Your basic investment-grade corporate bond has risen threefold, from just over 90 bps to almost 280 bps. Again, that puts a real squeeze on profits.

Merrill Lynch US Industrials Index

That’s the short-term view. Now, let’s drop back and look at what has happened since 1997. Credit spreads are now much higher than even in the worst of the last recession. (Source: Bespoke)

And if you have to go into the high-yield market, which is now once again referred to as the junk bond market, you have really been hit. Your spreads, on average, have risen from 240 bps to over 860 bps in the last year. That means IF (and that is a Big IF) you can find someone to loan you money, you will likely be paying an interest rate close to 13% for your money. (The spread is the green line in the chart below.)

Merrill Lynch US High Yield Index

One last chart. This one is the spread between LIBOR and the Fed funds rate. LIBOR is the London Inter Bank Offer Rate. This is what banks charge each other to lend money among themselves. (This chart courtesy of my friends at GaveKal.) Notice the spikes since 1988: the recession of 1991, the 1998 Long Term Capital Management crisis, and then the lead-up to Y2K. After that, LIBOR went flat.

LIBOR may be the most important rate of all, as so many contracts, including many US and European mortgages, are based on LIBOR. Hedge funds, mortgage banks, large and small corporations, and a host of interest-rate-sensitive investments borrow money based on LIBOR. Few of them anticipated such wild swings.

Bottom line? One of the clues as to the end of the credit crisis will be when credit spreads move back closer to historical norms. And we are not close to that yet.

The Coming Bank Credit Crunch

Banks in the US are going to need to roll over almost $800 billion dollars in medium-term debt in the next 16 months. Banks borrowed heavily in 2006, a lot of it in 2-3 year floating-rate notes, and now they must refinance those notes. Say a bank borrowed at LIBOR plus 50bps. In today’s environment, many banks are not going to be able to borrow at such low rates. Remember the two Ohio banks mentioned earlier? These regional banks will have to pay spreads of 7-9%, based on the price of their debt today. If you have to pay 12% to borrow money when prime is at 5% and you are lending at 6-8%, you clearly cannot make a profit. That means they will have to sell assets or raise very expensive equity capital.

There are a lot of small and regional banks that are in trouble. The FDIC has a list of 117. Out of (I think) 8500 banks that does not sound bad. But remember, Indy Mac, which failed a few months ago, was not on that list. Banks can get into trouble rather quickly if they cannot raise capital, sell assets, or borrow money due to perceived distress.

The problem is that these banks will have less money to lend and will be calling loans from otherwise good customers, which of course makes the economic situation even worse. It is a vicious cycle.

Even many mainstream economists are now suggesting we will be in a recession by the 4^th quarter, if we are not in one now. (The 2^nd quarter revised GDP was 3.3%. This is an anomaly, and is highly unlikely to be repeated.) The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads.

One other thing to watch. When the Fed feels it is no longer necessary to offer “temporary” Term Auction Facilities (loans) to commercial and investment banks, that will be a significant event. Notice that these were to be temporary. These auctions will last well into 2009 and maybe longer.

More Thoughts on Fannie and FreddieFirst, let me correct an error. It was not JP Morgan that Treasury Secretary Hank Paulson asked to come up with a plan to fix Fannie and Freddie. It was Morgan Stanley. Sorry.

Warren Buffett has stated that Freddie and Fannie are toast, as have many establishment analysts. Buffett told CNBC that the firms had no net worth and would need tens of billions of capital to shore up their balance sheets. Since their combined capitalization is less than $6 billion, it is unlikely that there is any way they could get even a sovereign wealth fund to come to their aid in the form of stock.

Congressional oversight committees estimate losses for Fannie and Freddie to be $25 billion, given current housing values. As home values drop, those estimates keep going up. Also, as the economy gets worse, those losses will increase. Independent estimates are double that or more. If only that were the extent of the problem.

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