Some Symptoms of the Credit Malaise

Proposed amendments to the financial institution recapitalization plan are being floated through the halls of Congress, and Friday could mark the passing of mind-numbingly expensive, sweeping legislation that will alter how the financial markets (especially on the fixed income side) function for the next several years. Proponents hail it as a plan that will save our financial system; detractors call it a socialist safety net for the rich at the detriment of the middle class. Both are wrong. The $700 billion plan will do a lot to prop up financials in need of liquid capital, but it is hardly the golden bullet, nor is it guaranteed to be the most effective application of funds.

Ben Bernanke remarked that there are no ideologues in financial crises. He's wrong too. There are plenty of ideologues in both parties who would sacrifice American prosperity for personal political gain. It's crucial that zero room is left for them to obstruct the passage of necessary measures. And there are actions the government can (and should, I believe) take.

And, of course, Alan Greenspan weighed in, saying that a recovery will occur "sooner rather than later" – a trite, vague, and nondescript throwback to his statements as Fed Chairman. He's wrong as well, because it seems like we've temporarily run out of asset classes to inflate.

Confusion and uncertainty rule the markets. From both a financial and public policy perspective, the issues are complex and rapidly evolving, but all can be reduced to a few core problems. When I was giving a presentation on the year-end outlook for the markets about three weeks back, my two core themes were that global decoupling is dead – meaning the world economy is slowing – and that is going to create a strongly detrimental feedback loop with credit – which will become extremely scarce, and expensive when available.

How to fix those two fundamental problems? There's no easy solution, obviously. One direct reason for this crisis we're in is cheap, far-too-available credit; more cheap credit applied in a shotgun manner is not going to give the solution anyone wants. Risk needs to be re-priced and capital re-allocated, and that is a process that is going to take time. The end result – rational risk premiums – were sorely lacking from the markets for a long time, and their reappearance will be healthy even if it means borrowing costs are somewhat higher. The interim process, however, worries me deeply, because the process has ground to a temporary halt, and there are places where credit is needed now. Consider the plight of AAA-rated banks and financials, who have seen their borrowing costs soar, especially relative to the direction of risk free rates.

As the chart shows, the spread between those borrowing costs and Fed Funds has increased fourteen-fold on five-year durations, and six-fold on ten-year durations. Keep in mind, that is for the highest rated (most creditworthy) borrowers – simultaneously, the spread between borrowing costs for AAA and AA (the next credit rating down) companies has never been wider. Even using an ultra-short-term metric like overnight LIBOR, borrowing costs between AAA and AA financials can exceed 250 basis points.

For another perspective, consider the rates on two-year Treasury swap spreads against LIBOR. Again, unprecedented levels of stress in the fixed income markets…

The last indicator here comes from two weeks back, showing the spread on two-year Treasuries against A2/P2 commercial paper. Treasuries yields fall in times like this, because of the flight to safety and expectation of Fed rate cuts, while the CP yields rise because of concerns about creditworthiness. This spread, too, has blown out more than ever before – including the 1998 Long-Term Capital Management crisis.

The Fed is fighting this by opening a fire hose of liquidity, but so far that doesn't seem to be working. A recent Fed release shows that Reserve credit grew 22% week-over-week, driven by a 60% ($130 billion) increase in loans to commercial banks and bond dealers, a 67% ($60 billion) increase in the primary dealer credit facility, and $100 billion for money market fund liquidity.

While the passage of the rescue plan in Congress will eventually do some good, the desired effects of the eventual implementation will take time to manifest. Until short-term rates stabilize and until the liquidity threat stops its Sword of Damocles act over mid-tier investment grade companies, I'm not a believer in the sustainability of any rally.

Hat Tip for the commercial paper info.

Disclosure: None.