Our finding is consistent with some recent, substantial volatility in the U.S. corporate bond market and leaves open a possibility that additional, future shocks to default premia may have long-lived effects.Financial crises

Massimo Guidolin

Yu Man Tam

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2009 ￿ Number 40
I
ncreasing—but still much debated—evidence indicates
the worst of the recent financial crisis is behind us.
This marks the first payoff of a series of aggressive and
coordinated steps by the Federal Reserve, Treasury, FDIC,
and Congress to (i) stem the financial panic following the
Lehman Brothers’ bankruptcy and (ii) restore the flow of
credit. Additional payoffs in the medium term are expect-
ed from the Fed’s decision to cut its key policy rate to near
zero and greatly expand the monetary base.
One of the most popular indicators of financial stress
are yield spreads—both default risk spreads (e.g., between
Baa- and Aaa-grade corporate debt) and liquidity spreads
(e.g., between interbank deposits and Treasury bills). Low
bond yields are instrumental to the goals of an expansionary
policy: They stimulate growth by reducing costs of capital
to firms and households.1 Yields on T-bills and notes have
decreased notably in response to a number of the Fed’s
credit-easing policies. However, transmission of monetary
impulses from Treasury yields to private sector yields—
such as short-term interbank deposits and long-term corpo-
rate bonds—may be difficult. Default spreads in corporate
bonds remain elevated: It has proven difficult to reduce
the yields of corporate bonds with a rating below invest-
ment-grade. Meanwhile, rates on
deposits used to trade short-term
funds have followed abnormal
paths, reflecting persistent concern
for borrowers’ solvency.
Do yield spreads now suggest
an end to the crisis? The table lists
some statistical facts for two key
yield spreads. The first, the 3-month
London Interbank Offering Rate–
Overnight Index Swap (LIBOR-OIS)
spread, indicates the magnitude
of the liquidity premium for imme-
diate convertibility of an asset into
cash. The second spread, the
Moody’s spread between corporate
bonds with Baa and Aaa ratings,
indicates the premium required to compensate for the
higher default probability of bonds without an investment-
grade rating (such as Baa).
The mean yield spreads in the table (the coefficient ʳ)
suggest that the means underwent substantial increases
during the financial crisis versus the pre-crisis period with
a gradual return since November 2008 toward pre-crisis
levels.2 But a more careful analysis reveals a less-tranquil
picture. We have estimated simple dynamic regressions
(coefficient β in the table) that capture the speed at which
a shock (i.e., an unpredictable change in the current level
of a spread) to any of the spreads dissipates.3 A negative β
suggests that a yield spread, once shocked, will return to
Is the Financial Crisis Over? A Yield Spread Perspective
Massimo Guidolin, Assistant Vice President and Economist
Yu Man Tam, Senior Research Associate
Our finding is consistent with some
recent, substantial volatility in the 
U.S. corporate bond market and 
leaves open a possibility that 
additional, future shocks to default
premia may have long-lived effects.
Default Spreads Dynamics
Regression coefficients
Subsample α βʳ (unconditional mean) R2
3-Month LIBOR-OIS liquidity spread
12/21/2001–8/10/2007 –0.082 –0.174** 0.109** 0.083
8/17/2001–10/17/2001 0.668** –0.061 1.068* 0.318
10/24/2008–8/31/2009 –0.026 –0.146** 0.530** 0.415
Moody’s Baa-Aaa default spread
12/21/2001–8/10/2007 0.156** –0.012** 0.898** 0.030
8/17/2001–10/17/2001 1.132** 0.034 1.048** 0.638
10/24/2008–8/31/2009 0.577** –0.007 0.104 0.462
NOTE: * and ** indicate significance at the 10 and 1 percent levels. The model estimated is 
∆st = α∆st–1 + β(st–1 – ʳ ) + ʵt, where st is the spread at time t. The dating was obtained by applying the
standard Andrews-Quandt break test and selecting dates as averages of break dates for the two series. its long-run mean; the larger the
coefficient (in absolute value), the
faster the effect of the shock 
vanishes.
The table shows that so far the
good news is limited to the liquid-
ity (LIBOR-OIS) spread; β returns
significantly negative and to levels
close to the pre-crisis standards
