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Economic SYNOPSES
short essays and reports on the economic issues of the day
2009 ■ Number 40

Is the Financial Crisis Over? A Yield Spread Perspective
Massimo Guidolin, Assistant Vice President and Economist
Yu Man Tam, Senior Research Associate
ncreasing—but still much debated—evidence indicates
indicates the premium required to compensate for the
the worst of the recent financial crisis is behind us.
higher default probability of bonds without an investmentThis marks the first payoff of a series of aggressive and
grade rating (such as Baa).
coordinated steps by the Federal Reserve, Treasury, FDIC,
and Congress to (i) stem the financial panic following the
Our finding is consistent with some
Lehman Brothers’ bankruptcy and (ii) restore the flow of
recent, substantial volatility in the
credit. Additional payoffs in the medium term are expectU.S. corporate bond market and
ed from the Fed’s decision to cut its key policy rate to near
zero and greatly expand the monetary base.
leaves open a possibility that
One of the most popular indicators of financial stress
additional, future shocks to default
are yield spreads—both default risk spreads (e.g., between
premia may have long-lived effects.
Baa- and Aaa-grade corporate debt) and liquidity spreads
(e.g., between interbank deposits and Treasury bills). Low
bond yields are instrumental to the goals of an expansionary
The mean yield spreads in the table (the coefficient γ )
suggest that the means underwent substantial increases
policy: They stimulate growth by reducing costs of capital
during the financial crisis versus the pre-crisis period with
to firms and households.1 Yields on T-bills and notes have
decreased notably in response to a number of the Fed’s
a gradual return since November 2008 toward pre-crisis
credit-easing policies. However, transmission of monetary
levels.2 But a more careful analysis reveals a less-tranquil
picture.
We have estimated simple dynamic regressions
impulses from Treasury yields to private sector yields—
(coefficient β in the table) that capture the speed at which
such as short-term interbank deposits and long-term corpoa shock (i.e., an unpredictable change in the current level
rate bonds—may be difficult. Default spreads in corporate
of a spread) to any of the spreads dissipates.3 A negative β
bonds remain elevated: It has proven difficult to reduce
suggests
that a yield spread, once shocked, will return to
the yields of corporate bonds with a rating below investment-grade. Meanwhile, rates on
deposits used to trade short-term
funds have followed abnormal
Default Spreads Dynamics
paths, reflecting persistent concern
Regression coefficients
for borrowers’ solvency.
Subsample
α
β
γ (unconditional mean)
R2
Do yield spreads now suggest
an end to the crisis? The table lists
3-Month LIBOR-OIS liquidity spread
some statistical facts for two key
12/21/2001–8/10/2007
–0.082
–0.174**
0.109**
0.083
8/17/2001–10/17/2001
0.668**
–0.061
1.068*
0.318
yield spreads. The first, the 3-month
10/24/2008–8/31/2009
–0.026
–0.146**
0.530**
0.415
London Interbank Offering Rate–
Moody’s
Baa-Aaa
default
spread
Overnight Index Swap (LIBOR-OIS)
12/21/2001–8/10/2007
0.156**
–0.012**
0.898**
0.030
spread, indicates the magnitude
8/17/2001–10/17/2001
1.132**
0.034
1.048**
0.638
of the liquidity premium for imme10/24/2008–8/31/2009
0.577**
–0.007
0.104
0.462
diate convertibility of an asset into
NOTE: * and ** indicate significance at the 10 and 1 percent levels. The model estimated is
cash. The second spread, the
∆st = α ∆st–1 + β (st–1 – γ ) + εt , where st is the spread at time t. The dating was obtained by applying the
standard Andrews-Quandt break test and selecting dates as averages of break dates for the two series.
Moody’s spread between corporate
bonds with Baa and Aaa ratings,

