Dealers are working amongst themselves and with customers to decide if and when the home equity ABS synthetic index should incorporate more than the 20 deals it currently references. Those interested in either creating a new index product or increasing the number of subprime deals included in each series of the ABX.HE index - perhaps to as many as 50 or 100 - say it is necessary to promote correlation trading. But some worry that changing the index too soon after it began trading in mid-January could cause some investors to pull out.
"Some dealers want to keep it the same because they are concerned about the fact that if they change it, it could affect liquidity, but the other side is that, in the long run, if you need good correlation trading, you're going to need more names in there," said Brian McManus, a senior analyst at Wachovia Securities.
Although there is no rule determining when the decision should be made, the 16 investment banks licensed as market makers in the index will likely decide before its scheduled July 19 roll date to adequately inform the market, said Ben Logan, director of product development at Markit Partners, which administers the index. "There is some discussion, but no decision," Logan said, "The driver behind all of this is there is client interest in starting to trade correlation product in synthetic ABS, and some accounts are saying that the index needs more names to be able to do this. Whether this is the right time for that is up for discussion," he added.
When the index rolls, a fresh set of new-issue deals will essentially double the amount of securities available for market players to reference - a fact that some say could be enough to deepen index liquidity over time, sparing the need for more than 20 names. Others point out, however, that it might create more pressure on certain vintages and heighten the effects of higher correlation. Because each new series will represent a vintage, investors in the future will be able to go short one vintage and long another. But, McManus notes, the chance that more investors will crowd in seeking protection on more poorly performing vintages than those offering it could lead to illiquidity on those deals.
For example, most investors have fled to buy protection on the lowest rated index tranches. "Prices keep going up and up. There is a flight from quality instead of a flight to quality," said William Smith, a director at UBS. Most demand on the index, which has tranches ranging from triple-A to double-B, has been on the triple-B and triple-B minus tranches. The demand for the triple-B tranche, for example, has sent its price up some 50 basis points since the inception of the index. As subprime mortgages underlying the index begin to age and show defaults, index investors will be looking to make trades based on credit quality instead of solely searching for spread plays, Smith said.
Under the ABX.HE's current make-up, one impairment - or default - would account for one-twentieth of the index, creating a product that bares a much higher level of correlation and is arguably less fluid than an index comprised of a larger group of names. "The more names you have, the more fluid the market can be, and the more fluid the market can be, the larger the synthetic ABS market can be," McManus said. For example, a lower level of correlation would mean that one could create an index tranche with a higher level of protection. According to McManus, it would take about 100 deals before diversification would kick in.
Higher correlation, however, is in the favor of investors looking to make trades in the index itself, particularly those wishing to take a short interest. CDO managers would most likely favor a 20-name index instead of a larger basket, according to UBS' Smith, because the pool of referenced names would likely become too muddy to express a precise view.
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