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The subprime virus has gone global. Starting as a localised outbreak in the US market for risky subprime mortgages, it has spread into the supposedly safer “Alt-A” tier and even into prime mortgages. Meanwhile, it has crossed into other loan species – particularly leveraged lending, where ballooning spreads have rattled the market and left banks holding big chunks of debt.

The sharp credit market reversal has in turn prompted a flight from risk. Stocks have slumped, especially financials, and Treasury yields have fallen. A number of credit hedge funds, carriers of the virus, have blown up around the world – even some without subprime exposure. Those with bad leveraged bets face falling collateral values, tighter lending from prime brokers and illiquidity in some assets. That is probably exacerbated by investors seeking redemptions after two Bear Stearns funds blew up in June. That can force a fire sale of assets or a redemption freeze and more fear.

That does not necessarily signal Armageddon. The credit markets needed to cool down. While there is a chance that a vicious circle develops, overall it is healthy that investors have rediscovered risk. And some institutions are making hay – witness Deutsche Bank’s results on Wednesday.

The question is whether the contagion, which started in US housing, spreads back from financial markets into the real economy. This is a real concern. The availability of credit has declined significantly for risky borrowers, which accounted for about a third of house purchases last year, according to Deutsche. The removal of marginal buyers will affect house prices, as will forced selling because of defaults. Even for prime borrowers, mortgage rates have not fallen with Treasury yields in recent weeks.

House prices are likely to come under more pressure. That could be a drag on consumption and further damp US growth. It is probably manageable, with companies well-financed overall and the global economy still buoyant. But it does not leave much margin for error if the long-stable US employment picture finally starts to worsen.

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