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ABX Reliability Questioned

Early classes repaid first, leaving more loss exposure for long-dated classes

May 21, 2008

By MortgageDaily.com staff

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.

Indices in the ABX Index may only provide limited insight into AAA-rated classes of subprime RMBS, according to a new report from Standard & Poor's Ratings Services.

Although the ABX, which was launched in January 2006 to enable the trading of risk on subprime RMBS, may be a good indicator of the overall U.S. subprime market, the AAA tranches that were part of the original ABX indices were the last-pay AAA bonds in their respective deals and are relatively more exposed to losses than priority AAA classes, S&P said.

"While all 'AAA' classes share equally in losses, a combination of principal prepayments, together with the typical time it takes to incur significant loss amounts, can make structural subordination meaningful," the report stated. "As the separation of credit quality becomes more meaningful at the AAA class level, the AAA bonds in the ABX indices become less representative of the overall AAA market."

Markit, which developed the ABX index, launched the Penultimate ABX index. The PenABX began trading on May 14. Even though the new sub-index provides more insight into next-to-last pay AAA tranches, S&P said it might be it may be less effective as a benchmark for first- or second-pay classes.

S&P explained that while all subprime RMBS classes have the same level of credit enhancement, structural subordination exists in the form of payment priority. Initially, principal prepayments are typically directed to pay down the first AAA class until it is paid off in full -- with all future principal directed to repay the next class in sequential order. Performance triggers may temporarily alter this 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.

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