with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . . In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.
In a nutshell: as the economy gets worse, more and more loans default, eating into banks’ capital cushions; investors are still nervous about all those toxic assets; and the continuing collapse of the housing market hurts all of those mortgages and mortgage-backed securities banks are holding. And as banks teeter toward insolvency, people stop lending them money, and they stop lending people money.
On the plus side, the famous TED spread dipped below 1 today, a sign that credit markets are doing much better than back in September. (The Calculated Risk article behind that link shows improvements in other parts of the credit markets, not just interbank lending.)
On the minus side, CDS spreads have shot up on Citigroup and Bank of America in the last week – here’s Bank of America:
The main peaks you see are the Lehman bankruptcy, the buildup to the bank recapitalization announcement, and the Citigroup crisis. So while there seems to be general improvement in the credit markets, the underlying problems have not been solved.
Originally published at the Baseline Scenario and reproduced here with the author’s permission.