A credit crisis occurs as a result of an unexpected reduction in accessibility to loans or credit and a sharp increase in the price of obtaining these loans. The credit markets are good indicators of the depth of a credit crisis. They can also provide clues as to when that crisis will ease up. To understand how to judge the severity of the crisis, we must be able to look at a number of factors, such as what is happening with U.S. Treasuries, how it is affecting the London Interbank Offered Rate (LIBOR), what effect this has on the TED spread and what all this means for commercial paper and high-yield bonds. In this article, we'll examine how these indicators can be used to determine the severity and overall depth of a credit crisis.
Tutorial: Understanding The Credit Crisis
Measuring the Severity of a Credit Crisis
There are several tools that can be used to measure the overall depth of a credit crisis:
U.S Treasuries: U.S. Treasuries are debt obligations issued and backed by the U.S. government. As a credit crisis unfolds, investors take their money out of other assets, such as stocks, bonds, certificates of deposit (CDs) and money markets. This money goes into U.S. Treasuries, which are considered to be one of the safest investments. As the money continues to flow into this area, it forces the yield on short-term treasuries (also known as Treasury bills) down. This lower yield is a sign of high anxiety in the markets as a whole as investors search for safer places to put their money. (To learn more, read Trying To Predict Interest Rates.)
LIBOR: LIBOR is the rate that banks charge other banks for short-term loans. These loans can be for one month, three months, six months and one year. When LIBOR rates are high, this is a sign that banks don't trust each other and will result in higher loan rates across the board. This means tighter lending standards and a general unwillingness among banks to take on risk.
TED Spread: This spread represents the change between the three-month LIBOR rate and the three-month rate for U.S. Treasury bills. It is used to measure the amount of pressure on the credit markets. Generally, the spread has stayed under 50 basis points. The bigger the difference between the two, the more worry there is about the credit markets. Economists will look at this to determine how risk-averse banks and investors really are.
Commercial Paper: Commercial papers are unsecured debts used by banks or companies to finance their short-term needs. These needs can range from accounts receivable (AR) to payroll to inventory. Generally, maturities for commercial paper range from overnight to nine months. Higher interest rates make it more difficult for businesses to obtain the money they need to fund their day-to-day operations so that they can continue to expand. These high rates can cause businesses to pay the higher costs or not borrow at all. This creates a situation in which companies look for ways to get the money they need to fund their short-term operations; when more commercial paper is issued, this can be a sign of a tight credit market. (To learn more see, Money Market: Commercial Paper.)
High-Yield Bonds: High-yield bonds are bonds that do not qualify for investment-grade status. Ratings agencies rate high-yield bonds as those with the greatest chance of default. The higher the yields on these types of bonds, the tighter the credit market is likely to be as this suggests that there are few borrowing opportunities for businesses. Businesses that are unable to get more favorable financing may issue bonds instead. (For further reading see, What Is A Corporate Credit Rating?)
Using Indicators to Understand a Credit Crisis
Any indicator by itself, while important, will not provide the overall big picture. However, when a combination of indicators consistently points in the same direction, this correlation can point to which direction the credit markets are headed. If the credit markets are headed toward crisis, these indicators can provide insight into how big the credit crisis will be and how afraid banks or investors are to take risk. If the fear is great enough, it can spill over into the general economy, causing recession. Conversely, when indicators are weakening, this suggests that banks and investors are willing to take risk. In this case, borrowing conditions are easy and businesses have access to the capital they need, causing the economy to expand.
There are several tools that can help determine the depth of a credit crisis. By looking at U.S. Treasuries, LIBOR, the TED spread, commercial paper and high-yield bonds, you can get a glimpse into how nervous bank and investors are about assuming risk, which is an important determinant of what the economy will look like going forward. While no single indicator is more important than another, the correlation of all of these will confirm the overall conditions in the credit markets.