I chose this elegant eatery near the World Financial Center and half a mile uptown from Wall Street for a reason. A little more than a year ago, in happier times for the financial services industry, I had a lunch there with the CEO of a broker-dealer. Back then the place was so busy, I had trouble deciphering my voice recorder over the hum and excited chatter of other diners.

Who: Tanya S. Azarchs, Managing Director, Financial Services Ratings, Standard & Poor’s

Where: Acappella, One Hudson Street, New York, August 13, 2008

On the Menu: Fusilli pesto, porpadelle boscaiola, paglia fieno and an anatomy of the credit crisis.

You’ll be glad to hear that even in mid-August the restaurant is far from empty. A year into the financial crisis, Wall Street types apparently still have money to pay for good North Italian food.

But they might have lost their appetite had they listened in on my conversation with Tanya Azarchs, managing director at Standard & Poor’s Corp. Her job is to rate the creditworthiness of money center banks and bulge bracket investment banks. Her view on the financial sector is not comforting.

“What we have seen so far is the first stage of the financial crisis, which affected mostly investment banks and money center banks. We are now entering the second stage of the crisis, in which a wider variety of lending institutions will become involved.”

Start at the BeginningAs befits a bond-rating analyst and a former teacher, she likes to start at the beginning, going through the history of the current financial crisis in a logical and methodical manner.

“There have been various explanations of the crisis,” she says, listing as examples a long period of easy monetary policy, excess liquidity from hedge funds and lax regulation. “But the subprime crisis came into being mainly due to loose underwriting standards,” she concludes.

Specialized mortgage lenders kept raising the ante, taking on more and more risk based on a fundamentally flawed assumption that real estate prices will always continue to rise and that households don’t default on their primary mortgages. While some sophisticated lenders came to believe this logic, in reality big banks had to play the game the way it was being played, even if they had misgivings. Azarchs quotes the now-infamous saying by Chuck Prince, the former CEO of Citigroup, admitting that being bankers, “as long as the music is playing, we’ve got to get up and dance.”

The music stopped in early August 2007. The result is well-known. When home prices fell, we learned that home owners regard their homes quite unsentimentally, just as they do any other investment, says Azarchs. Once they realized they are in a deep negative equity hole — and once their teaser rates adjusted sharply upward — they chose to cut their losses, leaving their homes for the lenders to dispose of as they saw fit.

When the music stopped playing, suddenly unsellable loans weighted down the banks’ balance sheets, causing multibillion-dollar write-offs and massive losses. The good news, says Azarchs, is that the subprime crisis has more or less run its course. After being dead in the water for months, the market for asset-backed collateralized debt obligations came back to life in late July, when Merrill Lynch sold $31 billion of such securities to an affiliate of Lone Star, a hedge fund. The price was 22 cents on the dollar.

Bad News Ahead”The hope is that this has set a floor for the value of such assets,” says Azarchs.

Of course, the securities are probably worth more, because most of the underlying mortgages are not going into default and investors will get most of their money if they hold them to maturity. But banks are forced to mark their holdings to market and, moreover, the temptation is to wipe the slate clean — especially if a new management team is brought in to sort out the mess.

“When you do this, you always leave money on the table,” says Azarchs.

This may not be a bad thing. At least hedge funds and other investors willing to buy distressed assets, including more adventurous sovereign wealth funds which are currently flush with cash, may be lured by an opportunity to make a large profit and will provide liquidity to the market.

But now the bad news. After the end of the subprime mortgage crisis comes a more conventional credit crunch, which can be expected to result from a fall in house prices, a sharp slowdown in the construction industry and a more general downturn in the real economy.

Azarchs produces a number of PowerPoint charts and lists problems and affected players. Construction loans, for example, are going sour as home builders become unable to carry huge unsold inventories of land and finished homes. Many regional banks have already been impacted by this development, even though such banks largely stayed away from subprime lending.

As unemployment rises, so do defaults on conventional loans. A higher tier of mortgages, known as Alt-A, are starting to experience problems, notes Azarchs, which could present a new problem to financial institutions since there are almost as many such loans out there as there are subprime mortgages. Credit card debt is going up, since consumers can no longer use home equity loans to fund their purchases, and so are credit card default rates.

All this is happening at a time when the financial system is highly stressed. Liquidity remains extremely tight, interbank rates are well above the Fed funds’ target rate and players in the market are extremely wary of counterparty risk. The Bear Stearns debacle was the result of this situation, says Azarchs, but it also serves as a warning to all surviving players, making them all the more wary of lending to each other.

Nevertheless, as far as conventional downturns go, Azarchs sees this one as not especially bad. The labor market remains healthy, merely creating jobs at a slower pace than at the height of the expansion. Corporate profits are still strong and consumers are not, by and large, shutting down their wallets.

An Imponderable FactorNor is Azarchs unhappy with the response from Washington. She points to government backing for banks willing to renegotiate loan terms with distressed borrowers to keep them from defaulting on their mortgages.

Nor has there been a knee-jerk reaction of excessive regulation. Unregulated mortgage lenders that were at the root of the subprime problem have disappeared, but that was because the market environment no longer allows them to sell their loans. This is a temporary phenomenon, says Azarchs.

“In this country, you can’t stop somebody from setting up an operation and going into business lending money.”

Moreover, the United States is better off than Spain, Ireland and other countries that had a spectacular run-up in residential property prices over the past decade and are now suffering the consequences. The U.S. economy, Azarchs believes, is resilient, and there are other factors, such as demographics, that will eventually help the market absorb the glut of unsold homes — even if it may take a few years in some grossly overbuilt markets. Things may get a lot worse before they get any better, but they are going to get better nevertheless.

In this case, for all the market panic that the global credit crunch has occasioned over the past year, does she think it is just a conventional cyclical downturn?

Not quite. This is the first time in history that the U.S. economy has seen sustained national price declines like this. The housing sector has always been considered the mainstay of the economy, closely linked to other sectors, admits Azarchs. This is why it may be too early to call the end of this crisis — or even be entirely sure that it won’t throw up more nasty surprises.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008