Credit Crisis: Market Effects
By Brian Perry
The credit crisis has been touted as one of the greatest threats to the global financial system since the 1930s. It is not surprising, then, that the crisis has also produced unprecedented volatility in the financial markets and large losses for many investors. Let's take a look at market movements during the credit crisis and the erosion of confidence investors experienced as a result.
Overview of Market Reactions
- T-bills trade with negative yields
- Corporate bond risk premiums soar
- The S&P 500 and global stocks record their worst weeks on record in October 2008
- Worldwide stock markets down more than 30% for 2008 year
- A general lack of confidence or liquidity in the market develops
At its inception, the credit crisis was primarily reflected in the bond market, as investors there began to avoid risky assets in favor of ultra-safe U.S. Treasury securities. The chart below shows the option adjusted spread (OAS) on the Merrill Lynch Corporate Bond Index. The OAS reflects the additional compensation investors require for purchasing corporate bonds as opposed to ultra-safe Treasury securities. After demonstrating virtually no volatility between 2003 and mid-2007, the OAS increased to record highs at the beginning of 2008, and then soared dramatically as the crisis intensified during the latter part of the year. Not only did this sharp increase cause large losses for many banks and investors, but it also reflected much higher borrowing costs for companies wishing to raise capital.
|Source: Merrill Lynch|
At the same time that bond market investors were selling risky assets, they were rushing to the safety of U.S. Treasury securities. During the credit crisis, the yield on the two-year Treasury bonds fell from more than 5% to less than 1%. Yields on shorter term Treasuries declined even further, and at one point the yield on some securities was actually negative. In other words, investors had so little confidence in the financial system that they were willing to pay the Treasury to hold their money, as opposed to investing it elsewhere and attempting to earn a reasonable rate of return. (To learn more, read Bond Yield Curve Holds Predictive Powers.)
The Stock Market
While stock prices have been steadily declining since reaching their highs in November 2007, the selling intensified following the bankruptcy of Lehman Brothers in September 2008. When the U.S. House of Representatives failed to pass the Treasury's bailout plan on September 29, the S&P 500 fell 8.8%, its largest one-day percentage decline since Black Monday in 1987. (To learn more, read What is Black Monday?) That same day, total
Poor performances in the bond and stock markets were the most visible reflections of the credit crisis. Less visible, but even more important, was what was happening to investor confidence. At its most basic level, the modern financial system depends on trust and confidence among investors. Without this trust, a dollar bill is just another piece of paper, and a stock certificate holds no value. The most dangerous aspect of the credit crisis was that this trust began to erode as investors questioned the solvency of banks and other financial institutions. This erosion of confidence ate away at the very foundation of the modern financial system and is the reason why the credit crisis posed such a grave threat. (For more on this, see Analyzing A Bank's Financial Statements.)
Confidence is not as easily measured as stock or bond movements; however, one good indicator of the level of market confidence during the credit crisis was movements in the London Interbank Offered Rate (LIBOR.) LIBOR represents the rate at which large global banks are willing to lend to each other on a short-term basis. In normal times, large banks present little credit risk and therefore LIBOR closely tracks the level and movements of short-term U.S. Treasury securities. This is why LIBOR is rarely discussed outside the confines of the bond market, despite the fact that an estimated $10 trillion in loans are linked to it. (For related reading, see Top 5 Signs Of A Credit Crisis.)
At the height of the credit crisis however, LIBOR became an important topic of mainstream conversation and one of the best indicators of the global credit freeze. After remaining unchanged for more than three months, LIBOR spiked sharply following the bankruptcy of Lehman Brothers in September of 2008. This spike reflected an increasing unwillingness on the part of banks to lend to one another. In a global economy based on credit and trust, this was an extremely troubling sign, and prompted concern among policymakers that the global financial system faced a systemic collapse. (To learn more about indicators, see Economic Indicators: Overview.)
Following its sharp increase, LIBOR fell dramatically in October 2008 as the combined actions of global policymakers helped to ease the fear among financial market participants. In fact, because of central bank's interest rate cuts, LIBOR actually fell to below where it was prior to the Lehman Brothers bankruptcy.
This chapter has examined some of the market reactions to the global credit crisis. Investors who followed the markets during this period do not need to be reminded of the unprecedented volatility markets experienced or the dramatic declines in the values of a wide range of asset classes. However, the most troubling aspect of the crisis was the erosion of investor confidence and trust. This erosion was demonstrated, in part, by the increase in the LIBOR rate. It was this erosion of confidence that caused such grave concern among policymakers and prompted the dramatic actions they chose to take.
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