Tuesday December 18, 2007 - 12:05:15 GMT
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Credit Market Analysis - A look back at a momentous year
Credit Market Analysis 17 December 2007
A look back at a
The first half saw
continued abundant credit...
The first half of 2007
saw a continuation of an extraordinary period of cheap credit, which led to a
significant underpricing of risk. Chart a shows that the VIX equity volatility
index, a key measure of investor sentiment, was below the long-term average from
2004 until mid- 2007, signalling strong investor risk appetite. Further, the
spread of corporate bond yields over risk-free government bond yields was at
unusually low levels in recent years, as chart b for the UK shows.
...but falling US house prices and
rising defaults led to a subprime mortgage crisis...
During this period of
abundant credit, investors sought to maintain returns by investing in riskier
assets, including complex structured finance products, such as so-called collateralised
debt obligations (CDOs) backed by US subprime mortgages.
However, as mortgage rates rose in the US and house prices fell,
mortgage defaults increased sharply, see chart c. Investors had been
over-reliant on credit ratings in assessing whether to invest in these complex products.
Subsequent ratings downgrades and growing uncertainties about valuations led to
a loss of investor confidence. It also became clear that the 'originate and distribute'
model for structured products, which had helped to diversify risks in the
financial system, also led to uncertainty about where these risks resided.
...which amplified into
a wider financial market crisis...
uncertainty amplified a crisis in the subprime mortgage market into the wider
financial markets. Banks, uncertain about counterparty credit risks, became
reluctant to lend to each other, leading to a rise in interbank rates, as chart
d shows. Investors shunned assetbacked commercial paper (ABCP) with exposure to
the US subprime market, which were issued by off balance sheet vehicles,
meaning that banks held on to liquidity in case they had to provide funding to
these vehicles. Chart e shows that outstanding US ABCP has shrunk by about a
third since August. Towards the end of the year, several banks reported large
writedowns related to CDOs.
...leading to downside
risks to the broader economy
Looking ahead, the
tightening of bank lending standards, as well as the increase in investor risk
aversion, will lead to higher financing costs for companies and households, and
therefore increased downside risks to economic growth. Credit spreads have
widened, particularly in the financial sector, as chart f shows. Non-financial
spreads have also widened, but to a lesser extent, because corporate default
rates still remain near historical lows, reflecting strong profit growth and
limited direct exposure to the US subprime market. We
will explore the outlook for 2008 in more detail in the next edition.
Hann-Ju Ho, Senior Economist
Research,10 Gresham Street,
Lloyds TSB Corporate
London EC2V 7AE,
0207 626 - 1500
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