Monday, September 22, 2008

The Debts of the World: Credit Markets Explained

Most investors focus on the DOW, Nasdaq, and other stock indices. These are widely known metrics that attract the media spotlight.

Less well known however are the credit markets. Credit markets are the realm of the big players - the place where commercial paper and other short term loans - are traded between banks, insurance companies, and industrial giants. This is the "shadow banking system" where companies obtain financing for short term financing - w/terms as short as overnight. The bid and ask spreads in this lending system are opaque and are called "dark pools of liquidity" since there is little if any government oversight. And taking place front and center in the credit markets is the TED spread.

The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. The name comes from a combination of "T-Bill" (3 month US debt) and "Ed" (the ticker symbol for 3 month Eurodollar futures). The T-bill part is set by US bond markets while the Ed part is set by British bond markets. The British bond market is set by the LIBOR or London Inter Bank Offered Rate.

It is also an indicator of market perception of credit risk, as T-bills are considered risk free while the LIBOR rate reflects counterparty credit risk in lending between commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will develop a preference for safer investments.

Spread sizes are denominated in basis points or percentage points. For ex: when the T-Bills are trading at 3.1% and Ed trading at 3.8%, the TED is said to be trading at .5% or 50 basis points.

During the past week, the TED spread rose dramatically as T-bill interest rates declined substantially while LIBOR rose. This huge gap was at one point close to 9%. It may not sound like a lot but consider that the TED spread is usually less than 1%.

The high spread was potentially lethal to banks and other financial institutions raised in an environment of cheap debt and poor capital w/lending ratios as high as 30:1. Case in point - Lehman Bros. had a 30:1 leveraged debt ratio and had to file bankruptcy last Monday.