Companies are Buying Fire Insurance

Happy Sunday.

• Friday's tech selloff took gold, silver and bitcoin down with it, while Treasuries and dividend-paying stocks held up because they pay you to own them.

• All through October, investors bought insurance against an AI bust: puts on CoreWeave, default protection on the big tech companies, and new contracts on the rent paid for Nvidia chips.

• Every one of those policies is only as good as whoever wrote it, and some are being bought mainly to get banks to lend more money for the same buildout.

• The govt, the chipmakers and the cloud giants are all tied to the same bet, so I'm watching whether insurance costs on the five biggest AI spenders start moving apart.

Some people in tech have been quitting their jobs so they're free to hedge their own stock. A Gateway Investment Advisers executive told the Journal that some of his clients used to work at big tech companies that restrict employee trading, and they're still sitting on piles of their old employer's shares. As long as they stayed on the payroll, they couldn't do much to protect themselves, so they left. I can't say I blame them. If I'd watched most of my net worth ride on one ticker through a day like Friday, I'd want a policy too.

You saw what happened Friday. The Nasdaq fell 2.9 percent, and Intel $INTC ( ▼ 28.58% )  dropped 29 percent, its worst day since 1974. Then the posts started going around saying there was nowhere to hide, with gold down about 3.5 percent, silver about 6 and bitcoin about 5. For the most part they were right. Three of the things people buy specifically for a day like Friday fell right along with the stocks they were supposed to protect. Treasuries were the one real exception, and I'll come back to why.

All through October, while most of us were watching prices, the market was out shopping for insurance. Put volume on CoreWeave $CRWV ( ▼ 9.66% ) hit a record for the month, according to Cboe. The cost of insuring against a default by Amazon, Alphabet, Microsoft, Meta or Oracle climbed to its highest level since 2021. And Jump Trading, the big quant trading firm, opened a desk that sells protection against a drop in the rent people pay for Nvidia chips. (I confess I didn't know you could insure the rent on a computer chip, either.)

For most of your investing life, protection came free. If you owned a few things that didn't move together, the arithmetic took care of the rest, and you never had to count on anyone to pay you. Today protection mostly has to be bought from somebody, and any policy is only as good as the firm that wrote it. A few of October's policies were bought for an odder reason still. In those cases the buyer wanted a bank to lend him more money so he could keep building the very thing he was insuring.

The free lunch closed

Harry Markowitz worked out the math in 1952. His point was that if you combine assets that don't move in lockstep, you can cut the risk of the whole pile without giving up any return. People took to calling it the only free lunch in finance, and it was free because nobody had to pay you when it worked. Your gold never owed you a dime. It was simply expected to go up on the days your stocks went down.

On Friday it didn't. Dave Keller, a chart guy I watch, called gold "the worst safe haven on the planet right now" on his Friday show, and he made a point I suspect most gold owners would rather not hear. Gold's correlation with stocks has never been reliably negative. In some stretches it moves with stocks and in others against them, and over long periods it averages out close to zero. What gold protects you against is a bad decade for paper money. It never made any promise about a bad Friday for chip stocks, and it's a little unfair to blame it for breaking one.

Crypto had troubles of its own. Thieves took $6.3 billion from Binance, the largest crypto exchange, which makes it the biggest crypto theft on record, and late Saturday the FBI said North Korea was behind it. According to the Journal, the heist rattled stock investors who were already nervous about AI spending, and money moved into Treasuries and German government bonds. I would not have guessed that a robbery at an offshore crypto exchange could help move the yield on a German 10-year bond, but that is how tightly the world's markets are tied together now.

Treasuries did their job. The 10-year yield fell about 0.36 percentage point in October, to 4.93 percent, its biggest monthly drop since December 2023. (When yields fall, bond prices rise, so the people who owned them made money.) I've written before about why I wouldn't count on that working for a whole decade, so I won't repeat myself here. Inside the stock market, the steadier businesses held up as well. On Friday, energy and consumer staples each rose more than 1 percent and utilities edged higher, while tech fell almost 5 percent.

If you look at what held up, you'll notice that every one of them pays you to own it. Treasuries pay interest. Utilities, staples companies and oil producers pay dividends out of cash they earned this year. Gold, silver and bitcoin pay nothing at all, so the only reason to own them is the price. And people who own something only for its price tend to sell it when the price goes against them, which is more or less what happened Friday.

