SHORT VIEW: FINANCIAL STRESS

By John Authers
Sunday marked the second anniversary of the day “the world changed”. Adam Applegarth, then chief executive of the stricken UK bank Northern Rock, said the world changed on August 9, when BNP Paribas froze access to a large money market fund and the European Central Bank responded by flooding the market with cash.
“Nobody could claim they saw it coming,” Mr Applegarth said. Was he right? Have we yet returned to a world that is safer for banks that rely on money markets for funding?
Using one measure of financial stress, the gap between Libor inter-bank lending rates and the target Fed Funds rate set by the Federal Reserve, then August 9 does indeed look like the day the world changed. Having been unchanged for months at 11 basis points, this spread doubled on that day to 25bps before hitting 332bps after the collapse of Lehman Brothers. It now stands at 21bps.
Other measures would have given an early warning. Indices of subprime loans based on credit default swaps had already hit the floor. By July 2007, Markit's ABX index showed that subprime mortgages were worth less than 40 cents on the dollar, having signalled virtually no risk of default in January.
The CBOE Vix index, which measures the cost of insuring against volatility in the S&P 500, had risen from below 10 in January, to 26.4 by August 9. It is at 25.4 now.
The spread of investment grade bonds over Treasuries, as measured by Moody's, tracked the Vix and rose from 1.6 to 1.8 percentage points in the weeks before August 9. This spread remains at 2.88 percentage points today.
So the market believes the banking system is almost out of the woods. For early warning of more trouble ahead, we should look at the Vix and at high-grade credit spreads.
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