In 2006 Alberto Ramirez, a migrant strawberry-farm worker in California, with poor English, earning $US14,000 a year, took out a $770,000 loan to buy a house in Hollister.

Alberto’s mortgage required him to pay $5,200 a month. But his monthly income was $1,166.

What has Alberto’s insane mortgage got to do with us here in Australia?

Unfortunately, it has everything to do with us.

Because Alberto and the hundreds of thousands of people like him is each a microcosm of the debt storm that has savaged world markets.

Alberto, was of course, a sub-prime borrower. It was clearly no surprise that Alberto walked away from his loan and threw the keys to the bank. You can do that in America: mortgage loans are non-recourse and the bank can only rely on the house as security.

But what has surprised most people is the contagion effect – the extent to which the sub-prime worries have flowed over into the wider financial markets.

The $1,200 billion US sub-prime mortgage market is financed by bonds, called residential mortgage-backed securities (RMBS), which are packaged and sold around the world to investors attracted by the high yields they have offered. About $650 billion of sub-prime bonds are still outstanding, according to Deutsche Bank. About three-quarters of those were rated AAA at issue.

Many of these RMBS found their way into the asset pools that back collateralised debt obligations (CDOs), another kind of high-yield security that has emerged in recent years. The asset pools that back CDOs contain all kinds of loans: prime and sub-prime housing loans, credit-card receivables, car loans, US student loans, loans to companies with investment-grade credit ratings. In many cases CDOs can be a perfectly safe investment. But it was the ones that contained sub-prime US homeloans that have caused all the problems.

What was bound to end in tears – and has – is that there were too many Albertos: people who were given loans they should never have been give. You can’t blame Alberto for wanting his slice of the American dream. You can blame the mortgage broker, who got her commission even though Alberto defaulted. You can blame the banks and non-bank lenders, who wanted market share at all costs. You can blame the Federal Reserve Board, which, fearful of a recession, cut interest rates all the way to a 46-year low of 1 per cent in 2003. Inflation was higher than that, so real interest rates were negative!

By 2006, sub-prime lending had grown to account for 25 per cent of total US home loans. In Australia, that figure is 2 per cent.

“Self-verification” loans, where applicants simply state their income and assets, grew to 21 per cent of outstanding US home loans and 39 per cent of mortgages written in 2006.

The more people who got home loans, the higher house prices were pushed, making lenders even more eager to lend. The result was a massive – and record – overbuild of houses. The inventory of unsold US homes stands at 10.3 months. It would be considered balanced between supply and demand at 5 months.

Naturally, prices have started to fall. 10 per cent house price falls have already happened in Florida, Arizona, Nevada, California and Michigan. These states make up one-quarter of US GDP – and Moody’s estimates that the five are already in recession. Which makes avoiding recession for the US as a whole pretty tough.

As prices have fallen, people like Alberto Ramirez, who can’t meet their mortgage payments, have no incentive to try. Loan defaults have surged. The US Mortgage Bankers Association, in its December quarter report Mortgage Delinquencies, says the rate of home loan delinquency is the highest since 1985 – and the rate of actual foreclosure is the highest ever.

And as defaults have surged, the cashflows that support the sub-prime bonds – and the CDOs that contained them – have collapsed.

Why is this a problem? Two reasons.

First is the “contagion effect”. Investors unable to sell these suddenly illiquid assets have had to sell more liquid assets, even areas that have no exposure to sub-prime mortgages at all, like syndicated loans and high-rated corporate paper. As a result, there has been indiscriminate selling of high-quality investment-grade credits.

Secondly, most of the mortgage-backed derivatives house of cards has been held off-balance-sheet in the banks’ ‘special investment vehicles’ (SIVs) and ‘conduit funds’. In theory, the risk was safely contained there. But in theory US house prices never fall, either. So the banks have discovered that their SIVs and conduits etc. are no comfort – the banks are having to bring these contingent-liability chickens home to roost on the balance sheet.

The problem with this is that the banks did not set aside enough capital to back them. That’s the whole point of having things Off-Balance-Sheet!

Bringing these exposures back on to the balance sheet has resulted in a river of red ink flowing through the books of some of the biggest names in global finance. All up, about $240 billion has been written-down do far. Citigroup has written-down $32 billion; Merrill Lynch, $25 billion; IBS, $18.4 billion; Morgan Stanley, $10.3 billion; and HSBC, $11.7 billion.

As the contagion effect has flowed around the world, many banks have severely impaired capital bases. With their capital ratios impaired, many banks face severe lending constraints. And those that have capital to lend want to be paid more for it.

This is the problem facing businesses worldwide. If they have to roll over debt, refinance it, in the short term, they face a problem. If their maturities are further out, they are OK. But the cost of credit is higher for everyone.

This is what has crippled the likes of Centro, Allco, ABC Learning, MFS, City Pacific and Credit Corp and RAMS.

Because of the re-pricing of risk, even the cream of corporate Australia – the likes of Commonwealth Bank, BHP Billiton and Woolworths – now has to pay four and five times the spread over bank bills that they had to pay last year. And remember, these are spreads over bank bills that are themselves now 80 basis points above cash. All because of Alberto Ramirez’s mortgage.

And those are the only companies that can borrow.

This shortage of capital is not going to be solved anytime soon. If it weren’t for the sovereign wealth funds – the likes of the Abu Dhabi Investment Authority and the Singapore Government’s Temasek Holdings – which have already tipped almost $100 billion into some of the biggest names in Western finance – there might well have been major bank failures.

Nobody knows when the pain will end. Standard & Poor’s said on Thursday that the end of writedowns related to sub-prime mortgage securities is “now in sight.” S&P said the global financial-services sector may end up writing down the fair value of such exposures by $285 billion. But Goldman Sachs estimates that sub-prime-related losses could go as high as $400 billion. If US house prices fall by more than 10 per cent, Goldman Sachs could be closer to the money.

Then there is the problem about the credit ratings of sub-prime securities: 75 per cent of the outstanding $650 billion of such bonds is still rated AAA – when everybody knows that’s a joke. Bloomberg reported last week on one such bond, a $75 million issue sold by Deutsche Bank in May 2006, in which 43 per cent of the underlying mortgages are delinquent. And it’s still rated AAA.

If the ratings agencies bite the bullet and downgrade these AAA and AA sub-prime bonds to below investment-grade, the banks and insurance companies that are the main holders of them will have to put aside up to ten times more capital to back them than they do at the moment. Bloomberg estimates that up to $120 billion of these securities would have to be re-rated at below investment-grade. That would shrink the pool of global capital even more. It doesn’t bear thinking about.

It’s all too worrying. So I won’t even start to talk about the notional $43 trillion – that’s $43,000 billion – that is outstanding in credit default swaps (CDSs). That’s insurance, and of course not all insurance is claimed. But bond market guru Bill Gross from PIMCO says it would only take US credit defaults to return to normal rates of 1.25 per cent to have up to $500 billion worth of CDSs blow up in traders’ faces.

Now that really doesn’t bear thinking about.

But – to lighten the mood a little – Australia has a lot of positives going for it.

1. Australia has not had an overbuild of housing: in fact it has unsatisfied demand from growing population.
2. Australia has the lowest unemployment rate in 33 years, and strong wages growth.
3. Australia has a federal budget surplus that is very firmly in the black.
4. Australia has continued strong demand from the fast-growing economies of China and India for its raw materials.
5. And Australia is emerging from the effects of a debilitating drought that had a severe impact on its GDP.

If only the external environment weren’t so damned gloomy!