Credit 2008: The year of the freeze

Credit 2008: The year of the freeze
The credit market endured a disastrous year in which the pipes of lending practically froze solid. But trillions of dollars of bailouts is sending credit on the road to recovery.
By David Goldman, CNNMoney.com staff writer
December 31, 2008: 9:39 AM ET

NEW YORK (CNNMoney.com) -- If the story of 2008 was the government's unprecedented multi-trillion dollar bailouts of the financial sector, then the credit market was the story behind the story.

The issue of credit moved to the forefront in the past year, as the typically benign market exploded into crisis-mode, and nervous investors bought up historical amounts of safe government debt. It was a year of violent changes in borrowing rates and lending behavior, guided by countless government programs aimed at easing credit for corporate America, banks and consumers.

The so-called credit crunch began after the subprime meltdown of late 2007. High-risk loans on banks' balance sheets became almost worthless, and as banks were forced to take large writedowns on these so-called "toxic assets," they became less likely to lend, unwilling to take on more risk.

For much of the year, financial institutions were in a quandary. They had difficulty acquiring loans and at the same time resisted issuing loans. The credit crunch made everything from financing payrolls to getting car, student and home loans difficult for businesses and borrowers.

Then, after the credit situation started to improve somewhat in the summer, Lehman Brothers' epic collapse on Sept. 15 marked a stunning turning point in the financial markets from which Wall Street is still recovering.

Within two days, overnight Libor, a key interbank lending rate, soared to an 8-month high of 3.06%. Within a week, the market for commercial paper, a key form of business lending, had shrunk to a 2-1/2 year low of $1.7 trillion. And within 10-days, two key measures of risk sentiment - the Libor-OIS spread and the TED spread - were at all-time highs.

However, as the year comes to a close, there are signs that the credit environment has been slowly improving.

Borrowing rates fell from historical highs to all-time lows: the 3-month Libor has dropped from a 2008 high of 4.82% to 1.42% on Dec. 31. And the overnight Libor rate has plunged from an all-time high of 6.88% on Sept. 30 to 0.14% at the end of the year - just 0.03 percentage points higher than the all-time low set a week ago.

Meanwhile, the "TED spread," a measure of banks' willingness to lend, slipped to 1.34 percentage points Wednesday - below where the measure stood just before Lehman's collapse.

But most economists believe it's still a long road to recovery. Though many of the bailouts have reduced borrowing and costs, all the lending facilities and liquidity programs in the world won't encourage private lending on their own. Many have said the Fed can only push on a string.

Alan Greenspan, the former Fed chief, has said that we will know the credit markets have returned to normal when the Libor-OIS spread returns to just a hair above the anticipated Fed funds rate. That will show that banks are confident about the market conditions and have resumed normal lending practices. Libor-OIS was less than 0.8 percentage points before Lehman collapsed. It reached a record high of 3.64 percentage points on Oct. 10, and sits at 1.24 today. So according to Greenspan, we're a little more than halfway to recovery.
Bonds in '08: The anti-stock

Led higher by investor anxiety about practically every other kind of asset, Treasurys had a remarkable year, returning 14.6% to investors, according to a Lehman Brothers index. That's the best return in 13 years.

Government bonds had just about everything going for them in 2008. As the stock market plummeted more than 40% and oil fell nearly 75%, so-called "flight to quality" became the name of the game, and the perceived safety of Treasurys became all the more attractive.

Inflation, which usually drives investors away from bonds, fell by a record amount toward the end of the year. Furthermore, the Federal Reserve began to discuss a potential quantitative easing program in which it would buy up Treasurys in an attempt to lower yields - targeting the mortgage rates that typically follow the yields' path.

Monetary policy and investor fear created what some analysts consider a bubble in the Treasury market. As prices soared, yields - which move in the opposite direction to prices - fell to historic lows.

Even hundreds of billions of dollars of record-priced auctions toward the end of the year aimed at financing the government's bailouts did nothing to scale back demand for bonds.

On the last trading day of the year, bonds barely moved in thin trading as stocks were mixed in lackluster trade.

The benchmark 10-year note fell 1/32 to 114-30/32 and its yield held steady at its record low of 2.07% set Tuesday. The yield started the year at 3.91% and rose as high as 4.27% on June 13.

The 30-year bond fell 1/32 to 139-31/32 and its yield declined to 2.56%, just higher than the record low 2.53% it hit Dec. 18. The long bond yield opened at 4.35% in 2008, rising to a yearly high of 4.79% on June 13.

The 2-year bond was unchanged at 100-9/32 and its yield held at 0.74%. The yield fell to an all-time low of 0.65% on Dec. 16 after hitting a yearly high of 3.05% on June 13 and opening at 2.88%.

Meanwhile, the 3-month yield - widely considered a gauge of investor confidence - edged lower to 0.07%, after falling below zero twice this year. Yields have been hovering at or around 0% for the month of December. They have been trending lower all year after opening at 3.26% and and rising as high on 3.27% on Jan. 7. To top of page