Well, that didn't take long. For a few heady days in mid-July, the markets let themselves hope the credit crisis, which celebrates its first birthday on 9 August, might be nearing the end. The rally was triggered by a fall in the oil price, prompt action by the Federal Reserve to prevent the collapse of mortgage bond insurers Fannie Mae and Freddie Mac, plus a handful of US banks reporting smaller losses. But it didn't last. This week's massive unexpected loss from Merrill Lynch, which has been forced to raise another $8.5bn in fresh capital, showed the crisis is far from over. But when will we reach the bottom? As I see it, there are five big risks.
1. Deleveraging
This is a fancy way of saying that borrowing across the financial system is still far too high and needs to come down. Banks are forced to hold a certain amount of equity to support their own borrowing and absorb any potential losses. Yet across the banking system, the ratio of debt to equity may even have gone up in the past year, as huge amounts of debt that was tucked away off bank balance sheets has had to be bought back on to the books.
Meanwhile, the global banking system has recognised $350bn of losses but raised only $400bn of new capital, says Morgan Stanley. For the crisis to end, banks must raise enough new capital to absorb the losses and return their leverage ratios to the levels required by regulators. They also have to raise enough new capital to support fresh lending. Until that happens whether through rights issues, cutting dividends, sacking staff or succumbing to takeovers credit will be scarce, making it hard for businesses and households to borrow.
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2. US housing market
The news from the US housing market is getting worse, not better. The Standard & Poor's Case Shiller index the most widely-watched measure of the market fell a record 15.8% in the year to May. And mortgage problems are now percolating beyond subprime borrowers into the mainstream the Wall Street Journal reports that middle-class Americans are now giving up on their mortgages.
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Fears that prime mortgages are vulnerable was behind the recent panic over Fannie Mae and Freddie Mac, which only ended when the US government agreed to make good their losses. The fear now is not only that US house prices will fall even further than people had been expecting leading to another wave of credit writedowns on mortgage bonds but that cash-strapped Americans will start defaulting on a much wider range of consumer debt, including credit cards, car loans and student loans.
3. Price of credit
Who will catch the falling knife? Various people have tried so far to end the financial crisis by making very public attempts to call the bottom from hedge funds, to private-equity firms, to sovereign wealth funds. So far, all have been left with egg on their face. The problem is that returns on many financial assets are still too low, which means that buyers need to use borrowed money to juice up their returns.
This week, Merrill Lynch off-loaded a huge portfolio of mortgage bonds to Lonestar, a US hedge fund, for just 22 cents in the dollar. But even at this knock-down price, Merrill had to lend Lonestar 75% of the money to make the numbers work. The snag is that not many buyers are currently willing to risk using borrowed money. Until yields on many securities reach levels where they look attractive even without borrowed money, no one can be confident the market has bottomed.
4. Oil and commodities
The sharp fall in the oil price from a recent high of nearly $150 a barrel has been a major relief for the markets. The hope is that this proves that the oil price spike was just a bubble driven by speculators and that oil prices will now continue to fall, leading to lower inflation and paving the way for central banks to cut interest rates.
But this is a pretty slender straw for optimists to clutch. After all, it's an odd sort of bubble that doesn't appear to have produced evidence of speculators making piles of money from it. On the other hand, if the recent fall is the result of a bubble bursting, the risk is that cutting interest rates will simply re-inflate it, causing the oil price to rise again.
5. China
Until recently, one of the key risks hanging over the global economy concerned China. The fear was that the Chinese would try to cool their over-heating economy by raising interest rates and allowing the renminbi to rise against a dollar, leading to a global slowdown and a jump in US inflation. That looks less of a risk, following the latest economic data from China, showing growth slowing to 10.1% and inflation falling to 7.1% from a February peak of 8.7%.
Perhaps the bigger risk now is that China concludes that its attempts to cool inflation have worked too well and that it decides to loosen monetary policy. If China's economy started to fire on all cylinders again, demand for oil and commodities would soar and push up global inflation. That is the last thing the West needs right now but there's not much we can do about it.
Simon Nixon is executive editor of Breakingviews.com.
