'AAA' ABX Index Plunges

A. I've been waiting and watching the higher rated ABX index for sharp movements, and it finally came yesterday. The 'AAA" ABX index absolutely plunged yesterday falling from 80.17 to 71.88, a plunge of over 10%! To put that into perspective, it would be like the DOW falling 1,340 points in one day; if that happened do you think people would notice? The blogosphere has been successful in analyzing and interpreting the ABX indices for some time now, so it's no surprise that I need to bring this up after yesterday's move. As the contagion hits higher rated paper and investors desperately try to buy credit protection for these holdings, is it only a matter of time for alt-a and prime mortgage backed securities to get their day at the confessional? Needless to say, alt-a & prime make up a significant larger portion of total loans outstanding than subprime.

First, lets look at the chart courtesy of Markit:

Wow. Quite a move. In fact, all of the ABX Indices got whacked again yesterday. The only difference today is that it now means something to people who normally would never monitor trends of these indices. It's just a clear sign that deeper problems still exist in creditville.

For those that are a bit more educated regarding these trades, or are employed in or around this industry, here is how the ABX trade works (courtesy of anonymous source right in the middle of this derivative trading action at a hedge fund). WARNING - This is not easy to understand and I don't fully get it, so don't ask:

Here is how an ABX trade works:

I want to buy protection on 100mm. The ABX coupon is 70 bps and the price is 95. I pay (1 - 0.95) * 100 mm = USD 5mm upfront. Every month (different compounding on ABX) I pay 70bps/12 * 100 mm = $58,000

1% of the pool defaults and I get paid USD 1mm. Going forward I pay the 70 bps on 99mm. In fixed income when 'spreads widen' then 'bonds gets cheaper' because you are discounting future cashflows at a higher rate.

When ABX spreads widen the bond price drops and I can close out the trade at say 85 by selling protection. I will receive (1 - 0.85) * 99mm = $15mm making a P&L of about 10 million, minus whatever coupons I paid plus whatever default payments I received.

You should recognize that this discounting of future cash flows assumes you know WHEN these cash flows will take place --> duration is critical.

Over the life of the trade the price will drift to 100. Imagine it with one day left - how much upfront would you pay for 1 day of protection ? = none.

Prepayments reduce the notional but don't trigger protection payments which is why you need to get the duration right initially. Quoting in bond points removes the need to agree on a duration - it's implied in the price. If we agree on a price we're done - you could have gotten to that price with different spread and duration assumptions than me.

KEY POINTS - there is a lot more to pricing an asset backed instrument than meets the eye - interest rates, mechanics, prepays, defaults, timing, carry all have to factor in and there is no simple answer. You need to put it all into some sort of model and your intuition is often wrong. There is a lot more to it than "I think there will be more defaults so spreads should go wider". Remember that when yields or spreads go up you are discounting future cash flow at a higher interest rate so the present value of a future dollar is less and the present value of the sum of these cash flows is less so the price is lower. This is the inverse relationship between bond prices and interest rates.

Don't say I didn't warn you in advance how the ABX trade works! Here are my concerns:

1. The FASB 157 accounting change will adjust how Level 3 assets are classified and how they get disclosed to investors. This is a major problem. What used to be able to be classified as tier 2, may now need to be adjusted to tier 3. Needless to say, banks & brokerages used this gray area to underestimate the exposure of assets considered under level 3 accounting disclosures.

2. The problem is no longer contained to subprime. The plunge in AAA ABX is consistent with what my sources were telling me for past 10 days or so. Investors are buying credit protection for alt a and prime mbs holdings. You can imagine the worry if its no longer just a subprime illness. Of course there were problems making AAA paper from subprime junk, but what if this spreads to higher quality paper before its securitized?

3. Ratings downgrades will have a two pronged effect. First, it will restrict who can buy the distressed assets as many pensions accounts and even hedge funds have restrictions on junk purchases. Second, level 3 accounting adjustments due to downgrades of holdings to markets that are untradable?

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