Does Subprime Index Amplify Risk?ABX Bond Tracker,Depending on View, Is On Mark, Off Base
By SERENA NG and JAMES R. HAGERTY
February 27, 2007; Page C2
The cost of insuring risky mortgage bonds as measured by a closely watched index has soared in recent weeks on fears of increasing defaults, rattling some investors while prompting a debate on whether the index is exaggerating the market's woes.
At issue is an index that tracks how much it costs to insure a group of BBB-minus-rated bonds backed by mortgages to borrowers with weak credit histories, the so-called subprime market. The index, part of the ABX family of bond indexes, is a derivative that falls in value when the cost of insurance rises, so it is seen as a proxy for the value of the underlying bonds.
RISKY POOL
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• The News: There has been a plunge in an index tracking bonds that are backed by subprime mortgages.
• What It Means: The plunge suggests the market believes riskier mortgage bonds stand to lose a large chunk of their value as defaults rise in the pools of loans backing them.
• What's Next: Many mortgage bonds eventually may have to be downgraded by ratings companies.
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The index has sunk nearly 30% since the start of this year, with most of the decline in February. That drop suggests the market believes riskier mortgage bonds stand to lose a large chunk of their value as defaults rise in the loans backing them.
"It reflects a disaster in the making in subprime, and I think it's just going to get worse," says Nouriel Roubini, chairman of economics research Web site Roubini Global Economics and a professor at New York University.
More than 20 subprime lenders have closed shop after repurchasing bad loans, as required by the terms under which they sold them. Some large lenders, including HSBC Holdings PLC and New Century Financial Corp., have reported big losses on their subprime mortgages.
"The risk the ABX is implying is way too pessimistic," argues Mark Adelson, a managing director at Nomura Securities International in New York. "There's a huge difference between the slow hissing that deflates a bubble and a bubble bursting."
The index, administered by Markit Group of London, was launched a little more than a year ago to give investors a way to bet on default trends and to hedge their risks by buying protection against a decline in the value of the underlying mortgage-backed bonds. Investors in the index can profit when they buy such protection cheaply and sell it at a higher rate. The index is one of only a few visible indicators of market sentiment for subprime mortgages, and Wall Street has become fixated with it.
The problem: "It's very, very widely followed, but more people look at the ABX than trade in it," says Peter Nolan, a bond-investment manager at Smith Breeden Associates, a fixed-income asset-management firm in Chapel Hill, N.C. When there are few buyers and sellers in a market, prices can jump around a lot, as has happened with this month's fall.
The ABX index reflects the cost of credit-default swaps -- essentially insurance policies that pay off when bonds drop in value -- on 20 subprime bonds that are selected by a group of Wall Street dealers.
In dollar terms, Wall Street firms charge investors approximately $1.6 million annually to insure the value of $10 million in BBB-minus-rated subprime bonds issued in 2006, up from $240,000 six months ago.
Critics say the ABX's 20 bond issues have performed more weakly than the overall market for subprime-mortgage securities.
Chris Flanagan, a mortgage researcher at J.P. Morgan Chase & Co., says the measure isn't perfect but is "a good reflection of long-overdue repricing of risk" of defaults.
Moody's Investors Service, a subsidiary of Moody's Corp., has lowered ratings on nine bonds from two subprime residential-mortgage-backed securities deals that were issued in 2006. It is reviewing 30 ratings on another 10 deals for possible downgrades. Together, these comprise less than 1% of the total number of subprime bonds Moody's rated last year. Fitch Ratings, a unit of Fimalac SA of Paris, and Standard & Poor's Ratings Services, a unit of McGraw-Hill Cos., have downgraded a small number of bonds.
The ABX's decline means that investors willing to sell protection against defaults can potentially reap gains if the problems in the subprime-mortgage market don't escalate.
For those with a bullish view on the housing market and U.S. borrowers' ability to pay off their mortgages, selling insurance at the current level is "probably a good bet but not necessarily a slam dunk," says Daniel Ivascyn, a portfolio manager at Pacific Investment Management Co., or Pimco, in Newport Beach, Calif. Making that bet at this time would take guts, though, he says, because lately the ABX index has been moving like "a one-way train."
Christian Stracke, an analyst at debt-research firm CreditSights in New York, says, "I think the ABX is accurately reflecting the panic being felt by some of the big mortgage players, and the hedge funds shorting it have increased the panic. But investors in the broader financial markets shouldn't be overly concerned." |
