Major Hedge Fund Failure?

NEW YORK (MarketWatch) -- Moody's Investors Service warned Thursday that the credit crunch roiling global markets has the potential to cause the collapse of a major hedge fund that could further disrupt markets.

The firm doesn't have a specific fund in mind. But it believes that as investors try to unload illiquid investments such as collateralized debt obligations, hedge funds that are unable to exit their positions could run into trouble, Chris Mahoney, vice chairman of Moody's, said during a conference call with investors.

The result could be the "failure and disorderly liquidation of a hedge fund of sufficient size to disrupt markets, as LTCM threatened to do," he said during the call. He was referring to Long Term Capital Management, a hedge fund that borrowed heavily and had to be bailed out by Wall Street banks after collapsing in 1998. Mahoney said the risk of such hedge fund failures will exist for the next three to six months.

In an interview, Mahoney noted that the collapses of several hedge funds over the past year haven't caused widespread financial trauma. But he said larger fund liquidations in the future could have the potential to ripple through the financial system due to the extent to which different financial institutions and asset classes are entwined. Mahoney estimated there's a roughly 50% chance of a big fund collapse triggering another LTCM-style crisis.

"We've seen quite a bit of contagion over the past two weeks, and it doesn't seem to be abating," he said.

Moody's, which earlier Thursday downgraded its ratings on Countrywide Financial Corp. (CFC) and Residential Capital LLC, or ResCap, also said that smaller financial institutions could be severely harmed in the current environment, possibly requiring unspecified outside intervention.

David Fanger, Moody's chief credit officer for financial institutions, said during the call that investors should brace for "impairment losses at many banks, and in some cases these will be sizable."

Nonetheless, the ratings agency said the current credit turmoil poses little systemic risk to the U.S. or global financial systems, even as some institutions are likely to come under stress.