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FX Blog - Credit Market Analysis - Is the credit crisis over? Falling liquidity risk versus rising default rates

Credit Market Analysis 20 May 2008

 Is the credit crisis over? Falling liquidity risk versus rising default rates

Credit spreads have fallen in recent weeks...

Since the Fed’s rescue of Bear Stearns in March and the acceptance of wider collateral by the world’s central banks, including the Bank of England with its Special Liquidity Scheme, there have been signs that the worst of the credit crisis may be over.

In the UK, interbank rates have fallen slightly in recent weeks, though they remain well above the Bank rate by historical standards. Global corporate credit spreads and credit default swaps have also fallen, reflecting lower liquidity risk premia, as financial market confidence slowly improves.

Hence, credit spreads, especially in the synthetic markets, are now nearer our estimate of fair value. However, the recent falls in credit spreads have to be balanced with prospects of rising corporate and personal default rates in the UK and elsewhere, resulting from slower economic growth, which will have an upward impact on corporate credit spreads.


...especially in the synthetic markets...

In our view, the Fed’s rescue of Bear Stearns and central bank schemes to swap top-rated assetbacked securities in exchange for sovereign debt acted as powerful signals to the financial markets that the authorities were serious about tackling the underlying blockages perpetuating the credit crisis.

In the past two months, credit spreads have narrowed significantly, largely reflecting lower liquidity risk premia. For example, the Merrill Lynch index of global high-yield corporate bond yields versus riskfree treasury yields fell from a peak of 853bps in March to 657bps recently (or from 661bps to 510bps in asset-swap terms), while global investment-grade corporate spreads also narrowed, though obviously to a lesser extent, given lower liquidity risk premia in top-rated bonds, see chart a.

The fall in liquidity risk premia is particularly evident with respect to credit derivatives. European credit default swaps fell from a high of 164bps in March to recent low of 58bps in early May, as chart b shows. Indeed, from a technical perspective, the chart shows a clear head-and-shoulders trend reversal pattern, reversing the previous spread widening trend. We believe cash spreads will fall further back towards comparable levels in synthetic credit spreads, reversing some of the current negative basis.


...but cash corporate spreads remain above fair value

We have therefore moved from a situation where there was an overpricing of risk earlier this year to a situation where credit spreads are a little nearer fair value, especially for credit derivatives.

A simple econometric model demonstrates the extent to which credit spreads deviated above ‘fair value’ earlier this year, which was the opposite of the underpricing of risk which had existed the period leading up to the start of the credit crisis last August.

Nevertheless, even now, credit spreads (at least in the cash markets) remain well above fair value, as chart c on page 1 shows for sterling corporates. Hence, there should still be some considerable scope for cash corporate spreads to fall, as investor confidence improves further, and as the US economy in particular recovers.


Money market tensions haved eased only slightly, so bank lending critieria remain tight

In the money markets, tensions have eased slightly recently, but they remain high by historical standards. Sterling interbank rates have edged lower, but 3m libor remains about 80bps above the Bank rate, compared with a historical average of 15-20bps, see chart d. There is, therefore, quite a long way to go before we reach full normalisation in the money markets.

Clearly, banks want to avoid being another Northern Rock or Bear Stearns at all costs and are still hoarding cash to a greater degree than usual. In turn, this means that credit conditions for companies and individuals will remain tight, as the recent Bank of England and ECB credit lending surveys confirm, see chart e, though strong take-up of central bank debtswap facilities should eventually lead to less tight conditions.


Prospects for credit spreads

What does this mean for cash credit spreads in the next 12 months or so? In our view, there are two competing forces driving spreads in the coming year. On the one hand, a further easing of credit market tensions, helped by central bank measures and greater market confidence, will reduce liquidity risk premia, especially for lower-grade securities.

On the other hand, the impact of tight credit conditions for companies and households – not to mention rising global inflation risks and therefore the need for central banks to keep interest rates high, despite weakening growth – mean that corporate and individual defaults are set to rise. This will have the effect of driving credit spreads wider.

In context, although corporate and individual default rates in the UK will rise this year, especially in sectors that are highly leveraged and exposed to consumer spending and property, they will not increase anywhere near as high as in the early 1990s recession, as chart f shows. The difference in our view between now and the early 1990s is that interest rates and unemployment are not rising as sharply.

Lower liquidity risk may outweigh impact of rising Defaults

The conclusion is therefore we will see pressure for corporate cash credit spreads to widen in response to higher default rates, but this is likely to be more than offset by further falls in liquidity risk premia associated with a gradual resolution of the credit crisis. Hence, we could see cash corporate spreads fall relative to synthetic CDS spreads which have already fallen significantly in the last two months.

In our view, rising global inflation risks may become the biggest obstacle to a significant rebound in economic growth next year, because central banks around the world will be forced to adopt a restrictive monetary policy stance to combat rising global inflation. In turn, this will add upside risks to our corporate and individual default forecasts.

However, we should not forget that rising global inflation risks partly reflect robust growth in emerging market economies, which will support export growth in developed economies such as the UK and US. Therefore, while there will only be a gradual resolution of the credit crisis, it looks like the worst may indeed be behind us.

Hann-Ju Ho, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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