Credit Crisis Watch: Signs of Progress?

Are the various central bank liquidity facilities and capital injections having the desired effect of unclogging credit markets and restoring confidence in the world’s financial system? This is precisely what the “Credit Crisis Watch” is all about – a regular review of a number of measures in order to ascertain to what extent the thawing of credit markets is under way.

Updating the report at this time is also to gauge the credit markets’ reaction to the Federal Open Market Committee’s (FOMC) announcement of a week ago about a Fed funds rate cut and specific actions that would move the Fed further towards a quantitative easing approach to monetary policy. (Also, see my “Words from the Wise” review.)

With the U.S. and some other countries pushing monetary policy into an era of Zirp (zero-interest-rate policy), the three-month dollar LIBOR interest rate that banks charge each other declined sharply to 1.47%. At this level, LIBOR trades at 122 basis points above the upper end of the Fed funds’ target range – still steep compared to the 43 basis-point premium at the start of 2008.

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Source: StockCharts.com

It is important to note that U.S. three-month Treasury Bills are still yielding almost nothing (0.015%), and are simply a way for nervous investors to “warehouse” their money with safety while receiving no return.

U.S. three-month Treasury Bill yield

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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 has eased to 1.46% – a level last seen prior to the Lehman bankruptcy in September.

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

Similar to the TED spread, the narrowing in the LIBOR-OIS spread over the past few weeks is also a move in the right direction.

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Source:Fullermoney

Eoin Treacy (Fullermoney) said:

Even although the rates at which banks lend to each other have eased from their peaks, banks have cut back significantly on the amount of money they are actually lending.

The U.S. Depository Institutions Aggregate Excess Reserves continue to skyrocket far in excess of the amount that banks need to keep on deposit to meet their reserve requirements (see chart below). This measure indicates that the balance sheets of banks remain under pressure, especially in view of the fact that the value of some assets is not known. A peak in the Excess Reserves graph should coincide with a turning point in the recovery of banks.

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Source: Fullermoney

Not illustrated by a chart, the spreads between ten-year Fannie Mae (FNM) and other Government Sponsored Enterprise (GSE) bonds and ten-year U.S. Treasury Notes have also tightened significantly over the past few weeks.

The average rates for a U.S. 30-year fixed mortgage declined by the end of last week to 5.19 from 6.30% at the beginning of November. However, the rate is still 372 basis points higher than the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis, indicating that lower rates are not being passed on to consumers.

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. The spread remains at an elevated level of 4.91%, indicating a crisis environment.

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Source: Federal Reserve Release – Commercial Paper

Similarly, junk bond yields remain at high levels, as shown by the Merrill Lynch U.S. High Yield Index. However, a slight decline of 200 basis points has taken place since the Index’s record high of 2,182 on December 15. This means the spread between high-yield debt and comparable U.S. Treasuries was 1,982 basis points by the close of business on Tuesday. With the U.S. 10-year Treasury note yield at 2.18%, high-yield borrowers have to pay 22.00% per year to borrow money for a ten-year period. At these rates, it is practically impossible for companies with a less-than-perfect credit status to conduct business profitably.

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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 higher premium in yield for increased risk. The Index is at an all-time low, indicating a lack of confidence in the economy.

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Source: I-Net Bridge

According to Markit, the cost of buying credit insurance for U.S., European, Japanese and other Asian companies has improved solidly over the past month, as shown by the tighter spreads (expressed in basis points) for the five-year credit derivative indices listed in the table below.

The notable exception has been the Markit iTraxx Europe Crossover Index, made up of 50 mostly high-yield companies, that has widened considerably on rising expectations of bond defaults among junk-grade names. The increase of 93 basis points in the Crossover spread means an increased cost of €93,000 (up from €915,000 to €1,008,000) to insure €10 million of debt annually over five years.

• CDX (North America, investment-grade) Index: down from 267 to 211
• CDX (North America, high-yield) Index: down from 1,546 to 1,233
• Markit iTraxx Europe Index: down from 183 to 181
• Markit iTraxx Europe Crossover Index: up from 915 to 1,008
• Markit iTraxx Japan Index: down from 350 to 295
• Markit iTraxx Asia ex Japan IG Index: down from 452 to 347
• Markit iTraxx Asia ex Japan HY Index: down from 1,375 to 1,263

The graphs of the CDX indices are shown below, with the red line indicating the spreads easing over the past month.

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Source: Markit

CDX (North America, high-yield) Index

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Source: Markit

Next, some credit default swap (CDS) statistics, courtesy of Bespoke. Since a month ago, the cost of insuring against government bankruptcy through CDSs has risen for all but nine countries in Bespoke’s list of 38 countries. The table below shows the current CDS prices, together with month-ago and start-of-year prices.

Argentina, Venezuela and Iceland have the highest default risk. Interestingly, Germany, Japan and France all have a lower default risk than the U.S. at the moment. It now costs $67 per year to insure $10,000 against U.S. default for the next five years. “While this may not seem high, it was at $8 earlier in the year, and $36 one month ago,” said Bespoke.

As shown in Bespoke’s table below, the U.K., Greece, the U.S., Austria and Australia have seen default risk rise the most over the last month. Notably, the U.S. has risen by 87%.

