The WSJ’s Carrick
Mollenkamp has a big piece on the ABX.HE index today – and about time,
too. The index, of mortgage-backed securities backed by subprime mortgages,
has been cited incessantly over the past few months as an indicator of how well
such securities are performing in the market. Recently, in the wake of the troubles
at Bear Stearns, the most-watched index, of the sub-investment-grade tranches,
has fallen to an all-time low.
But amidst all the hype and buzz, no one’s actually stopped to ask what the
ABX.HE index actually is. Many observers know what it isn’t: a simple
index like the S&P 500, which just looks at a large set of securities and
tells you where they’re trading. But the "about"
page at the index’s owner, Markit, is less than useful: it calculates the price
by "capturing daily price fixings". Er, thanks.
And Mollenkamp doesn’t really clarify things much either. This is all she writes
on how the ABX is calculated:
From offices in London, Markit collects credit-default-swap pricing data
from about 80 credit-market dealers. Markit’s computers then compile and clean
those data and distribute them early the next morning to clients.
What Mollenkamp doesn’t mention is that any given ABX.HE index comprises just
20 names, all of which are mortgage-backed securities with the same credit rating,
and all of which were issued within six months of each other. Each name carries
a 5% weight in the index.
The level of the index reflects not the price at which those names are trading,
but rather the price at which credit default swaps on those names are trading.
(The MBSs themselves barely trade.)
So if you ask me where the triple-B ABX index is trading, there’s no real answer:
the 06-01 series, which includes bonds issued in the second half of 2005, is
trading at 88.5. The 06-02 series, which includes bonds issued in the first
half of 2006, is trading at 74.9. And the 07-01 series is trading at 67.4. It
seems that older securities trade richer than more recently-issued ones, although
with only 20 bonds in each index, it’s not entirely clear how representative
they are.
To make matters worse, there’s orders of magnitude more liquidity in the index
than there is in any underlying name – and even the index isn’t all that
liquid, especially not during fraught times like now. So although it’s relatively
easy to make a directional bet on where the index is going, any investor doing
so is ultimately placing his bets on where a very small number of illiquid single-name
CDS contracts are going to trade. Worse still, there’s a general feeling in
the market that trades in the index drive trades in the underlying single names,
rather than the other way around.
What it all adds up to is something which is not necessarily representative
of anything much at all. But it’s the best we’ve got, so it’s what people use.