Contagion, at least of the buggy sort, can make for a terrific, spooky movie. Remember Gwyneth Paltrow and Matt Damon in Contagion? (Spoiler alert – she dies early on.) Got to admit, I love The Stand and Captain Trips; we all love a good scare… in the movies. In reality, however, contagion means bad things are happening: Bubonic Plague, excess body piercings and the 24 hour news stories (in no particular order). Contagion is very scary.

Want to talk residential mortgages?

I clearly remember back in 2007 blithely assuring colleagues and clients that the mess in the residential mortgage securitization business, replete with no doc loans, a certain amount of fraud, froth and frivolity, had nothing to do with our commercial real estate finance and securitization business. We had docs. We had cash flow. We were many things, but not frivolous. Underwriting might have gotten a little stressed as the economy had been on a tear for quite a while, but in our world we did not have the equivalent of the Walmart clerk borrowing to buy three condos and four parcels of developable land. Not us. Not our problem.

I was sure that the problems of the resi world were ring-walled. Ha! In a long history of picking Derby losers, that was one of my greatest picks! The problems of the residential mortgage finance and securitization industry swept across almost all fixed income asset categories wreaking havoc across CMBS, portfolio lending platforms and the bank and insurance sectors. Not correlated? Phooey! Everything was correlated. What a mess.

If you think about it, contagion is not really a thing. It’s not like adding a reagent to the flask causing the clear liquid solution to immediately turn green and bubble. It’s not a predictable A leads to B sort of thing; sometimes, it just happens. Often, the “why” is not clear even in hindsight and that makes contagion even scarier. Is it really all in our heads? You held a glass that was half full for a long time and then all of a sudden discover that it’s half empty? Run away! I don’t think it’s just in our heads, although our reptilian-brained hypothalamus – responsible for fight-or-flight – sure contributes.

Sometimes, it all makes sense afterwards. You can watch the dominoes fall. An institution suffers a loss on a trade. It then marks its portfolio to that trade. Maybe it shouldn’t have. Maybe it did not have to, but this time it did. The portfolio is levered, so the mark triggers margin calls and default ensues. The warehouse lender then marks its other warehouses, and these losses cascade through the system and other financial participants mimic the marks. Asset losses build on assets losses, driving values down, which impact capital, which impact lending capacity, which further impacts the value of the assets as leverage dries up. Users of capital are constrained and business plans suspended. Round and round we go. It’s a vicious cycle. By the time it stops massive damage can happen to the economy. Jobs are lost. Enterprises fail. Bankruptcies proliferate. Lawyers do workouts (okay, so it’s not all bad).

But what started it and why did the reaction go critical? It’s not often obvious. It’s often opaque and mysterious.

Can we tell what starts the conflagration and what fizzles out? Yelling “fire” in a crowded theater certainly initiates a riot, while being exposed to a really bad movie (usually) does not. Is there anything to learn from the distinction between one and the other?

We’ve had a lot of bad news over the past couple of years while the US economy continues to grind higher. Warmongering in the Mideast, Russian adventurism in Europe, Chinese militarization of the South China Sea, whatever the heck Korea does day in, day out, crisis in the European financial markets, something approaching almost open warfare in the US political arena and, yet – largely – the bad news got shrugged off. All of this is pretty horrible. All of this could be seen as the equivalent of yelling fire in the theatre and indicate that we should run for the exits. But we haven’t. What’s the difference between an accelerant and just more bad news?

Maybe it’s that you need to have a really frightful unstable solution before adding the reagent triggers an out of control chain reaction? If the house is not about ready to burn anyway, then the smoldering, mouse gnawed old wiring doesn’t matter? So, should we be scouring the news on the world economy  for evidence that the house is fixing to burn? Is that how we learn to predict disaster? That’s pretty hard to do. An inverted yield curve has predicted 9 of the last 6 US recessions. Not very helpful. Innumerable talking heads are always muttering “the end is neigh,” but apparently – to date – it ain’t.

How do you separate noise from something really consequential? Do you see a candidate out there now for the thing which brings us down?

It has become almost received wisdom that the corporate leveraged finance market is problematic. Bloomberg reported the other day that Bank of America chair Brian Moynihan warned of “carnage.” Carnage is a fairly unambiguous word. If the economy slows and corporates cannot carry existing debt, does this turbo us into a full blown recession? Is the US corporate debt market the reagent that explodes the solution when added? Does the residential lending market and the CRE market then also experience carnage?

Maybe the fragile solution looking to begin that unamiable chain reaction is Europe – that fantastic, magical, medievalist automaton comprised of 28 nations with vastly different polities, cultures and economics, yet sharing a common currency and a Frankenstein monster of a semi-sovereign political structure? Can it continue to tolerate continued material stress? Mario Draghi and his “whatever it takes” pledge worked once (he had to be a Dirty Harry fan, right? – Are you feeling lucky, punk?). But now? Don’t know, but I think Italy – by itself – could unravel the thing. Now Europe is better at can kicking than anyone…well anyone since the Romans began settling Goths in Italy, but this may be the proverbial straw. Or not?

My conclusion? I don’t know a potential unstable solution when I see it, nor a reagent that will set it all afire.

As Charlie Brown said, “I’m doomed.” I’m not going to see it coming.

But…I am entirely certain that when something important in our complex, in our interdependent economy goes off the rails, contagion will be our reality. When something so serious goes wrong somewhere, it’s likely to go casters up everywhere. That may have not always been the case, but the complexity and interconnectivity between and among markets combined with our always on and always panting instant and world-girding information culture and bang! Contagion is certain.

So, stop worrying. You won’t see it coming. Even if patient zero is not on your watch, the bad things will be coming for you anyway.