Have the Credit Markets Finally Healed?

Last week, Fed chief Ben Bernanke declared a cautious victory in his ongoing battle to defend the world financial system from collapse. Yet while many investors remain skeptical about the state of the economy, one big accomplishment is hard to argue with: The once-frozen credit markets, while perhaps not functioning perfectly, have thawed considerably from their ravaged state last fall.

How far we've come
At the peak of the financial crisis late last year, it was clear that the credit markets were hardly functioning. Treasury bills traded at negative interest rates as investors refused any but the safest possible places to put their money. Even money market mutual funds, long seen as among the most secure short-term investments, were threatened by failures in the commercial paper market. They required temporary federal guarantees in order to prevent the modern-day equivalent of the bank runs of the 1930s.

Since then, many things have improved. Here are just a few signs of how much progress has been made in restoring the credit markets to normal operations.

Mortgages on the cheap
Arguably one of the biggest problems the economy still faces lies on the housing front. While prices may finally be stabilizing, many wary critics still point to option-ARM mortgages that may recast in the next few years, potentially creating a new wave of defaults and foreclosures that will push the economy back down.

While it's true that some homeowners simply can't afford to make anything above the extremely low payments they got during the initial phases of their mortgages, the lending environment is about as favorable as it can get. Long-term fixed mortgages remain near multi-decade lows. Meanwhile, the short-term rates upon which many adjustable-rate mortgages are based have stayed at rock-bottom levels, which will soften the impact of many impending rate resets.

Not every problem in the mortgage market has been solved, though. The Fed continues to prop up the ailing housing market by purchasing mortgage-backed securities. However, recent jumps in shares of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), the two largest recipients of government purchases, at least indicate there is some speculative interest that the mortgage market isn't a lost cause.

Corporate debt on the mend
In addition, companies have had much more success lately managing their own debt situations. The spreads between corporate bond yields and comparable Treasury yields have narrowed by more than half, from six-plus percentage points at the end of 2008 to just more than 2.5 percentage points recently. Moreover, junk bond spreads have also tightened, from a steep 22 percentage points in March to less than 9 percentage points now.

The volatility in corporate debt has given companies a chance to use a variety of strategies. Those looking to raise cash are now able to issue debt at more favorable rates.

Perhaps more interesting, though, is how many companies have taken the opportunity to buy back debt at relatively low prices. Here's a sample of some of the companies that have bought back debt this year:

Source: WSJ, Yahoo Finance.

By repurchasing debt now, companies take two positive steps. First, they take advantage of a rare opportunity to retire debt and improve their balance sheets at a big discount. But perhaps even more importantly, their willingness to spend cash signals a big shift in sentiment. For months, frozen credit markets have given cash-rich companies a big competitive advantage. Now, though, it's apparent that even companies that aren't in the best financial shape are willing to spend their money when they can reap a big windfall by doing so.

Not out of the woods
Unfortunately, the credit markets aren't likely to return to the boom nature of years past anytime soon. The Fed and other government intervention could be necessary for some time before things return to normal. With any luck, though, the days of wondering which big institution will be the next to topple are over.