The market went shopping for a policy

The insurance people bought this month falls into two groups.

The first is the familiar kind. A put option is the right to sell a stock at a set price by a set date, and some of the most popular CoreWeave puts pay off if the stock falls to $35 by 2028. It closed Friday around $55. A credit-default swap, or CDS, pays you if a borrower defaults. Protection on all five of the hyperscalers (the giants building AI data centers) got more expensive over the past month, and Eugene Grinberg of the bond data firm Solve said there were no exceptions.

The second is the new kind, and I find it more interesting and a little more worrying. A neocloud, one of the newer companies like CoreWeave that rent out AI chips, can now pay Jump for the right to sell its Nvidia B300 capacity at, say, $4 an hour if demand dries up. That rent currently runs about $7.56 an hour, up roughly 56 percent this year, according to a Silicon Data index. Susquehanna, one of the largest trading firms on Wall Street, says data centers and neoclouds have been asking about puts on a compute index, partly to reassure the banks that lend to them. For some of these buyers, the main point of the put is getting the bank to say yes to the next loan.

Today’s Sponsor

Invest Alongside a Manager with a 40-Year Track Record

Private real estate has long been a cornerstone of institutional portfolios, but individual investors have often had limited access to the asset class - or have had to invest through pooled funds and intermediaries.

Lightstone DIRECT offers a different approach. Accredited investors can invest directly in select real estate opportunities alongside Lightstone, a vertically integrated owner/operator with more than four decades of experience and a $12 billion real estate portfolio.

We invest 20% or more of the equity in every offering, aligning our interests with yours from day one. Our in-house team oversees acquisitions, asset management, and investment execution, with property operations managed by Lightstone and, where appropriate, experienced third-party operators.

No blind funds. No intermediaries. Just direct partnership.

Accredited Investors only. $100k minimum investment.

Explore Opportunities

^{This communication is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities. Any such offer or solicitation will be made exclusively through the definitive offering documents. All investments involve risk of loss, including the potential loss of principal. Past performance is not a guarantee of future results. Any targeted returns or projections are forward-looking statements, are based on current assumptions, and are not guarantees of future performance. Actual results may differ materially.}

Fire insurance needs houses that burn one at a time

The catch is older than Wall Street.

Insurance is diversification sold back to you. In the late 1600s, underwriters at Edward Lloyd's coffee house in London each took a slice of a ship's voyage. It worked because ships sank one at a time, so one wreck never broke every underwriter in the room.

Wildfire breaks that. When one fire takes a whole county, every policy in the county pays out the same week, and the pool runs dry. That's a big reason State Farm stopped writing new homeowners policies in California in 2023. The fire risk was still there. There was just nobody left to share it with. If you own a house in California or Florida, you've lived some version of this.

Fire country teaches a second lesson. Cheap insurance changes where people build. For decades California held homeowners rates down by regulation, and towns kept spreading into the hills. When the insurers finally pulled back, the state's last-resort plan was left holding the homes nobody else would cover.

Markets have taught both lessons at once. In the years before 2008, AIG sold credit protection on hundreds of billions of dollars of mortgage-linked bonds, priced as if mortgages would go bad one at a time. Banks bought that protection partly so they could hold more of those bonds with less capital. The mortgages went bad together, and AIG needed a $182 billion government rescue to pay what it owed. Plenty of banks thought they were hedged. They were. Their hedge was AIG.

Jump, per the Journal, is closely checking the creditworthiness of everyone it trades with, and Jump itself may be perfectly good for the money. But a policy against an AI bust gets tested on the day of an AI bust, when every firm in the chain takes the hit at once. And every put that gets a neocloud its bank loan adds one more data center to the same street.

The week's live test

Binance ran the experiment in public this weekend.

The stolen tokens came out of the exchange's hot wallets, the ones kept online to process everyday withdrawals. Binance promised to cover all of it. Its emergency fund, called SAFU, is estimated at roughly $1 billion to $1.2 billion, about a third of the loss once you set aside the roughly $3 billion that got frozen. So Binance also tapped part of its futures insurance fund and its corporate treasury. By Saturday it said about 90 percent of the stolen assets had been replaced, and today it started reopening withdrawals, bitcoin first.

