"Several dealers are not at the right level of readiness because there are technicalities in the ABS product that are very different to the credit (iTraxx) product – modelling, behaviour, operational aspects of handling the flow," says Georges Assi, global co-head of CDO and structured credit at Lehman Brothers.
Only a limited number of the 16 or so dealers that are involved in TABX were making two-way markets during the early days of the product. Deutsche, Lehman, Merrill Lynch and JPMorgan were among those that were widely believed to be active market participants. However, banks such as Bear Stearns, Morgan Stanley and UBS said they were also involved.
"I think it’s not surprising – you saw the transition from models to market in credit correlation, which was easier to translate as most people’s models were roughly similar, ie, base correlation," says a structured credit veteran. "The problem with ABS is that it’s even more complicated – everyone’s view on that asset class is different. Not only are you going from model to market but you are going from multiple models to market. It will be very interesting to see how this thing unfolds."
Not only is it difficult to use a correlation framework to evaluate sub-prime ABS. The launch of tranches came just as poor performance at sub-prime originators dramatically reduced dealers’ risk appetite even for the most liquid index product, the precariousness of the underlying index resulted in dealers waiting for things to smooth over.
"It’s a market which we have decided not to provide liquidity to because it’s too choppy. There is not enough information and a number of other dealers are doing the same," says a ABX correlation trader.
There was truly dramatic ABX price action during February in the BBB– rated ABX sub-index. At the start of the year this version (third) of ABX was quoted at 98 – an implied spread somewhere in the region of 280 basis points over swaps. The index suffered a precipitous drop to 78.59 in mid February, equating to swaps plus 800bp.
Liquid proxy
The ABX index is the 20 most liquid US sub-prime RMBS deals, which is reconstituted every six months. This is then sliced into AAA, AA, A, BBB and BBB– portions of risk. The market’s liquidity is by far the highest in the latter two sub-indices, which represent a good way for dealers, investors, and hedge funds to express a negative view on the sub-prime sector.
The past few weeks have witnessed some hefty activity, with fairly heavy bets from the hedge funds on negative view in that market. Because of their ability to leverage, they can be quite powerful in using their weight to move the market around. This is something the ABS market has not really seen before as it has typically been a buy-and-hold investor base rather than a short-term trading-driven one.
Outside ABS originators, the hedge funds were the first substantial users of ABX, which they used for a hedge against their macro view and exposures. The US housing market is deemed something of a proxy for the performance of the US economy, as uncertainly about the housing market has grown funds have looked at what is the best way to express a negative view. Going short of ABX works because it is based on home equity – basically lower-quality mortgages – which are more likely to fall in value. Because it is already sliced into portions of risk buying protection on the BBB– it is effectively a leveraged hedge.
"This market is trading off expectations of losses for the sub-prime market. Obviously that perception is driven by a lot of factors. But basically it’s two things: it’s the underperforming economy and the outlook for the US housing market," says Tom Zimmerman, head of ABS research at UBS. The buyers of protection are effectively forecasting the impact on a triple B security in three to five years’ time. But UBS believes that it would take in the region of 8/9% cumulative losses to have an impact on cash bonds rated Triple B minus. There is a stark dislocation between the ABX on one side, and CDS and cash bonds on other. The 300bp difference largely reflects technicals; why go long of the index when it includes a portion of poor credits? Go long of the CDS or the underlying cash deals instead.
"Now you have a bunch of hedge funds that have decided to start driving this market – they are all saying ‘we are all short, the US economy hasn’t necessarily tanked but we know the housing market is not performing that well – so let’s go out and move the market wider.’ They have clearly driven it to a ridiculous level where Triple Bs are now trading 600 to 900 basis points over," says an ABS trader.
Outside ABS originators, the hedge funds were the first substantial users of ABX, which they used for a hedge against their macro view and exposures. The US housing market is deemed something of a proxy for the performance of the US economy, as uncertainly about the housing market has grown funds have looked at what is the best way to express a negative view. Going short of ABX works because it is based on home equity – basically lower-quality mortgages – which are more likely to fall in value. Because it is already sliced into portions of risk buying protection on the BBB– it is effectively a leveraged hedge.
"This market is trading off expectations of losses for the sub-prime market. Obviously that perception is driven by a lot of factors. But basically it’s two things: it’s the underperforming economy and the outlook for the US housing market," says Tom Zimmerman, head of ABS research at UBS. The buyers of protection are effectively forecasting the impact on a triple B security in three to five years’ time. But UBS believes that it would take in the region of 8/9% cumulative losses to have an impact on cash bonds rated Triple B minus. There is a stark dislocation between the ABX on one side, and CDS and cash bonds on other. The 300bp difference largely reflects technicals; why go long of the index when it includes a portion of poor credits? Go long of the CDS or the underlying cash deals instead.