Thursday, August 11, 2011

Credit Spreads and Risk Assessment

Ok. After a lengthy time away from posting I'm back.

Today's topic is credit spreads and risk assessment. The past 2 weeks' market roil has induced a fair amount of panic among many observers and not a few participants. Interbank spreads have widened significantly as can be expected in an environment that we are currently facing. In particular the catalyst for these fears are EU based concerns that French, Italian, and Spanish banks are not as stable as first perceived. E.g. the risk of contagion from Greece and Ireland has widened to envelop the core EU members previously thought of as the most stable.

But compare the levels of fear between 2008-2009 and the summer of 2011. I have included 2 charts above for your review. As you can see the elevated fears of risk today are nothing like that experienced 2-3 years ago.

The TED spread is not as relevant today as it was 2 years ago b/c of the persistent levels of government intervention. But it is still natural to expect interbank risk to rise and short term T-bills (the benchmark) to fall. TED has been stuck in a range bound carry trade level in order for the banks and other financial institutions to re-capitalize their balance sheets. For the common shareholders, they have lost some if not all of their funds (depending on their basis - just witness the government's effort to re-capitalize AIG, Citibank, Bank of America, etc). But for preferred shareholders the losses still bite but are offset to some degree by dividend payments.

Corporate spreads aren't that bad. Housing and mortgage rates have become dislocated from benchmarks. But corporate credit couldn't be better. Low treasury rates mean a rush by large caps to refinance at even lower rates than they were getting before.

What most people forget is the bad economic data out of the U.S. masks how well large-cap U.S. companies are doing. Second-quarter earnings have been outstanding so far, largely because the global U.S. companies are doing very well outside of their sluggish domestic market. In fact, for those w/the money this is a prime time to buy solid blue chip preferred stocks and just hold on through the market turmoil.

The bottom line: There is some panic in the markets - justifiably so in many cases. But the levels of fear being experienced today are nothing like 2008-2009 (at least so far).
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