That's a good outcome, and look at how it happened. The company's own balance sheet covered most of the loss, because it chose to. Michael Tanguma, who runs a bitcoin custody firm, put it to CNBC in seven words: "Nothing in the law requires it to."

It worked because the insurer and the thing it insured weren't on fire at the same time. Land the same theft in a month when Binance's own treasury is down hard, and there's less to cover it with.

Ryan Reck, a cybersecurity adviser, gave CNBC four questions to ask before trusting any platform. They're the best questions I read all week, and they work on every hedge you own, crypto or not.

What's covered? What's excluded? How much coverage exists for all customers combined? Do I have an enforceable right to be repaid?

Everybody's insurer is in the same trade

Run those questions on the biggest backstops in the market and the answers get uncomfortable.

The insurer of last resort for the American economy is Washington. On Friday it lost about $12 billion on paper, because the government owns 10 percent of Intel. Nvidia $NVDA ( ▼ 4.22% ) , which also holds a big Intel stake, lost about $6 billion on it the same day. The company selling the chips, the government that would rescue the buildout, and the chipmaker trying to supply it all took the hit on one ticker.

The hyperscalers were the other backstop, the companies that never needed anybody's money. Amazon $AMZN ( ▼ 1.41% ) just posted its second straight quarter of negative free cash flow, meaning it spent more on data centers and equipment than its business brought in. Alphabet burned $9.1 billion in the quarter, and Microsoft is raising $25 billion in bonds. Daniel Newman of Futurum Group described the new mood inside those companies as "We can't keep funding this on free cash flow."

The CDS market already told you how it reads all this. When protection on five different companies gets more expensive at the same time, with no exceptions, the market is pricing them as one bet.

The best case against me

The demand under all of this is real. Google Cloud revenue more than doubled to nearly $31 billion last quarter, and Meta $META ( ▼ 1.53% ) says AI is driving substantial new ad revenue. Chip rents up 56 percent this year is not what a glut looks like.

And heavy hedging can be bullish. Kriti Gupta and Nick Roberts at J.P. Morgan Private Bank made that case in a note dated Friday, written with data from before the selloff. When risks are well known, investors hedge ahead of them, and the scheduled events tend to clear without much damage. Over the last 29 years November has been the S&P 500's best month, averaging 2.3 percent, and 2.75 percent in midterm years. The midterms are Tuesday.

I'll take both points, and I'm not calling a top. Hedging ahead of Tuesday probably does help Tuesday clear. My claim is narrower. The free hedges failed, the paid ones come with a counterparty, and some of the paid ones are financing more of the same bet.

Read the policy

Usual reminder, I'm not a financial advisor and none of this is advice.

Here's how I'd run Reck's four questions on an ordinary portfolio.

Gold covers a long slide in what paper money buys. It excludes a Friday when everyone needs cash at once. Coverage for everyone combined is whatever the next buyer will pay, and nobody owes you a thing, which cuts both ways.

Treasuries give the strongest answer to question four. The government has to pay you back. It doesn't have to pay you back in dollars worth what they were.

A put listed on an exchange is backed by a clearinghouse, the Options Clearing Corporation, which stands between the buyer and the seller. A custom contract with a dealer is only as good as the dealer.

Crypto on an exchange is a pledge. This week the pledge got honored. It's still a pledge.

The boring stuff that held up Friday, the utilities and staples and the interest on a Treasury, does something none of the others do. It pays you on a schedule whether the fire comes or not.

The tell I'm watching is the CDS on those five hyperscalers. If protection keeps getting more expensive on all five together, the market is pricing the buildout as one credit, and every hedge tied to it is written on the same house. If the five start moving apart, say Oracle's protection keeps getting pricier (it's already up more than a full percentage point in October) while Microsoft's gets cheaper, the market is sorting winners from losers again, and the free kind of diversification is coming back.

Dave Olsen, Jump's president, made the case for hedging the way most people would. He doesn't think his house will catch fire, "but I still have insurance."

Fair enough. Right now everybody is buying fire insurance on the same neighborhood. Before you sign, check whether your insurer lives on your street.

Stay curious 😎

John

Today’s Sponsor

Your workflows and documentation could open a new revenue stream. AI labs pay to license useful operational data. Bezel helps established companies find a data partner.

Get a free estimate