Is this the end of cheap money?

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Have we hit a major turning point in the global credit markets?

On Tuesday, credit ratings agencies Standard & Poors and Moodys admitted that they had been a little overoptimistic about the quality of subprime-mortgage backed bonds.

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S & P threatened to downgrade the credit ratings on some $12bn of the bonds, while Moodys, said it would cut ratings on 399 mortgage-backed bonds with a face value of $5.7bn, citing 'higher-than-anticipated' rates of delinquency.

The markets duly responded. The Dow Jones closed 148 points lower. Brokerage houses Lehman Brothers and Bear Stearns fell 5% and 4% respectively and on this side of the Atlantic, big banks like BNP Paribas, UBS and Deutsche Bank were all lower.

There was a predictable rebound yesterday, but there's no doubt that the markets have been shaken. Are the dominoes starting to fall?

Sub-prime mortgages are home loans made to the kind of people who wouldn't normally be able to qualify for a mortgage. The idea behind them is simple. As long as house prices keep rising forever, these overstretched borrowers would always be able to refinance their loans against the increasing value of their house, to keep the payments low.

Unfortunately, house prices don't rise forever, and have in fact been on the retreat across the US for more than a year. So people have begun defaulting on their mortgages. S&P's chief economist said this week that house prices across the US would be 8% lower in 2008 than in 2006. Richard Bernstein at Merrill Lynch is even gloomier. He reckons that, although there may not be a vast, rapid crash, "home prices are unlikely to appreciate from today's valuations over the next 10 years."

Credit agencies such as Moody's got around this eventuality when according the top credit rating to sub-prime CDO debt, says Barron's, partly because their models assumed the US housing market was regional, not national. So while prices might fall in some states, they wouldn't fall in others. In effect, they reasoned that "large CDO pools, composed of mortgage slices from all over the US, would provide sufficient diversification to withstand localised meltdowns."

That was the theory. In reality, "it is", said Jeffrey Gundlach, chief investment officer at TWC Group, "an unmitigated disaster." Pension funds could now be holding on to bonds that are not, as they first thought, investment grade. In fact, they could be as good as junk. And because many of their charters only allow them to hold on to investment grade bonds, they'd have to sell them on. But who is going to buy a risky bond that's likely to default within the coming years?

Exactly. No one.

There are already murmurings of discontent about the role the ratings agencies have played in allowing this debacle to happen. Marc Dann, Attorney General of Ohio told Fortune magazine, "The ratings agencies cashed a check every time one of these sub-prime pools was created and an offering was made [they are] among the people who aided and abetted this continuing fraud." He has good reason to be worried. The Ohio Police & Fire Pension Fund has nearly 7% of its portfolio in mortgage- and asset-backed obligations.

The big worry is that if investors are forced to sell these things at a loss, they may then have to sell other, entirely unrelated holdings, to fund those losses. That's the type of thing that drives up general levels of fear in the market, which could hurt over-inflated asset prices across the board.

Already credit spreads (the difference between risky bonds and safe, government-backed ones) are widening - up by about 50 basis points, says John Authers in todays FT. The dollar is in a tailspin, and stock markets across the world are jittery, to say the least.

But the big boys on Wall Street are telling us not to worry. Credit Suisse this week estimated total losses from the sub-prime debacle could reach $52bn. It's a big figure, sure. But not one to worry about, the banks tells us. The world's 10 largest investment banks have about $513bn in equity - any defaults, the banks will be able to cover it.

We're not so sure. According to Bank of America, about $500bn of adjustable rate mortgages are going to be reset upwards this year by an average of 200 basis points. In 2008, it will be $700bn, of which nearly three quarters are sub-prime. So what we're going to see is an enormous number of people who already had difficulty meeting their mortgage repayments, suddenly facing interest rates that are 2% higher. If you think people are defaulting now, just wait until the end of 2008.

Bear Stearns and its Wall Street cohorts may have been able to suck up the pain so far, but theres a lot more to come.

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Turning to the wider markets...

