Whether you're a short-term trader or a long-term investor, you've been recently affected by what has been dubbed a "credit freeze" Of course that's just a clever analogy, but just for the sake of understanding, it may be worth actually knowing what is actually causing short-term loans to not be made.

To be clear, it's not that banks aren't willing to lend to other banks. It's just that no bank can afford to borrow from other banks. Lenders have cranked up their interest rates to the point where it just doesn't pay to borrow. Why? You already know why: the risk of bank default was very real.

The symptom is something called the TED spread. When it's relatively low (around 1.0), banks can borrow and lend profitably. When the TED spread is high (as in 3.0 or higher), it's just not worth it for a borrowing bank to take that loan, though it certainly is worth it for the lending bank to make the loan, if they can find a customer.

But what exactly is the TED spread? It's the difference between the short-term LIBOR rate (London Interbank Offered Rate) and the yield on 3-month U.S. Treasuries (a 'risk free' yield). The formula is simple enough -- subtract the 3-month Treasury yield from the LIBOR rate, and you're left with the TED spread.

The LIBOR rate is what most banks -- including U.S. banks -- use to determine what they'll charge each other for loans. The short-term Treasury yield is not "set" by the Fed, but is effectively determined by the Fed Funds interest rate.

And that's an important distinction to make. LIBOR is established by supply and demand, while the 3-month Treasury yield is established based on a government-established rate. The latter is largely mandated, while the former can move as high or low as the market will allow it. That's how a TED spread gets "too high."

So what makes the LIBOR rate so high that it widens the TED spread too much? In a word: fear.

As I mentioned above, the risk of bank default felt like it was very high a month ago, so banks were charging premium rates to make loans. Of course, the borrowing bank is only borrowing that money to lend out to their own customers. There's the rub. The borrowing bank's own customers couldn't afford the interest payments they were now being charged, if they could get a loan at all (some banks truly didn't have the money to lend). A consumer's choices - if they could get a loan at all - were (1) take a loan they couldn't afford, or (2) don't take a loan at all.

Since a picture is worth a thousand words, I'll include a chart of the TED spread here (and I'll thank Bloomberg.com for the chart). If you look closely, all the "credit freeze" chatter started right when the TED spread surged from just above 1.0 to above 3.0, and as high as the mid-4.0 area just a couple of weeks ago. Take a look at the chart, and then keep reading for my final thoughts.

TED Spread - 3 Years


The spread closed at 2.7 yesterday, so it's peeled back from staggering highs, and is currently pointed in a direction we all like. However, 2.7 still isn't a complete thaw of the credit market. It really needs to be under 2.0 to be tolerable for lenders and borrowers. However, at least now you know what to look for.

Keep in mind some stocks can and will move without regard for, or be reflective of, the TED spread. I think the widespread impact of a frozen credit market is overestimated, meaning there are some charts out there that are screaming values. That's good for traders as well as investors. And now that the dust seems to be settling, I don't expect to see all stocks getting crushed in unison.

Price Headley is the founder and chief analyst of BigTrends.com.