Credit Crisis Watch: Some Positive Developments

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.

First up is the LIBOR rate. This is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world.

After having peaked on October 10 at 4.82%, the three-month dollar LIBOR rate declined sharply to 1.08% on January 14, but the healing process has since not made headway, with the current rate at 1.23%. LIBOR is therefore trading at 98 basis points above the upper band of the Fed’s target range - a great improvement, but still steep compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

click to enlarge

Source: StockCharts.com

Importantly, U.S. three-month Treasury Bills have been heading higher, especially over the past few days, to 0.32% after momentarily trading in negative territory in December as nervous investors “warehoused” their money while receiving no return. The fact that some safe-haven money is now coming out of the Treasury market is a good sign.

U.S. Three-Month Treasury Bill Yield

click to enlarge

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 a seven-month low of 0.91% - well above the 38-point spread it averaged in the 12 months prior to the start of the crisis, but nevertheless a strong move in the right direction.

click to enlarge

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 since October is also a move in the right direction.

click to enlarge

Source: Fullermoney

Despite the interbank lending rates having declined from their peaks, banks have significantly curtailed the amount of money they are actually lending. The U.S. Depository Institutions Aggregate Excess Reserves continue their ascent at levels far in excess of the amount banks need to keep on deposit to meet their reserve requirements (see chart below). Although this measure recently started turning down, the level 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. As mentioned before, a definite peak in the Excess Reserves graph should coincide with a turning point in the recovery of banks.

click to enlarge

Source: Fullermoney

The spreads between ten-year Fannie Mae (FNM) and other Government-sponsored Enterprise (GSE) bonds and ten-year U.S. Treasury Notes have also compressed significantly during November and December, but have since kicked up again. However, to ensure the ultra-low rates on offer from the Fed are passed on to home buyers and those refinancing existing mortgages, mortgage spreads need to tighten further.

click to enlarge

Source: Fullermoney

Higher Treasury rates resulted in the national average rate for a U.S. 30-year fixed mortgage pushing up from 4.96% to 5.10% over the past two weeks (after hitting a peak of 6.46% in October last year). However, the lower rates are not being passed on to consumers, as seen from the 387 basis-point spread of the 30-year mortgage rate compared with the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis.

click to enlarge

Source: Fullermoney

The Fed’s Senior Loan Officer Opinion Survey of January 2009 contained indications of better tidings. Asha Bangalore (Northern Trust) said:

There were fewer bank officers reporting they had tightened loan underwriting standards for commercial and industrial loans for both small and large firms in January compared with December (see two charts below). In the case of both large and small firms, the demand for loans was weaker in January compared with December. Although the history of these data is short, in 2001, the demand for loans turned around only after the recession had reached its last leg, whereas the peak for the number of banks reporting tightening standards peaked slightly ahead.

click to enlarge

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low-quality) and AA (high-quality) 30-day non-financial commercial paper. The spread has declined markedly to 1.79% from almost 5% at the end of December.

click to enlarge

Source: Federal Reserve Release - Commercial Paper

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch U.S. High Yield Index. The Index dropped by 25.3% to 1,630 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable U.S. Treasuries was 1,630 basis points by the close of business on Tuesday. With the U.S. 10-year Treasury Note yield at 2.89%, high-yield borrowers have to pay 19.19% 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.

click to enlarge

Source: Merrill Lynch Global Index System

The iBoxx Investment Grade Corporate Bond Fund (LQD) and High Yield Corporate Bond Fund (HYG) recovered strongly from their October/November lows until the beginning of 2009, but have since been correcting what appeared to be “too-much-too-soon rallies.”

The corporate bond sector is worth watching for opportunities arising at lower levels. Also, the high-yield instruments - under intense pressure because of an avalanche of defaults predicted by the ultra-wide spreads - could see spreads contracting markedly if the defaults are not as bad as those priced in.

click to enlarge

Source: StockCharts.com

click to enlarge

Source: StockCharts.com

Another indicator worth monitoring 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. There has been an up-tick in the ratio since its all-time low in December, showing that bond investors are growing somewhat more confident and have started opting for bonds that are more speculative over high-grade bonds.

click to enlarge

Source: I-Net Bridge

Goldman Sachs reports as follows:

Accounting for expected default losses, the premium in non-financial investment-grade bonds is several standard deviations above its 20-year mean. High-yield risk premiums are very high in absolute terms even taking into account a surge in default losses. But elevated sovereign spreads effectively put a floor on how much corporate spreads can rally this year.

According to Markit, the cost of buying credit insurance for American and European investment-grade companies has declined strongly since the peaks of November. This is illustrated by the movement in the spreads (expressed in basis points) for the five-year credit derivative indices listed in the table below.

However, the debt of American and European high-yield companies, and all Asian and Japanese companies, has become dearer to insure. The increase of 196 basis points in the U.S. CDX High Yield spread means an increased cost of $196 000 (up from $1,262,000 to $1,458,000) to insure $10 million of debt annually over five years.

