Credit markets head into uncertain 2009

The credit markets, long a shadowy and little understood part of the financial system for many investors, turned into headline makers during 2008, simply because they stopped working.

And, at the start of the new year, they're still far from a level that anyone would call healthy — banks aren't lending freely despite the government's $700 billion rescue package. Yields on short-term Treasurys are still close to zero, indicating how fearful investors still are.

"I'm still waiting for the credit markets to open up," said Scott Fullman, director of derivatives investment strategy for WJB Capital Group in New York. "There's been some improvement, but not that kind everyone has been waiting for. The credit situation will still be the big story in 2009."

The paralysis that swept over the credit markets after the mortgage crisis felled Lehman Brothers Holdings in September was a major contributor to a two-month plunge on Wall Street and has also helped exacerbate the recession that started in December 2007. When Lehman went into bankruptcy, other financial institutions stopped lending to each other, and the normal flow of business in the U.S. and ultimately in other countries was disrupted.

Lending rates in what's known as the interbank market soared during the fall as banks, fearing there could be another downfall like Lehman's, demanded more money from prospective borrowers — those that they would agree to lend to. Companies couldn't secure the short-term loans known as commercial paper, and consumers had a hard time borrowing for homes, cars and college tuition. Municipal governments were forced to pay sharply higher interest in order to sell or roll over their bonds.

The stagnancy in the credit markets forced the Federal Reserve and other central banks to make a series of moves including interest rate cuts — the Fed's benchmark federal funds rate is now near zero percent — and cash infusions into the global banking system.

The Fed is also taking steps including buying some kinds of commercial paper. And the Treasury Department's rescue plan, which started with investments in banks, has also included purchases of some of the failed mortgage assets that started the credit spiral.

Among the positive signs in the markets: The Libor, or London Interbank Offered Rate, which reflects how comfortable banks are to lend to each other is down sharply. The cost of interbank lending soared to historic highs in 2008, with the overnight rate peaking at 6.88% and the 3-month Libor at 4.82%. On the last day of the year, the 3-month hit 1.42% and the overnight reached 0.14%.

And what's known as the "Ted spread" — another measure of banks' willingness to lend — has also retreated from its highest level in more than 25 years. The indicator, which is the difference between 3-month Libor and the yield on the 3-month Treasury bill, hit 3.5% this year and on Wednesday slipped to 1.34%.

But there are still negatives. Even as the stock market shows more tentative signs of recovery, investors remain anxious and continue to gravitate toward short-term Treasurys as a hedge against losses, even the three month T-bills that offer little or no return. Investors' feeling is that a meager return is better than losing principal.

The three-month Treasury bill's yield rose to 0.08% from 0.06% on Tuesday. That compares with 3.25% at the end of 2007.

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