Monday, November 12, 2007

The Risk of a Systemic Shock to the System is "Alarmingly High" – Morgan Stanley

The financial press has been turning increasingly pessimistic for the last month or so and the comments below appearing in a Reuters article are from Morgan Stanley continue in that vein. Text in bold is my emphasis.

By the way, some of the gloomiest news comes out on Friday night. That way no one will read it.

Investors may not be prepared for the real possibility of a further downturn in the financial sector, and the risk of a systemic shock to the system is "alarmingly high," analysts at Morgan Stanley said on Friday in a report.

"Over the past several weeks, we have worked ourselves into a full-fledged bearish lather," analysts, including Greg Peters, said in a report.

"At the root of our near-term negativity is the alarmingly high potential for a systemic shock, as well as concerns on the financial system and economic environment due to the derailment of the securitization process," they said.

For years, banks have profited from lending to consumers and then pooling the loans in deals known as collateralized debt obligations (CDOs) that were sold to investors, with banks pocketing a fee. The process is known as securitization.

Rising delinquencies in the mortgages backing the structures has dried up all demand for the products, leading to massive writedowns in the value of the deals. Many have also carried the safest "AAA" ratings, and confidence in this rating system has now completely eroded.

Banks, mortgage lenders and mortgage insurers are all under stress on losses stemming from the deals, and these losses have pushed many financial companies to post quarterly losses.

"For several years, investors of all types have taken great comfort in financials - given claims on the diversification of risk that sat on the balance sheet, as well as the miracles of risk-shedding/mitigation tools of securitization and credit default swaps," Morgan Stanley said.
"However, as the market tone suggests, those outlets are indeed less accommodating today," the bank said.

By passing on loans, banks have been able to free up capital for further lending, which has been a key factor in the ability of consumers to obtain loans. Now, as demand for the repackaged debt dries up, banks in turn have less capacity to lend and the cost of borrowing is also set to rise.

"In addition to our above concerns, if we begin factoring in escalating energy prices, the collapsing U.S. dollar and a possible wobbling in the emerging markets, we become even more convinced that the markets aren't braced for the downturn," Morgan Stanley said.

"We see more losses emanating form CDO portfolios, and continued derisking that will only put pressure on the financial sector going forward," the bank said. "Even though financials are much cheaper today, we remain extremely cautious on the sector."

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