Have Credit Default Indexes Become Frankenstein's Monster?

by: Jeff Miller

Bloomberg writers Neil Unmack and Sarah Mulholland do a nice survey of viewpoints (Swaps Tied to Losses Became `Frankenstein's Monster') on the problems in relating credit default swaps, indexes and cash markets.

A telling quotation comes from Kevin Gould, the head of data products and analytics at Markit, the source of various indexes. As expected he provides a defense for the product:

The ABX index has brought greater transparency to the market. Without it there would have been a number of market participants that would not have been aware of the levels of distress some of their assets were under.

Fair enough. But Gould also states, (Markit's) "indexes should be used as a tool to gauge the direction of credit markets, not necessarily to value the underlying assets."

Now they tell us!

Many believe that the (very real) credit problems have been exacerbated by faulty government regulation that does exactly what Gould says we should not do.

The Bloomberg Take

Anyone who wants to read all perspectives should check out the entire article. Mainstream media has given scant attention to this theme. Meanwhile, this segment captures the spirit of the article:

`Totally Uncorrelated'
The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz [head of asset backed bond research at Wachovia (NASDAQ:WB)], almost four times the 13.75 percent rate predicted by Wachovia.

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.

``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

Market Breakdown

The difficulty in using these indexes comes from the inability to arbitrage the widely perceived discrepancies. Brad De Long raises the question of how to make money from this. We examined the problem a few months ago in this post.

Anyone with a good answer to De Long's question can both make a profit and improve market efficiency.

Thanks to Gary D. Smith for pointing out this story, which seemed to get little attention.