Gundlach explained that, in recent years, the “garbage lending” that plagued public markets before the Great Recession has shifted into private markets. Private credit has become increasingly popular and is now over-allocated to by large asset pools. The core problem, according to Gundlach, lies in the fundamental lack of transparency and liquidity.

A major element of the private credit appeal is the Sharpe ratio argument, which suggests investors get comparable returns to public markets but with much lower volatility. However, Gundlach contends this is an illusion achieved by failing to market assets to market, similar to how a five-year CD appears stable even if its true value declines as interest rates rise. He provided an anecdote about private equity firms marking positions down slightly when the S&P 500 corrects, only to mark them back up when the market recovers, thereby underreporting volatility.

Gundlach illustrated the fragility of this pricing system by noting that private assets essentially have only two prices: 100 or zero. He cited a recent event concerning a home renovation business, Renovo, which went into Chapter 7 bankruptcy after issuing $150 million in private credit. The company listed liabilities between $100 million and $500 million, while listing assets as less than $50,000. Gundlach questioned how private firms could have marked this asset at 100 only weeks prior when the massive disparity between liabilities and assets was evident.

Given these vulnerabilities, Gundlach recommended investors allocate less to financial assets than typical, suggesting a maximum of 40% in equities (largely non-U.S.) and 25% in fixed income (favoring short-term Treasuries and non-dollar fixed income). He advocated for the remainder to be held in cash and real assets like gold. Gundlach reminded investors that market trends, even when correctly identified, take time to unfold, citing his own experience where being negative on packaged mortgages in 2004 took three years to start decaying.

One of America’s top institutional landlords, The Amherst Group CEO Sean Dobson, defended the subprime mortgage at the ResiDay conference in New York City earlier in November. “Subprime mortgages were serving millions of Americans to get them to buy homes,” he said. These weren’t junk mortgages, but were designed for people with below-average credit scores, he said, reminding the crowd that just “two missed payments” could send a credit score from 745 to the subprime 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.

To be sure, Gundlach is plenty concerned about AI, noting that it’s similar to one of the biggest ever breakthroughs in technology roughly 100 years 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 impossible is about to happen

The massive U.S. national debt and soaring interest expenses are creating a mathematical impossibility that requires radical government intervention potentially within the next five years, Gunldach told Odd Lots hosts Joe Weisenthal and Tracy Alloway. He recalled the beginning of big deficits in the Reagan years, when the national debt was considered a distant threat, but it used to be a 60-year problem, then a 40-year and a 20-year, but now it’s a five-year problem, which means it’s a “problem in real time.”

Gundlach said his conviction is based on the accelerating trajectory of U.S. government debt and interest costs. The official deficit stands at approximately 6% of GDP, a level historically associated with the depths of recessions. Currently, interest expense consumes about 30% of the $5 trillion in federal tax receipts. This figure is poised to climb higher as outstanding bonds, which have an average coupon of around 3% for the next few years, roll off and are replaced by new debt issued at higher rates (Treasuries are currently yielding up to 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 argues something will have to give: “What happens is that you have to blow up the entire system, because all the tax receipts would go to interest expense.” This inevitability means the traditional rule system must be abandoned. When something is impossible like this, Gundlach added, “you have to open up your mind to a radical change in the rule system.”