To an extent, this uncertainty reflects the fact that the tangible scale of defaults in the US mortgage arena is still unclear, particularly in that sector of the mortgage market known as "subprime" - loans extended to borrowers with poor credit histories. In the past year, the pace of defaults on subprime loans has risen sharply in America, particularly on mortgages made in 2006 and 2007. However, it is unclear what scale of losses this will eventually produce for banks, since it typically takes several months for lenders to foreclose on loans and then sell a property. Moreover, it is also very unclear how the pattern of mortgage defaults will develop. While some economists fear that the default ratios could rise sharply in the coming year, others suspect that the US government will force lenders to be lenient towards borrowers. Thus estimates of potential mortgage losses in the subprime sector range from $100bn (according to government figures) to several times that. However, when it comes to working out the impact on banks, the task becomes even harder. For in recent years, banks have not simply been acquiring subprime loans, they have been repackaging them into complex "asset-backed securities" (ABS) that can be difficult to value. The Bank of England, for example, suggests that on the basis of industry data some $700bn-worth of bonds backed by subprime loans are now in circulation in the world's financial system, with another $600bn of bonds backed by so-called "Alt A" loans, or those with slightly better credit quality. Moreover, these bonds have then been used to create even more complex securities backed by diversified pools of debt, known as collateralised debt obligations (CDOs). According to the Bank's calculations, for example, some $390bn of CDOs containing a proportion of mortgage debt were issued last year - though the precise level of the subprime component varies. The multi-layered nature of these complex financial flows means it is hard to assess how defaults by homeowners will affect the value of related securities. In recent weeks, some credit rating agencies have indeed started to downgrade their ratings of debt: Moody's and S&P, for example, downgraded about $100bn of mortgage-related securities last month. But most analysts think that this "downgrade" process is still at a very early stage - and in tangible terms, that means that subprime defaults have not yet delivered tangible losses for many security investors. "Most CDOs have yet to see many downgrades and there have been almost no actual defaults of the ABS bonds within the CDO portfolios," points out Matt King, analyst at Citigroup. "[But] all that is about to change." The other big problem that makes it hard to calculate the "real" scale of mortgage-linked losses at banks is that it is often fiendishly hard to get an accurate value for mortgage-linked assets - and thus determine how much prices have fallen so far. In other arenas of finance, such as equities, banks typically value their assets by looking at external markets: the share price of a British company, say, can be calculated within seconds, by glancing at the stock exchange. Mortgage-related securities have not been widely traded in recent years, and in the past couple of months activity has dried up almost completely - meaning there is no market, and thus no market value. Some banks have tried to get around this problem in the past by developing computer models to work out what the securities "should" be worth. However, these can be very unreliable and vary wildly between different banks. Recent calculations by the Bank of England, for example, show that if tiny changes are made to the type of model typically used by banks to value mortgage-linked debt, the implied price of supposedly "safe" assets can suddenly change by as much as 35 per cent. As a result, some analysts are now using another technique to work out their mortgage-linked losses, namely, extrapolating from prices based on derivatives indices such as the so-called ABX. For although mortgage bonds have not traded much in recent weeks, derivatives have been bought and sold - meaning that the ABX can offer a trading price. In recent weeks, this trading price has fallen sharply (see chart), which has increased the pressure on banks to mark their books down. However, the banks have not yet made write-offs as large as the ABX might imply. Merrill Lynch analysts, for example, calculate that mid-quality ABX debt is on average now trading at 40 cents in the dollar. But these analysts say that Merrill Lynch itself has only written this type of debt down to 63 cents in the dollar - and UBS is still assuming this debt is worth 90 cents. "Simple math would imply that UBS needs an additional $8bn write-down [on its $15.4bn holdings] if the ABX pricing is correct," Merrill says. But the problem is that no one really knows whether these numbers represent the "true" guide to tangible mortgage losses either; some analysts claim, for example, that the ABX is an unreliable guide to price. Moreover, most banks have not actually sold their troubled securities yet in an open market. And while there are reports that some banks have tried to arrange quasi-sales between institutions, on "sweetheart" terms in recent months, the US regulators now appear to be scrutinising these practices too - not least because this could potentially manipulate prices as well. But if these problems make it hard to calculate the scale of banks' subprime losses, the guesswork becomes even wilder when it comes to other financial groups. As the subprime credit chain has grown in recent years, it has left banks exposed not simply to these assets but