The meltdown of the subprime mortgage market has been in the eye of the storm this year. This crisis was anticipated by numerous institutions, given the deterioration in mortgage-loan underwriting practices, notably those mortgages originated in late 2005 and in 2006. Many now believe that subprime asset-backed securities (ABS) are ready to undergo significant writedowns in the future, given increasing delinquencies and foreclosures among the underlying mortgage loans. Though anticipated writedowns remain be seen, the ABX index, created by CDS IndexCo, a consortium of major ABS market makers in conjunction with Markit, has been invaluable in giving market participants a vehicle to express their views.
ABX, designed to be a tradable synthetic instrument, has become a key barometer of the subprime market's viability in the broad marketplace. The first set of tradable ABX indices was launched in January 2006, and the index family has been widely traded and referenced since then. The ABX, which rolls every six months, is composed of a static basket of 20 home-equity reference entities selected from the sub-prime ABS universe. Five subindices, determined by rating-namely BBB-, BBB, A, AA and AAA-are created from the selected 20 reference entities. Each index series contains the same 20 constituent reference entities with each reference obligation corresponding to the appropriate subindex rating.
The ABX indices provide transparency and liquidity to the synthetic subprime mortgage market by allowing market participants to take positions on a basket-referencing subprime ABS. Investors can take a long or short view on the ABX by buying or selling protection. Shorting ABX is equivalent to buying insurance on the basket of bonds referenced in the index to protect against realized losses due to interest shortfalls and principal writedowns.
Since the beginning of this year, dramatic deterioration in the prices of the ABX indices has occurred, due to a significant increase in the premium payable for protecting those baskets of bonds. The ABX.HE.BBB- indices have undergone a fairly consistent price decrease in 2007 and a sharper decrease since the Fed rate cut on September 18, breaking new lows day after day.
In August, the ABX.HE.A indices recovered 28.4% before the Fed-rate cut; after the cut, they resumed their downward trend. Even so, the recovery of the "A" class relative to the "BBB" & "BBB-" classes demonstrates the market's changing perception of different bonds' worth in the capital structure. The ABX.HE.BBB- indices recovered on average 6.64% during the same period and fell more dramatically after the rate cut. Those movements provide useful insight into the future values of mortgages underlying the reference obligations of the ABX.HE indices. The recent ABX.HE.BBB- prices seem to indicate plummeting confidence in the value of the more subordinate bonds in the ABX.HE index, while there is increased trading at the A level.
The biggest concern among ABS investors centers on adjustable-rate mortgages, especially for borrowers facing their first resets in the coming quarters. This concern comes during a soft housing market, when more stringent lending practices have been put in place. Some research reports have estimated that more than $400 billion of subprime adjustable-rate mortgages will reset between the end of 2007 and 2008. Over the past months, increases in foreclosures and delinquencies as well as declines in the prices of the ABX.HE indices have meant a less-than-rosy outlook for the subprime mortgage market.
However, not a single writedown has occurred on any of the ABX subindices thus far. Of the 1,088 subprime deals, issued since the launch of the ABX.HE index that are tracked by Markit RCD, only 3 basis points of the total notional have been written down. Even though there have been no realized losses in any of ABX.HE reference obligations, market participants can still take positions based on projections. The fate of the higher tranches of the ABX.HE indices remains unclear from their recent increase in volatility, notably at the single A level. However, the indices continue to provide market participants with an increased ability to gauge values of subprime mortgages and mortgage-backed securities.
The U.S.'s subprime debacle brought about a global credit crunch this summer with the ABX leading the charge. Subordinate tranches of the 06-2 and 07-1 series have lost over 75% of their value since the end of May. Even with the Fed rate cuts, the ABX free fall continues, particularly for the lower-rated tranches. Early signals surfaced in February, a month in which prices of the ABX BBB- tranches plunged more than 20%. Shareholder values of subprime mortgage lenders declined in the subsequent weeks, with the stock price of Accredited Home Lenders Holding Corporation dropping just more than 80% between February month-end and the mid-March low.
ABX.HE acts as a vehicle for investors to hedge their subprime exposure and express their views on the subprime market using a liquid and transparent instrument. The recent performance of the ABX does not bode well for the subprime mortgage market, but, of course, time will tell. For now, the ABX.HE index is the weatherman of the subprime mortgage market, and it's forecasting a rough storm ahead.
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