Earlier this year when the sharp rise in subprime delinquencies were announced, it was largely shrugged off by the markets due to the relatively small size of the submprime market in comparison to the rest of the mortgage industry. The risk of contagion was thought to be minute as the problems appeared to be specific to this particular segment of the market. What was not taken into consideration, however, was the widespread use of leverage across the board, fuelled by record low borrowing rates, reckless lending and the competitive pressure to generate higher returns in an environment of performance compression. The potent cocktail of illiquid investments and the heavy use of leverage led to a sharp selloff in August, prompting central bank intervention to restore normalcy. As calm returned, it became quickly evident that it would not last long as the core problem was far from being resolved.
The markets are in effect navigating without a compass as nobody has a full grasp of the extent of contagion. This is a result of the lag in reporting not only with regards to certain types of investment vehicles such as hedge funds (some of which are heavily exposed to the subprime market) , but also economic releases, a key barometer for the health of the economy. Today's negative U.S. employment figures for August are a good example of the lag. Reporting for the month of August (ground zero) is just beginning to surface now which means that we can expect more turbulence on the horizon.