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In London, the FTSE 100 ended the day 15 points lower, at 6,614, although off intra-day lows. Leisure company Whitbread went against the negative trend with gains of over 7% sparked by bid rumours, whilst investors also cheered BSkyB's better-than-expected broadband subscriber numbers. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 closed 18 points lower, at 6,001, whilst auto stocks including Daimler-Chrysler led the Frankfurt DAX-30 66 points lower to a close of 7,898.

Across the Atlantic, US stocks bounced back from Tuesday's sell-off as investor optimism on Q2 earnings offset concerns over the subprime market. The Dow Jones added 76 points to end the day at 13,577. The Nasdaq was 12 points higher, at 2,651. And the S&P 500 closed up 8 points at 1,518.

In Asia, Japanese stocks ended the session higher as the Bank of Japan kept rates on hold. The leading Nikkei-225 index added 63 points to close at 18,112. In Hong Kong, the Hang Seng had hit a new record high today, having risen as high as 290 points to 22,897.

Crude oil had climbed to $72.83 whilst Brent spot was at $76.77.

Spot gold was at $662.80 this morning, compared with $660.30 in New York late last night. And silver had crept up to $12.89. For a more in-depth gold market report, see our section on investing in gold.

In the currency markets, the pound hit a fresh 26-year peak of 2.0364 against the dollar this morning, but had since fallen back to 2.0339. Meanwhile, the pound was at 1.4756 and the dollar was at 0.7253 against the euro. And the dollar was at 122.06 against the Japanese yen.

And Anglo-Australian mining giant Rio Tinto has agreed to buy Canadian aluminium producer Alcan for $38.1bn. The latter has recommended the offer, which trumps a hostile $27.7bn bid by Alcoa. Shares in Rio Tinto hit an all-time high on the Australian stock exchange before trading was suspended but were just 0.1% higher in early London trading.

And our two recommended articles for today...

How will the Bear Stearns saga end?

- We are at a critical point as far as markets are concerned. But is the recent trouble in the subprime market enough to turn investor sentiment negative and trigger a sell-off? For more on how recent events look set to pan out, read: How will the Bear Stearns saga end?

We've reached the top of the global debt market - what next?

- Mortgage lenders are seeking to pass on the higher cost of borrowing to lend by increasing the spread on trackers and hiking arrangement fees. And it's not just homeowners who are suffering the effects of the credit crunch. For more on how the credit crunch went global, click here: We've reach the top of the global debt market - what next?

Sub-prime mortgages are home loans made to the kind of people who wouldn't normally be able to qualify for a mortgage. The idea behind them is simple. As long as house prices keep rising forever, these overstretched borrowers would always be able to refinance their loans against the increasing value of their house, to keep the payments low.

Unfortunately, house prices don't rise forever, and have in fact been on the retreat across the US for more than a year. So people have begun defaulting on their mortgages. S&P's chief economist said this week that house prices across the US would be 8% lower in 2008 than in 2006. Richard Bernstein at Merrill Lynch is even gloomier. He reckons that, although there may not be a vast, rapid crash, "home prices are unlikely to appreciate from today's valuations over the next 10 years."

Credit agencies such as Moody's got around this eventuality when according the top credit rating to sub-prime CDO debt, says Barron's, partly because their models assumed the US housing market was regional, not national. So while prices might fall in some states, they wouldn't fall in others. In effect, they reasoned that "large CDO pools, composed of mortgage slices from all over the US, would provide sufficient diversification to withstand localised meltdowns."

That was the theory. In reality, "it is", said Jeffrey Gundlach, chief investment officer at TWC Group, "an unmitigated disaster." Pension funds could now be holding on to bonds that are not, as they first thought, investment grade. In fact, they could be as good as junk. And because many of their charters only allow them to hold on to investment grade bonds, they'd have to sell them on. But who is going to buy a risky bond that's likely to default within the coming years?

Exactly. No one.

