The TED Spread and 2008 Financial Crisis

The TED spread is a measurement used to articulate the strain on financial markets. At first, the TED spread was the difference between interest rates of threemonth U.S. Treasuries contracts and three-month Eurodollar contracts. The London Interbank Offered Rate (LIBOR) stood for Eurodollar contracts. A switch was derived from the decision of the Chicago Mercantile Exchange to drop T-bill futures contracts, which are contractual agreements to buy or sell goods or services at a preset price in the future. The Chicago Mercantile Exchange eliminated T-bill contracts because of such a small demand for them. The TED spread is currently calculated as the difference

between interest rates on interbank loans (three-month LIBOR) and short-term U.S. government debt, otherwise known as three-month T-bills. The name TED is taken from an acronym formed from T-bill and ED, which is the symbol for a Eurodollar futures contract. Basis points (bps) are the common meter to gauge the size of the spread. A basis point is a unit that is equal to 1/100th of a percentage point and is commonly utilized to express percentage point changes of less than 1%. The Ted spread is known to fluctuate over time. However, a rising TED spread is often a prime indicator that foreshadows a decline in the U.S. stock market. The spread is also a measure of liquidity.

Consequently, it displays the willingness of banks to lend money to other banks. So, a rising spread also points to withdrawn liquidity. Moreover, the TED spread acts as an indicator of credit risk. This occurs because although T-bills are considered to be risk-free, LIBOR maintains the credit risk of

lending to commercial banks. Therefore, an increase of the TED spread may signal lenders that the risk of default on interbank loans is increasing. Investors will be more inclined to place their money is safe investments. As a result, these interbank lenders demand an increased interest rate. The relationship between the TED spread and the risk of bank defaults holds a positive correlation. In the fall of 2008, the TED spread drastically increased. Though the spread before 2008 fluctuated, it remained between 10 and 50 bps, which is equivalent to 0.1% and 0.5%. As part of the 2008 Financial Crisis, several banks declared bankruptcy

leading to an increased TED spread. Bank failures led to a lack of confidence causing banks to be less willing to lend money amongst themselves. As a result of this reluctance to lend, credit markets froze making it difficult to use debt as a means to finance purchases. On September 17, 2008 the spread reached 330 bps. A little less than a month later on October 10, 2008, the TED spread climbed to 460 bps. As market stress increased, banks began to charge one another larger interest rate premiums, which was more than that charged to the U.S. government. As a result, investors had an increased demand for safe short-term government securities. A lack of investor confidence

deterred investors from placing their money in more volatile markets. Liquidity further declined as the possibility of bank failures led to the selling of their stocks. This shift in demand was prompted by a loss of confidence in high yielding assets. Consequently, an increased demand for short-term securities was created. A movement towards a more safe short-term security increased bond prices. An increased demand for short-term securities also lowered yields. Bond price and yields move inversely from one another.

To remedy the situation, on October 1, 2008, an Emergency Economic Stabilization Act was created. This bill gave the Treasury Secretary the ability and funds to buy failing financial assets as an attempt to unfreeze credit markets.

Bibliography

"2008 Financial Crisis." Wikinvest. 21 Feb. 2009. http://www.wikinvest.com/wiki/2008_ Financial_Crisis#Federal_Government_Bailout Basic Points: The Ghosts of Octobers Past. BMO Financial Group. 21 Feb. 2009. http://www.minesite.com/fileadmin/content/pdfs/BMO_NB_BP_Oct_2007.pdf TED Spread. Cobb. 22 Feb. 2009. http://cobb.typepad.com/cobb/2008/09/tedspread.html TED Spread. Wikinvest. 21 Feb. 2009. http://www.wikinvest.com/wiki/TED_Spread Understanding the TED Spread. Econbrowser. 21 Feb. 2009. http://www.econbrowser. com/archives/2008/09/understanding_t.html Whats the TED Spread? U.S. News & World Report. 21 Feb. 2009. http://www. usnews.com/blogs/new-money/2008/9/17/whats-the-ted-spread.html