ABA Banking Journal - July 2008 - (Page 56)

briefing The Economy JOHN SILVIA Chief Economist, Wachovia Corp, and a former member of the ABA Economic Advisory Committee Average 5-year CDS bank spreads Credit shocks: three questions 1. Is the worst over? Yes. The evidence suggests that the worst of the credit crunch has passed. In the top graph, we note that the peak in the credit default swap (CDS) spread for banks appeared in March. Federal Reserve actions to lower the federal funds rate and provide additional liquidity appear to be working. In markets, pricing is driven by new information, particularly, if that information runs contrary to the perceived wisdom. Effectively, the pattern of credit default spreads suggests that the market was caught off guard with the extent of the risk. Recently, such risk assessments have moderated so the worst may be over but the market is still searching for a new equilibrium. 2. Is there a disconnect? Yes. Credit spreads appear to have widened far outside the range of current corporate default experience, for example, as shown in the middle graph. On the opposite pole of experience, high-grade corporate spreads also did not reflect the credit crunch recession of 1990-1992 when corporate defaults rose dramatically. In that period, leveraged buyouts drove leveraged loans and high yield but did not impact investment-grade issuers. In today’s environment, by contrast, credit derivatives added significant leverage to the investment grade universe through synthetic collateralized debt obligations (CDOs). Therefore, the perceived risk in such structures has increased while the actual default experience remains quite good. This disconnect has also been cited in reference to the implied default rates on sub-prime mortgages against the likely actual default experience. 3. Has the risk/reward equilibrium shifted? One measure of risk, the TED spread (Treasury/Eurodollar) suggests a higher premium for risk has been priced into the market, relative to a year ago (bottom chart). This suggests an increased amount of credit/counterparty risk in the 240 200 160 120 80 40 0 basis points Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 % (basis points) 400 350 300 Investment grade spreads vs. corporate default rate Investment grade spreads: April @ 255 bp (left scale) Corporate default rates all corporates: April @ 0.61% (right scale) 5.0 4.5 4.0 3.5 250 200 150 100 50 0 1984 1989 1994 1999 2004 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Treasury/Eurodollar (TED) spread 250 200 150 100 50 basis points Q1-2007 Q2-2007 Q3-2007 Q4-2007 Q1-2008 Q2-2008 banking and financial sectors. Over time financial markets are searching for a new equilibrium of risk and reward. Yet, the pattern of the TED spread suggests that there has been a sequence of shocks, not just one shock as evidenced by the volatility of the spread. These shocks have altered the market’s perception of the risk/reward tradeoff. From this viewpoint, the market is not broken when prices jump. On the contrary, the market is efficiently accounting for new information, even when it’s disappointing. BJ 56 JULY 2008/ABA BANKING JOURNAL www.ababj.com/subscribe.html http://www.ababj.com/subscribe.html

Table of Contents Feed for the Digital Edition of ABA Banking Journal - July 2008

ABA Banking Journal - July 2008 Contents Editor’s Column Searching for New Paradigms at BIS Snapshot: C&I Asset Quality 100th Anniversary: Then & Now BofA "Event Concept" Wins Awards, and Customers ABA Resources ABA Chairman’s Position M&A: Beat Today's Market Blues Pass the Aspirin Cover Story: Workout Time Correspondent Banking: No Longer Just a Handshake Business Getting IT Right By Thinking It Through Webnotes Are You "Red Flag" Ready? Mailbox Banker’s Mart To Advertise/Index of Advertisers The Economy

ABA Banking Journal - July 2008

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