Considering the undisputed negative outlook for subprime mortgages, is it still possible for the ABX to overestimate expected losses on these loans? Experts say it is.
A recent JPMorgan Securities report said that current prices in the ABX senior tranches do two things: overstate expected loss and tail outcomes for losses. For instance, JPMorgan analysts said that in the case of ABX 07-1, they project a 36% cumulative loss in their worst-case scenario that results in 40% write-downs on the triple-A tranche. "Even with those levels of write-downs, current pricing would still offer returns of Libor plus 477 basis points, which already encompasses some premium for more bad news ahead,'" analysts wrote.
"People are overestimating losses in the market because everyone is trying to make a quick buck, even though they don't understand the index," a senior market observer said.
"There are no more natural buyers in the market and a zillion sellers - there's always a bit of a lemming mentality. When this came into being, it was a godsend to speculators (i.e., sellers)," he said.
The analysis in a recent Countrywide Securities report supports this. According to the firm, valuations based on the ABX continue to be inconsistent with actual subprime sector performance, even though it clearly has been poor.
Furthermore, Countrywide said it could be argued that depressed ABX valuations stem from the supply/demand imbalances in the product as protection buyers are both more numerous and more aggressive compared with protection sellers.
This phenomenon comes at a time when ABX swaps have taken on a significant role in the current market environment, Countrywide analysts said, adding that many investors utilized these contracts as a proxy - or at the very least a starting point - to price bonds.
In other words, these contracts are actually used for two ends - for trading purposes and for valuing bond positions that are held in inventory.
Critics of utilizing the ABX include Ingo Fender and Peter Hordahl, who are the authors of the BIS Quarterly Review for June 2008. In the report, Fender and Hordahl warn ABX index aficionados to be mindful of the potential sources of bias in relying on this measure.
There are the accounting issues. Although the size of the effect cannot be easily determined, different accounting treatments could cause deflated estimates of write-downs and impairment charges versus the mark-to-market losses that are based on the ABX.
Of course, there's always the fact that the ABX prices might not be representative of the total subprime universe because of the index's limited coverage of the overall market. In fact, the BIS said that the original balance across the four series has averaged about $31 billion. By contrast, the average monthly MBS issuance reached $36 billion in 10 quarters up to the middle of last year.
Also, the review authors said ABX prices might not be representative because each index series actually covers only part of the capital structure of the 20 deals included in the index. For instance, tranches referenced by the triple-A are not considered the most senior pieces in the capital structure, but those with the longest duration are.
Despite its limitations, the industry understands the value of using the ABX. "We recognize that ABX pricing is driven by the fact that the product is one of the few instruments by which investors can express a negative view on housing and, by implication, residential mortgage performance," Countrywide analysts wrote.
But they are also quick to add that it would not be a good idea or, as analysts put it, it would be "imprudent" to sell protection (i.e., buy the contract) as long as the supply/demand imbalance still exists.
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