Credit Markets Sick But Recovering

And while Wall Street remains shaky, credit is still flowing to small business.

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With Wall Street absorbed by billion-dollar bank write-downs and neck-snapping swings in stock prices, it has been easy to overlook recent developments in the credit markets—the very place where much of the current economic turmoil originated. So what do you want first, the good news or the bad news?

The Good News: After grinding to a near standstill in the late summer, the market for short-term bank credit has—at least for now—begun functioning normally again. This encouraging development is demonstrated by the narrowing of the spread between the London Interbank Offered Rate (LIBOR)—the rate at which banks offer to lend money to each another—and the federal funds rate. When credit markets are functioning smoothly, the LIBOR should be only slightly above the Fed funds rate. But as the subprime crisis gathered steam in the late summer, banks began to worry about each other's exposure to such troubled assets and grew increasingly unwilling to lend. As a result the difference between the one-month LIBOR and the Fed funds rate bloated to 57 basis points, or a bit more than half a percentage point, in early September.

But in recent weeks, after central bankers around the world injected billions of dollars into the market, the spread has narrowed dramatically. Recently, the one-month LIBOR has actually fallen below the Fed funds rate in anticipation that the Federal Reserve will continue to cut interest rates. David Resler, chief economist of Nomura Securities, says that the narrowing spread indicates that the actions taken by world central bankers have been largely successful. "The willingness to inject ample liquidity into the market has eased some of the concerns that banks have had about counterparty risk," Resler says. In addition, the painful write-downs that large financial institutions have recently taken have helped clarify their subprime exposure, thereby reducing the level of uncertainty in the markets. "This is definitely a positive development in the credit markets," Resler adds. "It's a sign of return to normal credit conditions in the bank lending market."

The Bad News: But while the LIBOR spread has narrowed, the difference between high-yield—or junk—bonds and safer treasury securities has only gotten wider. High-yield bonds are used by companies with less-than-stellar credit or limited collateral available to raise money. Since such companies are considered riskier, investors are typically paid a higher interest rate to purchase their debt. But in recent months, the spread between the payout rates on high-yield and government bonds has widened dramatically. Standard & Poor's speculative grade credit spread index shows that the spreads jumped from 5.61 percent to 6.84 percent in January alone, after being in the low-3-percent range early last year.

Diane Vazza, the managing director of global fixed income research at Standard & Poor's, says the widening gap shows investors have grown increasingly concerned that a slowing economy could lead to more defaults and are demanding a higher return on their risk. "What that's telling us is that the market is very nervous," Vazza says. "The market is pricing in an increase in default risk; they are pricing in questionable liquidity in the market, and the prices reflect also the volatility." The development is bad news for any company that doesn't have an investment-grade rating, increasing costs to refinance or raise capital. Furthermore, it will make it more difficult for below-investment-grade companies to enter the capital markets.

Consumers: Many have worried that tightening in the credit markets would reduce consumer access to credit and further the likelihood of a recession. But there is little evidence of that happening so far, says Michael Englund, chief economist at Action Economics. "Bank lending has actually accelerated since the credit market problems began, and consumer credit growth has remained strong," Englund says. This is because many smaller banks that engage in traditional lending—extending loans to customers and holding them on their books—have actually seen profit margins increase, Englund explains.