Back in March this year, we observed the complacency of the market regarding the slow-motioned unfolding of the sub-prime crisis (see Complacency! Market shrugging off sub-prime concerns). To the casual observer, it seemed that the sub-prime issue ?suddenly? popped up (say, sometime around February this year: see Marc Faber on why further correction is coming?Part 2) and developed into a ?contained? problem. There was a widespread belief that extraordinary liquidity will sweep away every woes in the market. Then all of a sudden, with the collapse of two of Bear Stearn’s hedge funds, the sub-prime problem seemed to begin to rear its ugly head again. There is now talk about liquidity crunch, narrowing of credit spread, etc.

In reality, the sub-prime issue was always lurking in the background. It was a problem that was slowly building up over a period of years. Today, it is finally blowing up in slow-motion. Contrarians had been warning about this problem but nobody took heed. For example, back in March 2004, Robert Blumen (who was associated with the Austrian School of economic thought of the Mises Institute) wrote in All Real Estate, All the Time:

The mainstream economist responded to these charges. “Home owners can simply extract equity from their home by refinancing and use the cash they take out to pay the difference between their income and their mortgage.” Home owners extracted $491 billion of equity from their homes last year according to the Wall Street Journal. “Home owners are already using home equity from refinancing to meet ongoing monthly expenses,” he continued, “It is a small step forward to start using these funds for the mortgage itself.”

As we said before in How does liquidity dry up?, the global economy’s drug supply of cheap and plentiful money is drying up. The consequence will be like a heroin addict suddenly running out of drugs for the next fix?cold turkey. Our belief is that this sub-prime contagion is probably going to spread further. What we see today is just the beginning. So, how may it spread?

We found that this article, Next victims of the credit squeeze, provides a good example of how such a debt crisis may infect the rest of the economy:

Turbulence in the credit markets has already claimed several casualties – from highly leveraged hedge funds to mortgage providers whose lenders have cut them off.

But the fallout could get worse. Some experts say the debt crunch could squeeze underperforming companies that have, until now, been able to finance their way out of trouble – and trigger a wave of corporate bankruptcies.

Mind you, if this scenario unfolds (which we believe can happen), it will lead to serious problems for the real economy.