Few would have predicted the tidal wave that hit markets globally last week, sending global indices and currencies – like a scattergun – in unpredictable directions. The eye of the storm was US sub-prime mortgages, an area of the market that, until recently, few investors in Australia even knew existed.

Spooked by fear of a liquidity crisis of global proportions, markets around the world fell in quick succession last week, leading from the epicentre of trouble, the US, to Australia, New Zealand, China, Sweden, Europe, Russia, South Korea, Brazil and Argentina.

While the Australian market has since recovered some of its losses, it’s likely that fear has set in – possible keeping a lid on future share price gains.

What’s troubling for investors is the difficulty of understanding what actually happened last week. What is a US sub-prime mortgage, and what on earth does it have to do with the Australian sharemarket?

US sub-prime mortgages are similar to the so-called low-doc loans in Australia. These are mortgages designed for investors who lack the income, savings or credit history to access loans via ordinary means. Mortgage brokers in cohorts with the major banks were active promoters of low-doc loans during the recent property boom in Australia. Since mortgage brokers received commissions on the number of loans put through the banks – peddling low-doc loans was a fairly common practice.

The trouble with low-doc loans, or US sub-prime mortgages, is that an interest rate or unemployment increase will inevitably result in a sea of struggling property owners who can’t service loans; they then default and are ultimately forced to sell up. Welcome to the US housing crisis.

But why should a housing crisis in the US affect the rest of the world?

Well, the answer lies in the wonderful world of securitisation. For those who don’t know, a security is a product that’s tradeable, such as a share or a bond. Securitisation, therefore, simply refers to the process of making something that isn’t tradeable – such as a mortgage – into a product that can be bought and sold for profit.

Over the past decade or so, securitisation departments in major banks have been busily pooling US sub-prime mortgages with other commercial and consumer loans, and converting them into tradeable securities, or bonds. These bonds effectively pass on the interest paid on the underlying loans – such as Mum and Dad making regular mortgage repayments – to bondholders. Investors around the world purchase these securities (bonds) mainly for the yield offered.

An increasingly popular activity of securitisation departments was to combine these bonds with leverage (borrowings), and this higher-risk derivative on the underlying mortgages, termed a collateralised-debt obligation (CDO), was on-sold to hedge fund managers, institutional and retail investors. The CDO market was so popular that the global issuance of CDOs totalled USD$489 billion in 2006, up from USD$157 billion in 2004, according to the Securities Industry and Financial Markets Association.

It’s not surprising, therefore, that when the US sub-prime mortgage market started to show cracks under a rising number of defaults – the CDO market took an even bigger beating. Today, CDOs have become almost impossible to trade, and the size of the losses incurred by banks and hedge funds worldwide is yet to be calculated in full.

In Australia, Macquarie Bank, Babcock & Brown, RAMS, hedge fund manager Absolute Capital Group and even a number of NSW councils have owned up to being exposed to CDOs – suffering large losses as a result.

Why did Central Banks around the world intervene?

Last week the word “liquidity crisis” was bandied around in the financial press a lot, which mostly served to increase the pulse rate of investors with funds in the market, rather than enlightening them as to what was actually happening.

Basically, the crisis was occurring in the interbank lending market. This is the market that banks use to lend and borrow money from each other, depending on whether they are short or have excess cash for the day. The interest rate charged generally mirrors the interest rate set by the Central Bank.

As the extent of the US sub-prime fiasco emerged, banks – suddenly unsure of the risk that other banks faced to the crisis – become reluctant to lend money to each other. A dearth of funds in the money market quickly prevailed. And the interbank rate spiked.

It’s clear that an injection of cash by Central Banks around the world – kicked off by the European Central Bank – was like putting a band aid on a weeping wound. As the money market became flush with cash, banks were more willing to participate and the prevailing interest rate declined. Whether it will be a cure-all to stop the fear that currently prevails in the market, however, is still too early to tell.

What are the risks of the US entering recession?

The fact that the US Federal Reserve thought it necessary to drop rates by 50 basis points is of some concern. The last time the US was forced to suddenly drop rates was during the Long Term Capital Management crisis in 1998. Its actions should make it clear to investors that this current crisis is severe.

US fundamentals aren’t good. Family debt is near record highs, and consumers facing shrinking equity in their homes as property prices fall – are paring back spending. And as we all know, the resilience of the US consumer to continue shopping amidst calamity has been their only savour in the past.

Should Australian investors be worried?

The crisis that hit financial markets last week was fairly severe, and although Central Banks have quickly reacted by pumping cash into the market, and the Federal Reserve has dutifully dropped rates, it’s likely that the fallout from the US sub-prime market has further to go. It may take weeks or months for banks to assess the damage of the CDO exposure to their balance sheets.

Until the time comes when the extent of the crisis is fully laid out on the table for all to see, investors should act with a caution – and speculators beware.