Bank stocks rally and the worst may be over – but don’t pop the champagne just yet

If you had invested in bank stocks a couple of weeks ago in the wake of the Bear Stearns crash, you would now be sitting on such a healthy profit you could be tempted to bank your winnings and go and sit on a beach for the rest of the year. UK bank stocks are up 16% in two weeks.

The euphoria that has greeted this latest rally has led many in the City to start talking excitedly about whether the worst of the credit crunch is now behind us. The US authorities have signalled they will do whatever it takes to prevent this turning into a systemic crisis. You can't fight the Fed, as the saying goes.

On this analysis, even this week's latest bank mega-writedowns are good news. They show that banks are no longer in denial but are starting to come clean about their losses and taking steps to repair their balance sheets.

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UBS this week revealed another $19bn of writedowns on US mortgage securities, fired its chairman and launched a $15bn rights issue. Lehman is also to raise capital via a convertible bond. Deutsche Bank has revealed a further round of writedowns and rumours are swirling that Merrill Lynch may be about to do the same. With banks facing up to their difficulties and central banks offering support, the chances of more bank failures are slim.

Is this true? Perhaps. The actions of the Fed and the banks themselves have certainly reduced the immediate risk of a systemic collapse. It is now much less likely any major banks will suffer serious liquidity problems. But that does not mean the wider credit crunch is over. The process of deleveraging as debt is removed from the financial system still looks to have some way to run, both here and in the US. This week First Direct joined a growing list of UK mortgage lenders to stop offering loans to new customers. The big unknown is what impact this will have on the real economy and whether it leads to a new round of problems for banks.

Even so, it may mean that we are now near the bottom in terms of the credit markets. The bottom of any bear market is only reached when buyers return to the market in force. So far, the evidence this is happening in the credit markets is pretty sketchy. A few brokers tell me they've seen a few funds starting to dip their toes in the water again; and every fund I've talked to tells me they are just waiting to come back in although admittedly, every fund I've talked to has been saying that since last September. Some of the bounce in the last week or two may just be short sellers covering their positions, rather than new money coming in to the market.

For new money to come in, buyers will need to feel confident of making decent returns on an unleveraged basis that is, without the need to juice up returns with debt. At the peak of the credit bubble, hedge funds were leveraging up some assets, such as mortgage securities, by up to 50 times. At that level, it only took a 2% fall in the value of the underlying collateral to wipe out their equity. On the other hand, it also meant that the underlying bonds only had to yield a few basis points more than the money they were borrowing to make a killing.

Credit market analysts will tell you that many debt securities already trade at or close to levels that offer good returns on an unleveraged basis. For example, leveraged loans bank loans to private equity-backed companies are trading at about 400% over Libor, which gives you an annual return of about 9%. On top of that, many loans are trading at 80p in the pound, which gives about 25% of capital appreciation over the remaining life of the loan, assuming no default. Other credit instruments look equally oversold. The iTraxx index of credit default swaps was until this week trading at a level that assumed half the underlying companies were going to go bust.

So where are the buyers? Perhaps they are just waiting for some big buyers to give a lead and restore confidence, putting a floor under prices. But it may be that what is really holding people back is fear about the impact of the disappearance of cheap and easy credit on the real economy. It's not just a question of default rates, which are bound to rise although admittedly they would have to rise to historically very high levels before some of these assets looked expensive. It's also a question of when, and whether, borrowers are able to repay the capital at the end of the term.

I'm sceptical that all that securitisation the slicing and dicing of risk that made the whole bubble possible is going to come back any time soon. So credit will remain expensive and difficult to get. That's bound to hit the real economy hard. House price falls and job losses seem inevitable. So even if the worst of the credit crisis is over, and even if we are close to the bottom of the credit bear market, it will not feel much like it. In fact, for most of us, it will feel as if the crisis is only starting.