Ending the Credit Crunch: Four Benchmarks to Watch

BusinessWeek -Friday September 26, 8:08

From a report released Sept. 22 by Standard & Poor's Market, Credit and Risk Strategies

The credit crunch has been with us for more than a year. The Federal Open Market Committee (FOMC) started cutting rates on Sept. 18, 2007, and fiscal stimulus provided a boost to second- and third-quarter gross domestic product, yet there are few signs that the combined efforts of the U.S. Fed and Treasury are making headway at putting the credit crunch to rest.


Financial market participants are still waiting for clear signs that monetary and fiscal policy stimuli have established an environment where the U.S. economy can grow its way out of its housing and credit problems. Furthermore, there are scant signs that the stimuli now in place will enable the economy to avoid a recession that would further complicate the dynamics of credit crunch and contagion.

What handful of key economic and market variables can be tracked over the next 6 to 12 months to best help us gauge whether or not U.S. policymakers are winning the war against the credit crunch?

S&P's recovery checklist

Standard & Poor's Market, Credit and Risk Strategies (MCRS) has created a short checklist of economic and market variables and identified the general developments to track. We will continue to monitor and report on these crucial metrics in the months to come:

1. Real estate values -- must stabilize or edge higher

2. The rate of existing and new home sales -- must rebound

3. Credit conditions -- must ease up substantially

4. Crude oil prices -- must continue to decline, and then stabilize

How are things tracking now?

1. Real estate values: encouraging

2. The rate of existing and new home sales: less encouraging

3. Credit conditions: discouraging

4. Crude oil prices: encouraging

Let's take a closer look at the checklist items:

1. Real estate values

First and foremost, real estate values must at least stabilize and preferably, edge higher. This will relieve anxieties surrounding residential mortgage-backed securities that -- rightly or wrongly -- are widely perceived to be a large collateral stake for the entire U.S. financial system. On this front, there is very good news: The average sales price of an existing single-family home has tentatively bottomed since February. Prices of existing single-family homes are currently holding at levels comparable to prices last seen in fourth-quarter 2007&mdashand before that, first-quarter 2005. The average selling price of a single-family home rebounded to $256,800 in June 2008, according to monthly data from the National Association of Realtors (NAR). That is the highest price recorded since August 2007, just after the start of the credit crunch. Continuation of this trend is vital to the stability and recovery of the credit markets.

2. The rate of existing- and new-home sales

The rate of existing- and new-home sales must rebound to a level that gradually clears away the massive inventory of homes offered for sale in the U.S. The sales-volume trend for existing homes -- seasonally adjusted annual rates (SAAR) -- has been depressed to the 5 million-unit level since October 2007 because of the credit crunch. This is less than encouraging, considering that the current inventory of 3.9 million single-family homes offered for sale is more than double the 1.9 million average level of inventories seen between 1993 and 2004, according to NAR data. A modest rebound in sales, even to as few as 5.5 million units SAAR, would be encouraging.

Since we also want to see home prices remain stable, or preferably edge higher from current levels, upticks in housing affordability will have to come on the mortgage interest rate front. After rising from a low of 5.8% in early May to as high as 6.6% in mid-July, conventional 30-year fixed-mortgage interest rates have been inching lower in recent weeks as fears of FOMC tightening subside. Conventional 30-year fixed interest rates in a range of 6% to 6.25% should support transaction volume and accelerate reductions in the housing overhang.

3. Credit conditions

Credit conditions need to ease up substantially before the liquidity-starved U.S. economy can resume trend-like gross domestic product growth. Considering the drastic repricing of credit risk that has occurred in the last year, it is a wonder that the broad economy has not followed the homebuilding industry into deep recession. The normalization of credit-risk spreads would help prop up the U.S. housing finance market specifically, and the U.S. economy generally. We are looking for signs that global credit markets are reacting to early signs of stability in U.S. housing by compressing risk spreads.

-- Three-month London interbank offered rate (LIBOR) spread over Fed Funds

At minimum, we want to see 3-month LIBOR fall below a spread of 50 basis points (bps) on overnight federal funds versus the current spread of 80+ bps, as shown in chart 3. In a credit-contagion-free world, the fed fund-LIBOR spread would normally fall within a range of 12 bps to 25 bps, but we will take anything below 50 bps as a sign of improving credit conditions.

-- Five-year USD swap spread

We also want to see 5-year USD interest rate swap spreads return to a range of 60 bps to 70 bps, versus the 95 bps spread seen today. The 60-bps-to-70-bps range represents the middle ground between the credit risk apathy range of 30 bps to 55 bps seen between 2003 and mid-year 2007, and the post-credit crunch range of 70 bps to 100 bps witnessed since July 2007.

4. Crude Oil Prices

To round out our credit crunch checklist, it would be very helpful if the price of crude oil were to keep declining and then stabilize in the neighborhood of $100 per barrel. This would help prop up the value of the U.S. dollar in the global currency market, ease commodity-driven inflation concerns within the Federal Reserve, and help underpin the consumer-driven U.S. economy, all of which would help ease credit crunch anxieties in global financial markets.

A premature housing-bottom signal?

The unprecedented decline in recent times of U.S. real estate valuations has dealt a severe blow to the balance sheets of leveraged global financial institutions. This occurred as market mechanisms quickly repriced longstanding assumptions about credit risk spreads, market volatility, and the overall credit quality of asset-backed securities in general. Not only has this prompted a great deal of risk aversion in how financial intermediaries conduct business with their client firms, but it also has precipitated a great deal of suspicion among investment-grade financial institutions in terms of counterparty risk, as reflected in the exceptionally wide fed fund-LIBOR spreads. None of this has been good news for the near-term growth prospects of the U.S. economy.

While the past year's escalating rate of residential mortgage delinquencies and defaults has been priced into the credit markets for many months, along with declining home prices, early signs of housing stability are not yet alleviating stress in the credit markets, thereby narrowing spreads. The credit markets sooner or later will have to take notice if the average selling price of an existing single-family home remains stable, or better yet, continues to rise. When this occurs, we may quickly find ourselves checking off the other items on our credit crunch checklist. If, however, it turns out that the average selling price of an existing single-family home is only prematurely signaling a bottom for housing, keep your powder dry and put this checklist in the file cabinet for the balance of 2008.

This report was prepared by Standard & Poor's Market, Credit and Risk Strategies group, which is analytically and editorially independent from any other analytical group at Standard & Poor's, including Standard & Poor's Ratings Services.