Subprime Fault Lines: How Bank Stress Could Touch Other Markets

Summary

The U.S. subprime mortgage turmoil has taken a toll on virtually every sector of the global financial system. The contraction of the credit markets and loss of market confidence have left few sectors or regions untouched. Banking systems worldwide have been particularly challenged. Several global banks have taken multi-billion-dollar charges to write down the value of collateralized debt obligations (CDOs) and other structures affected by faltering subprime mortgages. The response of banks to these hits to their capital levels, in turn, shapes how other parts of the financial markets have fared. In this comment, Moody’s considers how credit problems at banks could affect other sectors.
Corporates would likely see a significant impact from bank stress, as reduced liquidity and tightening lending standards reduce access to credit, particularly for lower-rated companies. We also identify money-market funds as susceptible to bank stress, although the underlying events which could produce this contagion — such as a downgrade of a bank’s short-term ratings or a bank’s outright removal of support for a fund it sponsors — are unlikely. Banks are also vulnerable to one another’s stress through interbank funding, derivative counterparty transactions and other ties. In this report, we examine banks’ links to these and nine other sectors, including CDOs, commercial real estate and financial guarantors.
We categorize effects of bank stress on other sectors as likely, somewhat likely, or unlikely. Our analysis assumes a market environment that is moderately more severe than current conditions and that extends for at least another 12 months, in order to tease out connections that might not be evident under today’s conditions.

For internal reference only.

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