to a host of other investment institutions as well, including insurance companies, pension funds and hedge funds. These institutions sometimes use different approaches to reporting their subprime exposures from those adopted by bulge-bracket banks - and these differences are further magnified by the fact that they are operating under different national accounting regimes. In some corners of the global financial system, institutions are already trying to come clean about the pain. It is relatively easy, for example, to calculate the losses at so-called structured investment vehicles (SIVs) - a breed of specialist fund - because they are required to publish regular "net asset value" numbers. According to the rating agencies, for example, the average value of assets in SIV vehicles has fallen by a third since the start of the summer. Some investors with holdings of SIVs have recently come clean about their losses. TPG-Axon, the US hedge fund, is understood to have written off the value of all the junior notes issued by its SIV. A number of Taiwanese banks - which have been among the biggest buyers of such paper - have also been surprisingly frank. For example, Bank SinoPacsaid it would take a third-quarter hit of $43m on its $350m of SIV holdings. However, for every example of transparency there is a case - or several - of an institution reluctant to reveal losses. In jurisdictions such as Japan, for example, it is widely accepted that institutions need not mark all their assets to market, since they often hold these to maturity. Similarly, uncertainty dogs large parts of the asset management world in continental Europe. Meanwhile, the insurance industry is generating particular anxiety among some investors. In recent days, for example, the share price of the largest US monoline insurance groups, such as MBIA (NYSE:MBI) and Ambac, have collapsed in spectacular fashion due to concerns about potential exposure to mortgage-linked CDOs. The two companies say that they do not have any serious problems - and point out that the proportion of mortgage-related assets in their business is tiny. But the challenge that dogs these "monoline" groups is that their balance sheet accounting is poorly understood by most investors. Optimists within the financial world point out that such uncertainty is not unique to the 2007 credit squeeze: 15 years ago, for example, the financial world was presented with a similar fog, when it tried to untangle the losses that hit the Lloyd's insurance syndicate. "There are a lot of parallels today," says Adam Ridley, a senior London financier who was heavily involved in the Lloyd's affair. However, the challenge for policymakers today is that the 2007 credit storm - unlike the Lloyd's debacle - is not a contained affair: on the contrary, the opaque subprime chain has created unexpected linkages between an extraordinarily wide range of investors and institutions around the world. The longer investors continue to fear that this chain could produce unexpectedly large future losses, the greater the danger of a downward spiral in investor confidence - and thus the higher the risk of a knock-on impact on the "real" economy.
ABX Indexes Tumble Amid Downgrades of CDOs, Home-Price Report By Jody Shenn Nov. 21 (Bloomberg) -- ABX indexes tied to the highest-rated subprime-mortgage bonds fell to new lows, a sign of deterioration in the perceived risk of the securities following a report showing home prices are declining in more than a third of U.S. cities. An index of credit-default swaps tied to 20 subprime-loan bonds rated AAA and created in the second half of 2006 fell 3.2 percent to 69.7, according to Markit Group Ltd., the administrator. The ABX-HE-AAA 06-2 index tied to AAA bonds from the first half of 2006 fell 3.1 percent to 80.1. Home prices dropped in 54 of 150 metropolitan areas in the third quarter and the median sale price tumbled 2 percent nationwide, the National Association of Realtors said today. Also today, Fitch Ratings downgraded $29.8 billion of collateralized debt obligations linked to mortgage bonds, while Standard & Poor's cut rating on $5 billion of CDOs. New ABX indexes are created every six months by securities firms, including Goldman Sachs Group Inc. and Deutsche Bank AG, and London-based Markit. The indexes indicate prices for credit- default swaps linked to 20 bonds, not for swaps on each. The swaps offer protection if the securities aren't repaid as expected, in return for regular insurance-like premiums. The indexes have tumbled this year as investors expect defaults on home loans to keep rising. Subprime loans are given to borrowers with weak credit or high debt. CDOs repackage pools of assets such as mortgage securities or buyout loans into new debt with varying degrees of risk. Owners of CDOs made up of mortgage bonds have been using ABX contracts to offload their risk, according to investors including Don Brownstein, chief executive officer of Structured Portfolio Management LLC, a Stamford, Connecticut-based hedge-fund manager that oversees about $700 million in assets. To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net Last Updated: November 21, 2007 16:35 EST
well after 4 months ABX indices look to be bouncing over the past few days. Interesting development with banks yr ends on tap nov 30.
With no new series roll and the TABX market basically dead in the water, I'm curious to see how the ABX game ends. Get some nudges from time to time to do some relative value trades in the area, but the profiles all look terrible upon thinking
ABX indices are they key benchmark for CDO prices. So if you're watching the credit crisis for turning points this is ground zero.