Credit Crisis Watch (December 8, 2008)

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In order to gauge the progress being made to unclog credit markets and restore confidence in the world’s financial system, I monitor a range of financial spreads and other measures. By perusing these, as summarised in this “Credit Crisis Watch” review, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

First up is the LIBOR rate. This is the interest rate that 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, and which is then published and used as the benchmark for banks’ rates around the world.

After having peaked on October 10 at 4.82%, the three-month dollar LIBOR rate declined sharply to 2.13% on November 12, but the healing process has since been moving sideways with the current rate at 2.19%. LIBOR is therefore trading at 119 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 US three-month Treasury Bills are trading at a “non-existent” 0.015%, indicating that liquidity is still being hoarded by risk-averse investors.

US 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 1.75%, but has since widened to 2.18%.

8-dec-4.jpg

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 properly.

8-dec-5.jpg

Source: Fullermoney

Fed actions to buy up to $500 billion of mortgage securities backed by Fannie Mae, Freddie Mac and Federal Home Loan Banks and purchase up to $100 billion of debt issued by these agencies have resulted in a sharp drop in mortgage rates. The 30-year fixed-rate mortgage averaged 5.53% for the week ended December 5, down from 5.97% the previous week following a high of 6.36% for the week ended October 31. This is certainly a move in the right direction.

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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 has kicked up from 4.27% a week ago to its record high of 4.83%, indicating a crisis environment.

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Source: Federal Reserve Release – Commercial Paper

Similarly, junk bond yields continue to rise in parabolic fashion, scaling record highs as shown by the Merrill Lynch US High Yield Index. The spread between high-yield debt and comparable US Treasuries was 2,074 basis points by the close of business on Friday – an increase of more than 750% since bottoming in June 2007. With the US 10-year Treasury Note yield at 2.71%, high-yield borrowers have to pay 23.45% per year to borrow money for a ten-year period. At these rates it will be practically impossible for those companies with 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. A slight improvement has taken place over the past week, but hardly of the magnitude to indicate restored confidence in the economy.

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Source: I-Net Bridge

According to Markit, the cost of buying credit insurance for US, European, Japanese and other Asian companies worsened considerably over the past week as shown by the wider spreads (basis points) for the following five-year credit indices (in some instances rising to record levels):

• CDX (North American, investment-grade) Index: down from 233 to 274
• CDX (North America, high-yield) Index: down from 1,376 to 1,461

• Markit iTraxx Europe Index: down from 163 to 216
• Markit iTraxx Europe Crossover Index: down from 869 to 1,094

• Markit iTraxx Japan Index: down from 320 to 375
• Markit iTraxx Asia ex Japan IG Index: down from 360 to 435
• Markit iTraxx Asia ex Japan HY Index: down from 1,218 to 1,300

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

Quoting Moody’s Investors Services, the Financial Times reported that since the Lehman bankruptcy yields on BAA-rated bonds (investment grade) have risen by a third while yields on equivalent US Treasury bonds have dropped by a quarter. “That means the extra yield investors need before they will lend to investment-grade companies has gone from 2.7 to 5.9 percentage points in three months. This is a crisis,” said the article.

Credit markets are therefore bracing for huge defaults. According to Deutsche Bank, “current spreads imply a 50% default rate for high-yield credits and an ‘inconceivable’ default rate for investment-grade companies.” They believe government intervention to prevent defaults on such a scale would be inevitable.

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 two countries (Lebanon and Argentina) in Bespoke’s list of 38 countries. The table below shows the current (December 4) 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 lower default risk than the US at the moment. It now costs $60 per year to insure $10,000 against US 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.

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As shown in the table below, Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. Notably, the US has risen by 68%.

8-dec-13.jpg

Still on the issue of CDSs, Bespoke points out that even as equity markets and the financial group have begun to show some signs of stability, default risk remains elevated. This is seen from the graph of their Bank and Broker CDS Index that measures default risk for 13 global financial firms. “While default risk is not nearly as high as it was prior to the initial TARP plan, its inability to ease is still cause for concern,” said Bespoke.

