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Banks Curb Lending: Analyst's Toolkit

The so-called TED spread is showing that banks are more wary of lending, a threat to the recovery.

BOSTON (TheStreet) -- Much of the money pumped into the economy over the past two years was aimed at getting the likes of Citigroup (C) - Get Report, Bank of America (BAC) - Get Report and Credit Suisse (CS) - Get Report to start lending again.

Lending is crucial for the economy to function properly because companies depend on short-term loans to meet obligations while cash is tied up in the business. Recently, however, the flow of money seems to be slowing, indicating trouble ahead.

The TED spread is a measure of liquidity in the banking system. As the chart shows, it's been rising in the second quarter. Calculating the spread is easy: It's the difference between the 3-month London Interbank Offered Rate (LIBOR) and the 3-month Treasury bill yield. Currently, LIBOR stands at about 54 basis points (bps) while the 3 month T-bill is trading at 13 bps, resulting in a TED spread of about 41 bps. (TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.)

In isolation, the number means little, but when tracking its movement, it can tell us plenty.

Banks effectively set the LIBOR rate by deciding how much to charge one another in interest on loans. So it's essentially a gauge of risk aversion. The higher LIBOR climbs, the more compensation banks demand to lend to one another.

As an extension, the TED spread adjusts the level of LIBOR for the rate at which the U.S. government lends, the latter of which is closest thing to a sure bet as there is in investing. That way, if short-term government rates are high, the LIBOR will be high. When the TED spread widens, however, it signals a disconnect between government rates and the rates banks charge one another, indicating risk aversion at banks and fewer funds available for lending. That shrinks liquidity in the credit markets and erodes growth potential.

At the height of the credit crisis, the TED spread jumped to a previously unfathomable 425 bps, 10 times today's level. That indicated a near-grinding halt to the economy, so the current spread isn't even in the same league. Still, the increase is a concern.

As banks begin to reassess lending money to one another, the ramifications for other business will likely be worse since typical corporate borrowers have to pay a spread above LIBOR, making their cost of capital higher and their returns less attractive.

Most of the trouble stems from the sovereign-debt crisis in Europe. Most of the big banks have exposure to the region, but the real magnitude is unknown due to transparency issues with derivative contracts.

Investors should keep their eyes on the TED spread as an indicator of the status of lending. Slower lending will necessarily lead to slower growth and the potential for more pain.

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-- Reported by David MacDougall in Boston.

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Prior to joining TheStreet 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.