Is the Credit Crisis Winding Down?

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S. Ananth
Head, Research, Krisani Knowledge Resources, Hyderabad.
12th December 2008.
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 Is the Credit Crisis Winding Down?
Is the credit crisis winding down? That surely is a multi-trillion dollar question for which there is no reliable answer. While a lot
of questions do remain this brief note is hope to provide a faint ray of hope for an another extremely bleak year (global
economy wise). It would be too early to claim that the storm has passed but the following note with diagrammatic representations
would provide evidence that may indicate that things may be returning to normal gradually. The note will not have definitive
answers and should instead be seen as a classic conundrum that the world economy faces at its terminal point: Is the glass half
full or half empty? If the glass is half full then our prognosis of a stabilisation and recovery by October 2009 would be right. If
the proposition that the glass is half empty holds true then it would be déjà vu all over again.

A sceptic would like to point out that the bears may only be halting for breadth. Possible. An optimist would like to claim that
coordinated regulator action may finally be holding sway. Given below is a combination of indicators that had worked well to
predict the intensity and even a collapse in the credit markets over the past one year. So an overview of these indicators (and
their charts) may provide some early warning indicators for the global economy. But it is imperative to note that the charts and
the readings are based on past price action and they are only indicative in nature.

There are important questions that come to our mind when we are looking for the till date elusive recovery. Each question
clearly indicates that it is too early to celebrate. But, they also indicate that there may not be too much of a reason to remain
overly despondent. In January 2008 people were sure that India would decouple from the problems in the USA. Now they are
sure that the crisis will continue for another two years at least. Conventional wisdom has it that the crowd is always wrong.
The major questions that one has to ponder over in the first month of 2009 are:

• Is the worst over?

• What is going to be in 2009: Deflation or Inflation?

• Bloomberg has reported that nearly 85 percent of the speculative grade bonds (defined as company bonds at least
10% above the US Treasury bonds) are in distress1. Would it be possible for so many companies to default? Possible
but rare.

• More importantly the Baltic Dry Index has collapsed by more than 95%. Would that be indicative of a future collapse in
the quantum of world trade? Theoretically possible. But that has not happened except during the World War’s and
probably not even during the Great Depression.

• Should we be fearful when others are greedy and greedy when others are fearful?

• Are the major global financial institutions safe?

• When will the cash that is on the sidelines going to come back and what is the reaction of the markets likely to be when
this cash comes stampeding its way back? Bloomberg has reported that cash positions of the funds is at a 18 year high
and is nearly equivalent of 74 percent of the market value of companies1. Benjamin Graham had recommended one
time when investors should buy (when he talked about the 1930s) was when the cash (hard cash and equivalent at that
time there were no derivatives) that company possessed was more than the market value. This would mean that the
company could be liquidated and still be profitable for investors.

• Are we sure that there are no Madoffs and Enrons lurking in the corner to ambush us?

• In the case of the markets will it be a very sharp bear market rally or a market reversal in 2009?

• What is the likely shape of the new global regulatory regime that may be put in place of the decadent system of the
present that caught the regulators sleeping at the wheel?

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 Is the Credit Crisis Winding Down?
The following chart provides an overview of Bloomberg Index of Banks Lending to Each Other. Readings close to Zero indicates
banks willingness to lend to each other while a high indicator means that they are not willing to trust each other. The index is
showing signs of a return to the pre-Lehman levels for the first time since the event.

US-TED Spread

TED spread is considered an important indicator as it provides an overview of cost at which banks borrow from the market. It
is the difference between the US Fed rate and rate at which the major banks borrow. At this particular point of time, one should
not read too much into this indicator as the Fed Funds rate is near Zero. But the fact that the spreads are decreasing is a good
sign.

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 Is the Credit Crisis Winding Down?

Baltic Dry Index

VIX (Popularly known as the Fear Indicator

This (VIX) had emerged as an important indicator over the past few months. A higher reading indicates great fear among the
investment community, while a lower reading complacency of the investment community. While this should not be construed as
a reliable indicator of the economy, it would be important to consider it if we agree with the view that the markets are good at
forecasting the future. However, with due respect to the ability of the markets, it is pertinent to note that the stock markets have
been consistently wrong since the start of the credit crisis.

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 Is the Credit Crisis Winding Down?

30 Year US Treasury Bonds

The yield now stands at nearly 2.63 percent.

A crude extrapolation of inflation and bond yields would suggest that people are so bearish that they are willing to lend money
to the US government at a negative real rate of return. This is based on the assumption that inflation would be less than 2
percent over the next thirty years or investors are expecting a depression/recession to last a that long. Leaving out the
academic nuances is that possible. It has never happened in history. More importantly lending money to the biggest debtor
nation is more risky than lending it at such a low rate. Agreed, they are only country that can print their way out (printing US
dollars) a crisis. But that would be possible only if the present status quo continues. Betting on a status for that long seems to
be awfully brave for an investor. A more profitable (and less risky strategy) would be buy Citigroup (at US$3) as the US
government anyway owns a big part of it and more importantly it is going to rescue the bank again, if need be. Why not take
advantage of the system that has socialised risk and privatised profit-at least as long as the party lasts? A prolonged severe
recession or depression would probably lead to consequences that would be devastating for the largest economy in the world
and if the US economy collapses, then invariably it would lead to problems for the debt holders.

Other indicators are not so positive. The inventories of Copper and Aluminium continue to increase by the day and unless they
show a decisive down move, healthy scepticism may be more prudent.

There is light at the end of the tunnel for the US economy. This comes largely from the possible positive effects of the Obama
stimulus (though it is too early to speculate on its consequences) and more importantly, the fact that US will again think in terms
of savings rather than spending (and living beyond their means).

Post Script:

Technically the Bloomberg Index of Banks and Financial services companies (Chart Given Below) is showing signs of positive
divergence on the charts. This is undoubtedly a good indicator, but it that enough to suggest a bottom? Only time will solve that
riddle.

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Is the Credit Crisis Winding Down?

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