• CDX (North America, investment-grade) Index: down from 218 to 196
• CDX (North America, high-yield) Index: up from 1,262 to 1,458
• Markit iTraxx Europe Index: down from 169 to 161
• Markit iTraxx Europe Crossover Index: up from 978 to 1,065
• Markit iTraxx Japan Index: up from 291 to 400
• Markit iTraxx Asia ex Japan IG Index: up from 307 to 363
• Markit iTraxx Asia ex Japan HY Index: up from 1,132 to 1,210

The graphs of the CDX indices are shown below, with the red line indicating the spread.

CDX (North America, investment-grade) Index

click to enlarge

Source: Markit

CDX (North America, high-yield BB) Index

click to enlarge

Source: Markit

Several firms have issued bonds at attractive yields over the past few days. According to Markit:

The success of these placings demonstrated that there is a market for new debt, but it has to come from high-quality issuers.

Lastly, the tables below show some country CDS statistics, again 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 $167 per year to insure $10,000 of debt.

Among the G7 countries, it is noteworthy that Germany and Japan have a lower default risk than the U.S. It now costs $63 per year to insure $10,000 against U.S. default for the next five years. Although this is down from $71 a week ago, the corresponding numbers were $8 early last year and $36 in November. As in the case of the U.S., U.K. CDS spreads are also trading close to record levels as investors are spooked by the levels of national debt.

The price of insurance against debt default by Eurozone members Ireland, Greece, Italy, Spain, and even Belgium, has jumped in recent weeks, yield spreads against German bunds have ballooned, and the sovereign debt ratings of Greece, Portugal and Spain have recently been downgraded. According to Asha Bangalore (Northern Trust):

These developments do not reflect an increased risk of default by any Eurozone member, but rather show that investors have finally woken up to the fact that not all Eurozone sovereigns are equal. The global credit crunch has led to an overdue market re-evaluation of the Eurozone members.

A marked deterioration was also seen over the past few days in the sovereign credit risk of, amongst others, Russia, Kazakhstan and Lithuania.

click to enlarge

click to enlarge

click to enlarge

In summary, the past few months saw progress on the credit front, with a number of spreads having peaked. The TED spread (down to 0.91% from 4.65% on October 10), LIBOR-OIS spread (down to 0.98%% from 3.64% on October 10) and GSE mortgage spreads have all narrowed markedly since the record highs. Corporate bonds have also seen a strong improvement, but high-yield spreads remain at distressed levels.

Although the investment-grade credit derivative indices have mostly shown a tightening since the highs of November, the high-yield indices are in some cases still close to their peaks.

Over the past few days, U.S. Treasury Bills have started moving higher as investors switched some Treasury money to less risk-averse investments.

The credit market tide seems to be turning, although additional data are required to confirm that the banking system is on the mend. In short, progress has been made, but the thawing of the credit markets has a way to go before liquidity starts to move freely and confidence returns to the world’s financial system.

Comments

[ROLEX18:]

Where all your graphs were when DJIA was 14500, instead of showing your talent in the field of CDO's and SDS' swaps, better serve investors who don't want to lose more money, if you are not up to a job, I will tell them:
Don't buy stocks in this envirinment if you are not daytrader or sophisticated investor who trades long/short, if you are only buy and hold type and look for a market bottom to average on your 2008 losing positions, don't even try to time the market, I call it market the market.
If you want to have your shirt and some savings going to retirement, if your retirement is fast approaching, I can't help you, but if it is in 20-30 years, I beg you, from now on and till the day you retire: buy only one thing, which is:
TIPS government bonds linked to inflation (CPI), bank CD's, money market funds THAT'S IT.
If you want to risk your future and exchange your wellbeing for wellbeing of Wall Street, then buy stocks, after 20-30 years you will not lose actually as the DJIA and SP 500 in 20 years will be same as today.

Feb 04 06:51 AM

[James Wilson:]

The market is resetting to early 1990 levels in my opinion. The markets can not stand this 6 % to 8% push for growth year after year. 3% to 4% limits will be best for everyone.

Feb 04 08:42 AM

[David Roskoph:]

Very nice but shhhhhhh the herd is still selling.

Feb 04 09:06 AM

[Alphameister:]

Excellent article. Well documented demonstration that the worst is almost surely behind us. Thanks for a very helpful post.

Feb 04 09:13 AM

[LR European:]

Excellent review of the major credit metrics. Thank you.

Rolex18, what is that all about? Maybe you were hoping to read an article about something else altogether? FWIW, my own view is that buying TIPS right now would be one of the highest risk strategies. We are sliding into deflation, not inflation. Money is being lost faster than it being created. Yes, we all know that government spending on this scale (let alone potential quantitative easing) is inflationary. We also know that governments must be (desperately) hoping for inflation to erode their debt burden. What we don't know is when. We could follow a variant of the Japanese template with an extended deflationary environment for many years.... I do agree, though, that in this situation, keeping investment thinking short term is appropriate.

