December 24, 2008

“A banker is a fellow who lends you his umbrella when the sun is shining,
but wants it back the minute it begins to rain.” — Mark Twain

Less Than Zero

Last week, the rate-setting Federal Open Market Committee of the U.S. Federal Reserve Bank took extraordinary steps to help free-up frozen credit markets.

The Fed slashed its benchmark rate of interest, the Fed funds rate, to a “target range” of between 0% and 0.25%^[I]. That’s a major move in interest rate policy considering the typical baby steps the Fed has used in the past. Of course, these aren’t typical times for credit markets.

But a funny thing happened on the way to ZERO interest rates... investors STILL appear eager to stash their cash in short-term Treasuries — even when they’re getting paid NOTHING in return.

An extraordinary event occurred in the bond market recently. Three-month Treasury bill rates fell below 0% interest for the first time in history. In fact, 3-month bills were auctioned to investors at a price that absolutely assures a LOSS for the buyer if held to maturity^[II]!

In other words, investors are so frightened of the ongoing credit crunch that they’re willing to PAY Uncle Sam to hide in short term T-bills for a small loss, rather than run the risk of larger losses in other investments.

These are indeed interesting times.

In spite of the Fed slashing its benchmark interest rate to the bone, other market-based interest rates for consumer and commercial loans remain sky-high...

Since the Fed began cutting rates last year, the Fed funds rate fell five percentage points — but interest rates on 30-year mortgage loans have only declined by about one percent since then.^[III]

Interest rate spreads (or the difference) between 3-month bank loans (the Libor rate) — and 3-month Treasury bills — are SIX-TIMES higher than normal.^[IV]

Corporate bond spreads for non-investment grade firms have gone through the roof, too — with rates blowing-out to 21.4 percentage points above Treasury bonds — up from just 1.3 percentage points just 18-months ago.^[V]

It’s crystal clear that credit markets have NOT yet returned to “normal,” in spite of the Fed’s unprecedented efforts to pump money into the banking system. After suffering almost $1 trillion in credit losses and write-offs already as a result of this crisis, banks are incredibly reluctant to lend. Instead, they’re hoarding as much cash as they can, while tightening lending standards still further.^[VI]

As Santa Claus prepares to make his appointed rounds tonight, financial markets remain largely frozen, but there are some hopeful signs of a coming thaw.

The TED spread, a closely watched indicator of bank lending, has narrowed considerably since October. Following the Fed’s recent move, the spread fell some more, indicating that banks are perhaps becoming more comfortable making loans.

This data can also be distorted by year-end funding needs for banks — many try to keep their balance sheets slim at this time of year. The real test for credit markets may come in January, as investors look forward to a New Year’s thaw.

Happy Holidays!

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

^[I] Bloomberg: “Banks Show No Signs of Easing Credit in Step With Fed’s Rates”, 12/17/08
^[II] Ibid
^[III] Economagic.com, 11/22/08
^[IV] Bloomberg: “Banks Show No Signs of Easing Credit in Step With Fed’s Rates”, 12/17/08
^[V] Ibid
^[VI] Ibid