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The Credit Crisis Revisited, Part 1


Entering phase two of the crunch.

When is the credit crisis going to end? And how will we know?

It's All About the Spreads

Credit spreads have been increasing and getting ever more volatile. I'm going to look at them in detail this week, since one of the signs that the credit crisis is abating will be when spreads start behaving more normally.

Briefly, when we talk about credit spreads we are generally talking about the difference between a benchmark cost of a bond or index and the higher cost for another unrelated loan or bond. As an example, as of Wednesday, a high-grade corporate bond yielded 3.15% more than US Treasury bonds, based on a Merrill Lynch (MER) index. In finance terms, that means a typical corporation paid 315 basis points more than a similar longer-dated US Treasury. Thus we talk about the spread being 315 basis points or bps. (A basis point is 1/100 of a percent, which means that there are 100 basis points for each 1% difference in interest rates.)

To see how much credit spreads have moved over the past year, let's look at a few charts (I apologize for some of the fuzziness, but I had to resize them). The data is from First, let's look at the cost for a typical US financial firm. The cost has gone from 70 bps to 390 bps! That is over a 500% move – a big hit to margins and profitability.

Merrill Lynch US Financials Index

And it can get much worse for some banks.

In the "for what it's worth" department, Iraq's bonds are now considered safer than those of many US banks. The country's $2.7 billion of 5.8% bonds due 2028 have gained 45% since August 2007, according to Merrill Lynch's indexes.

Investors demand 4.84 percentage points more in yield to own the debt instead of Treasuries, down from 7.26 percentage points a year ago. The spread is narrower than for notes of Ohio banks National City (NCC) and KeyCorp (KEY), which have debt ratings of A and spreads of 959 basis points (9.59%) and 7.55 basis points (7.55%), respectively. Iraq's debt has no ratings. This suggests that Baghdad may be safer for bond investors than Cleveland.

Clearly, the market's ignoring the rating agencies which give the banks an "A" rating. Their debt is priced at the junk level. Go figure.
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