Feb 04 10:14 AM

[Emerald:]

Excellent reporting on credit spreads and the bond market. So many websites are dedicated to pushing stocks despite the enormous size of the bond market. Best investments for 2009-10 will be in bonds due to narrowing spreads. Earnings on stocks are still declining as we deleverage throughout this year.

Feb 04 10:16 AM

[rjm51a:]

The improvement is modestly significant but may prove to be temporary. It reflects the tremendous liquidity being pumped into the system by almost every central bank in the world as well as the fact that investors are becoming more comfortable with the risks that they currently are familiar with.

However, that could change in a hurry. Many countries in Europe are deteriorating rapidly. Several countries may default on their foreign debts. Protests, thus far fairly civil, have occurred in Iceland, Latvia, Bulgaria and France, yet news reports of civil unrest are barely referenced on the left-biased prime networks on this side of the pond.

We all are aware of the problems created by Wall Street greed and brain dead policy decisions by Congress and the Bush administration. What we don't know is the sheer magnitude of the globabl debt problem. Thus far, the worst credits have been exposed; however, unemployment is rising alarmingly fast and some credits that would be secure in most recessionary environments could quickly assume a higher risk profile over the coming months.

The improvement in credit market liquidity could reverse in a hurry.

Feb 04 12:05 PM

[Mark Anthony:]

Nice observations. Should the credit freeze up start to thaw, one sector that will benefit gigantically, is dry bulk shipping. The BDI shipping index has been up 12 days in a row. How often do you see something up 12 consecutive days, and it was strong up each day.

Most people have totally missed the story and the opportunity there:
seekingalpha.com/artic...

Shipping and precious metals are the two best sectors to be in right now.

Feb 04 01:07 PM

[The Good Ne...:]

Prieur,

As always, you've excellently documented what's really happening with credit market fundamentals.

Sorry I missed your analysis last evening on your site...

I'll roll it up tomorrow... but since friday of last week, the good news is rolling in so fast it has been hard for me to keep up...
goodnewseconomist.com/...

Again thanks for all you do in documenting, charting, and posting depth of analysis.

GNE
http//goodnewseconomis...

Feb 04 01:19 PM

[Glen L.:]

If the credit freeze-up thaws it will spark a bear market rally, but the resulting inflation caused by dumping all that money in the market will be very high. What benefit is there in stocks climbing, say, 40%, if inflation hits 50% or higher? Granted, we have never seen inflation rates that high in the US in modern times, but the Fed never doubled the money supply before, either. Right now the banks are sitting on the TARP funds, lending back to the Fed at rates below what they pay depositors, still afraid to lend in this environment; the Fed is desperate that they NOT start lending all at once, which will unleash the dogs of inflation.

Bernanke's tightrope walk continues. I'm betting he's gonna fall. Unfortunately, when he does the US dollar, and all of us, fall with him.

Feb 04 01:54 PM

[Moon Kil Woong:]

Thanks for the graphs and good article. As you can see, since CDS and CDO's are unregulated no one can be sure of the accuracy of any reporting on them. Also as you can see, since they are unregulated banks or financial institutions can gamble on anything with them. It is funny, scary, that their recent love affair is gambling on what country will be first to fall, default on their obligations and ruin their currency. It is also funny to see how many banks use TARP money to gamble against the US government. Since most CDS and CDO contracts are written and bought in the US you can guess a great many bad banks are betting on the destruction of the US currency.

Why you might ask. If the US dollar goes to 0 or near that, they get paid off in Euroes and can pay off all their bad losses at the US citizen's expense because their liabilities are now worth hundred of a euro to the dollar. Problem solved for them. Thus your interests are 100% at odds with off balance sheed derivatives mega bank speculators in this regards. The worse they get and the more money they beg off government the closer they get to ressurection either through taxpayer bailouts or destruction of the US dollar. This is one reason these derivatives must be regulated and disclosed. Why don't they write contracts betting on their own bank's collapse. Oops, they probably did already.

That is why nothing is getting better. These people are out of control and too many people know it even though the government keeps letting them hide in very black off balance sheet accounting boxes. My bet is if you only saw what they are doing there it would make a coven of satanists look like angels.

Feb 04 07:56 PM

[Did U Think...:]

On Feb 04 09:06 AM David Roskoph wrote:
> Very nice but shhhhhhh the herd is still selling.

If you think this is over with the Dow only haven gone as low as 7500 then you are sorely mistaken. This is the same level that marked the bottom during dot bomb. During dot bomb S+P 500 earnings were actually growing exponentially. Now they are collapsing. Global trade is collapsing. Jim Rogers says the Pound Sterling is finished. I could go on and on, but there is no way this market avoids a trip back to Dow 4k.

Feb 04 08:14 PM