Academic journal article ABA Banking Journal

Credit Shocks: Three Questions

Academic journal article ABA Banking Journal

Credit Shocks: Three Questions

Article excerpt

1. Is the worst over?

Yes. The evidence suggests that the worst of the credit crunch has passed. In the top graph, we note that the peak in the credit default swap (CDS) spread for banks appeared in March. Federal Reserve actions to lower the federal funds rate and provide additional liquidity appear to be working. In markets, pricing is driven by new information, particularly, if that information runs contrary to the perceived wisdom.

Effectively, the pattern of credit default spreads suggests that the market was caught off guard with the extent of the risk. Recently, such risk assessments have moderated so the worst may be over but the market is still searching for a new equilibrium.

2. Is there a disconnect?

Yes. Credit spreads appear to have widened far outside the range of current corporate default experience, for example, as shown in the middle graph. On the opposite pole of experience, high-grade corporate spreads also did not reflect the credit crunch recession of 1990-1992 when corporate defaults rose dramatically. In that period, leveraged buyouts drove leveraged loans and high yield but did not impact investment-grade issuers.

In today's environment, by contrast, credit derivatives added significant leverage to the investment grade universe through synthetic collateralized debt obligations (CDOs). …

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