(–0.15 vs. –0.17), starting in late
2008.4 However, recent develop-
ments for the default (Moody’s
Baa-Aaa) spread remain indecisive.
While in the pre-crisis period, the
β estimate was small in absolute
value (–0.012) but highly statisti-
cally significant, during the crisis
β becomes positive. Even though
β has returned to negative since
December 2008, there is little evi-
dence that it may actually be dif-
ferent from zero. This is consistent
with some recent, substantial
volatility in the U.S. corporate
bond market and leaves open a
possibility that additional, future shocks to default premia
may have long-lived effects.
Alternatively, the chart shows the estimates of β obtained
using a fixed rolling window of 3 years of data. The seven
vertical bars denote the timing of seven major events—
one date accepted as the onset of the crisis (1) followed by
six major policy actions by the Fed. The horizontal, dotted
line separates the region of dynamic stability from the insta-
bility for the spreads. The crisis has taken both spreads into
the instability region (suddenly in the case of the liquidity
premium, slowly but inexorably in the case of the default
premium), but the Fed’s policy interventions managed to
lower the liquidity premium to the stability region by
November 2008. In the case of the default premium, the
goal of stability is being gradually achieved, but the small
distance between the border of the stability region and
recent β estimates stresses that the recovery from the crisis
may still be fragile. ￿
1 See Guidolin, Massimo and Tam, Yu Man. “Taming the Long-Term Spreads.”
Federal Reserve Bank of St. Louis Economic Synopses, No. 26, May 22, 2009;
http://research.stlouisfed.org/publications/es/09/ES0926.pdf.
2 Our estimates in the table concern three distinct subsamples: December 2001–
August 2007 is the pre-crisis period; August 2007–October 2008 captures the
heights of the crisis, culminating with the Lehman Brothers demise in September
2008; November 2008–July 2009 is argued to mark a return to normality. 
3 The model has been applied to alternative definitions of liquidity spreads (e.g.,
on-the-run vs. off-the-run Treasury). See Meyer, Lawrence H. and Sack, Brian P.
“Liquidity Premiums: How Big for How Long?” Fixed Income Focus. St. Louis:
Macroeconomic Advisers, 2009.
4 If one believes that fluctuations in risk premia are subject to long and unpredict  -
able swings, care is necessary before drawing strong conclusions about “normal”
dynamics of the risk premia as represented by 2001–2007 data. See Anderson,
Richard G. (2009). “Bagehot on the Financial Crises of 1825…and 2008.” Federal
Reserve Bank of St. Louis Economic Synopses, No. 7; January 23, 2009;
http://research.stlouisfed.org/publications/es/09/ES0907.pdf.
Economic SYNOPSES Federal Reserve Bank of St. Louis 2
research.stlouisfed.org
Posted on September 21, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Speed of Mean Reversion Parameter β 3-Year Rolling Window Estimates
–0.5
–0.4
–0.3
–0.2
–0.1
0
0.1
0.2
0.3
0.4
0.5
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Moody Baa-Aaa and 3-Month LIBOR-OIS
(1) (2) (3)(4) (5)(6)(7)
NOTE:
(1) On August 16, 2007, Fitch Ratings downgrades Countrywide Financial Corporation to BBB+, its third-lowest 
investment-grade rating, and Countrywide borrows the entire $11.5 billion available in its credit lines with other banks.
(2) On December 12, 2007, the Fed announces the creation of the Term Auction Facility (TAF).
(3) On March 11, 2008, the Fed announces the creation of the Term Securities Lending Facility (TSLF).
(4) On March 16, 2008, the Fed establishes the Primary Dealer Credit Facility (PDCF).
(5) On September 19, 2008, the FED announces the creation of the Asset-Backed Commercial Paper Money Market 
Mutual Fund Liquidity Facility (AMLF).
(6) On October 21, 2008, the FED announces the creation of the Money Market Investor Funding Facility (MMIFF).
(7) On November 25, 2008, the FED announces the creation of the Term Asset-Backed Securities Lending Facility (TALF).
SOURCE: http://timeline.stlouisfed.org/.

Is the financial crisis over? a yield spread perspective

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Is the financial crisis over? a yield spread perspective

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