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Economic SYNOPSES

Federal Reserve Bank of St. Louis

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its long-run mean; the larger the
Speed of Mean Reversion Parameter β 3-Year Rolling Window Estimates
coefficient (in absolute value), the
(2) (3)(4)
(5)(6)(7)
(1)
faster the effect of the shock
1
0.5
vanishes.
Moody Baa-Aaa and 3-Month LIBOR-OIS
0.9
0.4
The table shows that so far the
0.8
0.3
good news is limited to the liquid0.7
0.2
ity (LIBOR-OIS) spread; β returns
0.6
0.1
significantly negative and to levels
0.5
0
close to the pre-crisis standards
0.4
–0.1
(–0.15 vs. –0.17), starting in late
0.3
–0.2
2008.4 However, recent develop0.2
–0.3
ments for the default (Moody’s
0.1
–0.4
Baa-Aaa) spread remain indecisive.
0
–0.5
While in the pre-crisis period, the
β estimate was small in absolute
NOTE:
value (–0.012) but highly statisti(1) On August 16, 2007, Fitch Ratings downgrades Countrywide Financial Corporation to BBB+, its third-lowest
cally significant, during the crisis
investment-grade rating, and Countrywide borrows the entire $11.5 billion available in its credit lines with other banks.
(2) On December 12, 2007, the Fed announces the creation of the Term Auction Facility (TAF).
β becomes positive. Even though
(3) On March 11, 2008, the Fed announces the creation of the Term Securities Lending Facility (TSLF).
(4) On March 16, 2008, the Fed establishes the Primary Dealer Credit Facility (PDCF).
β has returned to negative since
(5) On September 19, 2008, the FED announces the creation of the Asset-Backed Commercial Paper Money Market
December 2008, there is little eviMutual Fund Liquidity Facility (AMLF).
(6) On October 21, 2008, the FED announces the creation of the Money Market Investor Funding Facility (MMIFF).
dence that it may actually be dif(7) On November 25, 2008, the FED announces the creation of the Term Asset-Backed Securities Lending Facility (TALF).
ferent from zero. This is consistent
SOURCE: http://timeline.stlouisfed.org/.
with some recent, substantial
volatility in the U.S. corporate
bond market and leaves open a
possibility that additional, future shocks to default premia
may have long-lived effects.
1 See Guidolin, Massimo and Tam, Yu Man. “Taming the Long-Term Spreads.”
Alternatively, the chart shows the estimates of β obtained
Federal Reserve Bank of St. Louis Economic Synopses, No. 26, May 22, 2009;
using a fixed rolling window of 3 years of data. The seven
http://research.stlouisfed.org/publications/es/09/ES0926.pdf.
vertical bars denote the timing of seven major events—
2 Our estimates in the table concern three distinct subsamples: December 2001–
one date accepted as the onset of the crisis (1) followed by
August 2007 is the pre-crisis period; August 2007–October 2008 captures the
six major policy actions by the Fed. The horizontal, dotted
heights of the crisis, culminating with the Lehman Brothers demise in September
2008; November 2008–July 2009 is argued to mark a return to normality.
line separates the region of dynamic stability from the insta3 The model has been applied to alternative definitions of liquidity spreads (e.g.,
bility for the spreads. The crisis has taken both spreads into
on-the-run vs. off-the-run Treasury). See Meyer, Lawrence H. and Sack, Brian P.
the instability region (suddenly in the case of the liquidity
“Liquidity Premiums: How Big for How Long?” Fixed Income Focus. St. Louis:
premium, slowly but inexorably in the case of the default
Macroeconomic Advisers, 2009.
4 If one believes that fluctuations in risk premia are subject to long and unpredictpremium), but the Fed’s policy interventions managed to
able swings, care is necessary before drawing strong conclusions about “normal”
lower the liquidity premium to the stability region by
dynamics of the risk premia as represented by 2001–2007 data. See Anderson,
November 2008. In the case of the default premium, the
Richard G. (2009). “Bagehot on the Financial Crises of 1825…and 2008.” Federal
goal of stability is being gradually achieved, but the small
Reserve Bank of St. Louis Economic Synopses, No. 7; January 23, 2009;
http://research.stlouisfed.org/publications/es/09/ES0907.pdf.
distance between the border of the stability region and
recent β estimates stresses that the recovery from the crisis
may still be fragile. ■

Posted on September 21, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

research.stlouisfed.org