In Understanding the Current Financial Turmoil, Arnold Kling explains the difference between a default premium and a risk premium and then summarizes the current situation:
With some institutional investors burned in the sub-prime mortgage market, this has caused other institutions to question their own portfolios: which of our investments might have more potential to default than we have been allowing for? What if it turns out that bond ratings are less reliable than we thought?The net result is that risk premiums, which had been trending down in recent years to historically low levels, have bounced back up in the past several weeks. This adversely affects companies, such as Countrwide Financial, that rely on their strong credit ratings to be able to finance their portfolios using low-cost debt. A small increase in the risk premium faced by Countrywide can cause an enormous drop in its profit margin.
Sebastian Mallaby calls this “irrationality” on the part of investors. Instead, I think of it as a breakdown in trust of the financial intermediation process. This breakdown is occurring not so much at the level of the average consumer, but among large institutional investors. Money managers who a year ago were willing to accept low risk premiums for securities are no longer willing to do so. No one is really sure whose tools for evaluating default probabilities are reliable and whose tools are not. Until financial intermediaries can re-establish the reliability of their estimates of the likely performance of various credit instruments, institutional investors will be skeptical of the hide-and-seek process. This will keep the risk premium high, with adverse effects on housing and business investment.