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by David Stanowski 20 October 2008 What is a credit crisis, and what does it look like? A credit crisis occurs when something happens to force market participants to reevaluate the risk of high-risk debt instruments. The current crisis began last year when the risk of mortgage-backed securities, created during the housing bubble, suddenly looked a lot more risky than they did a short time before. This was due to the realization that the bubble had burst. Over long periods of time, credit markets establish a "normal relationship" between low-risk and high-risk debt instruments. When the credit crisis hits, the spreads widen dramatically as investors begin to flee the high-risk debt for the safety of the low-risk debt. The yields go up on the former and down on the latter, due to simple supply and demand. The first graph shows the relationship between the benchmark short-term debt instruments; 3-month Eurodollars (also known as LIBOR) and 13-week TBills. TBills are considered the safest debt in the world, and Eurodollars are normally only slightly riskier. However, in recent weeks, TBills often pay less than 1%, as investors will take any yield for the safe return of their money. Notice how their normal relationship, a spread of less than 1%, has surged to just shy of 6%! The data on this spread goes back 43 years, and this is only the second time it has bumped up against 6%. The other was at the December 1974 stock market low.  This spread is telling us that the markets see anything less than U.S. Treasury Bills as six times more risky than they were just one year ago! When investors and traders see this amount of increased risk, they are also much less likely to invest in businesses and stocks. THIS is the underlying cause of the plunge in the stock market, and it should now be crystal clear why it has dropped so much; confidence has plunged by a factor of six! It is highly unlikely that the stock market can mount a major rally until this spread narrows which will indicate that risk is declining. The long end of the market looks just as bad! The following graph is the spread between what many publicly-traded corporations have to pay for bonds versus what a few blue-chip corporations are paying. Currently, corporations that are not considered "investment grade" are paying over 22% to issue bonds, while the higher grade debt is going for just under 9%; creating a spread of over 13%! A year or two ago, the "normal relationship" was established at about 2%, so the move to above 13% also shows that risk has increased by a factor of six!  It is very likely that these spreads will peak sometime this month, and make way for a sizable rally in the stock market. However, this problem probably began in the early 1980s when the amount of debt in the system began to accelerate. It is not likely that almost three decades of debt build up will be unwound in just one year. Total Credit Market Debt as a % of GDP stood at 170% at the 1929 stock market high, and at 147% at the 1966 stock market top. Currently, Total Credit Market Debt as a % of GDP stands at more than double those levels; 356%. There is still a tremendous amount of risk from the unwinding of this debt, and even if these spreads narrow for a few weeks, there is a lot of room for them to widen in the near future.
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