AI Big Short? Why rising credit default swaps are spooking investors and how is it similar to 2008 housing crisis

Michael Burry’s credit default swaps, which made him millions during the 2008 financial collapse, are often seen as an example of how such bets act as a premonition of a big crash ahead. However, investors are now worrying if the rising credit default swaps for big tech giants today may be a signal for a big AI-driven market crash in the near future.

New AI innovations and rising spending on the nascent technology led investors to believe that AI would be the next big driver of the market rally earlier this year. The expectations were indeed true, briefly, as tech-faced markets sharply rallied. South Korea’s Kospi, the face of this rally, skyrocketed more than 120%, before things began to go haywire.

Analysts soon began sounding the alarm over the massive AI spending and rising debt of the tech giants, questioning if they will actually bear fruit in the future. The worries sparked a sharp selloff in the AI stocks, with Kospi crashing 40% in just a month. However, this might just be the beginning, which is what rising credit default swaps may be indicating.


What are credit default swaps?

Credit default swap (CDS) is a derivative that provides protection against the risk that a bond issuer, such as a company or government, fails to ⁠meet its debt obligations. In simple terms, these instruments are designed to protect investors in case a firm fails to repay its debt and faces bankruptcy.

So rising CDS in a sector can imply that investors expect the major players to default on debt, which in turn can lead to a big crash in that segment. If it is a heavyweight sector, then it affects the overall market.

What did Michael Burry do during the 2008 crisis?

Just before the 2008 financial collapse, people believed that the US housing market was secure and booming, and that home prices would not fall. Banks increasingly issued subprime loans, riskier mortgages were given to borrowers with weaker credit, under the assumption that rising prices would shield them from losses. Despite the misplaced optimism, Burry voiced his opinion that the market was on the brink of collapse, which most people did not believe.

After tirelessly studying mortgage securities, he concluded that subprime loans would collapse by 2007, taking down the broader economy with them. Burry bought credit default swaps against subprime mortgage securities, effectively betting that the market would crash. Burry made around $100 million personally and $725 million for investors when the housing market finally collapsed.

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CDS rises again, raising worries

Banks mostly dominate the corporate CDS market, but technology companies are gradually gaining ground. Trading linked to the sector reached nearly $650 million in the second quarter, up 20% from the first quarter and almost 600% ‌from a ⁠year earlier, helped by new entrants such as Meta, Nvidia and Alphabet, DTCC data shows, as reported by Reuters.

However, it is important to note that CDS trading can be relatively thin. Average daily trades, even for large companies, can sometimes be in the single digits, meaning small transactions can have an outsized impact on prices.

It is only time that will tell whether these rising CDS levels are simply investors’ protecting themselves from any risk, or their belief that a bigger crash is coming. Interestingly, Burry himself is betting against the AI giants, further spooking investors.

Earlier this year, Burry wrote on a Substack post that he sees many indicators, both technical and fundamental, lining up for the same conclusion as the Dotcom crash. "1999 went where no market had gone before, and I would say so can this one...It is already there on a number of indicators," he said, arguing that massive venture capital flows, rising AI debt issuance, and extreme market optimism are creating conditions where valuations may detach from economic reality.

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(With inputs from agencies)

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