Credit Crisis Watch: Are the Markets Thawing?

For the world’s financial system to start functioning normally again, it is imperative that confidence in the credit markets be restored. In order to gauge the progress being made to unclog credit markets, I regularly monitor a range of financial sector spreads and other measures. By perusing these one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

I am planning on updating this “Credit Crisis Watch” regularly as I believe a grip on the credit situation will be key to determining the appropriate investment strategy.

First up is the three-month dollar LIBOR rate. After having peaked on October 10 at 4.82%, the rate declined sharply to 2.13% on November 12, but the healing process has since experienced a setback with the rate edging up to 2.18%. LIBOR trades at 118 basis points above the Fed’s target rate of 1.0%, compared with 43 basis points at the start of the year.

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Source: StockCharts.com

Importantly, the U.S. three-month Treasury Bills are trading at a minuscule 0.071%, indicating that liquidity is still being hoarded.

U.S. three-month Treasury Bill rate

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Source: The Wall Street Journal

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10, the measure eased to 1.75%, but has since worsened to 2.10%.

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Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread is increasing, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. The opposite applies to a narrowing LIBOR-OIS spread.

The movement in the LIBOR-OIS spread over the past few weeks is similar to the TED spread and shows that credit markets are still not functioning smoothly.

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Source: Fullermoney

As far as commercial paper is concerned, the A2P2 spread measures the difference between A2/P2 (low quality) and AA (high quality) 30-day non-financial commercial paper. Although the spread has declined from a record high of 4.83% to 4.27%, it remains at an elevated (i.e. crisis) level.

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Source: Federal Reserve Release - Commercial Paper

A declining ratio indicates that investors are demanding a higher premium in yield for increased risk, showing waning confidence in the economy.

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Source: Merrill Lynch Global Index System

Another indicator worth keeping an eye on is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. A declining ratio indicates that investors are demanding a lower premium in yield for increased risk, showing waning confidence in the economy.

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Source: I-Net Bridge

According to Markit, the cost of buying credit insurance for U.S. and European companies eased somewhat over the past week as shown by the narrower spreads (basis points) for the following credit indices:

• CDX (North American, investment grade) Index: down from 267 to 233
• CDX (North America, high yield) Index: down from 1,546 to 1,376


• Markit iTraxx Europe Index: down from 183 to 163
• Markit iTraxx Europe Crossover Index: down from 915 to 869


• Markit iTraxx Japan Index: down from 350 to 320
• Markit iTraxx Asia ex Japan IG Index: down from 452 to 360
• Markit iTraxx Asia ex Japan HY Index: down from 1,375 to 1,218

The graphs of the CDX Indices are shown below, with the red line indicating the spreads easing over the past few days.

CDX (North American, investment grade) Index

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Source: Markit

CDX (North America, high yield) Index

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Source: Markit

Lastly, let's look at some CDS statistics (as at November 26), courtesy of Markit. These prices represent the cost per year to insure $10,000 of debt for five years. For example, Italy is in most trouble among the G7 countries with a cost of $139 per year to insure $10,000 of debt.

It is noteworthy that the U.S. and U.K. CDSs are trading at record levels as unease over the level of national debt takes its toll on their sovereign credit risk.

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The TED and the LIBOR-OIS spreads have eased (i.e. narrowed) since the panic levels of October 10, whereas the CDX and iTraxx indices have also shown some improvement over the past few days. However, U.S. Treasury Bills and high-yield spreads are still at distressed levels.

In summary, although some progress has been made as a result of central banks’ liquidity facilities and capital injections, the credit markets are not yet thawing.

Comments

[Andrew Hughes:]

Very timely analysis Prieur. Knee jerk reactions by the markets seem to come right after any piece of news from the Treasuries of various countries. But with the underlying Economic indices becoming steadily worse by the day, reality has to set in at some stage. The easing of credit has to rely on the creditworthiness of the borrower, not the willingness of the lender. This latter scenario has been the cause of so much destruction to date. Creditworthiness is decreasing with every extra person on an unemployment line and every other firm gone to the wall. Until this fall has bottomed, I can't see any Bank easing access to credit without exposing themselves to even more defaults.

