The WSJ takes a look at the notorious
ABX today, and although it’s more polite than me, it still shows
how bad the index is as a gauge of the subprime mortgage market
Wachovia Capital Markets analysts Glenn Schultz and John McElravey say the
price of the ABX that tracks AAA-rated mortgage debt implies losses of around
49% among pools of subprime mortgages issued in 2006. A cumulative loss of
49% would be achieved if all 2006 subprime mortgages were to default and recover
only half their value after foreclosing on the homes, or if half were to default
and recover nothing.
Most Wall Street analysts expect 10% to 15% in cumulative losses for these
loans. As of August, the delinquency rate on all subprime loans was around
20%. For 2006 subprime mortgages, around 27% have already been paid down,
many through refinancing, and 2% have defaulted.
The part of the article which interested me was this:
Critics say the relatively thin trading of the ABX on some days makes it
prone to being moved by a few large trades. Much of the trading in the index
also has leaned in the same direction. Banks use it to hedge against mortgage
risk, and hedge funds use it to bet on further drops in housing; both trades
tend to depress it.
As I understand it, anybody can make a bet on where the ABX will be in the
future. But the ABX index isn’t a security which goes down when a lot of people
want to sell it and few people want to buy it: it’s simply a reflection of where
certain mortgage-backed CDS contracts are trading. In order for bets on the
ABX to move the index, an arbitrageur would have to go out and go long the index
while going short hedging by buying the underlying CDS.
Do such people exist? There’s an easy way to tell: find a bunch of subprime
CDS which aren’t in the ABX index, and compare their prices to those of similar
subprime CDS which are in the ABX index. If the anonymous critics are right
and the ABX is being driven down by hedgers and speculators, you’ll find a big
diffence in price.
Has anybody done that?
Update: Alea
emails to say that it’s basically not possible to arbitrage the ABX against
the underlying CDS.