If you’d woken up on Monday morning and wondered, “what will we see in the financial markets this week, more subprime problems?” you’d have been right.

But just where the problems would erupt was another thing. If you’d said a big American mortgage lender which wasn’t in subprime, or a medium-sized German industrial bank, or two big US mortgage insurers, or an Australian investment fund, you would have been laughed at.

Stockmarkets looked at last week’s problems and said “so what” and we had two days of rises here as did Europe and the US was heading the same way last night until out of the blue several more problems emerged, one of which was in Australia.

At least The Australian managed a Page 1 pointer to a story on the third Australian fund in trouble, with total losses across the trio of around $1 billion.

Was there a story on Page 1 of the nation’s business paper, the Australian Financial Review? Not there, but buried on page 60 with no Page 1 pointer.

The involvement of Macquarie Fortress was as surprising as those of Basis and Absolute Capital. No-one would have nominated it, although many would have suspected that Macquarie Bank might be involved in some way, such is its reputation for pushing the envelope in search of new business and returns.

It’s why Macquarie Bank shares hit a recent low of $80 last Friday (they recovered $2.50 to $82.50 yesterday and will need watching today).

The story is that Macquarie Bank investment fund offshoot, Macquarie Fortress, is facing losses of 25%, or $300 million in two of its high yield funds, not from investing in subprime mortgages but because of what they call a “contagion factor”.

That’s when problems in one part of the market spread into sounder sectors. In this case, the failures and losses in subprime mortgages and lending are spilling over into better rated bonds, into housing construction (which fell last month in the US), into private equity deals, into the stockmarket generally, and throwing up surprising victims.

And that’s what’s has knocked Macquarie Fortress: demands from its lenders for more money to cover falling asset values over which Fortress has no control. It had around $220 million of capital and total assets, including borrowings of $1.5 billion; meaning it was ‘leveraged’ six or seven times. That’s great for making big money, but when markets turn as they have, a 4% loss in a week, which is what Fortress has suffered, becomes a loss of up to 25%.

A month ago who would have thought three Australian funds, Basis Capital, Absolute Capital and now Macquarie Fortress, would have been caught up in the subprime disaster and its shock waves? That’s losses of at least $A1 billion there alone, some of it from super funds, some it from individual investors.

Basis had the highest exposure to subprime bonds and went first; Absolute says it was exposed for only 5% of its portfolio, but the value of other bonds fell and it too, like Basis and Fortress, found it could not make the margin calls of its lenders (which is a demand for more money to cover the declining value of investments).

So much for the silly comment piece on page 60 of today’s Australian Financial Review: “Australia safe from subprime drama.” And directly above it was the Macquarie Fortress story. The comment piece’s claims were nonsense, given what the AFR was reporting and what we now know about Basis and Absolute Capital.

And, yes I know it was a comment that the problems in subprime lending can’t happen here. Of course they can’t because our low doc loans are a tiny proportion of home mortgages compared to America. But the fallout is landing here because at least three institutions funded the subprime mortgage market, or invested in other high yield bonds, in their pursuit of higher returns. The subprime problem is now a problem for all nigh yield bonds.

News of Macquarie Fortress’ woes spread quickly to America where the market was rising slowly after a solid day Monday.

Investors had already been wondering if the big US mortgage lender, American Home, would survive a cash flow crisis. It had $US20 US billion in net assets and a net worth of $1.3 billion or so early last week. Now it had suspended dividends and couldn’t meet calls to refinance loans it had borrowed money to make.

This was a day after a medium-sized German industrial bank, 38% owned by a German Government finance body, sacked its CEO, withdrawn its profit forecasts and said it faced huge losses on subprime investments.

The government body stepped in to say it would cover all losses: in effect a bailout but no-none could explain how this bank, which lends to small and medium businesses in Germany, came to be playing in the unregulated subprime markets in the US.

And during the day in the US it became apparent that another, bigger shock was in store.

MGIC, the largest private mortgage insurer in the US (and which has insured hundreds of millions of house mortgages) and a smaller insurer called Radian, disclosed they had probably lost $US1 billion invested in a jointly owned company that operated and serviced the subprime mortgage markets.

MGIC Investment Corp shares fell by the biggest amount ever and Radian Group saw its shares fall by the biggest amount in eight years after the two home-loan insurers said their stakes in the subprime mortgage company, valued at more than $US1 billion last month, may now be worthless.

US brokers said the steep falls in these and the investment bank shares shows that in spite of the equity market’s rally on Monday, many companies remain highly vulnerable to the credit concerns that have repeatedly surfaced in the most unexpected way in recent weeks.

The shares of big investment banks like Lehman Brothers Holdings Inc., Bear Stearns Cos. and Goldman Sachs Group led the brokerage industry to a 10-month low (wiping out all the gains in 2007 so far) because the prospect of American Home liquidating assets threatens to depress the value of all mortgage securities traded on Wall Street for the next short while. That’s the scary part. That why someone will probably buy part, or all of its portfolio, to stop this mass liquidation.

American Home revealed late last Friday night that it was in a bind and was stopping all dividend payments.

Its shares fell sharply last week, continued falling Monday and followed up with a 90% plunge Tuesday in the US as investors concluded it was broke and massive losses would be taken.

American Home clients were better than subprime, but not quite good enough for top-rated mortgages. The company’s problems reinforce the view that the subprime problems are spreading to other parts of the credit markets in defiance of comments that ‘it can’t or won’t happen’.

These bonds and other securities are acting in very unpredictable ways and catching short companies and financial groups whom most investors or others interest in finance would not have picked.

And the US bond market saw a late rally as billions rushed into Government-owned securities: the yield on 10-year Government securities fell from 4.80% mid afternoon to 4.74% by the close.

And what of the US housing market where the damage was first seen?

Well there was more news overnight that the worst isn’t over. US home foreclosure filings jumped 58% in the first six months of this year and could top two million by December as the housing market continues to deteriorate.

A report from a company which tracks foreclosures said they jumped to 925,986 by the end of June. And the rate of filings is also rising steeply and if this continues, actual foreclosures will “surpass 2 million by the end of the year,” which would 65% higher than in 2006.

And another report on property prices showed the prices of homes in 20 American cities fell 2.8% in June, the largest fall on six years as measured by the Standard & Poor’s/Case-Sheller index of home prices in 20 metropolitan areas.

But given all this gloom, what are we to make of the news that a third report showed US consumer sentiment rose more than forecast in July, to the highest level in almost six years.

And we in Australia have to remember that we are hooked into China for our economic growth and we will survive, even a rate rise next week. But the surprises will keep coming from the US hedge fund and corporate bond problems.

Jobs figures for the US for July are out on Friday. They could tell us if the US economy itself is starting to be impacted in its strongest area, job creation.

In late news, the Wall Street Journal says a third hedge fund sponsored by investment bank, Bear Stearns is refusing to return investor funds and is facing big losses as a result of the turmoil in credit markets markets.

The news comes a fortnight after the investment bank closed two hedge funds that specialised in investment in subprime linked securities. The loss in these funds could be $US2 billion.

The WSJ said that the value of the $US900 million Bear Stearns Asset-Backed Securities Fund has fallen because of mortgage markdowns and there are now fears it will have to close.

The investment bank says it has decided to try and ride out the turmoil in credit markets and that’s why it is not honouring redemptions. That’s similar to what Basis and Absolute Capital are trying to Australia.

News of the third Bear Stearns fund in trouble broke well after New York trading had closed and the news won’t help sentiment that was hit by the problems at American Home Mortgage and the $US1 billion in losses incurred by two major privately mortgage insurers (who are supposed to be insurers, not investors).