Amid an endless stream of increasingly bad news in the mortgage market, investors have been shorting the ABX index, expecting further deterioration and hedging their positions in the stagnant CDO arena.
However, a growing number of investors and researchers have recently advocated holding long positions, suggesting that there is more value in the market than what the index is currently trading at.
"People tend to panic and assume the worst - that the index is valueless. They throw the baby out with the bathwater, so to speak, and do not wait to see if it will get better," said a market participant who suggested that the higher-rated tranches and even some of the triple-Bs in the ABX indices were trading at a discount below their actual values, a solid opportunity to lock in return at reduced prices.
In particular, Wachovia Capital Markets noted value in taking a long position in the triple-B flats in the 2006-2 index. "While the triple-Bs in the 2006-1s do have some value, they are not as far away from their fair value as the 2006-2s," said Glenn Schultz, managing director and head of ABS and nonconforming mortgage research at Wachovia Capital Markets.
The bank tests two different models. One is a full blown, econometric, one-level delinquency, default severity model, which is run within the OAS framework, Schultz said. This model accounts for the different states of each of the loans at the current time and is run with zero OAS pricing on the ABX. The bank also does a zero net present value pricing on the ABX to get to the spread, which is also done for the underlying constituents. "[When tests on the underlying constituents] are rolled up into the ABX, we tend to get a much higher price, because there is a time-value-of-money component to receiving the fixed leg up front against backdated potential losses," Schultz said. The bank also utilizes a heuristic model, which is essentially a loss-timing model. "We look at cumulative losses on this timing model and targeted credit enhancement for a particular deal, and we look at the ratio of credit enhancement and targeted credit enhancement," Schultz said. That suggests the 2006-2 triple-Bs have approximately 30 points of upside, based on the evaluation process.
And while 2006-2s have greater uncertainty associated with them, in the end they have more upside, Schultz said. He cited the JPMAC 06-FRE1 deal in the 2006-2, index, which is most likely going to hit its cumulative loss trigger in the next remittance data on the deal, binding cumulative losses on that deal. When the bank either runs the deal through its econometric model or does cash flow analysis on it, it finds that the bond has interest shortfalls, but it may not incur further principal losses if loss severity remains below 50% on the defaulted loans, and it goes out to a 10 plus-year life, "which tells you that the deal structure works. A CDS contract on that bond would extend and get really long," Schultz said. "Now think about it from being a seller of protection long the risk. If you think that scenario is right, that structure is, by and large, going to hold and protect the triple-B holder. If you go from a five-year average life to a 10-year average life, and you're a buyer of protection paying the spread, the value of the fixed payment is going up and you are short the IO piece. From the seller-of-protection perspective, the seller is extending average life in a credit situation but getting paid for it from the extension of the fixed leg."
Higher Value
JPMorgan Securities was not as bullish on the triple-Bs and triple-B minuses, suggesting that they were still overvalued with significant price downside remaining. The bank did find value in the higher-rated pieces, particularly the triple-A and the double-A tranches, noting that downgrades and poor remittance data that came in at the end of July have created excess exposure for many holders of both ABS and CDOs that own the ABS. In turn, these holders have tapped the ABX to provide a way to lay off that exposure into a relatively liquid market, going high up the capital structure with pricing on these tranches providing meaningful downside once the shorts were put in place. "Those benefits, while they made sense from a liquidity standpoint and a desire-to-hedge standpoint, have created fundamentally oversold conditions in the triple-As and double-As," said Chris Flanagan, global head of ABS and CDO research at JPMorgan, on a call last week.
Credit Suisse analysts also noted value in the triple-A and double-A tranches of the ABX indices. which they felt were trading at "fairly substantial discounts," given the historical credit performance of subprime triple-As, the bank said in a recent report. In fact, over the past 10 years, only one triple-A deal, Indymac 2001-A, experienced downgrades, and while double-A deals have been downgraded, the only default was in a 1998 deal by First Union, the bank said. "Current market prices are implying writedowns to the triple-A tranches in the 10% range, which would require collateral losses to reach extraordinarily high levels even to produce a reasonably small probability that the triple-As would suffer principal impairment," Credit Suisse analysts said.
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