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Wednesday, November 21, 2007

ABX and CMBX: Your Daily Plunge!

by Calculated Risk on 11/21/2007 02:49:00 PM

See the ABX-HE-AAA- 07-2 close today.

Another day, another record low.

The CMBX indices are setting new records too.

Note: Up is down for the CMBX indices. The CMBX is quoted as spreads, whereas ABX is quoted as bond prices. When the spreads increase - chart going up - the bond prices are going down.

See the CMBX-NA-AAA-3 close today.

For some background, here is a post at the Cleveland Fed back in March:

the ABX.HE index is telling us something about credit default swaps (CDS). A CDS is like a derivative that gives you insurance. For example, a bank may wish to buy protection against default by RiskyCorp (perhaps because they’ve given RiskyCorp a loan). They do this by entering into a contract where they pay another firm (who is selling protection) a fixed amount, periodically, as long as RiskyCorp doesn’t default on its corporate bonds. (In general, the “credit event” might be something else, such as a major downgrade, missed payments, or so forth.) If RiskyCorp does default, the seller of protection makes a payment to the buyer of protection. This might be a cash payment equal to the value of the bond, it might be the bond itself, or potentially whatever the contracting parties agree to. We like to think of the “swap rate” or “swap spread” that the protection buyer must pay as an insurance premium.

Notice that the more likely RiskyCorp is to default, the higher the insurance premium, that is, the higher the swap spread, so this market can give us some idea of how risky some firms are. In a frictionless market, the swap spread should be comparable to the risk premium on one of RiskyCorp’s corporate bonds (corporate bond yield minus the comparable riskless yield). Furthermore, because the CDSs are more standardized and generally more liquid than corporate bonds, you can see why Federal Reserve Vice Chairman Donald Kohn states that “instead of looking to the bond market to measure default risk, we are increasingly turning to the market for credit default swaps” (the full text of his remarks to the Board Conference on Credit Risk and Credit Derivatives is well worth reading).

Credit default swaps eventually became based on other types of assets, such as mortgage-backed securities, whose payoff is derived from a pool of mortgages (such asset-based swaps became known as ABCDS, for obvious reasons). Likewise, there was no reason to restrict your CDS so that it protected you against default from only one firm, and although such “single-name” CDSs still make up the bulk of the market, “multiname” CDSs are growing in popularity.

Mortgage-backed securities offer several different levels of risk or tranches. Tranches are ways of slicing up the payment stream from homeowners to give different levels of risk, so roughly speaking, the tranches first in line for payments are less risky than those further down the line.

At long last: the ABX.HE is a series of five indexes that track CDSs based on tranches of mortgage-backed securities comprised of subprime mortgages and home equity loans. The tranches differ by their ratings, from AAA (best credit) to BBB-, (least good credit). See MarkiT, which produces the indexes for the real details. For an example of how indexes work, see here.
The CMBX is a CMBS (Commercial Mortgage-Backed Securities) credit default index just like the ABX - except up is down. The rising delinquencies (see previous post of Q3 data from the Fed) for commercial real estate is probably impacting the CMBX.