Misleading Index of the Year : ABX.HE
Here is a recent piece from Bloomberg :
Risk on AAA Subprime-Mortgage Bonds Rises, ABX Index Shows.
The perceived risk of AAA rated subprime-mortgage securities rose after Wells Fargo & Co., Wachovia Corp. and other lenders tightened standards for less risky homeowners, benchmark credit-derivatives prices show.
An index of ABX credit-default swaps tied to 20 bonds rated AAA and created in the second half of 2006 fell 1.8 percent to a new low of 88, according to administrator Markit Group Ltd. GFI Group Inc. The ABX-HE-AAA 07-1 index has dropped by more than 11 percent since June, suggesting a similar fall in the value of the bonds. All other ABX indexes also fell to record lows.
Here is a picture of the class structure of one of the “reference obligations” constituting the index.
First, only 14% of the capital structure is included in the index.
Second, the Class A-2d included in the ABX.HE AAA 07-2 sub-index grossly misrepresents the AAA classes themselves, it is fifth in the “waterfall” and represents around 8% of the AAA classes capital.
So what does it mean when the “AAA” index drops ? Nothing other than the bottom 8% of the AAA classes has a very long shot chance of being impaired.In the current end of the world atmosphere, it has been conveniently forgotten than none of 20 traded indexes has experienced a single dollar loss in principal writedown.That will change but it is a very long way to the top of the waterfall.
August 7th, 2007 at 1:14 pm
I’m genuinely confused by this. Why would Markit choose the smallest (and therefore presumably least liquid) of the AAA tranches as the reference obligation for its index? And it looks like they did that with the AA, A, and BBB tranches too. Is there some kind of weird logic to this which eludes me?
August 7th, 2007 at 2:24 pm
One of the reason (I am guessing) is that the most senior AAA will amortize faster and may not have the required average life (> 5 years) under certain scenario.The index has a long legal life (30 years) and the senior AAA will be gone long before that.But I am at a loss to explain why they did this for other tranches.I didn’t check all the prospectus but the pattern is the same for the ones I checked.The point is that the index is really misleading if you think it represents the “AAA” top 2 tranches (the largest by far) or the BBB- in the index which is not the most junior and is additionnally protected by credit enhancement.It will take an amazing disaster to justify the prices we see now.Good luck to Mr Paulson when he wants to bail out.
August 9th, 2007 at 7:01 pm
How can all these classes be rated AAA if they have material differences in standing with respect to payment of principal?
Some tranches are more ‘AAA’ than others?
August 10th, 2007 at 1:30 am
Yes, some tranches are more AAA than others, the ones at the top of the waterfall amortize faster and have a shorter life.The slicing and dicing of the AAA tranches (and others) affect their expected maturity.The lower AAA is still AAA but it is first in line to be downgraded in something funny happens.
October 30th, 2007 at 12:15 pm
[...] Related: Misleading Index of the Year : ABX.HE [...]
October 30th, 2007 at 3:03 pm
So when Merrill Lynch says they have super senior notes still on their books, I assume that would mean the top of the AAA?
October 30th, 2007 at 3:22 pm
So when Merrill Lynch says they have super senior notes still on their books, I assume that would mean the top of the AAA?
Super senior tranches sit above AAA, and are typically unrated.
October 30th, 2007 at 3:36 pm
OK, but doesn’t everything below a1 become subject to stoppage of coupon etc. in the event of an event of default? (Which I understand to be a certain % of nonperformance in the lower tranches?).
All coupon etc get diverted to super senior until its fully paid, and then only then do the waterfalls come back into play?
October 30th, 2007 at 3:57 pm
Super Senior - not rated? That is not true. In some CDO deals you have a super senior piece that may be unrated (and unfunded for that matter), but in CMBS, as an example, the super senior is the longest (~9.75 years) AAA class with the highest subordination (30%). Further, Markit has explicitly defined rules of inclusion for both ABX and CMBX. They are not picking illiquid tranches - quite the opposite. I don’t understand what is misleading at all about either ABX or CMBX.
So what exactly is misleading - in terms of the structure? Seems to be exactly what Markit (and the dealers) say it is.
Now, right a story about how uncorrelated it is to its constituents, or how the market price/spread does not line up with the implied spread on the CDS(s) of the constituents… that would be interesting.
In regards to Brian’s question, the most basic waterfall structure applies principal payments (including prepayments) on collateral to the top of the waterfall (AAA classes) first, sequentially until each class is paid down through the lowest rated classes. Losses are applied to the bottom of the waterfall first (lowest rated or unrated classes) up through the highest rated classes. There are more complex structures, and various performance triggers that might trap cash to pay down more senior classes first, or pay pro rata payments, but the most common structure for both the ABS and CMBS bonds that serve as collateral in ABX and CMBX, are sequential structures.
November 2nd, 2007 at 3:39 am
[...] index to price assets, just when everybody is fleeing the market…. Time for a picture, and an explanation: the ABX doesn’t price the AAA tranche but one of the AAA tranches (there are 5 of them) and [...]
March 9th, 2008 at 12:01 pm
[...] They capture only a narrow slice of the market: the ABX references 20 securities, for instance [it’s much worse than that]. And they are prone to distortion (mostly downwards) by heavy speculation. “They are not liquid [...]
May 1st, 2008 at 2:35 pm
[...] As not many people know, the AAA referenced by Markit is the lowest ranking AAA as there are as many as 4 or 5 AAA senior to the one listed. Related: Misleading Index of the Year : ABX.HE [...]
June 4th, 2008 at 11:06 pm
so- according to reply #9, unlike other ABS where there are multiple classes of AAA that are time tranched (seqeuntial pay), that convert to pro-rate or pari passu if a credit event occurs, with RMBS, there is no pro-rata pay down when triggers are breached? How can you have 5 priority classes of AAA RMBS bonds- if you don’t have first dibs on collateral, than how can you ever be AAA?
June 5th, 2008 at 6:44 am
for the basic structure, roughly: interest is pro-rata and principal is sequential.