By: Russ Kamp, CEO, Ryan ALM, Inc.
I’ve spent considerable time recently questioning whether the extraordinary investment in artificial intelligence (AI) will ultimately produce acceptable returns for investors. As I’ve stated before, I don’t question the technology’s potential to transform our economy, improve productivity, and create enormous opportunities. But there is a significant difference between an exciting technological advancement and a profitable investment. According to the Financial Times, several major banks are increasingly looking to purchase credit insurance to protect themselves against potential losses on loans financing AI infrastructure.
Please think about that for a moment. The banks providing billions of dollars to finance this incredible expansion are looking for ways to transfer some of that risk to someone else. Shouldn’t that get investors’ attention?
The Financial Times reports that Barclays has explored insurance protection involving more than $10 billion in AI infrastructure loans, while HSBC has also investigated similar arrangements. JPMorgan Chase supposedly considered the strategy but ultimately decided against it. These arrangements generally allow banks to transfer 20% to 50% of their exposure to insurance companies, freeing up capacity to make additional loans. However, that protection isn’t cheap! According to the report, insurance premiums can consume 50% to 70% of the lending income associated with the insured portion of these loans.
Furthermore, some insurers are reportedly approaching their own concentration limits for data-center exposure. Are we simply transferring risk from one part of the financial system to another? Credit insurance can be a perfectly legitimate risk-management tool, but it doesn’t eliminate the underlying risk. It merely changes who bears the potential losses.
Compounding the financing challenge is yesterday’s significant increase in U.S. Treasury yields. Following another disappointing inflation report, the 10-year Treasury yield climbed approximately 12 basis points to get back to nearly 5%, while the two-year yield rose roughly 18 basis points. It’s largest one day move in nearly 18-months. This development is important because the enormous AI infrastructure buildout depends upon access to capital at a cost that allows projects to generate acceptable returns. The higher Treasury yields increase the baseline cost of borrowing, while widening credit spreads can make financing even more expensive.
We’ve already witnessed substantial credit deterioration among some highly leveraged AI infrastructure providers. Now banks are seeking additional protection against their exposure. What happens when the cost of financing rises at the same time that lenders become increasingly selective about which projects they are willing to support? The answer could be delayed or eliminated construction, reduced investment, lower profitability, and ultimately disappointing returns for investors. More to come!