2008 Nov 28 08:34 AM

[mplaut:]

In my opinion, measures that rely on US Treasury rates as the basis of a "risk free" investment are distorted by the artificially low rates of US Treasury paper in recent months. The "flight" to safety has driven the rates to artificially low levels that do not represent the true rate of a risk free investment but the rate that a panic stricken investor is willing to accept for a risk free investment.

LIBOR rates do not include this element of panic and are thus higher, so the spread appears to be wider than it really is.

It may well be at normal levels already.

That is, it may not be the LIBOR rate that is unusually high, but the US Treasury rates that are artificially low.

JMO

2008 Nov 28 08:48 AM

[travelite:]

Great analysis. I'd guess that all recessions are accompanied by a degree of credit tightening (increasing spreads). Is it possible to adjust the above data to remove the recession component so that we can see the true impact of today's financial collapse/crises.

DMB

2008 Nov 28 09:52 AM

[Dave Lewenz:]

The availability of credit for small business is all but none existing. Our company has had its American Express credit line cut off and for no reason, We never have been late on a payment, nor have we ever missed a payment and have always paid more off our line then the minimum required.
We see no slow down in residential foreclosures, If you look at the top ten markets for foreclosures prices are heading down ward steadily indicating future losses for the banks. Commercial space vacancies are increasing significantly across the country putting additional pressure on landlords and their abilities to make mortgage payments on their properties. The amount of corporate debt for marginal companies is yet another shoe to drop next year, as decrease in cash flow does not allow for debt service for many companies. We are no were near the bottom.

2008 Nov 28 10:14 AM

[jepittman:]

It is still too soon for normalcy to return to these markets. I saw a good piece by Tony Crescenzi that looked at the credit market distortions immediately after the 1987 panic. It showed that it took several months for the markets to settle down and return to normal. His point was that as the emotions of fear and panic subsided so did the credit markets. It doesn't happen quickly but it does happen. It is likely we will experience something similar in this panic.

2008 Nov 28 10:17 AM

[axelrod608:]

I regain faith in Americans when I read comments like the above. There are clearer heads out in investorland than in DC.

The thesis of the article is based on a faulty assumption - that the credit markets of 2006 were "normal". Nothing could be further from the truth. After a decade of a flood of cheap, easy, unlimited credit by Alan "Bubbles" Greenspin, the nation's financial markets were awash in excessive credit exuberance. And the assumption that returning credit markets to that bloated condition will somehow "fix" the economy is ludicrous.

The credit markets and the bloated financial corporations we brought into the 21st century were and still are unsustainable. The bubble can no more be reinflated than can the Hindenburg. And there's Hank and Ben pouring gas onto the fire.

Change ? Hope ? Based on the choices other than Volker that the next Pres has made, I see a future of seamless policy to keep shoveling dollars by the cubic yard into the inferno. I am skeptical of these functionaries' grasp of the underlying problem

The rules need to change. The dinosaurs need to be allowed to die. And if federal money is to be thrown around, let it go to small and mid-size businesses with hands on owners, reasonably compensatesd officers and employees, not to the goons that once called themselves "masters of the universe" who, it turns out, can't run a company anywhere but into the ground.

The unfixable cannot be fixed. The 2006 credit market was Humpty Dumpty. He fell.

2008 Nov 28 11:19 AM

[OldLimey:]

Agree entirely with axelrod608.

I've no particular axe to grind about anybody in US politics, but I have to admit to being surprised by how quickly President-elect Obama's eloquent rhetoric of change has given way to the 'business as usual' subtext underlying his economic appointments. It's hardly surprising that every newly announced appointment gets a cheer from Wall Street; each one is further confirmation that the foxes remain firmly in charge of the hen-house.

2008 Nov 28 11:36 AM

[ebworthen:]

LOL

I enjoyed reading that.

I agree with your point that solving a credit bubble with more credit, either to institutions or individuals who mismanaged the debt the first time, is throwing gas on the fire.

They may turn around "sentiment" and get banks to lend more but with the fed spending taxpyer dollars on the institutions that leveraged themselves into crisis; how can that end well?

The institutions and individuals will simply engage in more debt leveraging and spending until the party really ends.

Better to sink the tug boat in the harbor than the Battleship in the Pacific.


