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Credit Crisis Watch: December 9, 2008


Understanding credit landscape key to wise investment strategy.


Editor's Note: This article is part of a series monitoring financial sector spreads in order to give an accurate, up-to-date picture of the credit crisis. See the first part here.

In order to gauge the progress being made to unclog credit markets and restore confidence in the world's financial system, I monitor a range of financial spreads and other measures. By perusing these, as summarized in this Credit Crisis Watch, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

First up is the LIBOR rate. This is the interest rate that banks charge each other for 1-month, 3-month, 6-month and 1-year loans. LIBOR is an acronym for "London InterBank Offered Rate," and is the rate charged by London banks which is then published and used as the benchmark for banks' rates around the world.

After peaking on October 10th at 4.82%, the 3-month dollar LIBOR rate declined sharply to 2.13% on November 12, but the healing process has since been moving sideways with the current rate at 2.19%. LIBOR is therefore trading at 119 basis points above the Fed's target rate of 1.0%, compared with 43 basis points at the start of the year.

Click here to enlarge.

Click here to enlarge.

Importantly, the US 3-month Treasury Bills are trading at a "non-existent" 0.015%, indicating that liquidity is still being hoarded by risk-averse investors.

The TED spread (i.e. 3-month dollar LIBOR less 3-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread's peak of 4.65% on October 10th, the measure has eased to 1.75%, but has since widened to 2.18%.

Click here to enlarge.

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread is increasing, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. The opposite applies to a narrowing LIBOR-OIS spread.

The movement in the LIBOR-OIS spread over the past few weeks is similar to the TED spread and shows that credit markets are still not functioning properly.

Click to enlarge.
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