Credit Markets Show Healing, Bumpy Road Ahead
This week and next, TheStreet and RealMoney will be exploring the aftermath of Lehman Brothers' bankruptcy filing and the ensuing market chaos it brought to a head almost a year ago.
NEW YORK (
) -- It has been a year since the collapse of
Lehman Brothers
triggered a panic that led to a near implosion of the U.S. financial system.
Since then, government bailouts, low interest rates and bankruptcies have righted the banking world. But investors are still wondering if the crisis is mostly behind us or if more drama lies ahead. To answer that question, the most logical place to look is ground zero: the credit markets, where it all began.
Citigroup
(C) - Get Report
and
Goldman Sachs
(GS) - Get Report
were feared to be at risk due to the freezing of the credit markets, as losses on derivatives and mortgage securities exploded. That concern was evident in the increased cost of insurance on their debt (credit default swaps). Credit default swaps for both companies skyrocketed as word spread about the depths of the danger baked into financial stocks.
The following graph shows the sudden increase in the price of CDSs for Goldman and Citigroup as well as for New York and California, both of which have suffered more than most states in the recession.
The graph shows a tight correlation between Citigroup and Goldman in the days leading up to September 2008, with a pop in March, when
Bear Stearns
became the first casualty of the meltdown. After Lehman collapsed, everything went haywire. The graph becomes a jumbled mess of zigzagging lines as the market tried to make sense of the rapidly deteriorating economy.
The failure of a major financial institution freaked out an already skittish market. That can be seen even more clearly in the so-called TED Spread, the yellow line on the graph. The TED Spread is the difference between the London Interbank Offered Rate (Libor) and the yield on T-bills. That figure measures trust among financial institutions. A higher number signifies a large premium required on interbank loans due to a lack of confidence, and vice versa for a smaller number.
The TED Spread reached terrifying heights at the end of 2008 but has been on a steady trend down and now sits at a level not seen since February 2007. That suggests banks have regained confidence in their peers, and credit is flowing among them at reasonable rates again. Those benefits should be felt in all parts of the economy as borrowing costs fall.
Despite the greatly improved view on perceived counterparty risk shown in the TED Spread, CDS spreads remain at elevated levels compared with pre-crisis norms. That suggests there is still a high amount of uncertainty in the solvency of major financial institutions.
That is also true for institutions not included on the graph, such as
Bank of America
(BAC) - Get Report
and
Morgan Stanley
(MS) - Get Report
. The only major bank that has avoided a rampant increase in its CDS price is
JPMorgan Chase
(JPM) - Get Report
, which is below 100 basis points, less than half of Bank of America's level.
The fear of insolvency also has spread to municipal securities. Spreads on New York and California bonds have dramatically increased, indicating little confidence in the solvency of the states. Credit protection for those states didn't exist before the recession began at the end of 2007.
Government securities are a reflection of the tumult. Institutional investors' equivalent of stuffing money under a mattress is purchasing Treasury securities, considered to be risk-free. As big investors pull money out of stocks and dump it into Treasuries, yields plummet. As a result, investors can get a feel for institutional investors' expectations for the stock market simply by observing the Treasury yield curve.
In the past month, yields have fallen across the board, with longer-term securities dropping much faster than short-term ones. That indicates that a market pullback may be a reality in the near future. As investors move into longer-term, safe assets, the support for the rally we have enjoyed these past few months may falter.
Since March, the
S&P 500
index has gained more than 30%, helping investors recoup some of what was lost in the crash. Many investors are rethinking the speed of the bounce. Based on CDS spreads and the minuscule yields on Treasury securities, it is clear that there is still a huge amount of fear gripping the markets. Don't be surprised by a stock market decline as investors suffer flashbacks to the nightmare that was 2008.
-- Reported by David MacDougall in Boston.
Follow TheStreet.com on
and become a fan on
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.
