Let me ask you a question though.... if you were a lender, would you ever do something because the government did it first? I didn't think so. I wouldn't either. 

I still can't for the life of me figure out why these guys in Washington, Paulson, and Bernanke don't quite get it. It's not that lenders can't - it's that lenders won't. It's just not a risk-adjusted venture right now. If the government is willing to take on the risk, that's their problem. Besides, offering is one thing. Getting taken up on the offer is another. And, with Tuesday's 5% selloff across the board, investors seem to feel the same way. 

The symptom and the hint of lending health - though not the solution - is the TED spread.
 

	The What Spread?

I don't know if I've ever talked about the TED spread before. I haven't needed to in years, so I doubt that I have. Right now though, it's the heart of the problem. 

The TED spread is just the difference in rates between inter-bank loans and short-term government debt (T-bills). Or, to be more direct, the TED spread is the difference in interest rates for 3-month T-Bills and the 3-month LIBOR rate. The LIBOR rate (London Interbank Offered Rate) is what banks charge each other for short-term loans. 

More important to us, the TED spread measures the lending market's overall perceived credit risk....the difference between risk-free rates and still-relatively-low-risk inter-bank lending rates. Like any lender, when one bank is unsure about lending to another bank they charge a slightly higher rate, causing the LIBOR rate to go up. 

Usually - in a normal credit environment - the TED spread is minimal, as banks don't see much more risk in lending to other banks than they do in holding government debt. The TED spread will vary from 10 basis points to 40 basis points in a healthy environment where bank lending risk is perceived to be low. 

When it's risky to lend to other banks (like now), the TED spread can move much higher. Over the last month, the TED spread has been holding its ground between 300 and 400 basis points. In fact, the TED spread as of Tuesday afternoon was 340 basis points. The 3-month LIBOR rate is 4.27%, while the 3-month (13 week) T-bill is yielding 0.87%. And no, that wasn't a misprint - the rate for 13-week government paper is 0.87%. 

But wait a second... wouldn't a weak return on T-bills and a strong return on inter-bank lending inspire the more profitable inter-bank lending? It should, intuitively. That's the point though - it's not! It's great for lenders, but terrible for borrowers... and the lenders aren't budging (not that I blame them). That's why the credit market is frozen. 

That's also why I said above that the TED spread is a symptom, and not a cure. The TED numbers are wildly attractive to banks that lend, so the government is happy on that front. Yet, it doesn't help a bit. Why?The risk (perceived or real) is still there, and banks don't want to take any chances unless they get paid nicely (relatively). That's why the LIBOR rate is still so high... too high for most borrowers. 

That's my primary beef with the economic prod of buying short-term paper. The Fed and the Treasury can do whatever they want - it won't matter. They don't control interest rates that are ultimately determined by supply and demand (LIBOR). 
 

	Problem, or Symptom?

As counter-intuitive as it might sound, the TED spread will have to shrink before banks feel confident enough to lend to each other again. They could make considerably better money by lending when the TED spread was high (and the borrowing/lending margins are wide), without really taking on any more actual risk. Despite the beneficial math of the wide spread though, their unwillingness to get involved on either side of the table is what's gumming up lending. 

The irony? There won't have to actually be any less risk in inter-bank lending if the TED spread contracts; banks will just feel like there is.

To be clear, the stock market can and may well recover before the TED spread shrinks. While banks are hesitant to lend money to each other, they can borrow plenty from the central bank ...if they really need to. I don't know to what extent the option is being utilized, though I suspect minimally. However, it could be what's keeping the credit market on life support while everything else is getting worked out. 

Or, the stock market is fully capable of breaking down even if the TED spread shrinks and despite the government's willingness to lend. 

Either way, eventually banks will have to get off of life support. In the meantime though, well, there's still some volatility we may need to work through as the spreads get worked out. That could be good or bad, but definitely trade-worthy. 

The big clue to healthier times, however, I think will be a smaller TED spread. Until the credit market is unfrozen by a narrow(er) spread, the underlying technical problem will still persist. That's now why I'm on a TED spread vigil. I'll be posting semi-regular updates in the blog. 
 

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