Trying To Make Sense of the Mortgage-Backed Market

Andrew Leonard says that I'm "a voice of calm and restraint when the rest of the econo-blogosphere is racing to the windows to see if the sky has started to rain suicidal investment bankers". Always happy to help. So let me revisit the issue of US mortgage-backed bonds, and try to put yesterday's panic into a bit of context.

But first, it's useful to get some real datapoints. As Leonard also notes, the media has a habit of obsessing over the ABX indices, and invariably it will emphasize whichever ABX index has dropped the most that day. At the moment, the most underperforming of the ABX indices is the ABX-HE-BBB- 07-1, which is an index of credit default swaps on the riskiest tranches (rated BBB-) of bonds backed by subprime mortgages and issued in the second half of 2006. The index closed yesterday at 51.4.

Does this mean that bonds issued at the end of last year are now worth just 51 cents on the dollar? I'm not sure. Check out the fire sale prices being quoted by Calculated Risk today. Bonds rated below investment grade – which would be either equity tranches or bonds which have already been downgraded by ratings agencies – are apparently being offered for between 28 cents and 58 cents. Which means that bonds rated below BBB- still have value. What's more, the most expensive of those bonds, the ones asking 58 cents, are from Ameriquest, one of the names where, to read the press, value has already been obliterated.

Remember that the way mortgage-backed securities get tranched, the lowest tranches have to be wiped out entirely before the next tranche up takes any losses at all. So if investment-grade bonds are going to suffer losses, you can be sure that non-investment-grade bonds will be worth zero. Of course, if you mark to market, you can suffer losses long before that. But the fact that junk-rated bonds from Ameriquest mortgages are being sold for over 50 cents on the dollar in a fire sale doesn't make me feel that the end is necessarily nigh.

On the other hand, I have to say I'm surprised that the weakest of the ABX indices is the 07-01 series, which is limited to bonds issued in the second half of 2006. Anecdotally, underwriting standards were meant to have tightened up significantly over the course of those six months, but you'd never suspect it from the way the bonds are performing. What's more, house prices were meant to have already started falling by then, which means that earlier-vintage bonds should have larger amounts of negative equity and consequently lower valuations.

Clearly the big worry facing the markets is that the ratings agencies will downgrade a lot of BBB- and even BBB paper to junk status, which could trigger a wave of forced sales from buy-side firms who aren't allowed to hold junk bonds. On the other hand, the same worry faced the market when GM and Ford got downgraded to junk, and the market barely blinked. Often fear of downgrades – the kind of fear sparked by yesterday's announcements – is worse than the downgrades themselves.

All of which leaves me in the "still baffled" camp. I don't understand what's going on in the 07-01 ABX series, I don't know how many fund managers, in reality, are not allowed to hold junk-rated paper, and I still don't have much of a grip on how credit default swaps on mortgage-backed bonds are structured, and what constitutes a credit event under such contracts. I'd also love to get a much clearer bead on who's been buying protection in the CDS market, whether they're making loads of money right now, and what's happening to those profits. Any recommendations for an expert in such matters who I should talk to?

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