SERIOUS MONEY:Warren Buffett, the world's most successful investor, famously quipped that "it's only when the tide goes out that you learn who's swimming naked".

His words are an appropriate description of the current environment in global capital markets. Stock markets have been gripped by a sense of panic following the latest revelations in the US's ongoing saga in the subprime mortgage market. Liquidity has evaporated and excesses are being exposed as the enthusiasm for risky assets at any price wanes. The dash for trash, or investors' seemingly insatiable appetite for junk of all shapes and sizes, which saw prices climb to absurd levels, is well and truly over.

Problems in the US mortgage market have been apparent for some time. Indeed, more than 100 mortgage lenders have shut their doors since the start of the year and the number of closures has risen sharply in recent weeks.

However, equity investors seemed to be oblivious to the growing crisis, as stock prices soared to all-time highs. The music stopped a few weeks ago when Bear Stearns revealed that two of its hedge funds were in serious difficulty, and the extent of the potential damage has become increasingly evident in recent sessions. The cumulative losses of $100 billion (€74 billion) estimated by Ben Bernanke, chairman of the US Federal Reserve, appear to be ridiculously low.

The subprime meltdown in the US has proved to be a global problem. IKB, a relatively small German bank, needed a capital injection of almost $5 billion to cover potential losses and stay afloat, while BNP, France's largest bank, revealed that it had frozen more than $2 billion of mortgage-exposed funds and had barred further redemptions.

Last week's disturbing news has been followed by revelations this week that a number of Goldman Sachs's hedge funds are experiencing difficulties. Is it any wonder the markets are struggling?

The plunge protection teams - ie the world's leading central banks - are riding to the rescue with massive injections of liquidity, but their efforts to ensure financial markets remain fully operational have done little to underpin stock prices. That said, global stock markets, despite the recent turbulence, have not dropped that far, and the cumulative decline is still in single-digit territory. Indeed, the US stock market has gone more than 1,000 trading sessions without a setback of 10 per cent or more - one of the longest stretches in its history.

The current setback has been long overdue. Unfortunately, the present turmoil - brief rallies aside - is likely to persist.

The American housing market has not hit bottom and there are signs that subprime troubles are gravitating upwards to supposedly stronger segments of the housing market. Additionally, more than half a trillion dollars of adjustable-rate mortgages are set to reprice upwards during the first six months of 2008, more than all of the total for this year.

Higher mortgage payments combined with a softer labour market are likely to prove too much for an already heavily-indebted consumer to bear. The obvious conclusion is that a recession draws ever closer. The optimists, who only a matter of weeks ago argued that the subprime crisis would be contained, will point to corporate health as a reason for good cheer. It is true that corporate balance sheets in aggregate paint a pleasant picture. However, detailed analysis shows that there are major causes for concern.

Indeed, the high-yield segment, which now accounts for more than half of all corporate bond issuers, is currently sporting the highest leverage ratios in more than a decade. Additionally, more than half of low-rated leveraged loans are set to mature over the next three years, or almost $500 billion.

Given that most of these loans have been made by short-term, performance-based investors, refinancing could be a problem and default rates could soar from their historically low levels at present. The mortgage crisis is likely to spread to high-yield debt. Investors have been delivered a long-overdue wake-up call in recent weeks and the unhealthy disrespect for risk is at an end. Recession risks are rising, which means that stock prices will continue to struggle, while credit spreads will remain elevated. A focus on capital preservation and quality is the appropriate action in today's volatile markets.

charliefell@sequoia1.ie