The crisis is the bond market, not the economy. Yes, the economy is slowing – retail sales are way down and unemployment is rising. But what happened to the so called credit crisis? Banks continue to lend and the derivative markets continue to operate.
According to the most recent reports from the Federal Reserve, bank credit is 9 percent higher than the same time last year. Commercial loans are 15 percent higher and even real estate lending is up 7 percent.
Banks are clearly tightening their credit standards, but that doesn’t mean they are not lending. They have plenty of money to lend. The monetary base, which includes total reserves and banks and all the currency, has grown nearly 50 percent as the Federal Reserve lowered interest rates and increased their lending to the financial markets.
The standard measure of the money supply, M2, is up over 7 percent.
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What banks are not doing is selling off loans to the bond market. The bond market continues to see little new issuance of securities.
Meanwhile, the bond derivative market shows ample activity. Interest rates swaps and credit default swaps (CDS) are contracts used to hedge and speculate on interest rate changes and the risk a borrower defaults on their bonds, respectively. An interest rate swap can switch a borrower’s obligation from fixed interest rates to variable interest rates without refinancing the entire bond.
A CDS contract requires the buyer to pay premiums to the seller, who agrees to pay back the principal if the issuer of the bonds doesn't. Both of these credit derivative markets have grown rapidly in the past 10 years and continue to operate well today. So where’s the crisis? The U.S. lacks a well-functioning corporate bond market today. Bank lending is up because corporations do not have a strong secondary market for their debt.
Investors continue to poor cash into short-term U.S. Treasury debt. The difference between the rate on short-term and long-term Treasuries is at historical highs. Investors are seeking safety.
Meanwhile, the difference between investment-grade bonds and high-yield bonds is at ‘ridiculous’ levels. According to a report from Forbes last week, current prices on many corporate bonds suggest 18.5 percent of all bonds will default this next year – much higher than the 13 percent default rate seen in the last bond crisis of 1991.
Bond mutual fund investors are also fleeing for safety. Net flows to taxable bond funds were negative $39 billion from mid-September through the end of October, but flows to government bonds are at record highs.
To get things back on track we need a more transparent corporate bond market.
Unlike the stock market, bonds are bought and sold in primarily in an institutional market. Trading in corporate bonds is almost entirely an over-the-counter market. Trading occurs on closed, proprietary bond-trading systems, or via phone, between major commercial and investment banks.
Individual investors who wish to participate in this market must depend on their brokers and what they can find. The pricing of bonds on this secondary market is opaque and difficult to track.
In 2006, the New York Stock Exchange instituted new rules for exchange-traded bonds. Bond trading on the exchange remains very small compared to over-the-counter bank trading, but the NYSE’s automated system, which includes many of the same stock-exchange-listed companies, will go a long way to improving this market.
When U.S. corporations push for more central and transparent trading of their debt, the country will move past this credit crisis.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.