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

NEW YORK -- 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 ...