Moody's: Credit Crisis Serves as Stress Test of Current Financial System

The credit crunch initiated by the ongoing mortgage subprime woes began as an overdue and disorderly risk reappraisal but ballooned into a crisis due to a combination of too much leverage, financial innovation, price-sensitive accounting rules and opacity, according to a new report by Moody's Investors Service.

The report by Moody's vice chairman Christopher Mahoney and chief economist Pierre Cailleteau, entitled, "Stress Testing the Modern Financial System," suggests that the proximate causes of the current credit crisis include the deflation of the house price bubble coinciding with a severe drop in subprime mortgage underwriting standards, recently originated subprime mortgage loans becoming delinquent at unprecedented rates, and rating agencies beginning to downgrade subprime RMBS and ABS CDOs by substantial numbers of notches.

These downgrades engendered distrust of structured securities, causing secondary market prices for RMBS and CDOs of ABS to plummet from par to less than 50 cents on the dollar for junior tranches. Additionally, according to Moody's, some hedge funds that invested in subprime RMBS or CDOs suffered large mark-to-market losses and consequent liquidity problems. Hedge funds were subject to margin calls and a liquidity squeeze. Forced sales by hedge funds pushed down prices across many asset classes including CLOs.

"The credit crisis has imposed a major stress test on the modern disintermediated financial system while also offering the possibility of corrective reforms," said Mr. Mahoney.

The report argues that, while credit crunches in earlier days resulted from tight monetary policy, modern credit crunches are caused by psychological shocks to market confidence. This leads to a fight from risk and liquidity stresses for financial actors dependent on confidence-sensitive funding.

"The challenge is to ensure not just 'liquidity' but 'fluidity' throughout the system, ensuring that systematically important non-bank financial institutions obtain vital funding," Mr. Mahoney added. As for the possible risk scenarios for the months ahead, Moody's suggests that the most likely scenario remains one of robust global growth with temporary slowdowns in large mature market economies. This should help the healing process, the largest part of the losses being absorbed in the next couple of quarters. The resolution of central banks and public authorities to protect banking systems from liquidity stress would succeed. For most banks, Moody's analysts believe that there should not be structural franchise impairments requiring rating changes. Structured finance deals will be slowly unfrozen and the ABCP market stabilizes.

"We expect market and official pressure to require greater transparency from financial actors, to introduce larger liquidity buffers into the system and to consider ways to introduce automatic stabilizers to counter some of the pro-cyclicality inherent in an increasingly market price-sensitive accounting system," said Mr. Mahoney.

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