As bad as that has been for the banking industry, not to mention the individual homeowners, it was only be the tip of the iceberg. It now appears that hedge funds invested an unknown amount in these mortgage-backed securities. Unlike mutual funds, hedge funds are not as tightly regulated by the SEC, and so it is unknown how many funds will be affected by the defaults. Since hedge funds use sophisticated derivatives, the impact of any downturn will be magnified. This is because derivatives allow hedge funds to essentially borrow money to make investments, creating higher returns in a good market, and greater losses in a bad one.
Fear of such a downturn has caused the Dow Jones Industrial Average to plummet since June 2007. A market decline alone is enough to cause an economic downturn, by reducing the value of companies and their ability to raise new funds on the financial markets.
Even worse, the fear of further defaults caused banks to refrain from loaning to each other, causing a liquidity crisis. This could stop businesses from raising short-term capital needed to keep their businesses running. If left unchecked, these crises could cause the economy, already weakened by the housing market decline, to fall into recession.
