ABS Is Poor Predictor of Subprime Losses

The widely-used ABX price indices are not a good predictor of likely losses on subprime-backed mortgage backed securities, a new paper published in the latest Bank for International Settlements Quarterly Review suggests.

The so-called ABX indices, which are based on credit derivatives written on MBS backed by subprime mortgage loans, track the price of credit default insurance on a basket of such deals. Since the start of the recent financial turmoil in the summer of 2007, the ABX index family has served as a widely followed barometer of the collapsing valuations in the US subprime mortgage market, which have been at the core of observed credit market developments. Despite some shortcomings, ABX price information also seems to have been widely used by banks and other investors as a tool for hedging and trading as well as for gauging valuation effects on subprime mortgage portfolios more generally.

Importantly, the empirical results provide tentative evidence suggesting that observed ABX prices are unlikely to be good predictors of future default-related cash flow shortfalls on outstanding subprime MBS, especially for tranches at the higher end of the capital structure. This is in part because coverage of the ABX indices extends only to a small fraction of the outstanding subprime MBS universe, which can lead to significant price divergence across like-rated products even in the absence of sizeable risk premia.

The paper also suggests that declining risk appetite and rising concerns about market illiquidity have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007.

While proxies for fundamental drivers of subprime mortgage risk, such as indicators of housing market activity, have continued to exert a strong influence on the subordinated ABX indices, the AA and AAA indices have tended to react more to the general deterioration of the financial market environment. These results underline the well established view that risk premia are important components of observed prices for default-risky products, and that the relative importance of non-default-related risk factors will tend to increase in periods of strong repricing of risk.

This suggests that theoretical pricing models that do not sufficiently account for these factors may be inappropriate, particularly in periods of heightened market pressure.