The Financial Sector Seeks Stability; Intense Intervention into the Financial System by the Government Including the Federal Reserve and Other Regulatory Agencies Loosened the Grip of the Economic Crisis That Dominated 2008. Sustaining the Recovery Is the Focus for Policymakers in 2010

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In 2009, the most severe financial crisis since the 1930s began receding. However, normalcy has not yet returned to financial markets, with many areas of the credit market and financial institutions still receiving support from government and other agencies. In addition, ongoing debt reduction among businesses and households could continue to constrain economic growth heading into 2010.

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Credit markets obtain stress relief

Many areas of the credit market underwent tremendous stress in 2008 and into 2009 before stabilizing and then improving during much of this year. For example, the LIBOR-to-OIS spread--a closely watched measure of short-term interbank strain--has dropped remarkably close to its precrisis level and is now at a small fraction of where it began the year (see chart 1). The CDX (an index of credit default swaps for investment-grade corporations) is nearly half of what it was at the start of the year, indicating reduced investor concern over default risk among top-rated companies. The risk spreads on asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) have experienced similar declines, indicting reduced risk premia for securitized credit instruments backed by consumer loans and commercial real estate loans, respectively.

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Despite marked progress, financial markets still have some distance to go before they can be said to be functioning normally. Notably, some areas of the credit market are still relying on support from specially created Federal Reserve programs such as the Term Asset-Backed Securities Loan Facility (TALF). The TALF was designed to jumpstart. the frozen securitization markets, which are important sources of credit for households and businesses.

Significant programs from the U.S. Treasury also remain in place, some of which provide general support to the banking system. For example, through the Capital Purchase Program (CPP), the Treasury has purchased preferred shares of qualified financial institutions to improve banks' capital positions.

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The TALF as well as other Federal Reserve programs designed to support commercial paper markets and money market mutual funds and provide short-term liquidity are scheduled to expire in the first half of 2010. While some institutions have repaid the government's CPP investment, many still have outstanding balances, and the CPP will stop funding transactions in October 2010. Market participants will likely pay close attention to how markets react as these and other banking sector and financial market support programs wind down.

Debt reduction under way

In 2009, households continued to whittle away at their debt by decreasing their use of credit. Federal Reserve data show that the amount of outstanding consumer credit has declined by 3.8 percent from its peak in July 2008 through October 2009, marking the largest decline since 1943. Additionally, the Fed's Senior Loan Officer Survey points to continued weak demand for credit from consumers while banks have lightened the standards and terms on many types of loans. Consumers' newfound distaste for debt indicates a greater reliance on current income to finance consumption. With the labor market likely to remain weak for some time and labor income unlikely to recover rapidly, a growing tendency toward a pay-as-you-go approach to spending decisions will provide additional headwinds to consumer spending.

On the corporate side, many businesses have enjoyed improved access to the bond market as indicated by robust issuance in 2009, declines in the cost of credit, and narrowing risk spreads. Bond investors have been more willing to come back to the market as average monthly issuance of corporate bonds more than doubled in 2009 (through October) to $74 billion, compared with issuance in the second half of 2008 of about. $31 billion, according to the Securities Industry and Financial Markets Association. …