Amid the uncertainties in the capital markets, one thing seems well agreed: the troubled US sub-prime mortgage market - representing just under 5% of the huge US$14 trillion (€1 trn) US mortgage market - triggered last month's financial turmoil.

Sub-prime mortgage lending, that is extending mortgages to homeowners with tarnished credit histories, really took off in the US in 2005 when it was the fastest growing segment of the US mortgage market. It seems to have descended into a lending free-for-all as, about a year later, things were clearly going badly wrong. Several of the sub-prime lenders, including one now owned by HSBC, have reported that bad debt provisions would be significantly larger than predicted.

In March the shares of New Century Financial, one of the major lenders in this sector, were suspended by the New York Stock Exchange and on 2 April the company filed for Chapter 11 bankruptcy. And that's when the domino effect really started to get underway, other lenders admitting they too were in trouble. The illness was not confined to sub-prime nor to the US, with some high profile European banks admitting that they would not be unscathed. By early August, after one of the rating agencies announced that a raft of residential mortgage-backed securities was now on negative watch, the sub-prime problems erupted triggering a global flight-to-quality and with it market pandemonium.

Via today's complex derivatives markets, the connections - those ‘avenues of contagion' - from sub-prime reach very wide indeed. Not only are there many participants in the secondary markets for mortgages, from the loan brokers, to the bankers, to investors there is also the now enormous CDO sector, which has become the main buyer of sub-prime and most especially its lower rated paper.

While there have been volatile financial sell-offs in the past, with multi-percentage point drops in world stock indices and sharply amplified credit spreads, the complete drying up of liquidity in certain parts of the money markets is worrying. It was this liquidity freeze which pushed the central banks into action, bringing interbank rates in line with official targets, aiming to offset market disruption as quickly as possible.

A similar liquidity crunch occurred in 1998, following the Russian default and the implosion of Long Term Capital Management. When banks get really concerned about counterparty risk, they hold back on their overnight lending activities, which then drives up rates. As in 1998, there is today significant apprehension as to the magnitude of the losses of mortgage-related credit products out there in the market, and who may or may not be in trouble.

The problems in the sub-prime sector itself are deep-rooted and will last for some time; certainly the US housing market is not about to execute a speedy turnaround. The question is how long those difficulties will influence trading in other financial markets and the real economy.

Economists are downgrading US GDP growth forecasts, though the consensus agrees that recession should be avoided. Corporates and economies, most notably the emerging markets, across the world are in reasonably good health.

China is now a hugely significant economy, and growth there, though not immune to a US slowdown,
should remain strongly positive. Other big economies benefit a great deal from China.

At the corporate level, there will be an increase in defaults as debt servicing costs continue to rise, but the current strength of balance sheets should mitigate against too a sharp rise in the default rate.

Historically low risk premia have pushed the yield hungry into an orgy of diminishing-quality credit leveraging. Although markets are adept at slicing and parcelling out risk, it means that buyers of risk are further removed from the origination process, and perhaps diligence becomes less focused as deal complexity increases.

Spreads and volatility are both on the rise, and there has to be a phase - perhaps lasting months - of sometimes painful de-leveraging. If those lows in risk premia were part of a cyclical rather than a structural phenomenon then it could be a long time before they come round again.

While there has already been a sharp re-pricing of risk across the asset spectrum, it would be naïve to assume that we have already reached the wides or that the trend will be smooth. The US is not the only country where property prices have risen dramatically funded by cheap loans, and there will doubtless be more shocking disclosures from banks and funds, even from the less aggressive ones. Central banks do need to stay vigilant: the level of uncertainty and suspicion is such that a tidal wave of selling in a ‘flight-to-quality' remains a small, but chilling, possibility.