Recent financial data indicate that the current default risk for financial assets is drastically overestimated by the bond market. The difference between the rate that prominent banks pay each other in order to borrow money and the three month U.S. Treasury rate is at its highest point since the mid-1980s. This spread, known as the "TED spread," implies that even blue chip financial firms have an extremely high risk of defaulting. Consequently, bargain hunters will soon recognize the opportunity to profit from these unreasonable risk scenarios. 

Senior Fellow Kevin A. Hassett

As policymakers huddle in Washington and scheme up plans to end this financial crisis, markets around the world have continued to panic. Such a response may well reflect a prudential understanding of Congress's innate inability to respond rationally to virtually any economic circumstances, let alone a crisis. 

But part of the problem may well be a kind of myopia. All crises end, and this one will too. It will end not because of a government intervention, but rather, because asset prices have adjusted to the point that taking risk makes sense. Governments do not have enough resources to purchase all of the world's risky assets. Investors do.

In other words, bargain hunting is the only thing that can save us.

So when can we expect bargain hunting to begin? By definition, it should occur when asset prices have moved to the point that the scenario priced into asset values is so negative that it could not possibly occur. At that point, taking on risk is attractive, precisely because profit can be expected.

Have prices of risky assets fallen to that point? There are numerous signs that they have.  The chart provides one such example.

The chart plots the difference between the rate that the world's most prominent banks pay each other in order to borrow money for 3 months and the 3 month U.S. Treasury rate. The first rate is called the LIBOR, or the London Interbank Offered Rate. Their difference is known in the industry as the "TED spread."

If Deutsche Bank borrows money from JP Morgan for three months and pays them 4 percent interest, and the U.S. 3-month Treasury rate is 3, then the spread on the chart would be 1 percent. Over history, this spread has been about half a percentage point. In late September, it climbed to the highest it has ever been, 3.5 percent.

In other words, if you lent money to Deutsche Bank for 3 months at the end of September instead of purchasing a Treasury, you got 3.5 percent more interest.

Such a high interest rate only makes sense if there is a high probability that Deutsche Bank will default on its debt over the next 3 months. But such a default is almost impossible. Surely, if such a big institution were to approach failure, governments would step in.

The TED spread is just the tip of the iceberg. As of late September, AAA rated 10 year bonds were priced as if the probability of default for the bluest of blue chip firms was 39 percent. If 39 percent of AAA firms default on their debt, then we will not have an economy left. It can not happen.

The financial panic has advanced to the point that interest rates for even miniscule risks are absurdly high. 

At some point, hopefully soon, investors will notice that, and financial markets will begin to reverse themselves.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.