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Still on the issue of CDSs, over the past week Bespoke’s Bank and Broker default risk index has declined by 6%, while it has dropped by 11.5% over the past month. A decline in the financial sector’s default risk is a necessary requirement for an improvement in confidence.

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In summary, the TED spread, LIBOR-OIS spread and GSE mortgage spreads have narrowed markedly since the recent record highs. Furthermore, the CDX and iTraxx credit derivative indices have mostly shown a solid improvement over the past few weeks. However, U.S. Treasury Bills and high-yield spreads are still at distressed levels.

Although the Fed and other central banks’ actions have resulted in some progress being made to fix the broken credit machine, the thawing of the credit markets still has a considerable way to go before liquidity starts to move freely and the world’s financial system functions normally again.

Comments

[jepittman:]

Very good work. The thawing of the credit markets and return of normal money flows is key to the economy recovering. IMO this is a process rather than an event. The trends appear favorable. Fears will slowly abate and traditional economic incentives will reassert themselves allowing an economic recovery to gradually assert itself. As the author implies there is a ways to go but the improvement is apparant.

2008 Dec 24 09:37 AM

[ain't no fo...:]

Thanks... you've put together a great overall picture of the credit markets.

2008 Dec 24 10:13 AM

[Mark Anthony:]

Thanks. You have presented very good data to support that credit freee-up has started to thaw. One sector that benefit greatly is the global shipping industry. Due to credit freeze-up the global shipping virtually grinded to a halt as goods can not be shipped when exporters can not obtain bank guarantee of payments. As a result stockpiles of goods are piled up on harbors. Such backlog is a huge business opportunity for shippers once things start to move again.

It's now best time to buy dry bulk shippers like DRYS, EXM, EGLE.

I also expect hyper inflation to kick in soon. Where do you find a Safe Haven? Read my reasonings:
seekingalpha.com/artic...

2008 Dec 24 10:31 AM

[Poor me:]

As far as I can see, there has been no capital injection any where, and until they do what they were supposed to do with the bail out money nothing has, or will change. They have stuffed it in a glass jar and burried it in the back yard so to speak, but the back yard might be off shore in this case while the American people, and the economy just keep getting worse.

2008 Dec 24 01:27 PM

[ScottEX:]

I agree with joepublic.. A low rate of interest is meaningless if the banks aren't going to lend. You can bet your bottom dollar that TARP money is going offshore.

I really think it might have been just as well if not better to have let the failed banks collapse. The blank checks going to these companies will result in more fraud, more detriment to the US Economy, and there will be absolutely zero transparency so when the swindlers come back to ask for another trillion in TARP, they'll probably get it without question.

Imagine the average Joe really understood the true nature of the banks problems. Didn't a bunch of guys from Enron go to jail for off balance sheet fraud. I worked in the finance department at ML and I saw the network of accounting entities, some 1500 of them. I saw traders working in one entity booking trades though others, trading with themselves in some cases, and crazier things that probably aren't legal. Why don't we treat those responsible like the fraudsters they are instead of giving them more money. Most of those banks should be killed and buried. That's the only real solution to their problems, in my opinion. I do believe that was probably the part of the purpose behind killing Lehman actually. All the major bank's CEO's got together and agreed that was the best way to preserve their illustrious selves. The TARP money won't add a dime of liquidity on the US taxpayers investment, not on its own. If only the taxpayer knew the truth. I'm sure they would demand a different solution, and one would think that with the unlimited money printing option in effect it would be easy enough to setup a few new commercial banks.

Compare the financial bailout to the autos bailout. One offers transparency, the other does not. So all we hear about for weeks on end is about the plant workers earning too much and their retirements costing too much and how it would be better to not make a tiny bridge loan to save the industry, better to destroy thousands of lives and start fresh. Why not do that with Wall Street. Wouldn't a Trillion dollars actually buy a few banks? Seems to me that would make more sense than buying up the same amount worth of bad derivative paper. This all started on Wall Street, but as usual they will not be the ones paying for their blatant fraud. No, they will get paid their bonuses, maybe a tad smaller this year, but they will get paid. Listening to that redneck Republican who scuttled the auto bridge loan in congress just made me sick. (um, aren't we trying to increase credit so companies can loan money, the remember the Trillion TARP), listening to him dump all over the hard working men and women who have toiled their entire lives working for an honest wage while the criminals responsible get blank checks is really trying my faith in the good side of America. You hear about executive compensation now and again in the media, but nowhere near the extent. They sure didn't kill the bank bailout on account of people earning too much, but hell, if a key industry employers workers making a dime more than a worker in Korea, well, better to kill that. No, there are a lot of very rich bankers who should be sharing a cell with Kenneth Lay, but it would seem fraud on wall street is more accepted by the public. They don't seem to get mad about that and obviously it's because they don't understand what these banks have been up to, and now they have another Trillion to go back at it. Nobody will will ever really get into the banks books. You would need an army of specialized accountants that just doesn't exist today. Perhaps if the auto industry had kept its business more secretive over the years, and of course put a nice sounding anacronym to their bridge loan, then everybody's problems would be taken care of, not just the pigs on wall street.

