One interesting instrument that has been used to take the pulse of the nonagency securitized residential mortgage market has been the U.S. subprime credit default swap index, and recently Fitch Solutions' dropped modestly and reversed its direction, ending what previously had been an unprecedented rally. This trend has looked likely to continue, although it could be short term.

As Fitch Solutions director David Austerweil recently explained that loosely put, what the U.S. subprime CDS index reflects is an aggregate weighted summation of prices from a seller perspective of "protection" on U.S. subprime RMBS.

The index can reflect to some extent prices in the subprime RMBS market itself in that‹again, skipping over some details‹if subprime RMBS are not performing well a seller would find it more expensive to provide protection and cause the index to decrease.

This came into play recently because one of the Fed¹s Maiden Lane auctions added supply to the subprime RMBS market that was not well absorbed in the market and was credited with contributing to the end of U.S. subprime CDS index¹s rally.

Also contributing were some modest increases in delinquency and roll rates, which are more typical drivers of the index. But because subprime is not a fully liquid market as well as one of the most distressed secondary markets, developments like a large supply of bonds may push prices temporarily away from the future value of the expected cash flows, Austerweil explained.
In such circumstances, expectations of future sales, as long as they are possible, can act as a temporary cap on prices.

When asked whether something like Maiden Lane could affect something like roll rates, Fitch senior director Alexander Reyngold indicated it possibly could.

Austerweil said this could occur if, for example, the selling by Maiden Lane is an expectation that the collateral in the RMBS pools is going to deteriorate, but it would not be a direct cash flow impact.

Reyngold indicated in the most recent monthly U.S. subprime CDS report, reflecting June, that after several months of stagnancy there has been some movement in the delinquency and foreclosure pipeline.

Bonds can be deliverable into a credit default swap if a credit event occurs, which in the case of subprime CDS can be an interruption in cash flows rather than a "hard" credit event or termination such as is the case with corporate CDS.

Making a blanket statement about what constitutes a credit event in a subprime CDS is difficult as deals are very complicated and idiosyncratic, with reserves that build that can offset arrearages in interest payments, Austerweil said. So if you have a credit event today, it theoretically could be remedied in future due to some changes in cash flows.

This has led to some speculation as to whether in the future there could be bonds written up because of, say, an RMBS settlement like the possible one discussed for certain Bank of America Countrywide RMBS.

But it is not clear exactly how that process would work as it was probably not contemplated when contracts were drawn up, Austerweil said.

Depending on one¹s needs and/or interests, a subprime credit default swap index may be favored as an indicator for the securitized subprime mortgage market over, say, the ABX.HE index as it reflects the market value of a broader range of deals in this category and their trading prices. The U.S. subprime index itself does not trade.

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