Why did it get so bad so quickly in credit markets?

In the last couple of weeks we have been witnessing neat cataclysmic events shaking debt markets. Let's first look at the facts:
- Major hedge funds are failing and are being forced to sell down their positions with huge losses to their investors
- Financial markets for all types of debt instruments - Mortgage backed securities, CDOs, Commercial paper, etc... are practically at a standstill
- The same debt markets are experiencing an unprecedented flight to quality with yields for treasuries moving a full percentage point in a day - practically unheard of before
- Anything that is not guaranteed by US government is considered toxic and uninvestable
At first glance looks pretty scary, doesn't it. While i cannot claim any special expertise in the fixed income area, one cannot help but think that things are not as bad as financial media would lead us to believe.

The whole thing started once many of the subprime mortgages started resetting and were causing a bunch of foreclosures which directly impacted investors in such exotic instruments as Collateralized Mortgage Obligations (CMOs). The default rates on these mortgages have taken out a lot of investors in the riskier tranches of these securities and at the same time threatened supposedly unflappable AAA rated tranches created from the same potentially toxic subprime loans. The people who were most hurt by this are hedge funds that used high to improve their returns from these securities. As an example a hedge fund that uses a 10x leverage can suffer only a 5% in their asset values but lose 50% of their investors equity. I believe this is exactly what happened to funds run by BNP Paribas, Dillon Read, and Bear Stearns. Pretty messed up for funds investors but the lenders of these funds are still not experiencing any real losses.

This got people thinking. Lenders that have in the last couple of years lost risk aversion due to extremely benign economic environment realized that maybe that loan of 8x EBITDA to a private equity buyout with no covenants at Libor+200bps actually could be riskier than it looks. If these sub-prime mortgages could go bad this quickly, maybe their corporate equivalents, LBO loans, could suffer the same fate. As a result that market dried up as well.

While so far the events described are quiet logical what happened next no longer is. Investors in all these other new exotic debt instruments created by slicing and dicing pools of different debt securities started thinking that they might be at risk too. Many of those investors are not allowed to hold anything that is not AAA rated. Those instruments were never tested in the economic downturn. Are they really AAA rated? So they tried to sell everything they can and move to the safest thing out there - Short term treasury notes. If one person would do this it would not be so bad. But financial markets became very adapt at spreading risk using these exotic instruments. Since everyone held them---everyone was trying to get rid of them. As a result all credit markets completely ceased up....

I strongly believe that this was a huge overreaction. Holders of this AAA rated papers would only face defaults if practically ALL LOANS that were made would go into default. It is extremely difficult to imagine such scenario even in sub-prime mortgage backed papers - not even talking about instruments backed by relatively high quality corporate debt or prime mortgages. It will take a little while for people to figure this out but once they do - debt markets will come back and start functioning again. The major difference though will be that for at least little while risk appetite would go down to more reasonable levels - and this is a good thing.

Who will win? Banks that will be able to get higher interest rate on their loans.
Who will lose? Hedge funds and private equity funds that have depended on cheap leverage for their performance.

But in a meanwhile we will likely have a pretty horrible third quarter results from a lot of companies especially ones that produce large industrial equipment. I seriously doubt that firms that suddenly started worrying about their ability to finance themselves wouldn't delay some of their large investment projects.