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July 1, 2008

Gauging the Credit Crunch: A Do-It-Yourself Guide

Some simple advice for appraising the state of the ongoing credit crunch.

Charles M. Jones

Having trouble keeping up with developments in the current credit crunch? It’s not surprising if you are — there is no Dow Jones Industrial Average for the bond market. Most press articles focus on the market segment that is imploding that day — subprime mortgages, auction-rate securities or leveraged loans — so we read about the ABX Index, a credit-default swap index or another benchmark that is equally opaque.

To judge whether the situation is getting better or worse, you needn’t wait for a pronouncement from your favorite financial journalist. Just look at the Treasury-Eurodollar (TED) spread, which is usually defined as the difference between the three-month London Interbank Offered Rate (LIBOR) and the three-month Treasury bill yield.

LIBOR measures the unsecured borrowing rate for a financial institution with a high credit rating (AA, to be precise), and it is determined by surveying UK banks each morning. There were questions earlier this year about whether banks were responding honestly, but a little publicity seems to have improved the survey’s accuracy.

Why look at LIBOR? Unlike the T-bill, which has the full faith and credit of the U.S. government behind it, LIBOR has bank credit risk embedded in it. LIBOR yield spreads widen if investors raise their assessment of bank default risk or become more averse to bearing that default risk. Most adjustable-rate mortgages are based on LIBOR, as are most corporate bank loans.

LIBOR and T-bill yields are published in major newspapers every day; focus on the difference between the two to see how investors are viewing the creditworthiness of global financial firms.

Much of the last year (shown in figure 1) has been marked by a sharp flight to quality, where investors move their capital away from risky investments to safer options. In August 2007, investors worried that sharp downdrafts in the equity and credit markets would put pressure on banks’ financial health. At its peak that month, the TED spread hit 250 basis points. And in late March 2008, the TED spread again spiked above 200 basis points as investors worried that other banks might join Bear Stearns on the scrap heap.

Conditions have improved a bit since. As I write in early July, the TED spread is back down to about 110 basis points, still somewhat higher than normal. Until it narrows down to 50 basis points and stays there, we can’t pronounce the credit crunch over, but at least things seem to be moving in the right direction.

How does this compare historically? The last big flight to quality event in the bond market surrounded the collapse of prominent hedge fund Long-Term Capital Management in September 1998. As figure 2 shows, during that crisis the TED spread widened, came back in and then widened again in 1999 and 2000. Judging from the yield-spread metric, the current crisis is even worse. In fact, you have to go back to the stock market crash of 1987 to find TED spreads matching those of 2007 and 2008. And if 1998 is any indication, the recent dislocations we’ve seen in the bond market are likely to take a long time to resolve fully.

Why has the TED spread narrowed since March? First, investors are a bit more confident that the biggest losses for banks are behind us. Second, with its actions surrounding the collapse of Bear Stearns, the Federal Reserve has become the lender of last resort for investment banks as well as commercial banks in the United States. That backstop decreases the chance that an investment-bank failure will lead to a cascade of defaults across the financial system. In fact, U.S. Treasury secretary Henry Paulson probably had the TED spread in mind back in May when he said of the credit crunch, “We’re closer to the end of this than the beginning.”

A narrower TED spread is important for the rest of the economy as well. If banks can borrow at better rates, they can then turn around and lend at lower rates. A lower LIBOR should spur real investment by both corporations and individuals, eventually righting the economy. So you can be sure that Fed chairman Ben Bernanke is eyeing the LIBOR-Treasury bill spread as well.

It may seem a bit wonkish, but the TED spread is actually pretty easy to follow and understand. Keep watching this gauge if you want the latest on what is happening under the financial system’s hood.

This story originally appeared in the Winter 2008 issue of Columbia Ideas at Work. It has been revised and updated by the author.

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