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December 19, 2007

Gauging the Credit Crunch: A Do-it-yourself Guide

Charles Jones offers some simple advice for appraising the state of the ongoing credit crisis.


Having trouble keeping up with developments in the current credit crisis? It’s not surprising if you are — there is no Dow Jones Industrial Average for the bond market. Most press articles focus on just one market segment — subprime, high-yield or structured investment vehicles, for example — so we read about the ABX Index, a credit-default swap index or another benchmark that is equally opaque.

To judge whether the crisis is getting better or worse, you needn’t wait for a pronouncement from your favorite financial journalist. Just look at the three-month London Interbank Offered Rate (LIBOR) versus Treasury-bill yield spread.

LIBOR measures the unsecured borrowing rate for a financial institution with a high credit rating (AA, to be precise). 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.

Both rates are published in major newspapers every day; focus on the difference between the two to see how investors are viewing the creditworthiness of financial firms.

Examining the two rates during 2007 (figure 1) shows that a flight to quality — where investors move their capital away from risky investments to safer options — is still in full swing. Investors are worried about which bank will be next to announce a big bond-market or mortgage-lending loss. Mid-August was the worst; conditions improved in September and October but have eroded again in November. As I write in late November, the LIBOR versus T-bill yield spread is back up to about 190 basis points, far from a healthy norm of around 50 basis points and not far from its recent extreme of 250 basis points.

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 LIBOR versus T-bill yield spread widened, came back in and then widened again a year or two later. 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 LIBOR versus T-bill yield spreads matching those that transpired this summer and fall. And if 1998 is any indication, the dislocations we’ve seen in the bond market in 2007 are likely to take a long time to resolve.

Worse yet, a wide LIBOR versus T-bill yield spread is not just a marker for stress in the banking system. LIBOR’s moves have big effects on the economy because many corporate and individual borrowers pay a floating interest rate tied to LIBOR. And LIBOR isn’t coming down, despite the Fed’s efforts to ease the crunch. That means bigger interest payments on loans for everyone from auto manufacturers to subprime mortgage borrowers.

For example, after the initial teaser rate expires, a typical subprime mortgage rate might be LIBOR plus 500 basis points, or an interest rate of more than 10 percent at the moment. It’s no wonder observers predict mortgage defaults will get far worse before they get better. What doesn’t receive as much press is that even some industrial and corporate borrowers who have high credit ratings and are far removed from the mortgage mess are feeling the pain as well.

Whether you’re a floating-rate borrower or not, it is important to keep a watchful eye on LIBOR and on the LIBOR versus T-bill yield spread. The topic may be a bit dry for cocktail-party chitchat, but you will be very well informed about the progress of 2007’s credit crunch.

Charles Jones is professor of finance and economics at Columbia Business School.

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