Credit markets are finally melting

One quick way to measure credit risk is to look at the difference between the fed funds rate, the overnight rates banks lend to one another, and what’s called the US dollar LIBOR rate. LIBOR is available in most major currencies, but I will stick with the US for simplicity as well as the dollar’s status as the world’s reserve currency.

LIBOR tells us what banks can borrow unsecured over varying periods that reach one year. During normal times, the spread typically runs anywhere from 10 to 15 basis points (bp), or 0.10-0.15%, for three months. If Citigroup or Bank of America needed additional funds to meet reserve requirement, there were plenty of participants willing to lend over the short term. Remember, this is what happens in normal times.

But when the lending crisis began to get out of hand and banks started to lose faith in one another, they began to hoard funds, fearing that a short-term loan to another institution might go unpaid.

The results were predictable. Funds dried up and LIBOR rates soared, with the three-month LIBOR peaking at 4.82% last October as credit markets practically broke down. Even guarantees by major governments did not quickly quell jitters in the credit markets.

But a number of factors including time, those guarantees mentioned above, nascent signs that an economic recovery is on the horizon, and a renewed interest in risk all colluded to bring down rates. This morning, the three-month LIBOR fell 3 bp to 75 bp.

The TED spread – the difference between US Treasury bills and the rate banks can borrow – is another measure of risk. When fear was running rampant through the financial markets, investors eschewed all but the safest securities. Remember the yield on the three-month T-bill actually falling below zero? People were paying the Feds to hold their money!

What a difference a few months can make. Yesterday, the TED spread fell to the lowest rate since August 2007, per Bloomberg News, which pre-dates that start of the credit crisis.

The banks still have problems and all of those mortgage securities that are stamped Made in the USA still have the potential to do some damage. But credit markets are thawing, the uncertainties are known and apparently factored in, and any uptick in risk taking is sure to lend support to economic activity.

One final comment, growing confidence in the credit markets may also have an indirect but positive effect on mortgages rates, potentially narrowing the spread between the ten-year US Treasury note and the 30-year fixed mortgage. And many ARMs are tied to LIBOR so a pleasant surprise may be in store when the rate resets.