All eyes will be on Federal Reserve Chair Warsh's upcoming speech on inflation this Friday. Even if he remains noncommittal on the subject, any subsequent remarks from the central bank are set to trigger significant market reactions. Market consensus currently places a 45% probability on a rate hike before year-end, as tighter policy would pour cold water on the red-hot AI boom.
Just how chilling that water turns out to be depends on the size of the current bubble, which cannot be gauged by looking solely at balance-sheet financing. You have to examine off-balance-sheet obligations instead, and should you see the hidden debts of America's tech behemoths, you'd be so stunned you'd collapse into your chair, as if witnessing a nuclear detonation. The Wall Street Journal recently reported that nine top tech companies, including Alphabet Inc (NASDAQ: GOOGL), Meta Platforms Inc (NASDAQ: META), Microsoft Corp (NASDAQ: MSFT), Amazon.com Inc (NASDAQ: AMZN), Oracle Corp (NYSE: ORCL), Nvidia Corp (NASDAQ: NVDA), Broadcom Inc (NASDAQ: AVGO), SpaceX and Advanced Micro Devices Inc (NASDAQ: AMD), disclosed a combined total of roughly $3 trillion in off-balance-sheet commitments in the footnotes of their latest securities filings. Just the commitments from Alphabet, Meta, Microsoft and Amazon alone exceed $2.4 trillion.
What exactly does $3 trillion represent? It equals about one-tenth of the entire US GDP. So what are all these off-balance-sheet commitments, and why aren't they recorded on the balance sheet? Let's look at an example: Louisiana has seen the construction of a massive data center called "Hyperion," funded through bond issuance and leased to Meta. But rent payments aren't due immediately, as Meta has signed a lease starting in 2029, lasting four years with an option to renew for up to 20 years. The issue is that the bond proceeds rely on Meta's rent payments, so what happens if Meta walks away after 2033? Meta has grandly pledged to compensate bondholders for any shortfall if it terminates the lease early. Since the lease doesn't start until 2029, it is not recorded on the balance sheet and is classified as an "operating lease not yet commenced."
Across the nine major tech companies, these "not-yet-commenced leases" total a staggering $1.2 trillion. What becomes clear is that these so-called "off-balance-sheet commitments" are essentially debts these companies will be obligated to pay in the future, but since they don't need to pay out now, they aren't entered on the balance sheet, maintaining a facade of prosperity. The term "commitments" is used rather than "liabilities," meaning they promise to pay in the future, but they aren't debts at this moment, a clever bit of wordplay.
That's not all, there's another roughly $1.9 trillion in "off-balance-sheet commitments" that are also future liabilities, called "purchase commitments." Because GPUs and storage are in such high demand, major manufacturers must reserve production capacity in advance by signing long-term procurement contracts, which are exactly these "purchase commitments." Since they aren't bought now but in the future, they remain mere commitments rather than current liabilities, so they don't need to be on the balance sheet. Together, these "purchase commitments" and "not-yet-commenced leases" make up the over $3 trillion in off-balance-sheet commitments that the nine giants have kept off their ledgers.
So what happens if the Fed raises rates? Higher interest rates lower the discount rate on future cash flows, causing the giants' stock prices to fall and reducing the cash flow they can obtain through equity financing. Similarly, a rate hike increases the cost of borrowing for these companies. These future off-balance-sheet commitments will eventually come due, and the cost of borrowing money to pay them will rise considerably with higher rates. You might wonder, aren't these big companies quite profitable? Can't they just use their own cash flow to cover these future bills?
That's old news. In the AI arms race, both Alphabet and Amazon have seen their free cash flow turn negative, and the other companies are not faring much better. What about just defaulting? That's also extremely difficult, as signed purchase contracts and leases generally cannot be unilaterally cancelled. The problem is that the Strait of Hormuz is not fully reopened yet, and inflation could surge at any moment. If that happens, prices will spiral out of control without a rate hike. But if the Fed is forced to hike, tech stock prices will plummet, dragging down the valuations of AI startups along with them.
Tech companies would then have to borrow money to pay their future bills. If financing costs become unbearably high, default becomes the only option. Data centers that can't collect rent can't just sit idle; with no client payments coming in, they'd have to sell off their GPUs to recoup losses. A flood of second-hand GPUs would hit the market, prices would crash, and the market would begin reassessing the true liabilities of all chipmakers. The Financial Accounting Standards Board would require "not-yet-commenced leases" to be recorded on balance sheets at present value. Tech giants' debt ratios would surge, triggering cross-default clauses in debt covenants. The first wave of the $3 trillion in off-balance-sheet commitments would come due, leading to a cascading stampede on the market valuations of AI-heavy investors and startups alike.
This scenario echoes 1999, when the Fed's consecutive rate hikes ultimately burst the internet bubble. The current AI arms race among these giants is not only draining their cash flow but also piling up massive hidden debts off the balance sheet, which is truly terrifying. AI, much like the internet over two decades ago, has real promise. However, the internet bubble burst and wiped out a host of star companies. Today's tech giants aiming to win the AI race must not only invest heavily but also remain cautious about potential financial risks. If they don't compete, they risk falling behind technologically and missing the ticket to the next era; if they do compete, they burn through their capital and any slight risk could topple them into a crisis. Striking that delicate balance will be the ultimate test for the giants locked in this arms race.
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