Turmoil in Financial Markets

After reading your full article at TCS Daily, I would add the following: In addition to, and perhaps greater consequence than, the higher than expected default rate attributable to sub-primes, etc. one must add the artifact of reduced market value of all underlying collateral - even for performing loans. Your discussion of the lower grade loans, projected default rates, risk premiums and their impacts on interest rates is correct. And as you addressed, in most cases (as I understand this phenomena), such loans were bundled with a high percentage of low-risk types into marketable securities/bonds that were attractive to investors because they had relatively high yield, and were marketable/tradable in their own right due to underlying collateral asset values (home values) that were increasing at best and anticipated to remain stable at worst.

The current situation is one of a liquidity problem - the marketable/tradable nature of the collateralized debt obligations (CDO's) has changed (they are perceived to be more risky than originally thought) due to a market adjustment of the underlying collateral value of all loans.
Consider if the U.S. was still experiencing generally advancing home prices, rather than declining home prices. Even a higher than anticipated incidence of default would not result in loss of principal due to declining collateral value.

To add to Shayne's comment, it is one thing to foreclose on a house that you can sell for more than the original loan amount (which had been the situation before). It is quite another to foreclose on a house that will sell for less than the loan amount (which is the current situation).