Credit Stress Easing, but Risks Remain

Credit Stress Easing, but Risks Remain

Thanks to the Federal Reserve's concerted effort to use its (seemingly infinite) balance sheet in order to smoke risk-averse investors out of their hiding places, many credit market indicators have improved. For example, the TED spread (the difference between interbank lending rates and [presumably] risk-free U.S. Treasury's) has remained at or below 1 for the past few days. Normally, this measure would fluctuate in a range around 0.5, but since these are clearly not normal times, and just three months ago the spread was as high as 4.63, the current level can be seen a sign that some of the fear gripping financial markets has abated. Three-month LIBOR rates have plummeted to their lowest levels since 2004, offering borrowers out there a chance to save a lot in interest on any loan that might be tied to short-term rates. Other indicators such as commercial paper yields, 2-year swap spreads, etc., have seen similar declines.

Despite these efforts, problems at Bank of America and Citigroup show another crisis in credit markets are a looming threat. For one, numerous financial institutions are saddled with a pile of assets that are deteriorating in value, and continue to whittle away precious capital. Bank balance sheets could take an even bigger hit than they already have going forward should the housing market collapse worsen or the anticipated downturn in commercial real estate proves to be deeper than expected (see the Fed's Beige Book for a synopsis of both sectors). Finally, there remains the $2.3 trillion question surrounding the Federal Reserve's various interventions in the credit markets. It was one Chairman Bernanke addressed this week: how does the Fed withdraw its assistance when things begin to improve without causing markets to lock up again?

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