On Nov 28 11:19 AM axelrod608 wrote:

> I regain faith in Americans when I read comments like the above.
> There are clearer heads out in investorland than in DC.
>
> The thesis of the article is based on a faulty assumption - that
> the credit markets of 2006 were "normal". Nothing could be further
> from the truth. After a decade of a flood of cheap, easy, unlimited
> credit by Alan "Bubbles" Greenspin, the nation's financial markets
> were awash in excessive credit exuberance. And the assumption that
> returning credit markets to that bloated condition will somehow "fix"
> the economy is ludicrous.
>
> The credit markets and the bloated financial corporations we brought
> into the 21st century were and still are unsustainable. The bubble
> can no more be reinflated than can the Hindenburg. And there's Hank
> and Ben pouring gas onto the fire.
>
> Change ? Hope ? Based on the choices other than Volker that the next
> Pres has made, I see a future of seamless policy to keep shoveling
> dollars by the cubic yard into the inferno. I am skeptical of these
> functionaries' grasp of the underlying problem
>
> The rules need to change. The dinosaurs need to be allowed to die.
> And if federal money is to be thrown around, let it go to small and
> mid-size businesses with hands on owners, reasonably compensatesd
> officers and employees, not to the goons that once called themselves
> "masters of the universe" who, it turns out, can't run a company
> anywhere but into the ground.
>
> The unfixable cannot be fixed. The 2006 credit market was Humpty
> Dumpty. He fell.

2008 Nov 28 04:49 PM

[thannagan:]

Banks, specifically the largest international banks are obvioulsy not what they used to be years ago. They are riskier (for a variety of reasons). Meanwhile, the Fed's target rates are at resession wartime levels. And, for the moment, global fear-and-panic have bouyed the US$ and Treasury values as stores of safety (relative to other alternatives).

Who says LIBOR rates and TED spreads should be any lower. They probably shuld have been inching higher for several years, now. Risk wasn't properly priced into many things in the last few years or the whole subprime ponzi play would not have happended to begin with.

It's the real economy, now, and the resulting ability of individuals and businesses to make debt service payments - not capital markets.

2008 Nov 29 01:28 AM

[Gem Hudson:]

You know. The south in selling their cotton to manufacturing north also bought from the manufacture north their goods but succeeding the south neither bought nor sold anything and printing up the money made the money nothing else but paper money. That goes to say. Stimulating by bailing out to inflate is pumping up with all of King Henry hot air one very leaky balloon.

2008 Nov 29 09:39 AM

[happysoul77777:]

High yield spread is still high, because stocks can be manipulated and driven down to zero quickly by the use of CDO, CDS, futures, put options, short calls, ETF, leveraged ETF, naked short selling by market makers, naked short selling by "dark pools."

The market is structurally flawed and unstable!

The Fair Market Value accounting force lenders to be more conservative. Lending will suffer. The economy will stay weak. And the SEC will continue to not to protect the market and plan to keep the flawed and dangerous accounting rule. As a result, credit spreads will continue to stay high.

2008 Nov 29 10:16 AM

[a believer:]

Fact of life: companies whose business models depend on credit wil go hungry; those whose business model depends on leveraged debt will perish.

The reason is simple: The opaqueness of their transactions is quickly destroying the confidence that the benfactors (those with cash) have. The destruction of confidence was aided by credit ratings agencies that either could not keep up with the pace of credit deterioration, or outright lied about them.

So there is no thawing, nor will it occur for quite some time. Confidence takes decades to re-build, if ever. In the mean-time, all of the thieves and liars are still out there, trying to find someone else to deceive!

The survivors will be those companies and persons with cash flow and cash balance, that work hard to provide valuable goods and services to others. Like it used to be, and should be.

2008 Nov 29 12:48 PM

[Roger Knights:]

Typo?: "A declining ratio indicates that investors are demanding a lower premium in yield for increased risk, ..."

The previous paragraph had it correct, I think: "demanding a higher premium in yield for increased risk ..."

2008 Nov 30 09:11 AM

[Roger Knights:]

Typo?: "A declining ratio indicates that investors are demanding a lower premium in yield for increased risk, ..."

The previous paragraph had it correct, I think: "demanding a higher premium in yield for increased risk ..."

2008 Nov 30 09:11 AM