So far, the Fed’s magic is working as subprime leaves prime time…

The Federal Reserve and other global central banks have successfully tempered the credit crisis since mid-March. The Fed’s effective bailout of now defunct Bear Stearns created a floor under the subprime wreckage. The good news is that a host of high-risk credit indices have posted big rallies over the last eight weeks, including a blizzard of new fixed income issues hitting the markets as companies return en masse to fund their operations.

But don’t get too excited; the debt crisis is far from over.

LIBOR Rates Barely Budge Lower

While several indicators have improved recently, other pertinent sources of funding have started to percolate, suggesting the subprime crisis is now spreading from the mortgage-backed securitization market to consumer installment debt. Also, interbank lending rates have yet to fully recover from their pre-July 2007 levels, while bank credit is contracting, not expanding – an ominous sign as the United States struggles to escape a slowdown.

Three-month LIBOR rates or the London Interbank Borrowing Rate has barely narrowed since the Bear Stearns’ rescue as the majority of financial institutions continue to hoard cash and distrust overnight lending facilities.

While it’s safe to postulate that some areas of the credit markets have not relaxed, others have indeed started to breathe easier. Among those normalizing this spring is the subprime market.

Subprime is Finally Tamed

According to international credit rating agency, Fitch, banks have probably written off approximately 80% of their bad loans through mid-May. Some banks, including Switzerland’s Union Bank of Switzerland (UBS) continue to surprise the markets on a weekly basis with a host of spectacular losses tied to real estate, subprime, leveraged loans and auction rate securities.

For the most part, however, the subprime crisis is past its inflection point; what matters now is how and when other credit indicators important to the daily functioning of the U.S. and, therefore, global economy, normalize.

As of May 27, 2008, the subprime crisis has resulted in approximately $200 billion dollars’ worth of write-downs for global banks – mostly UBS and others in the United States and the United Kingdom. For the most part, Asia and Latin America have escaped the crisis and remain largely well capitalized and highly liquid compared to their peers in North America and parts of Western Europe. The securitization model, though still alive and kicking overseas, was not a primary investment source for Asian and Latin banks, which avoided most subprime products like collateralized debt obligations or CDOs.

Credit Spreads Narrow

As I continue to track the normalization of credit markets, I’m encouraged by the narrowing of credit spreads across several markets – a bullish development.

One key indicator I follow – the spread between three-month Treasury bills and three-month LIBOR has narrowed considerably since March to 0.85% from 1.83% back in early April. That tells me that the “safe haven” trade on short-term Treasury bills since the subprime crisis first erupted last summer is reversing as risk gradually returns to the credit markets. Prior to mid-April, three-month T-bills plunged way below the Federal Funds rate to a low of 0.81% -- severely overbought as investors scrambled for safety.

Another bullish indicator now flashing green is the yield spread between 30-year municipal bonds and 30-year Treasury bonds.

Prior to mid-March, the yield differential between 30-year municipal bonds and long-term T-bonds ballooned to their highest in history as investors fled municipal debt; the average yield on high quality municipal bonds has plummeted 70 basis points (0.70%) after reaching a peak on February 29. Earlier last winter, as yields soared, savvy investors like Bill Gross of PIMCO and venture capital investor, Wilbur Ross, scooped up those fat yields. In hindsight, that was a great speculation as yields have plunged versus T-bonds.

Also, some mortgage and financial companies, including non-financial issuers, are successfully raising capital again since April. Though financing remains much more expensive compared to 12 months ago, it’s nevertheless a positive development for global capital markets.

Beware of High Risk Debt Markets

High-yield bond indexes and preferred securities have also rallied since late March.

Preferred securities, which provide stock and income-like features, have also rallied. But preferred securities are mostly issued by financial services companies and write-downs are far from over. I would avoid preferred securities and those juicy, but dangerous yields.

The same is true for high-yield bonds and other busted credits, including subprime securities as the economy continues to slow. High-yield or junk bond defaults remain historically low at just below 2% of all outstanding issues; previous recessions have seen defaults surge almost three times this level. In my view, the recent rally is nothing more than a dead cat bounce. More junk bonds will default over the next 6-12 months.

The Next Credit Crisis: Consumer Installment Debt

I’m still highly dubious that credit markets have bottomed. Subprime is now largely history, but other segments of the credit spectrum that have a far more profound impact on the American consumer are just beginning to unravel.

The consumer is now threatened by a liquidity crisis as housing values continue to heavily contract and revolving credit instalment debt becomes harder to secure.

The culprit is less the write-downs themselves than a virtual “shutdown” in the securitization market, which, at its height, provided 66% of household borrowings in the first quarter of 2007. Without this market, consumer credit losses may be far worse than currently estimated. Auto loans, personal loans, mortgage loans and other segments of instalment debt are still contracting. Auto loans are especially vulnerable with defaults recently hitting a 10-year high of 3.4% in March. And more Americans are dropping the keys to their homes to their local lenders as housing values continue to plunge below the cost of their mortgages.

Consumer deflation has arrived at the absolute worst time as savings rate are barely positive. Soaring energy and food prices, declining home values, surging auto delinquency loans and gradually rising unemployment depict a growing liquidity crisis now underway for the consumer and most, if not all, instalment debt structured to finance domestic consumption. It’s not a pretty picture.

Stay defensive and avoid most debt markets, except high quality short-term Treasury’s and investment-grade bonds. The consumer credit bear market is underway.