We take you back to the credit basics to review everything you thought you already knew but were too afraid to ask... Michael Thompson of Standard & Poor's looks at factors influencing the credit crisis The credit crisis has now been with us for a full year, yet there are few signs that economic stimulus measures in place will enable the US economy to avoid a recession that would only further complicate the dynamics of the credit crisis and contagion. To help gauge whether US policymakers are winning the war against the credit crisis, here is a short checklist of economic and market variables to keep track of. 1. First and foremost, real estate values must stabilise and preferably need to edge higher. This will relieve anxieties surrounding RMBS that are perceived to be a large collateral stake for the entire US financial system. The good news is that existing single family home prices rebounded from $240,700 in February 2008 to $256,800 in June, according to the National Association of Realtors (NAR). Continuation of this trend is vital to stability and recovery of the credit markets. Home prices, however, dipped to $252,400 in July and further to $244,700 in August. 2. The rate of existing home sales must rebound to a rate that gradually clears out the massive inventory of homes offered for sale in the US. The June inventory of 3.9 million existing single family homes offered for sale is more than double the 1.9 million average level of inventories seen between 1993 and 2004 according to NAR data (3.6m Aug.). A modest rebound in sales to as few as 5.5 million units (seasonally adjusted annual rate) would be encouraging, but has not yet occurred (4.91m in Aug.). Improved housing affordability will have to come on the mortgage interest rate front. Conventional 30-year fixed mortgage interest rates have recently declined and stabilised below 6.25%, which should be very supportive to transaction volumes, helping to accelerate reductions in the housing overhang. 3. Credit conditions must ease substantially before the liquidity-starved US economy can resume trend-like GDP growth. We are on the lookout for signs that global credit markets are reacting to early indications of stability in US housing by compressing risk-spreads. Three-month Libor spread over Fed funds: Three-month Libor needs to fall below a spread of 50bp to overnight Fed funds vs. the current spread of 80+bp. The Fed funds/Libor spread would normally fall within a range of 12-25bp in a credit contagion-free world, but we will take anything below 50bp as a sign of improving credit conditions. Unfortunately, the Fed funds/Libor spread has held in a range of 80-170bp since July 2008. Five-year USD swap spread: We also want to see five-year USD interest rate swap spreads return to a range of 60-70bp vs. the 103bp spread seen today. The 60-70bp range represents the middle ground between the credit risk apathy range of 30-55bp seen between 2003 and mid-year 2007, and the post-credit crisis range of 70-100bp witnessed since July 2007. 4. The price of crude oil would ideally stabilise in the neighbourhood of $100 per barrel. This would help prop up the value of the US dollar in the global currency market, ease commodity-driven inflation concerns within the Federal Reserve, and help underpin the consumer-driven US economy, all of which would help alleviate the credit crisis. Spot crude oil has traded in a range of $90 to $120 since the start of September 2008. Michael Thompson is a managing director in the Market, Credit and Risk Strategies (MCRS) group at Standard & Poor's. The MCRS group is an independent research team that provides financial intelligence by analysing relationships across multiple asset classes and markets The credit crisis checklist: In brief It is clear that early signs of housing stability are not yet alleviating stress in the credit markets and narrowing spreads. But this may change if the average selling price of an existing single family home remains stable, or better yet, continues to rise. When this occurs, we may quickly find ourselves checking off the other items on our credit crisis checklist. However, if the average selling price of an existing single family home is prematurely signalling a bottom for housing, then you can put the checklist in the filing cabinet for the rest of 2008....
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