Hard times

Serious Money:Santa Claus arrived early on Wall Street, and November ended on a positive note. The Federal Reserve's chairman, Ben Bernanke, and vice-chairman, Donald Kohn, both spoke of the need for further monetary easing, while sultans from the Middle East injected much-needed capital into the ailing Citigroup, writes Charlie Fell

The blue-sky merchants appeared from their trenches, and some argued that predictions of an impending US recession should be viewed as "nonsense talk".

Stock prices duly responded and surged, but investors should be aware that the return of happy days should prove short-lived as the underlying fundamentals increasingly suggest that a full-blown credit crunch is at hand.

The Federal Reserve's interest rate actions so far have not eased the strain in credit markets as the loss of confidence, liquidity and doubts about the solvency of financial intermediaries persist.

The yields available on risk-free Treasury bills have dropped precipitously but have not been accompanied by similar declines in the rates that financial institutions lend to one another.

The differential between the two, known as the TED spread, an important signal of risk appetite, is more than two percentage points, and exceeds the levels recorded following the collapse of Long Term Capital Management in 1998.

Indeed, recent readings have only been surpassed in modern times by the extreme levels registered during the week the financial markets almost died in 1987.

Unfortunately, unlike the stock market crash of 20 years ago, today's elevated levels have persisted in the face of aggressive liquidity injections. The probability that the credit crisis ends in recession grows ever higher.

The notion that the credit crisis during the summer was a function of diminished liquidity with few solvency implications was always lame, and the recently-released report on the state of the banking industry for the third quarter from the Federal Deposit Insurance Corporation (FDIC) corroborates this opinion. Third-quarter earnings dropped by almost 25 per cent to the lowest level in almost five years, while return on assets declined to a 15-year low. Provisions for loan losses soared to the highest level in 20 years but the surge in non-performing loans saw the industry's coverage ratio drop to just 105 per cent.

The upward trend in problem loans, combined with the negligible cushion reflected in coverage ratios, means that financial institutions have little choice but to devote an increasing share of capital resources to loan-loss reserves.

The problems in the residential mortgage market are well-known, but the FDIC report shows that the US's indebted households appear increasingly fragile as difficulties are apparent in all categories of consumer loans.

Indebted consumers turned to their credit cards when the ability to extract equity from their homes disappeared, but the switch was ill-advised as evidenced by the surge in write-offs, which accounted for almost 40 per cent of bad debts in the third quarter.

America's debt-bloated consumer is clearly hanging by a thread, but do recent statistics herald an end to the irresponsible and reckless spending? The Conference Board's most recent survey of consumer confidence says yes. The overall index has dropped sharply since the six-year high recorded in July, and near-term expectations have declined even further.

Importantly, consumers' assessment of future business conditions sees those who expect deterioration exceed those who expect improvement for the first time in years. The figures for the labour market remain positive, though next month's survey should confirm that most Americans believe that jobs are no longer plentiful.

A consumer-induced recession looks ever more likely in the US as the market for credit remains subdued. The elite from the investment community will undoubtedly continue to argue for the "more of the same" muddle-through scenarios but such negligence no longer deserves a yellow card but a red. Astute investors should heed the adage: "Fool me once, shame on you. Fool me twice, shame on me."

Hard times are ahead, and preservation of capital is paramount.