Futures dip, oil tops $100 as Iran reviews U.S. peace plan - what’s moving markets
Fear is being spread on social media that some AI players are nearing default. The evidence, some say, lies in the Bloomberg graphs below showing the widening CDS spreads of Oracle (NYSE:ORCL) and CoreWeave (NASDAQ:CRWV). Before getting into some details about what the CDS markets may be warning about Oracle and CoreWeave, let’s explain what CDS is.
CDS stands for credit default swaps. These are derivative contracts in which one party, the default protection buyer, pays a quarterly fee, expressed in basis points. In return, the counterparty, or protection provider, assures that in the event of default, the buyer will receive par for their bonds. CDS spreads, or the cost of default insurance, provide the market with an easy way to quantify the implied market default probability. While simplified, here is the math to calculate default risk:
Essentially, the formula divides the cost of insurance by the bonds par value less the recovery rate. The recovery rate represents what bondholders will recover in the event of default. Often, the market assumes 30 to 40 cents on the dollar.
Applying this math to five-year Oracle and CoreWeave CDS spreads, and assuming a 35% default recovery, we get the following annual default probabilities.
Oracle CDS 108 bps: 108 / (10,000*(1-0.35)) = 1.66%
CoreWeave CDS 675 bps: 675 / (10,000*(1-0.35)) = 10.38%
We can then cumulate the annual probabilities above to determine the market implied odds that Oracle or CoreWeave defaults over the next five years. Currently, those odds stand at 8% for Oracle and 42% for CoreWeave. Further below in this Commentary, we discuss why the market is assigning a sizeable default probability for CoreWeave.
What’s Irking CoreWeave Investors
As we shared above, CoreWeave’s CDS is priced in a moderate chance of a failure. Why? The quick answer is that the company, offering cloud computing services, is highly levered and spending significantly to build out its products. Additionally, despite rapidly growing revenue, it is losing money and bleeding cash.
To add to concerns, they are extremely dependent on Nvidia to get an appropriate allocation of chips. Lastly, their ability to offer its clients and potential clients its products is heavily dependent on the electrical grid, which is constrained.
To raise capital recently, the company is using Nvidia chips as collateral. That collateral may be worth a lot today, but due to rapidly changing technology cycles, it may be outdated and worth a lot less tomorrow. Further, prices could fall rapidly on said chips, requiring CoreWeave to post more collateral.
The screenshot below, courtesy of Refinitiv, shows that CoreWeave has $18.6 billion of debt outstanding, spread out between bonds and loans. Over the last four quarters the company has sales of $1.92 billion but it has a net loss of nearly $1.5 billion over the same period.
Those buying protection are clearly worried that CoreWeave can not ramp up sales quick enough and or find enough new financing to make payments to meet their current obligations and additional capital to offset their losses. The bet by those selling CDS insurance is that its revenues and income rise rapidly to improve its financial situation.
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