDS contracts reportedly issued by JPMorgan this month against the tech giants raise concerns, as this came amid worries that the rising AI boom may simply be a bubble ready to burst. These tech giants are heavily investing in artificial intelligence, amid expectations that it will be the “next big thing”, leading to a rise in their debt.
Also read: Crude oil above $105 again as Iran rejects US proposal to end war. $150 in sight?
Back in February, Oracle announced plans to raise up to $50 billion in debt and equity financing. According to reports published last year, Oracle’s net debt could triple to $290 billion by 2028. Microsoft, Meta, Alphabet and others are also spending big amounts on AI developments.
Only time will tell whether this will be the next ‘Big Short’ and the beginning of another global financial crisis.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)