Look How Far We've Come

Most investors measure the health of the economy by focusing on one metric: The Dow Jones Industrial Average.

That's unfortunate, and not because the Dow is made up of a small group of companies with names like General Motors and Citigroup (NYSE:C) -- which I'd hope aren't reflective of the broader health of the nation.

It's unfortunate because most of the chaos we've experienced over the past 18 months has been in the credit markets, which are obscure beasts that rarely get much attention. There seems to be little interest in having a caption at the bottom of MSNBC's newscast that says "Watching the LIBOR OIS spread."

But this is where all the action is  
Yes, we've all enjoyed the recent stock rally. But it's the recovery in credit markets that's really been impressive.

Looking at a basket of credit-market statistics shows that we've not only improved markedly since last fall, but are almost back to levels considered "normal." Have a look:

*Basis points.

The stabilization in credit markets is encouraging for a few reasons:

• The bulk of our economic pain -- from unemployment to stock swoons -- is ultimately linked back to the credit markets in one way or another.
• Much of the downturn has been a factor of fear, uncertainty, and a lack of trust. The return to normal credit spreads shows most of this fear is abating.  

Consequently -- and reflecting pent-up demand -- the rush back into the credit markets has been a powerful one. In the past month, companies have been flooding the bond market to raise debt in amounts that would have been unfathomable late last year. Have a look:

Odds are not one of these companies could raise a penny at anything less than ridiculous interest rates when credit market hysteria peaked last fall. The renewed credit health is a big, big deal that isn't getting enough attention these days.

But can it last?
The improvements have been so phenomenal that FDIC Chairman Sheila Bair recently (and courageously) claimed: "The liquidity crisis is over."

That's quite bold. Investors could have also called the liquidity crisis "over" in the fall of 2007, and the spring of 2008. Similarly, in April 2007, then-Treasury Secretary Hank Paulson proudly claimed "the housing market is at or near the bottom." That brave call, uh, didn't work out so well.

Since markets contain so many moving parts, bottoms (and tops) are notoriously hard to predict, and are usually blind guesses. No one has a clue whether we've truly seen the final bottom in credit markets.  

What is fairly certain is that the health of credit markets going forward will be a balancing act between two forces:

• The Fed and Treasury implementing enough policies to convince investors that they won't let credit markets disintegrate on their own, as happened in the days after Lehman Brothers' collapse.
• Those policies actually working.

Cross your fingers. Prepare for the worst. Hope for the best.
Our liquidity crisis last fall was originally precipitated by a solvency problem. That is, banks stopped lending to each other and credit markets froze not because of a lack of money, but because no one trusted whether a borrower would be able to repay their debt.

That said, most of the policies implemented by the Fed and Treasury have targeted liquidity issues, such as an extremely loose monetary policy, TALF, and preferred stock issued through TARP. Those have done a tremendous amount to pump liquidity into the system, but there's still much less clarity around the solvency issue. In other words, we've attacked the symptoms (illiquidity) more than the root causes (insolvency).  

And since solvency fears ultimately create liquidity problems, it isn't a stretch to assume that the credit market demons haven't been laid to rest just yet.

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