Friday, August 12, 2011

ThisTime it Actually is Different

By Larry Swedroe

The massive market swings we’ve experienced this week have brought back fears of a swoon like the one we experienced in 2008. Thus, I thought it important to look at why this crisis is very different from that one.

The 2008 bear market was caused by a financial crisis that led to the financial markets “seizing up” and eventually to a severe recession. Today’s crisis isn’t even an economic crisis, let alone a financially driven one. U.S. banks are in much stronger shape today, having been forced to raise huge amounts of capital as part of the government’s “bail out” program.

A good indicator of how different things are is the TED spread, or the difference between the rate of Federal debt and the rate that banks charge to lend to each other (called the London Interbank Rate or LIBOR). LIBOR is currently around just 0.2 percent, and one-month bills yielding just 0.02 percent, meaning the spread between them is currently less than 0.2 percent At the height of the 2008 crisis, the difference between the two was nearly 4.5 percent. Such a wide spread indicated significant stress in the financial system. The capital markets had seized up, banks had to turn to the Federal Reserve to get funding, and the commercial paper market had virtually shut down. The situation was so desperate that the government had to provide guarantees on money market funds.

We don’t see any such signs of liquidity problems today, even after the downgrade. The interbank market, the commercial paper market and the repo market (which all function as ways for banks and other corporations to get the capital they need to conduct operations) are all functioning well. Each of those functioning well serves as an indicator that we’re not experiencing a financial crisis, which should be reassuring as we saw in 2008 what can happen during financial crises.

Today the financial system is much stronger as banks and investment banks alike were forced to raise large amounts of capital, the large investment banks converted to banks, and there is much less leverage in the financial system and among hedge funds as well. The reduction in leverage reduces systemic risks.

The difference in conditions helps to highlight that the problem we have today is not an economic one, but a political one. The market just needs to be convinced that our elected officials will take the necessary steps to prevent the crisis from becoming an economic one. It’s the uncertainty about the political will to act that has caused the equity market to crash, not an economic crisis.

However, just because this crisis is of a political nature, that doesn’t mean it’s any less dangerous. There’s no guarantee that all will end well. With that in mind, let’s look at some good news which you should keep in mind.

The Japanese economy has rapidly recovered, eliminating the headwinds that slowed economic growth around the world in the first two quarters.

Oil prices are down around 25 percent since hitting an intraday high of $114.83 on May 2.

Municipal Bonds
The municipal bond debacle infamously forecasted by Meredith Whitney hasn’t occurred.

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