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By Root 884 0

authorities at the major central banks, especially the Federal Reserve, understood that the shortage of intermediary capital was a potentially catastrophic threat to the financial system. Through a series of programs and facilities they quickly moved to help provide capital to intermediaries, both directly and through indirect federal guarantees. This brought the chaotic situation of bank capital under control relatively quickly. While the long-term health of these intermediaries remained in question, they were receiving sufficient funding over the short and medium terms so as to allow them to access capital at more normal prices. LIBOR OIS declined precipitously.

However, the shortage of capital in banks also resulted in very high shadow rates (usually not reported to the general public) for use of intermediary capital. This outcome is represented in Figure 20.6 by the black line, which delineates the bond-CDS basis—that is, the difference between the spreads on corporate bonds and the derivative contracts that insure them (i.e., credit default swaps, or CDS).3 Why the bond-CDS spread, and what does it tell us? CDS contracts are relatively liquidly traded contracts that measure the credit risk on bonds. In theory, this basis, the difference between bond and CDS yields, should be near zero, since the cost of insurance against a bond’s default should be about the same as the additional yield demanded by bondholders to compensate them against this same default. Thus, in terms of credit risk, bonds and CDS are approximately the same. However, in terms of liquidity, they are dramatically different. Intermediaries allow customers to write CDS insurance by putting up only a small amount of collateral relative to what they must put up to buy a bond. Moreover, bonds are generally traded far less frequently (this was true even before the current financial crisis), and with considerably higher bid-ask spreads, than CDS. All of this makes bonds riskier in terms of liquidity, though no different in terms of credit risk.

In September 2009, the bond-CDS basis exploded to levels never previously seen. Intermediaries, who faced real capital shortages, called in capital everywhere they could. The bond-CDS liquidity difference was an indication that their clients’ bond positions were far more collateral-intensive than were their CDS positions. So effectively, as intermediaries called in their capital, it became impossible (or inordinately expensive) to finance bond positions. Many investors were forced to sell their bonds—to de-lever because leverage was no longer available to many. Others who retained access to leverage sold voluntarily for fear that the last one out of the bond market would be left to shut off the lights. Some were also forced to liquidate CDS positions. Yet bond liquidation predominated: It released more collateral than CDS liquation, and, in any case, liquidation of CDS positions acted only to reduce the bond-CDS basis. By both cause and effect, liquidity disappeared from bond markets: The uncertainty around what bonds would actually fetch became further magnified. Bonds therefore rapidly became much cheaper than their associated CDS. The magnitude is stunning: The 400 basis point bond-CDS spread represents an undervaluation of bonds relative to CDS of between 20 percent and 25 percent.4

The behavior of LIBOR OIS suggests that intermediaries quickly regained access to capital after the seizure of markets in September 2008. Intermediaries could then fund themselves in debt markets. But they were willing to do the same for their clients because of the scarcity of equity capital. In essence, the shadow required return on intermediary risk capital rose to very high levels, so high that intermediaries would not lend capital out at anything like the normal lending rates. This is the analog of the relative increase in bond rates—and the relative decline in bond prices. The cycle of intermediary capital shortages, so pronounced in this recent financial crisis, is the same pattern we saw above in the catastrophe risk market