Mid-year report card on credit markets

A group of men review reports and market information online.

In Canada, there has been considerable improvement in credit conditions since last fall.

Financial markets rarely reflect current realities. Instead, they are better gauges of faith and fear. How else would one explain the remarkable surge by investors back into risk markets in the short span of the second quarter of 2009?

From the depths of their bear-cycle lows on March 9, equity markets around the world rebounded between 30% and 40% in unison. As prices are established by simple supply and demand, the only variable that materially changed was a strong positive shift in risk appetite. Behind this optimism is the belief that the worst of the global credit market and economic crises have now passed. Here is a review on the current state of credit market conditions.

Why the credit market matters

The credit market is at the heart of the world’s financial and economic problems. Arguably, the credit bubble burst in mid-2007 with the collapse of two Bear Stearn hedge funds that were invested in complex debt securities called collateralized debt obligations (CDOs), which were tied to U.S. mortgages. The collapse led to a negative chain of events around the world that culminated in the near-seizure of the global banking system with Lehman Brothers Holdings Inc.’s bankruptcy in September 2008. With the banking system nearly frozen, the restricted flow of credit soon began to negatively affect individuals, companies and economies.

In its April 2009 forecast, the International Monetary Fund (IMF) predicted the first global economic contraction in the 60 years since the Second World War. The IMF estimates that global gross domestic product (GDP) will contract by a 1.3% annual rate this year, before staging a modest 1.9% recovery in 2010.

While the debt market was seeing its darkest hour during Lehman’s failure, equity markets were slower to react, with the S&P/TSX Composite Index reaching its record high just three months prior. Fixing the credit market and stabilizing the banking system are the keys behind a sustained global economic recovery and equity market appreciation.

Credit markets still recovering

Credit market conditions have since improved, and fears of a catastrophic financial meltdown appear to have waned. Central banks’ massive liquidity injections into the markets, and governments’ success in preventing further major bank failures, have improved the environment dramatically since the dark days of late 2008.

According to Bloomberg L.P., the U.S. government and the Federal Reserve have spent, lent or guaranteed US$12.8 trillion to help repair the credit market, restore confidence in the banking system and stem the longest recession since the 1930s. The money nearly matches the nation’s GDP of US$14.2 trillion in 2008 and works out to US$42,105 for every man, woman and child in the U.S. Similar government stimulus and central bank aid programs have been synchronously provided around the world.

Without this exceptional scale of government intervention, the alternative could have been very much worse. While key gauges of credit market conditions such as the London Interbank Offered Rate (LIBOR) and corporate bond spreads over U.S. Treasury notes have improved substantially, they do not tell the whole story. Other gauges of risk remain well above levels seen before the financial crisis began in 2007, and many parts of the credit market are still relying on some form of government assistance, not yet able to stand on their own.

The latest IMF Global Financial System Report (April 2009) provided a grim outlook on the state of the global banking sector. It revised and nearly doubled its estimates for the extent of write-downs from the ongoing crisis to US$4.1 trillion, from its January 2009 forecast of US$2.2 trillion. So far, according to Bloomberg, the total write-downs globally for banks, insurers and government-sponsored enterprises stands at about US$1.33 trillion — just under one-third of the total losses expected.

The IMF considers the global financial system to be under “severe stress,” with systemic risks remaining high and the adverse feedback loop between the financial system and the real economy yet to be arrested. The IMF expects the credit crunch to be deep and long-lasting, notwithstanding signs of improvement in short-term lending conditions and the opening of some term markets. It anticipates that the process could possibly lead to a pronounced contraction of credit in the U.S. and Europe before recovery begins.

On May 8, U.S. Treasury Secretary Timothy Geithner echoed the IMF’s view that there were signs of easing credit conditions, but noted there was still “a long way to go” before the financial system returns to full health.

Canadian credit market conditions

In Canada, there has been considerable improvement in credit conditions since last fall. On April 21, 2009, the Bank of Canada lowered its overnight target interest rate to a record low of 0.25% and made an unprecedented commitment to hold that rate steady until mid-2010, conditional on the inflation outlook.

Investors are left with a very difficult choice — earn zero in their bank accounts or increase their risk parameters on investments to try and obtain a reasonable rate of return. Faced with little choice, investors have embraced the latter alternative.

With government-guaranteed bonds yielding an unappealing 1% to 3% for short- to mid-term maturities, investors have gravitated towards higher-yielding corporate bonds — particularly Canadian bank debt. The yields on bank Tier 1 hybrid bonds (callable in 10 years) have fallen from 10.22% in December 2008 to less than 6.5% at the end of June 2009.

Although credit conditions have not yet fully normalized to pre-credit crisis levels, the impact of near-zero short-term yields should continue to elevate investor risk appetites in all areas of financial markets.