It seems the Federal Reserve and other global central banks have successfully tempered the credit crisis since mid-March. The Fed’s effective bailout of the now defunct Bear Stearns created a floor under the sub-prime wreckage.

The good news is that a host of high-risk credit indices have posted big rallies over the last eight weeks. That includes a blizzard of new fixed-income issues as companies return en masse to fund their operations.

But don’t get too excited…The debt crisis is far from over.

LIBOR Rates Barely Budge Lower

While several indicators have improved recently, other important sources of funding remain under pressure. This tells me the sub-prime crisis is now spreading from the mortgage-backed securitization market to consumer installment debt.

Also, inter-bank lending rates have yet to fully recover from their pre-July 2007 levels while bank credit is contracting, not expanding – an ominous sign as the United States struggles to escape a slowdown.

Three-month London Inter-Bank Borrowing Rates (LIBOR) has barely budged since the Fed rescued Bear Stearns. The majority of financial institutions continues to hoard cash and refuses to trust overnight lending facilities.

The Main Sub-Prime Fear Factor:
Overnight Lending Rates Barely Move

While it’s safe to assume that some areas of the credit markets have not stabilized, other areas of the credit markets have indeed started to breathe easier. Among those normalizing this spring is the sub-prime market.

Sub-prime is Finally Tamed

According to Fitch, the international credit-rating agency, banks have probably written off approximately 80% of their bad loans through mid-May.

It’s not over for every bank. Some banks, including Switzerland’s Union Bank of Switzerland (UBS) continue to surprise the markets on a weekly basis with a host of spectacular losses tied to real estate, sub-prime, leveraged loans, and auction rate securities.

But for the most part, however, the sub-prime crisis is past its inflection point. What matters now is how and when other credit indicators normalize.

As of yesterday, the sub-prime crisis has resulted in approximately US$200 billion worth of write-downs for global banks. The lion’s share of those losses came from UBS and others in the United States and the United Kingdom.

For the most part, Asia and Latin America have escaped the crisis. Their banks remain highly liquid compared to their peers in North America and parts of Western Europe.

The securitization model (aka rolling sub-prime mortgages into securities and selling them) is still alive and kicking overseas, but it was NOT a primary investment source for Asian and Latin banks. Therefore these savvy banks avoided most toxic sub-prime products like collateralized debt obligations or CDOs.

Credit Spreads Narrow

As I continue to track the normalization of credit markets, I’m encouraged by the narrowing credit spreads across several markets – a bullish development.

One key indicator I follow – the spread between three-month Treasury bills and the three-month LIBOR – has narrowed considerably since March to 0.85% from 1.83% back in early April.

That tells me that the “safe haven” trade on short-term Treasury bills since the sub-prime crisis first erupted last summer is reversing. It also means that risk is gradually returning to the credit markets. Prior to mid-April, three-month T-bills plunged way below the Federal Funds rate to a low of 0.81% – severely overbought as investors scrambled for safety.

Another bullish indicator now flashing green is the yield spread between 30-year municipal bonds and 30-year Treasury bonds.

Prior to mid-March, the yield differential between 30-year municipal bonds and long-term T-bonds ballooned to their highest in history as investors fled municipal debt. The average yield on high quality municipal bonds has plummeted 70 basis points (0.70%) after reaching a peak on February 29.

Earlier last winter, as yields soared, savvy investors like Bill Gross of PIMCO and venture capital investor, Wilbur Ross, scooped-up those fat yields. In hindsight, that was a great speculation as yields have plunged versus T-bonds.

Also, some mortgage and financial companies, including non-financial issuers, are successfully raising capital again since April. Though financing remains much more expensive compared to 12 months ago, it’s nevertheless a positive development for global capital markets.

Beware of High-Risk Debt Markets

High-yield bond indexes and preferred securities have also rallied since late March.

Preferred securities, which provide stock and income-like features, have also rallied. But financial service companies that most issue these preferred securities and write-downs are far from done. I would avoid preferred securities and those juicy, but dangerous yields.

The same is true for high-yield bonds and other busted credits, including sub-prime securities as the economy continues to slow.

High-yield or junk bond defaults remain historically low at just below 2% of all outstanding issues. Previous recessions have seen defaults surge almost three times this level.

In my view, the recent rally is nothing more than a dead-cat bounce. More junk bonds will default over the next 6-12 months.

The Next Credit Crisis: Consumer Installment Debt

I’m still highly dubious that credit markets have bottomed. Sub-prime is now largely history. But other segments of the credit spectrum that have a far more profound impact on the American consumer are just beginning to unravel.

The consumer is now threatened by a liquidity crisis. Housing values continue to heavily contract and revolving credit installment debt is becoming harder to secure.

The culprit is less the write-downs themselves and more the virtual “shutdown” in the securitization market. At its height, the securitization market provided 66% of household borrowings in the first quarter of 2007. Without this market, consumer credit losses may be far worse than currently estimated.

Auto loans, personal loans, mortgage loans, and other segments of installment debt are still contracting. Auto loans are especially vulnerable with defaults recently hitting a 10-year high of 3.4% in March. And more Americans are dropping their house keys to their local lenders as housing values continue to plunge below the cost of their mortgages.

Consumer deflation has arrived at the absolute worst time as savings rates are barely positive. Soaring energy and food prices, declining home values, surging auto delinquency loans and gradually rising unemployment depict a growing liquidity crisis now underway for the consumer. Also, most, if not all, installment debt is structured to finance domestic consumption. It’s not a pretty picture.

Stay defensive and avoid most debt markets, except high quality short-term Treasuries and investment-grade bonds. The consumer credit bear-market is underway.

ERIC ROSEMAN, Investment Director

EDITOR’S NOTE: As of today, our Sovereign Society research team is working on a special report to give you the information you need to protect yourself from this second coming of sub-prime – when it hits the real economy – including your personal credit report. Please look for this special report coming to your email inbox this weekendSource: Is Sub-Prime Finally Over? Yes and No

Source: Is Sub-Prime Finally Over? Yes and No