Big AI giants are borrowing heavily, while Wall Street is busy with self-protection: brewing risk transfer, buying default swaps wildly...

Wall Street is preparing to offer massive loans to the giants in the field of artificial intelligence (AI), while also working to protect themselves from any bubbles that may be fueled by their financing. The urgency of banks reducing their risk exposure is evident throughout the credit market. The cost of using derivatives to protect Oracle Corporation (ORCL.US) debt from default has reached its highest level since the 2008 global financial crisis. Morgan Stanley is considering using significant risk transfer (a form of insurance against loan losses) to diversify some of the risks associated with its tech company borrowers. The five-year credit default swap price for Oracle Corporation has soared to a 16-year high. Tech giants like Oracle Corporation, Meta Platforms (META.US), and Alphabet Inc. Class C (GOOGL.US) are issuing massive amounts of debt for their AI capital expenditures, driving global bond issuance to over $6.46 trillion by 2025. These mega-tech companies, along with power companies and other enterprises, are expected to invest at least $5 trillion in competing to build data centers and other infrastructure to support AI technology that is expected to fundamentally change the global economy. The investment amounts are so large that issuers will have to tap into almost all major debt markets. JPMorgan Chase points out that these tech investments may take years to yield returns if they do at all. Steven Gray, chief investment officer of Grey Value Management, also said, "AI technology is impressive. But it doesn't mean you will profit from it." This surge in AI investments has left some lending institutions facing excessive risk exposure, so they are using a range of tools - credit derivatives, complex bonds, and some newer financial products - to transfer the risks of the AI investment boom to other investors. Real risks These risks became more real last week. A major disruption led to a temporary halt in trading for CME Group Inc. Class A, reminding investors that data center clients could be lost if failures occur repeatedly. Subsequently, Goldman Sachs Group, Inc. halted a planned $1.3 billion mortgage-backed security sale for data center operator CyrusOne. Banks are turning to the credit derivatives market to reduce their risk exposure. According to Barclays credit strategist Jagr Patel's analysis of Trading and reporting facilities data up to November 28th, the credit default swap trading volume for Oracle Corporation has surged to about $8 billion over the past nine weeks, far above the level of about $350 million in the same period last year. In a recent research report, Morgan Stanley highlighted that banks have provided the majority of the massive construction loans for data centers, with Oracle Corporation expected to be a tenant, which may be a major driver for Oracle Corporation's hedging transactions. These include a $38 billion loan portfolio and a $18 billion loan for the construction of multiple new data center facilities in Texas, Wisconsin, and New Mexico. Default swap costs rising In addition to Oracle Corporation, prices for other default swaps are also rising. On Thursday, the five-year credit default swap annual cost to protect $10 million of debt from default for Microsoft Corporation (MSFT.US) was about $34,000 (i.e. 34 basis points), higher than the nearly $20,000 in mid-October. Andrew Wenberg, portfolio manager at hedge fund Saba Capital Management, said that the credit spread for Microsoft Corporation's default swap is unusually wide for a AAA-rated company. In contrast, on Thursday, another American AAA-rated company Johnson & Johnson's default swap cost was around 19 basis points. He said, "Selling protection on Microsoft Corporation's default swap at a level more than 50% higher than Johnson & Johnson, which is also a AAA-rated company, is a rare opportunity." Oracle Corporation, Meta, and Alphabet Inc. Class C also present similar opportunities. Wenberg explained that despite their massive borrowing, their credit default swap transactions have a high spread relative to their default risk, making selling protection meaningful. He added that even if these companies were downgraded, these positions should perform well as they already reflect so much potential bad news. Increased urgency The massive scale of the latest debt issuances has intensified this urgency. Just recently, investors considered a $10 billion trade in the US investment-grade bond market to be a big deal. But Teddy Hodgson, global co-head of investment-grade debt capital markets at Morgan Stanley, said that for companies with market values in the trillions and funding needs in the hundreds of billions, a $10 billion bond sale is just a drop in the ocean. Hodgson said, "We raised $30 billion for Meta through a 'one-day bridge' - that's a bond sale completed in a day. It's never been done before. Investors will have to get used to even larger deals from mega-tech companies, as they have become so massive, and seizing the opportunity with AI will require massive investments." Reducing risk exposure As a key player in AI race financing, Morgan Stanley is considering shedding some of its data center risk exposure through a transaction known as Significant Risk Transfer (SRT). This transaction can provide banks with default protection for a portion of 5% to 15% of a specified loan portfolio. SRT typically involves the sale of bonds known as credit-linked notes, which may embed credit derivatives related to companies or loan portfolios. If the borrower defaults, the bank can receive compensation to offset losses. Reportedly, Morgan Stanley has had preliminary discussions with potential investors on an SRT linked to a portfolio of loans to AI infrastructure-related companies. Mark Craig, senior fixed income trader at Global Investments, said, "Banks are fully aware of the market's recent concerns about potential overinvestment and overvaluation in the AI sector. They may be exploring hedging or risk transfer mechanisms, which shouldn't come as a surprise to anyone." Insiders revealed that private equity firms, including Ares Management Corp., have been trying to take on some of the risk exposure in the SRTs tied to banks and data centers. The company has been in talks with banks about potential transactions. In addition, banks are seeking to create other products that will allow them to shed credit risks associated with mega-tech companies. Insiders said that at least two companies are trying to package a set of credit derivatives related to tech companies, similar to exchange-traded funds in the stock industry. Citadel Securities has started making markets for two sets of corporate bonds from mega-tech companies, allowing investors to quickly increase or decrease their exposure to these companies.