Consumerscope: Putting the Crisis in Context
The last 12 months have been tumultuous. What began with the implosion of inaccurately modeled and priced mortgages has moved throughout the credit and broader financial markets like wildfire. During this time we’ve seen the downfall of Washington Mutual, the largest bank failure in history, and the disappearance of an entire industry of independent broker dealers and investment banks.
As fear has dominated, banks have become increasingly unwilling to lend to one another. The “Ted Spread” is often used to measure for illustrating perceived risk within the financial system. It is derived by subtracting the three-month Treasury yield from the three-month LIBOR rate, which is the rate at which banks lend to one another for a three-month period. Since the three-month treasury rate is the perceived risk-free rate, this spread calculates the risk of lending between banks. Historically, the Ted Spread hovers between 30 and 40 points, highlighting the willingness of banks to lend to one another for short periods of time with very little compensation for risk.
The short-term nature of these loans and the caliber of the financial institutions backing them had traditionally made them low-risk instruments. But as the first chart illustrates, the Ted Spread has widened significantly. Banks are unwilling to lend to one another, and many of the credit markets have frozen up as a result. The Federal Reserve has tried to stymie the contagion and restore confidence in the financial markets but to little avail. Banks are afraid the loans will not be repaid or that they themselves will need the liquidity.