Australia's major banks have sufficient earnings capacity and capital to absorb direct housing loan-related credit losses, Moody's Investors Service reported yesterday.Moody's said the combination of elevated house prices and unprecedented household indebtedness exposes the Australian housing market to adverse shocks and so warrants caution. "While favourable economic trends may persist, we believe that the risk-return trade-off in the Australian housing market has tilted towards greater riskiness, exposing banks to the possibility of an adverse shock to asset quality," the ratings agency said.It also said that protracted deleveraging would lead to a broad-based correction in the housing market.Moody's ran two stress scenarios. An adverse scenario would look like the recession of the early 1990s, when unemployment went up to 11 per cent and interest rates reached 17 per cent.  A highly adverse scenario would look like the sub-prime mortgage crisis in the United States in 2008, where home loans in arrears reached more than 20 per cent.Moody's view is that, in the event of an adverse scenario, the major banks would absorb housing credit losses through earnings, with only a small decline in capital ratios.Even in the event of a highly adverse scenario, credit losses from housing portfolios would be unlikely to exceed earnings capacity."Major banks are insulated by the low average loan-to-valuation ratios and the relatively small percentage of low doc loans in their mortgage books," Moody's said.It estimates that the major banks' mortgage portfolios have an average LVR of less than 50 per cent, while the regionals have mortgage portfolio LVRs of between 45 per cent and 55 per cent.Low-doc loans make up less than five per cent of the major banks' mortgage portfolios and five to 10 per cent of regional banks' portfolios.Regional banks are more exposed to the risk of localised crises and would not fare so well. In the event of a highly adverse scenario, regional banks would suffer an average 1.6 percentage point deterioration in their tier-one capital ratios.Banks would withstand the second-order effects of such an adverse scenario, such as losses that are likely to occur in corporate and other lending books as a housing-led crisis hit the broader economy.However, the second-order effects of a highly adverse scenario would see the major banks' tier-one ratios fall by five percentage points and the regionals' ratios by 5.8 percentage points. In this case, banks would need to raise additional capital.Moody's estimates that there is a low-to-medium probability of an adverse scenario materialising. A highly adverse scenario would be "unprecedented".But Moody's warned that the increase in household debt and house prices since the 1990 recession would translate into "materially higher" losses should a housing downturn occur now.