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October 09, 2008

How high is financial risk today?

On a day as brutal as today, it is hard to find any port to hide from the storm. Maybe that is exactly the time for some perspective. At Businomics Blog, Bill Conerly does his best (hat tip, Mark Thoma), making a point that I have heard repeated more than a few times: Taken from the long view, many measures of risk that we take as symptomatic of extreme market stress are not entirely without historical precedent. Dr. Conerly uses this graph of the “TED spread”—the 3-month Libor rate minus the yield on 3-month Treasury bills—to drive the point home:

TED Spread

Here are a couple more graphs on the same theme: The spread between 3-month LIBOR rates and the effective funds rate (which I emphasized in an earlier post)…

3-Month Libor less Effective Funds Rate

… and the spread between yields on commercial paper and secondary-market 3-month Treasury bills.

Commercial Paper less 3-Month Treasury Yields

Comforting? Maybe not. As Conerly notes, your perceptions of the ugliness of the past month or so depends very much on what you believe to be the appropriate reference point. In the context of the period spanning the 60s and 70s the measures of risk and market stress depicted in these charts are not so impressive. However, if you believe that the world fundamentally changed in the 1980s—at the outset of the so-called “Great Moderation”—things are very dysfunctional at the moment.

For my part, I can’t help but recall the following exchange from the movie “No Country for Old Men” after two characters come across a gruesome murder scene.

Deputy Wendell: “It’s a mess, ain’t it sherriff.”

Sherriff Ed Tom Bell: “If it ain’t, it’ll do until the mess gets here.”

In other words, no matter what you compare it with the current environment is plenty challenging.

By David Altig, senior vice president and research director, Federal Reserve Bank of Atlanta

October 9, 2008 in Capital Markets, Financial System | Permalink

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Comments

Dave,

Thank you for the historical perspective. However, the graphs do not appear (?) to be updated with the latest (and more disconcerting) data -

TED Spread is currently at 4.23,

LIBOR of 5.09 less effective funds rate of ~1 to 1.5 (actually less recently) is around 4 - this would be quite literally off the chart in your graph.

(The figures are from Bloomberg)...

Posted by: Murph | October 09, 2008 at 10:27 PM

Is it possible that the TED spread chart that you published is out of date? Bloomberg is currently showing the TED spread as being in excess of 4

http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND

Posted by: SalvatoreM | October 10, 2008 at 06:00 AM

The graphs do not, in fact, reflect the circumstances of the last, very dramatic, few weeks. The TED spread is just the graph from Businomics Blog, but the other ones reflect monthly averages. Hence the last observations are from September, and somewhat smoothed at that.

In case it wasn't clear, I am not much convinced by the claim that things are not that unusual just because we can find comparable spreads in many series if we go back to the 60s or 70s (which I believe was Dr. Conerly's point as well). That the latest daily spreads would look worse than what is in the charts only serves to strengthen that conviction, and makes it all the more difficult to maintain the contrary position -- if there is really anyone left who is inclined to do so.

Posted by: Dave Altig | October 10, 2008 at 08:32 AM

Been trading this crap. Unbelievable. Another measure of risk is volatility. The VIX hit a record high today. A guy that trades Eurodollar Options told me that vol was running 102% in the at the money straddle for the most liquid contract!

In 1987, I recall the TED spread springing out to unprecedented levels. It snapped back quickly. The disconnect in the TED has persisted for around a year. It floated in a little, but since last August, the spread has ben bid-and has been volatile.

This market reminds me more of a cancer-1987 was a heart attack.

The way out is to eliminate the counter party risk between banks by using a clearing house to get in between their trades. Then they don't have to worry about balance sheets-they just have to put up risk capital with the clearing house to hold the position.

Posted by: Jeff | October 10, 2008 at 04:19 PM

Fairly dramatic. However, it's worth recalling that the rate of inflation was considerably higher in the mid-to-late 1970s than it is today. So it might be interesting to adjust for that and look at the "real" TED spread.

Posted by: Donald A. Coffin | October 12, 2008 at 07:54 PM

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