To date I believe W has agreed to a16B bridge loan, after much uproar about it. And this after issuing a few other big companies almost a Trillion! -- designed to induce lending... Lehman probably needed to be wiped, and any other bank that came knocking for money to pay for their sins should have been nationalized, cleaned out, and sold back to the public. It could be done. If money can be printed without to any level, it could be done. So here the taxpayer has purchased a Trillion in junk derivatives when the could be owning the banks that won't lend to them after all that.

Well, sadly, my forecast is for more of the same white glove criminal activity that defines the US financial system. The rich will get richer, (sorry to any of you if you were rich before Bernie), and the salt of the earth, the working man and woman, will suffer more and more in the years to come. Greed is Good. God bless America.

2008 Dec 24 07:12 PM

[wise:]

where is that little country Canada on that chart?

2008 Dec 24 08:19 PM

[Moon Kil Woong:]

A great slew of facts. Even though credit markets are thawing, the public is now frozen. I don't see the resumption of 2006-2007 spending anytime soon. I suppose that's a good thing since it was running US households into mass debt. Now the only lemming running towards that cliff remains the US government.

What will we do when 50% of all Federal taxes goes towards debt payments? I fear we will soon find out.

2008 Dec 24 09:40 PM

[Lin:]

ScottEX

Sadly , you are correct !

2008 Dec 24 10:59 PM

[enigmaman:]

Excellent technicals that actually shows the information that we need to know, forget about what the so called Walstreet Gurus have to say, they are just filling air time with their suspect opinions and predictions. The old adage "believe 1/2 of what you hear and 100% of what you see" fits here perfectly. The charts provided tell us how the Patient (USA) is really doing, how its responding to treatment, while still in the ICU the patients condition has been upgraded from critical to serious not a small matter. Once we find the patients conditon has stabilized we can breath a sign of relief knowing a full recovery is now more likely, knowing the patient will not likely die or not be permanently impaired will be greeted with a slow but sustaintable improvement in consumer confidence reflected on Wall Street. The next few months is critical, a defibubulator has to be available and ready 24/7 to provide the stimulus needed to keep the patient alive in the case of any relapse. We are hopeful for a full recovery of the patient but its not out of the woods yet.

2008 Dec 25 07:28 AM

[Duude:]

I can see quite a bit of impatience among some posters who don't understand why banks who have received government funding aren't lending out these dollars.
We are still in a state of de-leveraging of bank portfolios. It would be suicidal for some to lend out that which is saving their hide. It wouldn't serve any purpose for anyone if they lent it out only to be back in trouble with ratings agencies for their increased leverage. As for those who believe it would have been better to allow them to fail, I disagree. The world's largest bankers have foolishly tied millstones around their own necks and handcuffed themselves to one another. If you think this world recession is looking pretty bleak now, maybe we should replay this scenario and allow the dominoes to fall as they will. Lets then imagine a world economy with little or no leverage at all. Nearly all business would be negatively affected for a long, long time. Every homeowner would see their home values drop significantly with little ready market of cash only buyers. This isn't rocket science.

2008 Dec 25 05:30 PM

[Ross Snyder:]

Even if the credit thaw plays out positively, the velocity of money has slowed down so much that permanent damage will continue to occur for more than a year.

Entire industry sectors are unable to secure financing. Nonprofits are locked out of the credit market. Capital spending freezes are not just institutional - they're industry standard.

Deflation should be enormous for a year or so. Raw materials are sitting in harbors unbought - their production prices far exceed their spot prices. Whoever owns that deadweight midstream in supply channels will be dumping not at fire-sale prices, but at fire-storm prices.

I think world economies are in trouble for years to come, no matter when credit markets thaw. Especially as industries heat up one-by-one (it will take quarters and years for these frozen sectors to spend again), there will be too much quantity of money chasing too few assets. By the time more industries heat up, the inflationary damage will have been done.

The banks should be the first players to thaw. Where they put their money should start the inflationary pressures. Will they be believers and unleash credit, or will they shut down for doomsday and boost gold reserves?

2008 Dec 25 11:49 PM

[vaughn:]

Dude, why would banks lend out money when they can use the money to buy back their own debts at a huge discount, say 70 c on the dollar, which will produce instant profit of 30c, much much better than loan the money out, take the default risk and only earn a pittance spread of, say, 2.7%?

The more banks deleverage via redemption of their own debts, the better the capital ratio in their balance sheet, more profits shown on their income statement, and easier life for their CEOs.

2008 Dec 26 12:56 PM

[The Good Ne...:]

Prieur,

This is a fantastic reference on the fundamentals of the credit markets. I've not seen such a rich collection of links to material anywhere else.

I will return to your article (and its sources) often in the coming months.

Thanks much for such thorough work,
GNE
goodnewseconomist.com

2008 Dec 27 02:01 AM

[SeekingTruth:]

Not only great information , expertly presented, but a great tutorial as well. As fine a barometer of credit fluidity, interactions, and tensions that I have yet uncovered. You do us all an extraordinary and fine service. Bravo!

2008 Dec 27 02:49 PM