A second report this year has cast doubt on the ability of the ABX indices to accurately predict the performance of subprime securitization classes.
The latest report, The ABX: How Do The Markets Price Subprime Mortgage Risk?, was released Monday in the Quarterly Review from the Switzerland-based Bank for International Settlements, an international organization that serves as a bank for central banks and provides global economic research.
ABX indices were launched in January 2006 and have become a key barometer of subprime mortgage market conditions. They are based on credit default swaps written on 20 subprime mortgage-backed securities of at least $500 million each during the prior six months, and each consists of five sub-indices from different tranches of the same securitizations.
The number of deals from the same originator in a single securitization is limited, and each transaction needs to carry ratings at a corresponding level with both Moody's Investors Service and Standard & Poor's Ratings Service.
"The ABX 06-1 AAA index, for example, represents tranches with an original rating of AAA from a pool of MBS originated in the latter half of 2005," the report said. "The other sub-indices, in turn, are backed by tranches of the same securitizations at the AA, A, BBB and BBB- levels of credit quality."
After an index is launched, downgraded or upgraded ratings can cause them to no longer correspond with the index name.
During each issuance period represented by the indices, an average of $216 billion in total issuances were completed. But MBS issuances used in the indices averaged around $31 billion, and only some of the classes from the issuances were even utilized. Among utilized AAA classes, which accounted for around 80 percent of the balances, the indices reflected less than the most senior tranches.
"As a result, limited deal coverage makes it difficult to translate price data for, say, the ABX 07-1 AAA index into information on how other AAA subprime bonds originated in the second half of 2006 have or should have performed," the authors wrote.
By January 2008, collapsing subprime volume issuance forced a postponement of another index.
The report indicated that first-quarter 2008 MBS issuance volume was around $0.3 trillion, a pace well off 2007 volume of approximately $1.8 trillion, 2006 volume of about $1.9 trillion and the 2003 peak of roughly $2.6 trillion.
The results of a regression analysis suggest a declining appetite for risk and concern over the lack of market liquidity have significantly contributed to the collapse of ABX prices since mid-2007. Variables analyzed in the analysis were building permits, new home sales, the RPX residential property composite index and U.S. employees on non-farm payrolls.
"While proxies for fundamental drivers of subprime mortgage risk, such as indicators of housing market activity, have continued to exert a strong influence on the subordinated ABX indices, the AA and AAA indices have tended to react more to the general deterioration of the financial market environment," the report concluded. "Observed ABX prices are unlikely to be good predictors of future default-related cash flow shortfalls on outstanding subprime MBS, especially for tranches at the higher end of the capital structure . This is in part because coverage of the ABX indices extends only to a small fraction of the outstanding subprime MBS universe, which can lead to significant price divergence across like-rated products even in the absence of sizeable risk premia."
S&P issued a report in May also questioned the reliability of the ABX indices.
The ratings agency explained that while all subprime RMBS classes have the same level of credit enhancement, structural subordination exists in the form of payment priority. As a result, longer-dated AAA classes remain outstanding as losses build and reduce available credit enhancement even though classes with early claims have already seen principal repayment.
ABX Reliability Questioned
All AAA classes of subprime residential mortgage-backed securities are not created equal, a new report suggests. But the ABX index does not necessarily reflect this.
Anatomy of ABX Indices
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