The Myth of Stabilizing Money Markets
As the economy slows and borrowers need to refinance, actual losses will occur.
The beginning of 2008 has brought relief for banks. The difference between inter-bank rates and official targeted central bank money market rates has declined. Treasury-Eurodollar, or TED, spreads or 'swaps spread' have fallen.
In mid-January the spread actually went negative - the overnight rate U.S. LIBOR ("London interbank offered rate") closed below the Fed Funds target rate. The 3-month LIBOR for dollars has also fallen sharply - by around 20 basis points to 4.06%. This is its biggest fall since September 19, 2007 when the FOMC cut the Fed Funds rate by 50 basis points.
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The current decline in the spread, however, is technical in nature. Fears of a recession mean money markets expect a sharp cut in U.S. official rates shortly – a range of 50 to 75 basis points is being talked about. The inter-bank rates are merely anticipating the cut. If Fed Funds rates are cut then the TED spread will become positive.
The TED and swap spreads are first and foremost generalized market credit spreads that historically track the credit spread of AA /A rated bonds issued by financial institutions. Only changes in overall credit conditions and especially bank credit risk affect the TED or swap spread in the long run.
The outlook for bank credit remains uncertain. It looks likely that major global banks will record significantly lower profits and in some cases losses in 2007. Their capital positions have been sharply impaired. Assets --somewhere between $1 and 2 trln-- held in off-balance sheet structures continue to return onto bank balance sheets placing demands on funding and capital. This process has some way to run.
Recapitalization of the banks is heavily dependent upon the investment appetite of sovereign wealth funds and banks in Asia and the Middle East. Given the size of the requirement and the frequent trips, this well is at risk of running dry.
The quality of the banks' credit portfolios remains questionable. In 2007, the banks' losses were related to large mark-to-market changes in the value of structured securities (mortgage backed securities, Collateralized Debt Obligations) and leveraged loans. Ironically, there were few actual defaults.
As the economy slows and borrowers need to refinance, actual losses will occur. Lenders to non-investment grade companies and private equity transaction look vulnerable. Consumer lenders - American Express (AXP) and Capital One (COF) – have already reported slowdowns in consumer spending and increase in write-offs. Automobile loan delinquencies are also rising. Also, if the mortgage rate freeze plan does not have the intended effect, mortgage losses in the U.S. may also increase beyond anticipated levels.
Financial institutions also face a subdued profit outlook. Key areas of recent profitability (mortgages, securitization and structured credit) are not likely to return to previous levels for some time. Corporate finance and mergers and acquisition revenues are slowing. Strong trading revenues will slow as risk appetite and capital available for risk taking reduces.
One of the fascinating things about the current reporting season will be the level of provisions that financial institutions make in anticipation of these higher losses and guidance as to future earnings. It is unlikely that the credit quality of the banking system will rebound drastically. Certainly, the current share prices and credit default swap, or CDS, spreads are not optimistic.
An additional complication will be the CDS market itself. Banks have used this market to lay off risk. It is not clear whether all the CDS contracts will work when put to the test. There are significant documentary complexities – some untested. The efficacy of the CDS will depend on the quality of the counterparty to which risk has been transferred. If actual defaults occur and the CDS market does not function then uncertainty about who is holding which risk and concerns about bank credit quality may re-emerge.
The current central bank initiatives have minimal effect on the actual spread. In fact, they may make the position worse. If the central banks withdraw the emergency liquidity, as the European Central Bank intends, the money market liquidity condition will tighten. If the central banks continue to supply liquidity then they may set off inflationary expectations causing longer-term rates to increase sharply. This may be their strategy in any case.
The current spread in dollars between the 2-year and 10-year Treasury is around 120 basis points. In 2003, after the Fed cuts short-term rates to 1.00%, the spread went to 275 basis points. Traders currently expect the 2/10 spread to hit 250 basis points. Higher long-term rates will affect the cost of mortgage debt and term borrowings. This will not help the housing market and may in turn lead to higher defaults.
The current decline in TED and swap spreads may well be short lived. TED may not be dead, only sleeping. In the absence of a fundamental change in bank credit quality and credit condition, it is difficult to see there being much joy for banks and their customers.
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