The ABX Indices: Making the Bad Seem Worse

The flight to liquidity which is upsetting the credit markets at the moment is hard on reporters. They want to show how the prices of illiquid securities have dropped – but the problem is, of course, that those securities are illiquid, so it's very hard to get prices for them. As a result, they've more or less stopped looking for actual price data. Instead, they go straight to Markit's hugely popular ABX.HE indices, especially when they're writing about mortgage-backed securities.

The ABX.HE indices are a pretty weak indication, however, of what mortgage-backed bonds are actually worth.

The main reason is that they're not based on bond prices, but rather on credit default swap prices. In times of volatility, like now, credit default swaps tend to gap out much more than bonds. And you certainly can't say that a 1-point drop in the index corresponds to a 1-point drop in bond prices.

But there's another reason, too, as uncovered by Alea. A typical mortgage-backed security doesn't just have one AAA tranche, one AA tranche, and so on. It's got a whole series of securities, each with a different level of credit support – and the ratings agencies then throw a bunch of tranches into each ratings bucket.

It turns out that when Markit chooses a "typical" AAA or AA or A or BBB tranche for its index, it actually always chooses the weakest tranche with that rating. It's not clear why: Alea speculates it might have something to do with the bonds' required average life. But using one particular bond as an example, there are five different AAA-rated tranches, ranging in size from $77 million (the least safe) through $399 million (much safer) to $219 million (the safest). Markit uses the $77 million tranche as the one it puts in its benchmark. Says Alea:

The Class A-2d included in the ABX.HE AAA 07-2 sub-index grossly misrepresents the AAA classes themselves, it is fifth in the “waterfall” and represents around 8% of the AAA classes capital.
So what does it mean when the “AAA” index drops ? Nothing other than the bottom 8% of the AAA classes has a very long shot chance of being impaired.

Actually, it means even less than that. People are buying protection on those tranches not because they worry about the credit risk, necessarily, but because they want to hedge their AAA exposure more generally. Since credit default swaps gap out more than bonds do, the CDS is a good hedge against market risk, even if there's no credit risk at all. Remember that a flight to liquidity can impair the prices of AAA-rated bonds even if there's no chance at all they will default. So its doubly misleading to not only use the AAA tranche with the weakest credit, but to also use the smallest – and therefore most illiquid – AAA tranche.

Which would all be fine, if the ABX.HE indices were simply another exotic product traded by sophisticates. But now they're being picked up by the punditocracy, it's worth pointing out how weak they really are.