8-dec-14.jpg

In summary, the CDX and iTraxx credit indices, US Treasury Bills and high-yield spreads are still at distressed levels. Some improvement has been seen as a result of central banks’ actions, notably the tightening of the TED and LIBOR-OIS spreads, and the decline in mortgage rates.

As long as distrust in the banking sector remains high and banks do not lend to each other, the credit situation will remain tight. Credit spreads need to narrow further to indicate that liquidity is starting to move freely again. Only then will confidence in the financial system start improving and the thawing of credit markets get under way.

 

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10 comments to Credit Crisis Watch (December 8, 2008)

  • How about the oil companies “investing” in the carmakers ?

    Hasn’t the oil companies made billions $$ over the years from the auto industry ?

    Why hasn’t the monetary news commentators suggested this ?

    Just a short list of the folks that could lend the carmakers some money: (there are more !)

    Chevron-Texaco
    Conoco-Phillips
    Marathon Oil
    BP Oil
    Exxon
    Hess
    Valero
    Total SA
    Occidental
    Apache Oil

    If, it isn’t a good deal for these folks to lend some money then . . . why is it a good deal for the taxpayer ?

    Regards,
    Mark

  • Michael Mennell

    Excellent set of graphs. Very revealing. Thanks.

  • Derick

    Thannk you, Prieur. I find your analysis invaluable among the superficial articles which are found in many financial publications & blogs, please keep it up.

  • Ian Nunn

    This is a terrific page. It allows one to rapidly assess the situation of credit markets.

    One comment on the TED and LIBOR charts. Despite the summary remarks, if taken on the basis of the last 3-4 weeks, they are in a sideways to slightly increasing pattern. Taken with the other charts which are either sideways or increasing, credit markets are not healing further – something I think should be of concern.

    Given continuing Fed innovations, the bang for each additional buck thrown at the problem seems to be having less effect – unless it is delayed, which hopefully, is the case.

  • What kind of stupid comment is why don’t the oil companies loan the carmakers money? That is all we need the oil companies enslaving the car companies so we never get away from being 100% dependant on oil. Maybe have the ethanol, or algae fuel, or natural gas, or solar companies loan the car companies money – then that could prove to be an invaluable proposition.

  • dave

    @Mark H Smith:

    Um oil doesn’t see it as a good investment because it isn’t one. The auto companies can not feasibly provide ANYONE a return on their investment. Not even the US Government (i.e. the taxpayers.) The only reason they’re doing a bailout for them is so that the jobs the industy holds don’t all drop off at the same time everything else is tanking in the economy, not to mention there is a lot of political BS and favor mongering going on. Certainly it has nothing to do with it being a good investment, beacuse it’s not a good investment. Period.

  • Macy

    Just to let you know there are those of us who read you weekly but don’t subscribe to avoid another email message. Your site is great and your credit crisis watch is much appreciated.

  • ferdi

    Thanks for the information, although the charts content is already very well known; it explains what is happening….. and it is time to overview what is going to happen. I would recomend to make a deep diving in the CDS price chart; until now we have seen a crash in the companies financing,…… what about the governments in the future? RECESION, UNEMPLOYMENT, NEEDS OF FINANCING FROM PRIVATE SECTORS (ej. banks, car makers )…. is not a good cocktail for Government balance sheet.

  • [...] But investor angst was never completely allayed as seen from the yields on US one- and three-month Treasury Bills briefly trading in negative territory for the first time since 1940, indicating the willingness of risk-averse investors to pay the government for the “privilege” of holding their money. Three-month T-Bills ended the week in positive territory but barely so at a minuscule 0.036% yield, indicating that liquidity was still being hoarded. (Also see my “Credit Crisis Watch“.) [...]

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