BIS: ABX Overstating Potential Subprime RMBS Losses

In its second paper this year to take aim that the so-called ABX indices, which are based on credit derivatives written on MBS backed by subprime mortgage loans, the Bank for International Settlements suggested again late last week that financial firms marketing subprime RMBS assets based on pricing inputs from various ABX contracts may be overstating potential losses in the securities. The current BIS study used various econometric techniques to find evidence that both a declining risk appetite and rising concerns about market illiquidity have contributed more to the recent declines in ABX prices than have more fundamental drivers of subprime mortgage risk. In plain English, the study finds support for the idea that fears about the market’s future are affecting the securities well beyond their actual credit-default risk, especially when extrapolated to super-senior AAA RMBS bonds. See the full study. Much of the previous analysis around the market-skewing potential of the ABX has been centered on what researchers call an “adverse selection” mechanism: the idea that the underlying contracts comprising each ABX roll are the lowest in the credit ladder, either equity or mezzanine-level securities. The AAA-level contracts in the ABX are based primarily on the lowest AAA-rated level in a deal; this limited selection has led more than a few analysts to suggest that marking super-senior AAA subprime RMBS based off of ABX pricing inputs may be too conservative from a credit loss perspective. Such a viewpoint was the focus of a BIS-sponsored study released in June, which estimated that AAA-related subprime losses totaled just $73 billion, less than 15 percent of the roughly $600 billion in subprime MBS issued between 2005 and 2007. Pricing trends in the ABX indexes suggested a AAA loss experience of $119 billion, in contrast, according to the report. The findings support conclusions drawn in May by Standard & Poor’s analyst Andrew Guiduci, who said in a report at the time that the ABX was overstating losses for super-senior RMBS tranches. “While we believe the ABX provides insight into the U.S. residential subprime mortgage market, we think its indices provide only limited insight into class-level creditworthiness among ‘AAA’ rated U.S. RMBS,” he said. To combat some of the criticism of its index, MarkIt Group — which introduced the ABX roughly two years ago — recently rolled out the ABX.HE.PENAAA tranche sub-index series, or the “penultimate” AAA sub-index, which references AAA-rated bonds that are second to last in principal distribution priority.