WHEN the man approaching you is wearing boxing gloves, it makes sense to duck. The crisis in the American subprime-mortgage market was clearly visible months ago. Too many homebuyers with a poor or non-existent payment record were lent too much money. But when the rating agencies on July 10th finally got round to acknowledging the problem, investors were clobbered. Shares briefly wobbled and the dollar sank. Swap spreads, a measure of risk aversion, reached their highest point since 2003. Credit derivatives, where much of the financial innovation in recent years has taken place, recoiled (see chart). Investors flocked to the haven of Treasury bonds.

Why were investors so slow to react? It seems they have been consistently blindsided by how widespread the subprime problems have become—as well as complacent about the potential spillover into other areas of the debt markets.

At first, investors thought the subprime issue was confined to a few lenders, but the forthright website www.lenderimplode.com suggests that 97 of them have now been hit. Then they thought that defaults would be confined to a few states in the Midwest but the crisis has spread to heavily populated California and Florida.

The second delay was caused by the way that mortgages had been repackaged and sold. Initially they were bundled into residential mortgage-backed securities or RMBSs; Moody's, a rating agency, downgraded 399 of these bonds, while Standard & Poor's, a rival, indicated it was preparing to downgrade some 612 bonds, worth $12 billion. These bonds are only a small portion of the mortgage-related market. But according to Josh Rosner of the investment firm Graham Fisher, the agencies suggested further downgrades were to come.

The RMBSs are in turn divided up and placed in instruments called collateralised debt obligations or CDOs. These were sold to a wide range of investors, depending on their tolerance for risk. One set of securities, known as an equity tranche, pays the highest returns but is the first to suffer if the underlying bonds default; other securities offer a much lower yield but a triple-A credit rating, because a lot of defaults would be needed to trigger losses.

The result of this process has, in theory, helped the market. Bank failures have been at the heart of most financial crises. But instead of the banks taking the first hit from mortgage defaults, the pain will be spread round the financial system.

However, nobody knows where the risk now lies. Many of these securities are illiquid, so regular prices are not available. Indeed, highly rated CDO tranches may still be owned by banks that do not have to put a value on these securities. They may not recognise the problem until they are forced to by auditors or by ratings downgrades. On July 11th Moody's said it may cut its ratings on tranches of 91 CDOs worth about $5 billion. “My initial analysis suggests we could see massive cumulative losses into the double-A tranches of many RMBS-backed CDOs,” says Mr Rosner. (Double-A tranches, as their name suggests, are just below triple-A.)

Those required to ascribe a market value to these securities are faced with what ING, an investment bank, describes as a version of the prisoner's dilemma. Everybody would be better off if nobody traded, so that there would be no need to recognise lower prices. But if everybody is planning to sell, those who trade first will have an advantage.

This problem cropped up when two hedge funds run by Bear Stearns, an investment bank, got into trouble in June. The Bear funds had borrowed to enhance returns, and in doing so had to post collateral with lenders, known as prime brokers. When things went wrong, one of the brokers, Merrill Lynch, tried to sell its collateral but soon stopped when it transpired it was only succeeding in driving prices sharply lower. Eventually, Bear Stearns pledged some of its own money to fill the gap.

But prime brokers may also be shrinking the investor pool by increasing the margin that funds must put up when buying CDO assets; according to Matt King of Citigroup, the margin requirement on paper rated at the lowest level of investment grade has risen from 10-20% to 50%. That is bound to discourage some hedge funds.

All this may reduce the pool of potential mortgage investors. This effect may be reinforced by other developments. In recent years, there has been a concerted effort to increase the share of homeowners in America from the post-war average of around 63% to 70%. Lending standards were relaxed and deposits were no longer required. The extreme was reached with so-called NINJA loans (borrowers needed no income, job or assets). The influx of new buyers pushed up house prices, which made lenders even more eager.

But as the rating agencies have now discovered, fraud played a part too. Everybody had an incentive to do a deal, almost regardless of the homebuyers' ability to repay; the buyer hoping for a quick profit, the real-estate agent and mortgage broker hoping for a fee. And the banks did not need to be as concerned about creditworthiness as they used to be, given they would be quickly selling the loan.

Now that defaults have shot up, particularly on loans taken out last year, lending standards are being tightened. That will reduce the number of potential buyers and put downward pressure on prices.

Many homeowners are already in trouble. Figures from MacroMavens, an economic consultancy, suggest that 23% of adjustable-rate mortgages, covering loans with a value of $693 billion, are already in negative equity, where the loan is worth more than the property. But the full impact of defaults may not be felt until the low “teaser” rates on mortgages expire and push up borrowing costs. These teaser loans were done on a “two and 28” basis (with low rates applying for the first two years, and higher rates for the next 28). So the worst news from the 2006 vintage may not be felt until 2008.

Nor does default necessarily mean the end of the road. Few lenders want to foreclose, a process that takes ages, incurs massive costs and often causes the departing residents to trash the house. It is better to agree on a quick sale. But too much selling will force prices lower, weakening the rest of the portfolio.

So it may take a while for the property of struggling borrowers to trickle onto the market. Jeffrey Kirsch of American Residential Equities, a company specialising in buying delinquent loans, says foreclosing a property can take more than three years. He doubts the housing market will bottom out until the first quarter of 2009.

The current fear is not so much that the housing market could drive America into recession, although that could still happen. The worry is more that credit conditions may get tighter. The spread paid by higher-risk European firms has increased by almost a percentage point since mid-June. Investors are shying away from some loans being offered to finance leveraged buy-outs. A slowdown in such private equity-driven bids would hit the stockmarket.

Richard Bernstein, a Merrill Lynch strategist, says excessive lending has been fuelling the growth in financial markets in recent years. But he fears that now liquidity is drying up. That means no cushion when the punch lands.