Saturday, October 11, 2008

Don't Watch the Dow

Generations of Americans have been trained to follow the Dow Jones Industrial Average for a quick snapshot of how the economy is performing or is expected to perform. There's a lot that's ill-advised [1] about that habit, but, most importantly, attending to the ups and downs in the Dow won't tell you much about the current financial crisis. Ours is a crisis of credit: Financial firms are unwilling to lend to each other (at all-but-exorbitant rates) for fear that borrowing firms may fail or that they themselves may need the cash to fend off their own crisis.

Whereas the hourly fortunes of the Dow or any stock index are, at best, indirect reflections of this reluctance to lend, the TED Spread [2] measures credit conditions directly. Bloomberg tracks the TED Spread here [3]. What sounds like second-rate Nutella is actually the difference between the interest rate banks charge each other on three-month loans and the interest rate on three-month U.S. Treasury bills.

Why TED? The T comes from "T-bill," shorthand for short-term Treasury bills, and the ED comes from "eurodollar contracts." Because interbank lending is international, loans between banks are often called eurodollar transactions. The three-month interbank interest rate is what an American bank can expect to receive for a dollar loan to a European bank (or any other bank, for that matter-"euro" is just a bad substitute for global here), or vice versa. Not surprisingly, interest rates on loans between banks are higher than the interest rate on T-bills. The higher interest rate on interbank loans compensates for the fact that a short-term loan to a bank is riskier than a short-term loan to the U.S. government.

The TED Spread typically stays under 50 basis points (half a percentage point). Things got atypical in August 2007, when subprime mortgage troubles began making waves in the U.S. housing market. The spread moved above 100 basis points, climbing above 300 basis points in the more recent tumult surrounding the Emergency Economic Stabilization Act.

What explains the big spread? It's due, in part, to all of the toxic assets [4] the Treasury hopes to soak up from the financial system with the $700 billion Congress freed up last week. Lenders in the interbank market need an exceptionally high interest rate to extend credit to banks that may be overexposed to bad assets, pushing the interest rate on interbank loans further above the rate on three-month Treasuries. If the borrowing bank were to fold in the ensuing three months, the lender would find itself snared in the mess.

The spread reflects falling yields for three-month Treasury bills as well. As toxic assets poisoned the balance sheets of Bear Sterns, Fannie, Freddie, Lehman, and AIG, investors sought refuge in the relative safety of treasuries, paying higher prices for the three-month bills and accepting lower yields (even negative [5] yields at one point).

If the Treasury's program works as planned, it will remove a substantial bloc of toxic assets from the financial system and stabilize the prices for those that remain on banks' balance sheets. The stabilization should restore some confidence among both banks and financial markets in general. If so, we'd expect interbank lending rates to come down and Treasury yields to rise as investors stop worrying and start moving money back into equities, corporate bonds, money market mutual funds, and the like.

Thus, the TED Spread should fall. If not, it will remain unusually high, possibly rising even further. Of course, we can't expect the financial crisis to improve if the U.S. housing market gets worse. Keeping on eye on the Case-Shiller [6] home price indices (and related futures [7]) will give you an idea of whether or not policy-makers stand a chance.

By brandon.fuller
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