Tuesday, November 18, 2008

ABX & CMBX: Indicies at All Time Lows

Securitization is the process by which bonds are created from individual loans. Thousands of loans are bundled together and the cash flows from those loans are used to pay the principal and interest due on the bonds. Therefore, the bonds perform well when the loans perform well. Conversely, when the loans default, the bonds crater.

Asset backed security (ABS) is the market term for these bonds, although the term is usually used when describing bonds backed by credit card loans or auto loans. Mortgage backed securities (MBS) and commercial mortgage backed securities (CMBS) describe bonds backed by residential and commercial mortgages respectively. Please drop me a line if anyone is interested in a more expansive post, the subject deserves it. Much like a gun, securitization can be an extremely helpful tool. However, we all know the devastation a gun can wreak in the wrong hands.

ABX is an asset backed security index and CMBX is a commercial mortgage backed index. There are several tranches for each, divided by loan vintage and credit ratings. A trader or speculator can take a long or short position in the index.

ABX pricing is similar to the way a typical bond is priced. The ABX index rises when the underlying credit improves, i.e. the likelihood of default decreases.

CMBX trades on a credit spread basis. When the index rises, the underlying credit deteriorates (the likelihood of default increases).

I bring this up because EVERY SINGLE ABX AND CMBX TRANCHE IS TRADING AT THEIR ALL TIME WORST LEVELS. Market participants clearly do not want to hold credit risk in their portfolios.

Note, there is no ABX tranche for 2008 issuance. THAT IS BECAUSE THERE HAS BEEN SO LITTLE ISSUANCE TO HEDGE.

The problem is simply stated below. It represents the holdings of Federal Reserve primary dealers. Primary dealers are authorized to trade directly with the Federal Reserve. For a list, click the below link. The run-up in risky assets speaks volumes about the issues the financial markets are facing today.


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