Part of the problem in explaining a credit crisis is that unless you are directly experiencing it trying to trade debt securities, it's hard to understand. Here are five credit "spreads" I monitor to keep an eye on the financial conditions. Three are short term spreads measuring the availibility of short duration liquidity, and two are spreads that measure the cost of longer term financing.
Right now they are telling me the credit market is being held together with some spit and an old wad of chewing gum. The deteriorating financial market conditions, which began to show evidence of stress in July 2007, are now at their most strained in history.
TED Spread
The TED spread is a money market spread that measures the difference between the three month T-bill interest rate and three month LIBOR (the interest rate at which banks lend money to each other without posting collateral). The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.
The wider the spread, the more interest banks are asking as compensation for hightened risk. The TED spread is back at the same level it was on last Thursday when credit markets froze up on a "run" in money market accounts. The red line on the chart below shows the average spread over the past ten years. Right now, banks are reluctant to lend money to each other, let alone to individuals or corporations. If this situation gets worse, you could drive up to your neighborhood bank ATM and find there's no cash available since the bank can't get short-term funding to meet normal withdrawl requirements.
Click on chart to enlarge. Source: Bloomberg
OIS Spread
The OIS spread is a money market spread that measures the difference between the Overnight Indexed Swap (OIS) rate and three month LIBOR. The spread reflects credit risk. The OIS spread is at the highest level in history indicating extreme stress in the credit markets. The red line on the chart below shows the average OIS spread over the past ten years.
Since there remains widespread uncertainty about the strength of banks’ balance sheets, LIBOR loans are risky and the spread reflects the market assessment of such risk. It could also reflect a “shortage of bank capital,” since unconstrained banks could arbitrage away the spread. For this to happen, however, the unconstrained banks should be large relative to the market. Otherwise, as they lend at LIBOR, they will also eventually hit a capital constraint. VOX has a nice explination of the different interpretations of the OIS spread.
Click on chart to enlarge. Source: Bloomberg
Commercial Paper – T bill Spread
This spread represents the difference between the three month T-bill interest rate and three month industrial commercial paper. The spread is a measure of liquidity and shows the degree to which the market is willing to lend money to corporations. The commercial paper spread is rising which increases the borrowing costs to corporations. The red line shows the average spread over the past ten years.
Click on chart to enlarge. Source: Bloomberg
High Yield Corporate – Treasury Spread
This spread measures the difference between the 10 Year Treasury interest rate and 10 Year industrial bond rate which are below investment grade. The spread is a measure of liquidity and shows the degree to which the market is willing to lend to higher risk borrowers.
Click on chart to enlarge. Source: Bloomberg
Corporate – Treasury Spread
This spread measures the difference between the 10 Year Treasury interest rate and 10 Year A rated industrial bonds. The spread is a measure of liquidity and shows the degree to which the market is willing to lend.
Click on chart to enlarge. Source: Bloomberg
The credit spreads indicate extreme stress. Even though you can't see the stress in the stock market (yet!), doesn't mean is isn't there. If the situation isn't addressed soon, a major downdraft in equities will be inevitable as insitutions sell anything that isn't nailed to the floor to raise liquidity.
Thank you very much for this explanation!
Having read this post, I have learned for myself a lot of the new.