‘Bond King’ Jeffrey Gundlach warns of the next financial crisis: ‘It has the same trappings as subprime mortgage repackaging in 2006’

Gundlach noted that the “garbage lending” that previously affected public markets before the Great Recession has, in recent years, moved into private markets. Private credit has seen a surge in popularity, with substantial asset pools now over-invested in it. Gundlach identified the primary issue as a fundamental absence of transparency and liquidity.

Investors are drawn to private credit largely because of the Sharpe ratio argument, implying they can achieve public market-like returns with significantly less fluctuation. Nevertheless, Gundlach argues this is a misperception, stemming from a failure to value assets at their current market worth, akin to how a five-year CD seems steady even as its actual worth diminishes when interest rates climb. He shared an example of private equity firms making minor downward adjustments to their holdings during S&P 500 downturns, only to revalue them upward when the market rebounds, thus artificially suppressing reported volatility.

Gundlach highlighted how unstable this pricing structure is, pointing out that private assets are effectively valued at either full price or nothing. He referenced a recent situation involving Renovo, a home renovation company, which experienced financial distress went into Chapter 7 bankruptcy subsequent to securing $150 million in private credit. The business reported debts ranging from $100 million to $500 million, with assets valued under $50,000. Gundlach raised concerns about how private companies could have assigned a value of 100 to these assets just weeks earlier, given the significant imbalance between their obligations and holdings.

Considering these risks, Gundlach advised investors to hold fewer financial assets than usual, proposing a cap of 40% in stocks (primarily international) and 25% in bonds (preferring short-duration Treasuries and non-dollar bonds). He suggested keeping the rest in cash and tangible assets such as gold. Gundlach cautioned investors that market shifts, even when accurately predicted, require patience to materialize, recalling his own situation when his bearish stance on bundled mortgages in 2004 took three years to show effects.

A leading U.S. Institutional property owner, The Amherst Group CEO Sean Dobson, spoke in defense of subprime mortgages at the ResiDay conference held in New York City this past November. “Subprime mortgages were serving millions of Americans to get them to buy homes,” he stated. He clarified that these were not poor-quality loans but were intended for individuals with credit scores below the average, noting that a mere “two missed payments” could cause a credit score to drop from 745 to the subprime range of 645. “You can go from prime to subprime in two months.”

The AI ‘mania’

Other top economists are issuing similar warnings. Mohamed El-Erian, for instance, told the Yahoo Finance Invest conference that he fears the AI bubble will “end in tears” for many, while agreeing that private credit was a concern. He used Jamie Dimon’s metaphor of “credit cockroaches,” while arguing that the problems aren’t “termites”—in other words, not eating away at the foundations of the economy.

Bank of America Research estimated private credit as a $22 trillion industry through late 2024, so big it would be the world’s second-largest economy. It has more than doubled in size since 2012, BofA added, as the number of companies listed on public markets has halved. The S&P 500 is extraordinarily concentrated, with Scott Galloway repeatedly warning in recent weeks that there’s “nowhere to hide” if the AI story turns negative. A whopping 40% of the S&P’s market cap lies in just 10 companies, and those companies are overwhelmingly invested in AI, Galloway and NYU Stern Finance professor Aswath Damodaran recently discussed. Unsettlingly, Gundlach seemed to be arguing that private capital is a giant iceberg sitting underneath what could be a melting icecap of equity markets.

Indeed, Gundlach harbors significant concerns regarding AI, drawing a parallel to one of history's most impactful technological advancements approximately a century ago: electricity.

“Electricity being put into people’s homes was probably one of the biggest changes of all time,” he said, with the result that “electricity stocks ere in a huge mania” around 1900, and they performed very well. Unfortunately, this peaked in 1911.

“People love to look at the benefits of these transformative technologies,” but those benefits get priced in very early, during what Gundlach called “mania periods,” adding, “I just don’t think there’s any argument against the fact that we’re in a mania.” But Gundlach also argued that some impossible things are happening on the national debt.

When the improbable is on the verge of occurring

Gunldach informed Odd Lots hosts Joe Weisenthal and Tracy Alloway that the substantial U.S. National debt and escalating interest payments are leading to a mathematical predicament necessitating drastic government action, possibly within the coming five years. He referenced the onset of significant deficits during the Reagan administration, when the national debt was viewed as a remote concern; however, what was once a 60-year issue evolved into a 40-year, then a 20-year problem, and is now a five-year problem, indicating it's a “problem in real time.”

Gundlach stated his belief stems from the escalating path of U.S. Government debt and its associated interest expenses. The reported deficit is roughly 6% of GDP, a figure typically seen during severe economic downturns. Presently, servicing the debt uses about 30% of the $5 trillion collected in federal taxes. This proportion is expected to rise as existing bonds, carrying an average coupon near 3% for the immediate future, mature and are refinanced with new debt at elevated rates (Treasuries are presently yielding as much as 4.5%).

Drawing on plausible assumptions regarding deficit growth, Gundlach outlined a stark prognosis for the end of the decade. Under the current tax and borrowing regime, he said, it is “quite plausible” that by 2030, 60% of all tax receipts will be allocated to interest expense. Pushing the projections further under a pessimistic scenario (Treasury rates hitting 9% and the deficit reaching 12% of GDP), the situation becomes mathematically impossible: “by around 2030, you would have 120% of tax receipts going to interest expense, which of course is impossible.”

Gundlach contends that a change is unavoidable: “What happens is that you have to blow up the entire system, because all the tax receipts would go to interest expense.” This unavoidable situation necessitates discarding the conventional rule framework. Gundlach further stated that when faced with such an impossibility, “you have to open up your mind to a radical change in the rule system.”