There are already murmurings of discontent about the role the ratings agencies have played in allowing this debacle to happen. Marc Dann, Attorney General of Ohio told Fortune magazine, "The ratings agencies cashed a check every time one of these sub-prime pools was created and an offering was made [they are] among the people who aided and abetted this continuing fraud." He has good reason to be worried. The Ohio Police & Fire Pension Fund has nearly 7% of its portfolio in mortgage- and asset-backed obligations.

The big worry is that if investors are forced to sell these things at a loss, they may then have to sell other, entirely unrelated holdings, to fund those losses. That's the type of thing that drives up general levels of fear in the market, which could hurt over-inflated asset prices across the board.

Already credit spreads (the difference between risky bonds and safe, government-backed ones) are widening - up by about 50 basis points, says John Authers in todays FT. The dollar is in a tailspin, and stock markets across the world are jittery, to say the least.

But the big boys on Wall Street are telling us not to worry. Credit Suisse this week estimated total losses from the sub-prime debacle could reach $52bn. It's a big figure, sure. But not one to worry about, the banks tells us. The world's 10 largest investment banks have about $513bn in equity - any defaults, the banks will be able to cover it.

We're not so sure. According to Bank of America, about $500bn of adjustable rate mortgages are going to be reset upwards this year by an average of 200 basis points. In 2008, it will be $700bn, of which nearly three quarters are sub-prime. So what we're going to see is an enormous number of people who already had difficulty meeting their mortgage repayments, suddenly facing interest rates that are 2% higher. If you think people are defaulting now, just wait until the end of 2008.

Bear Stearns and its Wall Street cohorts may have been able to suck up the pain so far, but theres a lot more to come.

If you're not already a subscriber, you can sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.

Turning to the wider markets...

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email

In London, the FTSE 100 ended the day 15 points lower, at 6,614, although off intra-day lows. Leisure company Whitbread went against the negative trend with gains of over 7% sparked by bid rumours, whilst investors also cheered BSkyB's better-than-expected broadband subscriber numbers. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 closed 18 points lower, at 6,001, whilst auto stocks including Daimler-Chrysler led the Frankfurt DAX-30 66 points lower to a close of 7,898.

Across the Atlantic, US stocks bounced back from Tuesday's sell-off as investor optimism on Q2 earnings offset concerns over the subprime market. The Dow Jones added 76 points to end the day at 13,577. The Nasdaq was 12 points higher, at 2,651. And the S&P 500 closed up 8 points at 1,518.

In Asia, Japanese stocks ended the session higher as the Bank of Japan kept rates on hold. The leading Nikkei-225 index added 63 points to close at 18,112. In Hong Kong, the Hang Seng had hit a new record high today, having risen as high as 290 points to 22,897.

Crude oil had climbed to $72.83 whilst Brent spot was at $76.77.

Spot gold was at $662.80 this morning, compared with $660.30 in New York late last night. And silver had crept up to $12.89. For a more in-depth gold market report, see our section on investing in gold.

In the currency markets, the pound hit a fresh 26-year peak of 2.0364 against the dollar this morning, but had since fallen back to 2.0339. Meanwhile, the pound was at 1.4756 and the dollar was at 0.7253 against the euro. And the dollar was at 122.06 against the Japanese yen.

And Anglo-Australian mining giant Rio Tinto has agreed to buy Canadian aluminium producer Alcan for $38.1bn. The latter has recommended the offer, which trumps a hostile $27.7bn bid by Alcoa. Shares in Rio Tinto hit an all-time high on the Australian stock exchange before trading was suspended but were just 0.1% higher in early London trading.

And our two recommended articles for today...

How will the Bear Stearns saga end?

- We are at a critical point as far as markets are concerned. But is the recent trouble in the subprime market enough to turn investor sentiment negative and trigger a sell-off? For more on how recent events look set to pan out, read: How will the Bear Stearns saga end?

We've reached the top of the global debt market - what next?

- Mortgage lenders are seeking to pass on the higher cost of borrowing to lend by increasing the spread on trackers and hiking arrangement fees. And it's not just homeowners who are suffering the effects of the credit crunch. For more on how the credit crunch went global, click here: We've reach the top of the global debt market - what next?